Corporate Financial Management 221 December 30, 1899

CORPORATE FINANCIAL MANAGEMENT 221

(CFM 221)
2023

MODULE
221 6

Capital Budgeting

Contents:

Module information
1. Required readings
2. Pre-lecture questions
3. Tutorials for the week

Management Accounting
 Module Objectives
 Introduction
 Module notes

Questions
 Shampers (assessed loss in project)
 Flip Chip (assessed loss in company)
 Bushmanskloof (exam 2021, see old test papers)
 Salo Ltd (change in working capital, calculation of WACC, tax over two years)
 Mahagra Ltd (inflation, working capital incremental)
 18-4 Lucas Mining Co (debt:equity ratio, WACC)
 5-4 Trident Ltd (capacity constraint)


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1. Required readings
Correia, Flynn, Uliana & Wormald; Financial Management 7th edition:
Chapters 8, 9 and certain sections of Chapter 10. (No break-even calculations)

2. Pre-lecture questions
1. What is capital budgeting?
2. What cash flows are used in the calculation of net present value?
3. How does taxation influence the cash flow table?
4. What discount rate should be used to calculate net present value?
5. What other strategic factors should be considered when making an investment
decision?
6. Capital budgeting is an investment decision and WACC is used as discount rate.

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1. Module objectives

i) Discuss the importance of the capital budgeting decision for the company
ii) Understand the importance of relevant operating cash flows rather than accounting
earnings in evaluating investment projects
iii) Determine the relevant cash flows to be included in the analysis
iv) Calculate and interpret the net present value of a project
v) Discuss the appropriate discount rate that is used to calculate the net present value
vi) Define the types of investment projects
vii) Discuss the strategic factors that may influence the investment decision

2. Introduction

Capital budgeting can be described as the procedure of valuing capital (long-term)

expenditures or projects for the purpose of making an investment decision. The value of a
project is determined by discounting the relevant future cash flows and is much like the
Discounted Cash Flow (DCF) valuation principle covered in Module 4. Capital budgets are an
investment decision with a certain life span, while DCF is a valuation model with an
indefinite life, but it works on the same principles.

In order to compare and decide between alternative projects, the relevant future cash flows
for each project are calculated and discounted in order to determine the net present value
of each project.

3. Module notes

In the module on Discounted Cash Flows, we introduced the fact that DCF valuations can be
used to value the ordinary equity of the company by:

A. Discounting Operating cash flows @ the Weighted Average Cost of Capital (WACC) in
order to establish the Present Value of Operations. WACC is used because it is the
combined risk attached to all the securities used to finance the company in the long-
term (refer to pooling of funds and target capital structure)

When valuing a capital budgeting project or investment the above DCF valuation principle is
adjusted as follows:

B. Discounting Relevant (project-specific) operating cash flows @ the WACC (or

appropriate risk related rate – refer to section 3.5) in order to establish the Net
Present Value of the project or investment.
C. When valuing a project the investment has a finite life, whereas with DCF
valuations you are valuing a company with an indefinite life.

This calculation can be laid out as follows (refer to the next page):

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3.1 COMPONENTS OF A CAPITAL BUDGETING CALCULATION

Net Present Value (NPV) of a project:

Yr 0 Yr 1 Yr 2 Yr 3
Initial capital outlay A (xxx)
Increase, changes and recovery of net B (xxx) (xxx) (xxx) xxx
working capital
Operating cash profits C xxx xxx xxx
Opportunity costs D (xxx) (xxx) (xxx)
Proceeds from sale of capital asset E xxx
Taxation F (xx) (xx) (xx)
Project cash flows (xxx) xxx xxx xxx
NPV @ WACC (note 3.5)

Taxation cash flow of a project

The relevant tax cash flows: Determine the change in tax cash flows as a result of investing
in the project.

The aim is to calculate the taxable income of the project and then calculate the tax effect on
the project cash flows.

Yr 0 Yr 1 Yr 2 Yr 3
Operating cash flow xxx xxx xxx
Wear and tear allowance (xxx) (xxx) (xxx)
Opportunity cost (xxx) (xxx) (xxx)
Tax recoupment / (scrapping allowance) xx/(xx)
Incremental TAXABLE INCOME xxx xxx xxx
Taxation @ 28% xx xx xx

3.2 CAPITAL BUDGETING PRINCIPLE

All relevant operating cash flows should be discounted at the risk appropriate rate.

Relevant: Only project-specific cash flows that are directly affected by the investment or
project should be taken into consideration. This means only cash flows that differ depending
on whether the project is undertaken or not. Items such as sunk costs, allocated overheads
or opportunity costs (refer to note D) should be excluded.

Operating: Only operating cash flows that result from accepting the project are taken into
consideration. This means financing costs, such as interest expenses, are ignored when
calculating the NPV. Remember: The financing decisions are separately evaluated from the
investing decisions.

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Cash flows: Only cash flows are taken into account (REMEMBER: The value of anything is the
present value of the discounted future cash flows of that thing). This means depreciation
charges and other non-cash items need to be ignored when calculating the NPV of a
project.

3.3 PROJECT CASH FLOWS

A. Initial capital outlay

The initial capital cost of the project usually takes place at the start of the project, i.e., Year
0. This means that the cost is at present value and need not be discounted.

Remember to show the initial capital cost as a negative cash flow.

B. Net working capital

Three elements of net working capital should be taken into account:

- Initial investment
- Change in the level of working capital
- Recovery of working capital

A new project often requires an incremental investment in working capital and results in a
cash outflow at the start of the project. If the working capital is recovered at the end of the
project it is included as a positive cash flow in the last period. Usually working capital will be
recovered at the end of the project life (e.g., debtors will pay, inventory levels will be
depleted and creditors will be settled).

The relevant cash flows are the incremental changes in the levels of working capital.

C. Cash on operating profits

Only incremental (relevant, project specific) operating cash profits that result from the
decision to accept the project should be included as cash flows.

All non-cash flow items should be ignored and might include the following items:
- Depreciation (not cash flow)
- Allocated fixed costs (unless they are project specific)
- Head office expenses (unless the project will cause increased head office expenses)

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D. Opportunity cost/benefits

The cash flow that would have occurred if the project was not accepted must be taken into
account.

Some examples include, if a new manufacturing machine is to be installed in an empty

warehouse that could otherwise have been let out, the lost rental should be included as an
opportunity cost of investing in the new machinery. Or loss of income due to the
replacement of an old machine with a new machine.

Take note: It is not a direct cash flow that will result, but are that which will be given up.
Some examples include other income forgone, cannibalisation of existing products, the
effect of replacement decisions (refer to note 3.4) and the tax effects (refer to note F).

Consider: Capacity constraints versus spare capacity

Loss of operating cash profits due to project

Competitive or substitute products from the new project could have a negative impact on
the sales of existing product lines. This decrease in contribution from the loss of sales should
be included as a cash outflow in evaluating the new project.

Example
A company selling imported fridges is considering an investment in a local factory to start
manufacturing fridges. The manufactured fridges will have a negative effect on the imported
fridge sales.

The decrease in contribution of the imported fridges should be included as a cash outflow in
the cash flow table of the new project.

E. Proceeds from sale of capital asset (i.e., disinvestment at the end of the project life)

The amount received when the capital asset is sold at the end of the period is included as a
cash inflow in the last period.

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F. Taxation

The aim is to calculate the effect on the company’s taxable income as a result of the
decision to accept the project.

Yr 0 Yr 1 Yr 2 Yr 3
Operating cash profits (i) xxx xxx xxx
Wear and tear allowance (ii) (xxx) (xxx) (xxx)
Opportunity costs (iii (xxx) (xxx) (xxx)
)
Tax recoupment / (scrapping allowance) (v) xx/(xx)
Incremental TAXABLE INCOME xxx xxx xxx
Taxation @ 28% xx xx xx

i) Wear and tear allowance

SARS allows certain wear and tear allowances to be deducted when acquiring capital assets.
These allowable deductions result in a decreased taxable income, which in turn results in a
lower tax liability. The amount by which the taxation expense reduces represents a cash-
saving to the company - typically Section 12C or Section 11(e).

To calculate the deduction, apply the SARS allowance to the capital cost of the project.

Remember that the allowance is only deducted until the initial cost has been written down
to a tax value of R Nil.

ii) Opportunity cost

Remember to take into account the tax effect of opportunity costs. When an opportunity
cost is included in the project cash flows as a cash outflow, the tax effect of this opportunity
cost must be shown as a cash saving (or cash inflow).

For replacement decisions refer to note 3.4.

iii) Tax recoupment, (scrapping allowance) and capital gains

The tax recoupment (or scrapping allowance) should be added (or deducted) from the
taxable income calculation.

Remember: The carrying amount of an asset for accounting purposes differs from the
taxation value of an asset.

Carrying amount = Cost price – Accumulated depreciation

Taxation value = Cost price – Accumulated wear and tear allowances

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The sale of an asset results in TWO relevant cash flows:

i) Proceeds from the sale of the asset

ii) Tax payable on a recoupment OR tax saving on a scrapping allowance

Recoupment: Proceeds > Tax value

Example:
Cost R500 000
Wear and tear 20% straight line
Proceeds after 4 years R150 000
Tax value = R500 000- R400 000 = R100 000, Selling price = R150 000.
Taxed on R50 000

Scrapping allowance: Proceeds < Tax value

Example:
Cost R500 000
Wear and tear 20% straight line
Proceeds after 4 years R50 000
Tax value = R100 000, Selling price = R50 000. No tax payable

Capital gain: Proceeds > Cost

Example:
Cost R500 000
Wear and tear 20% straight line
Proceeds after 4 years R550 000
Tax value = R100 000, Selling price = R550 000, Capital gain of R50 000 and
taxable

iv) Assessed losses

If there is an assessed loss available that cannot be utilised by the existing profits of the
company, the assessed loss may be used to reduce the taxable income of the project. This
will result in a relevant cash flow in the form of a tax saving.

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Example

A new project results in a cash inflow of R10m per year.

The existing product lines of the company are currently also producing income of R10m per year.

REQUIRED

Calculate the effect on the cash flows of the new project if the assessed loss was:

1. R7m
2. R20m

v) Cash flow effect of taxation on the project cash flows

Example
A new machine will cost R1 000 000 and SARS allows wear and tear of 40% in year 1 and
20% on the straight-line basis there-after to be deducted. Net operating cash flows from the
machine will amount to R300 000 per annum for three years, after which the machine will
be sold for R500 000. Opportunity costs amount to R2 000 per month.

REQUIRED

Calculate the tax effect on the project cash flows in each of the following scenarios:

1. There is no taxable income from existing operations

2. The tax effects of the project are ring-fenced
3. The company has an assessed loss of R2 million and currently earn taxable
income of R1 million per annum from existing operations.
4. The company has no assessed loss and currently earn taxable income of
R1_million per annum

After calculating the taxable income, the corporate tax rate of 28% should be applied to
calculate the effect on the project cash flow. This amount should be included in line F in the
initial cash flow table on page 4.

ANSWERS TO THESE TWO EXAMPLES ARE ON THE EXTRA NOTES ON ASSESSED LOSSES.

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Think about financial accounting:

For financial accounting purposes, a calculation very similar to a NPV calculation is done
when performing an impairment test. In fact, at a fast glance this impairment test looks
exactly like an NPV calculation performed to evaluate the value of an investment. Identify in
detail in what ways an impairment test and an NPV calculation are the same and based on
the same principles, and in what way/principles the two differ.

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3.4 REPLACEMENT DECISIONS

1. Net Present Value (NPV) of a project:

Yr 0 Yr 1 Yr 2 Yr 3
Initial capital outlay A (xxx)
Proceeds from sale of old asset xxx
Increase in net working capital B (xxx) xxx
Operating cash profits C xxx xxx xxx
Cash profits from old asset (xxx) (xxx)
Opportunity costs D (xxx) (xxx) (xxx)
Proceeds from sale of capital asset E xxx
Proceeds from sale of old asset (xxx)
Taxation (see 2 below) F (xx) (xx) (xx)
Project cash flows (xxx) xxx Xxx xxx
NPV @ WACC (note 3.5)

2. Taxation:

Yr 0 Yr 1 Yr 2 Yr 3
Operating cash profits (i) xxx Xxx xxx
Cash profits from old asset (xxx) (xxx)
Wear and tear allowance (ii) (xxx) (xxx) (xxx)
Wear and tear allowance on old asset xxx
Opportunity costs (iii) (xxx) (xxx) (xxx)
Recoupment / (scrapping allowance) on xx/(xx)
old asset
Recoupment / (scrapping allowance) (v) xx/(xx)
Recoupment / (scrapping allowance) on xx/(xx)
old asset (opportunity cost)
Incremental TAXABLE INCOME xxx Xxx xxx
Taxation @ 28% xx Xx xx

3.5 COST OF CAPITAL

i) Project specific vs. WACC for company

If the project is part of the normal operating activities within the same industry and
geographic location as the company’s existing operating activities, the WACC of the
company may be used to discount the cash flows in calculating the NPV.

The discount rate should take the specific risks (e.g. operating risk and sovereign risk if
applicable) involved in the project into account. If the project is exposed to increased risk
the WACC should be adjusted to reflect this.

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Some examples:
- Shoprite opens a new store in Juba, South Sudan
- Mr Price opens up a sports bar in the V&A Waterfront

If the project is in a different industry, the project discount rate can be compared to other
companies operating in that specific industry (see discussion of WACC in Part 3 of the
solution to the AM Ltd case study).

3.6 INVESTMENT ANALYSIS: OTHER CONSIDERATIONS

i) Independent and mutually exclusive projects (assuming equal lives and no capital
rationing)

Independent projects are evaluated separately from any other projects.

 Choose all projects with a positive NPV

If the projects are mutually exclusive, deciding on one project excludes all the other
projects.

 Choose the project with the highest NPV

ii) Project break-even (as part of risk assessment) NOT PART OF CFM 221 SYLLABUS

The project demand is usually uncertain and calculating the project break-even is useful to
analyse the risk. In capital budgeting, the break-even point is the number of units that need
to be sold to get a NPV of zero.

Illustrative example – Break-even units

Assume a project with the following details:

Cost of project R2 500 000

Selling price per unit R35
Variable cost per unit R20
Fixed cash costs R450 000
Project life 4 years
WACC 12%
Residual value Nil
Ignore the effect of taxation

REQUIRED

Determine the break-even number of units.

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The break-even gives an indication of the margin of safety where there is uncertain future
demand.

Illustrative example – Break-even selling price

Assume a project with the following details:

Cost of project R2 500 000

Annual sales demand 80 000 units
Variable cost per unit R20
Fixed cash costs R450 000
Project life 4 years
WACC 12%
Residual value Nil
Ignore the effect of taxation

REQUIRED

Determine the break-even selling price per unit.

*****

3.6.2 QUALITATIVE CONSIDERATIONS

(Source: Correia, Flynn, Uliana & Wormald; Financial Management 7th edition: Chapters 8,
9 and certain sections of Chapter 10)

i. Other strategic considerations and risks that need to be taken into account when
making an investment decision.

Some examples include the following:

- Flexibility of the process. Can it be abandoned, expanded, delayed or temporarily moth-

balled?
- Is there an exit strategy
- Possible opportunities relating to R&D and exploration
- Sequencing of investments to test viability
- Taxation effects
- Capital exposure
- Sensitivity of cash flows to changes in estimates
- Foreign exchange and commodity price exposure (volatility)
- Rapid technological changes in the industry
- Environmental, health and social consequences

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- Political uncertainty: licencing; nationalisation; beneficiation

ii. Porter’s five forces and industry profitability

1. Rivalry amongst existing firms

o Industry growth
o Fixed cost relative to variable costs
o Perishability of products
o High switching costs
o High exit barriers and excess capacity

2. Threat of substitute products

a. Ability to raise prices
b. Changes in technology
c. Power of brands

3. Threats of new entrants and barriers to entry

a. Economies of scale required
b. Research and development costs
c. Brand advertising required
d. Investments in plant and equipment
e. Governmental and legal barriers to entry
f. Patents and licences (for a defined period only)
g. First-mover advantages
h. Specialised technology, plant and equipment
i. Distribution channels and relationships

4. The bargaining power of buyers

5. The bargaining power of suppliers

Information required for a typical capital budgeting calculation:

1) Initial capital outlay/ initial inflows/outflows

2) Period of Project
3) Annual Cash flows
 Annual contribution
 Annual fixed costs
4) Tax effects
5) End of project cash flow effects e.g., Residual value etc.
6) WACC

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EXTRA NOTES ON CAPITAL BUDGETS

Investment and financing decisions

 Evaluate the investment
 Calculate using the payback, discounted payback period, Net Present Value,
Pofitability index (or NPV index) and Internal Rate of Return.
 Evaluate keep versus replace options
 Evaluate financing decisions (debt: equity ratio/capital structure)
 Compare debt versus lease options NOT IN CFM 221

Replace or purchase new assets to expand/grow

Perform a capital budget to decide whether the investment will add value to the company.
Future cash flows discounted @ WACC – Initial outflow = Net Present Value (NPV)
If the NPV is positive then the investment should be undertaken.

Problems?
 Target WACC (adjusted if risk is high for the new project)
 Estimating future relevant sales and costs
 Length of the project
 Value of the assets at the end of the project
 Only relevant cash flows applicable

All projects of equal business risk are evaluated on an equal basis @ WACC
Adjust WACC if the project shows more risk than the normal operating risk in the company.
No prejudice to the method of finance (finance decision is a separate decision)
Investment decision and WACC is used for discounting cash flows.
IF the NPV is positive, then determine the correct financing that will, over the long-term,
move towards the target debt:equity ratio at which point the WACC will be at it’s lowest.

Traditional methods for investment appraisal:

 Payback period (no TMV applied)
 Discounted payback period
 Net Present Value (NPV)
 Net Present Value Index
 Internal Rate of Return (IRR)

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Example to illustrate the basic principles of each method:

Project A Project B PV factor PV A PV B

@8%
YR 0 capital -30 000 -50 000 1 -30 000 -50 000
outlay
YR 1 cash 4 000 15 000 0.9259 3 704 13 888
flow
YR 2 cash 8 000 15 000 0.8573 6 858 12 860
flow
YR 3 cash 12 000 10 000 0.7938 9 526 7 936
flow
YR 4 cash 8 000 10 000 0.7350 5 880 7 350
flow
YR 5 cash 5 000 15 000 0.6806 3 403 10 209
flow
YR 6 cash 4 000 0 0.6302 2 521 0
flow
Net Present 1 892 2 245
value

Present value factor @ 8% year 1 = 1/1.08 = 0.9259. No discounting for YR 0 cash flows.

Payback period for project A:

30 000 – 4 000 – 8 000 – 12 000 – 6 000 = 0
In year 4, where the cash flow is R8 000, we need R6 000 to cover the initial outflow of
R30 000
6 000/8 000 = 0.75
0.75 * 12 months = 9 months
Therefor the payback period for A is 3 years and 9 months (or 3.75 years)

Payback period for B = 4 years.

A is a better project than B (payback is shorter)
This method ignores Time Value of money and the cash flows after the payback period (e.g.,
the cash flow of R15 000 for B in year 5 is ignored)
Companies might set limits for payback periods and it might mean that both projects will be
accepted, if the company rule is a payback period of less than 5 years.
If only ONE project is allowed, then A will be the better project.

Discounted payback period for A:

Same principle as with payback period, but use discounted cash flows.
30 000 – 3 704 – 6 858 – 9 526 – 5 880 – 3 403 – 629 = 0
629/2 521 (discounted cash flow year 6) = 0.25

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5 years and 3 months (0.25 * 12 = 3 months)

Weakness is that the cash flows after the payback period is ignored (same as with payback
period method), but the time value of money is applied.

Net Present Value (NPV) of A:

ASSUMES THAT ALL CASH FLOWS ARE RE INVESTED AT THE DISCOUNT RATE WHICH IS
WACC.
Original cash flow minus all the discounted cash flows
30 000 – 3 704 – 6 858 – 9 526 – 5 880 – 3 403 – 2 521 = 1 892
(The total of the discounted cash flows = R31 892)
NPV is positive, therefor the project gives a higher return than WACC.
Positive NPV adds value to the company.
NPV of B is R2 245.
Project B is therefor a better project than A.

If rationing was applied (only have R60 000 available for investment), the choose project B
With mutually exclusive projects, for example you can choose only one of the two possible
projects, then choose the best project which is B.
If projects are divisible, then you can choose part of a project do invest in. (e.g., you can
build the swimming pool, but leave the clubhouse for the moment, given that the pool and
clubhouse is one project.

Net Present Value Index (profitability index)

(Initial investment + Present value of cash flows)/ initial investment
Project A: (30 000 + 1 892)/30 000 = 1.06
Project B: (50 000 + 2 245)/50 000 = 1.04

This method is used when different outlays apply and capital rationing.
The answer 1.06 gives you the NPV per R1 investment.
Choose A because the NPV per R1 investment is more than with project B.

Internal Rate of Return (IRR):

ASSUME THE FUTURE CASH FLOWS ARE RE INVESTED AT THE IRR RATE.
This assumption is a bit unrealistic as the IRR might be higher than the market rate on
investments in the market.

IRR is the cost of capital that equates the present value of future cash flows to the initial
outlay. OR, where the NPV of the project is ZERO.
You set NPV = 0 and solve “I” which is the discount rate/IRR. You can use “CFj” function on
your calculator.

If IRR is more than WACC, then the project adds value to the company (positive leverage)
A project can have more than one IRR (if the inflow changes to an outflow in a specific year,
the IRR will also change).

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You can also use trial and error method to find the rate where the NPV of the project is
Zero.

IRR A = 10.11% (NPV = R1 892)

IRR B = 9.75% (NPV = R2 245)
Choose A if IRR method is applied.

Marginal Internal Rate of Return will be addressed in your third year.

Conflict in the ranking???? (A if IRR is used, B if NPV is used)

Why?
Cash flow of B is more towards the end which gives B the advantage on NPV method.
Interest on cash flows have little impact on the total income generated which gives A the
advantage on IRR method.

NPV method is superior to IRR as NPV assumes cash flows will be re invested @ WACC which
is a much more realistic approach.

Summary of investment decisions/Capital budgeting:

 Inflation: nominal rates versus real rates, WACC normally includes inflation as
it is based on market values.
 Relevant costs and revenues should be used.
 Depreciation NOT a cash flow
 Allocated costs NOT relevant
 Marginal/specific fixed costs to the project are relevant
 Opportunity costs/revenues which is relevant to the project
 Research and Development costs normally sunken cost and not relevant
 Discount rate = WACC = risk profile of the company
 WACC can be adjusted for risk, if the new investment has a different risk
profile than the normal operations in the company
 Initial working Capital investment and incremental investment, and whether
it is freed-up after the project.
 Issue costs is normally part of the initial investment
 Financing: ignore the interest on cash flows as this is included in WACC
 Tax losses (refer to extra notes, Shampers and Flip Chip)
 Recoupments and the tax value on the assets
 Tax time lags, normally 12 months
 Tax allowances on new machine and opportunity cost of wear and tear lost
on old machine (if it is a replacement of an asset)
 Book value versus Tax values
 New investment or replacement of old machine with a new machine
 Lease versus buy (addressed in third year of studies)
 Other issues before the final decision should be relevant to the question and
the business environment

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