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Introduction To Capital Budgeting

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20 views3 pages

Introduction To Capital Budgeting

Uploaded by

CUNNYMAN
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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INTRODUCTION TO CAPITAL BUDGETING

Capital expenditure; Capital expenditure is spending on non-current assets, such as buildings and
equipment, or investing in a new business. As a result of capital expenditure, a new non-current asset
appears on the statement of financial position (balance sheet), possibly as an ‘investment in
subsidiary’

Investment appraisal; is the evaluation of proposed investment projects involving capital


expenditure. The purpose of investment appraisal is to make a decision about whether the capital
expenditure is worthwhile and whether the investment project should be undertaken.

Capital expenditure by a company should provide a long-term financial return, and spending should
therefore be consistent with the company’s long-term corporate and financial objectives. Capital
expenditure should therefore be made with the intention of implementing chosen business strategies
that have been agreed by the board of directors.

Investment appraisal and capital budgets


Investment appraisal therefore takes place within the framework of a capital budget and strategic
planning. It involves 
 Generating capital investment proposals in line with the company’s strategic objectives.
 Forecasting relevant cash flows relating to the project
 Evaluating the projects
 Implementing projects which satisfy the company’s criteria for deciding whether the project will
earn a satisfactory return on investment
 Monitoring the performance of investment projects to ensure that they perform in line with
expectations.

Methods of investment appraisal There are four methods of evaluating a proposed capital
expenditure project. Any or all of the methods can be used, but some methods are preferable to
others, because they provide a more accurate and meaningful assessment. The four methods of
appraisal are:
 Accounting rate of return (ARR) method 
 Payback method 
 Discounted cash flow (DCF) methods: 
Net present value (NPV) method 
Internal rate of return (IRR) method

Each method of appraisal considers a different financial aspect of the proposed capital investment

ACCOUNTING RATE OF RETURN [ARR] METHOD


If accounting rate of return (ARR) is used to decide whether or not to make a capital investment, we
calculate the expected annual accounting return over the life of the project. The financial return will
vary from one year to the next during the project; therefore we have to calculate an average annual
return. If the ARR of the project exceeds a target accounting return, the project would be undertaken.
If its ARR is less than the minimum target, the project should be rejected and should not be
undertaken

Unfortunately, a standard definition of accounting rate of return does not exist. There are two main
definitions: 
Average annual profit as a percentage of the average investment in the project 
Average annual profit as a percentage of the initial investment.

You would normally be told which definition to apply. If in doubt, assume that capital employed is the
average amount of capital employed over the project life.

ARR = Average accounting profit/ Average capital employed


Average accounting profit = Total profit/ number of years
Average Capital employed = [(opening investment + residual value)/2] + working capital

.QUESTION 1
A company is considering a project which requires an investment of ₦120,000 in machinery. The
machinery will last four years after which it will have scrap value of ₦20,000. The investment in
additional working capital will be ₦15,000. The expected annual profits before depreciation are:
Year 1 ₦45,000
2 ₦45,000
3 ₦40,000
4 ₦25,000
The company requires a minimum accounting rate of return of 15% from projects of this type. ARR is
measured as average annual profits as a percentage of the average investment.
Should the project be undertaken?

QUESTION 2
A capital project would involve the purchase of an item of equipment costing ₦240,000. The
equipment will have a useful life of six years and would generate cash flows of ₦66,000 each year for
the first three years and ₦42,000 each year for the final three years. The scrap value of the equipment
is expected to be ₦24,000 after six years. An additional investment of ₦40,000 in working capital
would be required.
The business currently achieves a return on capital employed, as measured from the data in its
financial statements, of 10%.
Required;
(a) Calculate the ARR of the project, using the initial cost of the equipment to calculate capital
employed.
(b) Calculate the ARR of the project, using the average cost of the equipment to calculate capital
employed.
(c) Suggest whether or not the project should be undertaken, on the basis of its expected ARR

THE PAYBACK METHOD


Payback is measured by cash flows, not profits. It is the length of time before the cash invested in a
project will be recovered (paid back) from the net cash returns from the investment project.

Using the payback method, a maximum acceptable payback period is decided, as a matter of policy.
The expected payback period for the project is calculated. 
If the expected payback is within the maximum acceptable time limit, the project is acceptable.
If the expected payback does not happen until after the maximum acceptable time limit, the project is
not acceptable.

The time value of money is ignored, and the total return on investment is not considered.
.
Example: Payback
A company requires all investment projects to pay back their initial investment within three years. It
is considering a new project requiring a capital outlay of ₦140,000 on plant and equipment and an
investment of ₦20,000 in working capital. The project is expected to earn the following net cash
receipts:
Year 1 ₦40,000
2 ₦50,000
3 ₦90,000
4 ₦25,000
Should the investment be undertaken?

Practice questions 2
A company must choose between two investments, Project A and Project B. It cannot undertake both
investments. The expected cash flows for each project are:
YEAR PROJECT A PROJECT B
0 (80,000) (80,000)
1 20,000 60,000
2 36,000 24,000
3 36,000 2,000
4 17,000

The company has a policy that the maximum permissible payback period for an investment is three
years and if a choice has to be made between two projects, the project with the earlier payback will
be chosen.

Required
1) Calculate the payback period for each project:
(a) assuming that cash flows occur at that year end
(b) assuming that cash flows after Year 0 occur at a constant rate throughout each year
2) Are the projects acceptable, according to the company’s payback rule? Which project should be
selected?
3) Do you agree that this is the most appropriate investment decision

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