CAPITAL BUDGETING
Illustration – Calculation of NPV, Simple Payback and Discounted Payback
Happy Singh Taxiwala is a long established tour operator providing high quality transport to their clients. It currently owns and runs 250 cars and has turnover of A 100 lakhs p.a. The current system for allocating jobs to drivers is very inefficient. Happy Singh is considering the implementation of a new computerized tracking system called ‘Banta’. This will make the allocation of jobs far more efficient. You are as accounting technician, for an accounting firm, has been appointed to advice Happy Singh to decide whether ‘Banta’ should be implemented. The project is being appraised over five years. The costs and benefits of the new system are as follows: (i) (ii) (iii) (iv) The Central Tracking System costs A 21,00,000 to implement. This amount will be payable in three equal instalments. One immediately, the second in one year’s time, and the third in two year’s time. Depreciation on the new system will be provided at A 4,20,000 p.a. Staff will need to be trained how to use the new system. This will cost Happy Singh A 4,25,000 in the first year. If ‘Banta’ is implemented, revenues will rise to an estimated A 110 lakhs this year, thereafter increasing by 5% per annum (Compounded). Even if Banta is not implemented, revenue will increase by an estimated A 2,00,000 per annum, from their current level of A 100 lakhs per annum. Despite increased revenues, ‘Banta’ will still make overall savings in terms of vehicle running costs. These costs are estimated at 1% of the post ‘Banta’ revenues each year (i.e. the A 110 lakhs revenue rising by 5% thereafter, as referred to in (iv) above. Six new staff operatives will be recruited to manage the ‘Banta’ system. Their wages will cost the company A 1,20,000 per annum in the first year, A 2,00,000 in the second year, thereafter increasing by 5% per annum (i.e. compounded). Happy Singh will have to take out an annual maintenance contract for ‘Banta’ system. This will cost A 75,000 per annum. Interest on money borrowed to finance the project will cost A 1,50,000 per annum. Happy Singh Taxiwala’s cost of capital is 10% per annum.
(v)
(vi)
(vii) (viii) (ix)
Required: (a) Calculate the net present value (NPV) of the new ‘Banta’ system nearest to A ‘000. (b) Calculate the simple pay back period of the project and interpret the result. (c) Calculate the discounted payback period for the project and interpret the result.
Solution: Working Notes: 1 year 1. Increased Revenue
Revenue (5% increase/year)
2 years 11,550 (10,400) 1,150
3 years 12,128 (10,600) 1,528
4 year 12,734 (10,800) 1,934
(A ‘000) 5 year 13,371 (11,000) 2,371
Without Banta
11,000 (10,200) 800
2. Saving in Cost Annual Revenues Saving @ 1 % 3. Operative Cost Additional Cost (with 5% increase from 3 year) 4. Annual Cash inflows Increased Revenue (1) Cost Saving (2) Operative Cost (3) Maintenance Cost 5. Calculation Net Cash Flow Implementation Cost Training Cost Annual Cash Inflows (4)
11,000 110
11,550 116
12,128 121
12,734 127
13,371 134
120
200
210
221
232
800 110 (120) (75) 715 (700) (425) 715 (410)
1,150 116 (200) (75) 991 (700) 991 291
1,528 121 (210) (75) 1,364 1,364 1,364
1,934 127 (221) (75) 1,765 1,765 1,765
2,371 134 (232) (75) 2,198 2,198 2,198
(a) Net Present Value Period Present Value Flow at 10% 1.00 0.909 0.826 0.751 0.683 0.621 Cash Flow (A ‘000) -700 -410 291 1364 1765 2198 Present Value (A ‘000) -700 -373 240 1024 1205 1365 2761
Implementation Cost Cash Flows
0 1 2 3 4 5
Net Present Value NPV = A 27,61,000 (Approx.)
(b) Simple Pay Back Time Annual Cash Flow (A ‘000) 0 -700 1 -410 2 291 3 1364 4 1765 5 2198 Pay back period shall 2 Year + 819/1364 Year = 2.60 years.
Cumulative Cash Inflows (A ‘000) -700 -1110 -819 545 2310 4508
(c) Discounted Pay back Period Time Annual Cash Flows (A ‘000) 0 -700 1 -373 2 240 3 1024 4 1205 5 1365 The discounted pay back period shall be 2 years + 833/1024 years = 2.81 years.
Cumulative Cash Flow (A ‘000) -700 -1073 -833 191 1396 2761
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Illustration – Calculation of MIRR
An investment of A 1, 36,000 yields the following cash inflows (profits before depreciation but after tax). Determine MIRR considering 8% Cost of Capital. Year 1 2 3 4 5 (in A) 30,000 40,000 60,000 30,000 20,000 1,80,000
Solution Year 0 Year 1 2 3 4 5 Cash flows (A) 30,000 40,000 60,000 30,000 20,000 Cash Flow 1,36,000 @ 8% reinvestment rate factor 1.3605 1.2597 1.1664 1.0800 1.0000 (A) 40,815 50,388 69,984 32,400 20,000
The net cash flows from the Investment shall be compounded to the terminal year at 8% as follows;
MIRR of the Investment based on a single cash inflow of A 2,13,587 and a zeroth year cash outflow of A 1,36,000 is 9.4% (approx.)
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COMPARISON OF NET PRESENT VALUE AND INTERNAL RATE OF RETURN METHODS
A]. Similarities ? Both consider the time value of money. ? Both consider all cash flows over the expected useful life of the project. ? Both are consistent with the objective of maximizing the wealth of owners. ? Both are equivalent as regards the acceptance/rejection of conventional investments. B] Differences There are circumstances/scenarios under which the net present value method and the internal rate of return methods will reach different conclusions. These scenarios are as follows:Scenario 1 – Large initial investment
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NPV: The net present value method will favour a project with a large initial investment because the project is more likely to generate large net cash inflows. IRR: Because the internal rate of return method uses percentages to evaluate the relative profitability of an investment, the amount of the initial investment has no effect on the outcome. Conclusion: Therefore, the internal rate of return method is more appropriate in this scenario.
Scenario 2 – Difference in the timing and amount of net cash inflows
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NPV: The net present value method assumes that all net cash inflows from an investment earn the desired rate of return used in the calculation. The desired rate of return used by the net present value method is usually the organization’s weighted-average cost of capital, a more conservative and more realistic expectation in most cases. IRR: Differences in the timing and amount of net cash inflows affect a project’s internal rate of return. This results from the fact that the internal rate of return method assumes that all net cash inflows from a project earn the same rate of return as the project’s internal rate of return. Conclusion: In this scenario choosing NPV is a better choice.
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Scenario 3 – Projects with long useful life
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NPV: Both methods favour projects with long useful lives as long as a project earns positive net cash inflow during the extended years. As long as the net cash inflow in a year is positive, no matter how small, the net present value increases, and the projects desirability improves. IRR: Likewise, the internal rate of return method considers each additional useful year of a project another year that its cumulative net cash inflow will earn a return equal to the project’s internal rate of return. Conclusion: Both NPV and IRR suitable.
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Scenario 4 – Varying cost of capital As an organization’s financial condition or operating environment changes, its cost of capital could also change. A proper capital budgeting procedure should incorporate changes in the organization’s cost of capital or desired rate of return in evaluating capital investments.
? ? ?
NPV: The net present value method can accommodate different rates of return over the years by using the appropriate discount rates for the net cash inflow of different periods. IRR: The internal rate of return method calculates a single rate that reflects the return of the project under consideration and cannot easily handle situations with varying desired rates of return. Conclusion: NPV is a better method in these circumstances.
Scenario 5 – Multiple Investments
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NPV: The net present value method evaluates investment projects in cash amounts. The net present values from multiple projects can be added to arrive at a single total net present value for all investment. IRR: The internal rate of return method evaluates investment projects in percentages or rates. The percentages or rates of return on multiple projects cannot be added to determine an overall rate of return. A combination of projects requires a recalculation of the internal rate of return. Conclusion: NPV is a better method in these circumstances.
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doc_823019227.pdf
Illustration – Calculation of NPV, Simple Payback and Discounted Payback
Happy Singh Taxiwala is a long established tour operator providing high quality transport to their clients. It currently owns and runs 250 cars and has turnover of A 100 lakhs p.a. The current system for allocating jobs to drivers is very inefficient. Happy Singh is considering the implementation of a new computerized tracking system called ‘Banta’. This will make the allocation of jobs far more efficient. You are as accounting technician, for an accounting firm, has been appointed to advice Happy Singh to decide whether ‘Banta’ should be implemented. The project is being appraised over five years. The costs and benefits of the new system are as follows: (i) (ii) (iii) (iv) The Central Tracking System costs A 21,00,000 to implement. This amount will be payable in three equal instalments. One immediately, the second in one year’s time, and the third in two year’s time. Depreciation on the new system will be provided at A 4,20,000 p.a. Staff will need to be trained how to use the new system. This will cost Happy Singh A 4,25,000 in the first year. If ‘Banta’ is implemented, revenues will rise to an estimated A 110 lakhs this year, thereafter increasing by 5% per annum (Compounded). Even if Banta is not implemented, revenue will increase by an estimated A 2,00,000 per annum, from their current level of A 100 lakhs per annum. Despite increased revenues, ‘Banta’ will still make overall savings in terms of vehicle running costs. These costs are estimated at 1% of the post ‘Banta’ revenues each year (i.e. the A 110 lakhs revenue rising by 5% thereafter, as referred to in (iv) above. Six new staff operatives will be recruited to manage the ‘Banta’ system. Their wages will cost the company A 1,20,000 per annum in the first year, A 2,00,000 in the second year, thereafter increasing by 5% per annum (i.e. compounded). Happy Singh will have to take out an annual maintenance contract for ‘Banta’ system. This will cost A 75,000 per annum. Interest on money borrowed to finance the project will cost A 1,50,000 per annum. Happy Singh Taxiwala’s cost of capital is 10% per annum.
(v)
(vi)
(vii) (viii) (ix)
Required: (a) Calculate the net present value (NPV) of the new ‘Banta’ system nearest to A ‘000. (b) Calculate the simple pay back period of the project and interpret the result. (c) Calculate the discounted payback period for the project and interpret the result.
Solution: Working Notes: 1 year 1. Increased Revenue
Revenue (5% increase/year)
2 years 11,550 (10,400) 1,150
3 years 12,128 (10,600) 1,528
4 year 12,734 (10,800) 1,934
(A ‘000) 5 year 13,371 (11,000) 2,371
Without Banta
11,000 (10,200) 800
2. Saving in Cost Annual Revenues Saving @ 1 % 3. Operative Cost Additional Cost (with 5% increase from 3 year) 4. Annual Cash inflows Increased Revenue (1) Cost Saving (2) Operative Cost (3) Maintenance Cost 5. Calculation Net Cash Flow Implementation Cost Training Cost Annual Cash Inflows (4)
11,000 110
11,550 116
12,128 121
12,734 127
13,371 134
120
200
210
221
232
800 110 (120) (75) 715 (700) (425) 715 (410)
1,150 116 (200) (75) 991 (700) 991 291
1,528 121 (210) (75) 1,364 1,364 1,364
1,934 127 (221) (75) 1,765 1,765 1,765
2,371 134 (232) (75) 2,198 2,198 2,198
(a) Net Present Value Period Present Value Flow at 10% 1.00 0.909 0.826 0.751 0.683 0.621 Cash Flow (A ‘000) -700 -410 291 1364 1765 2198 Present Value (A ‘000) -700 -373 240 1024 1205 1365 2761
Implementation Cost Cash Flows
0 1 2 3 4 5
Net Present Value NPV = A 27,61,000 (Approx.)
(b) Simple Pay Back Time Annual Cash Flow (A ‘000) 0 -700 1 -410 2 291 3 1364 4 1765 5 2198 Pay back period shall 2 Year + 819/1364 Year = 2.60 years.
Cumulative Cash Inflows (A ‘000) -700 -1110 -819 545 2310 4508
(c) Discounted Pay back Period Time Annual Cash Flows (A ‘000) 0 -700 1 -373 2 240 3 1024 4 1205 5 1365 The discounted pay back period shall be 2 years + 833/1024 years = 2.81 years.
Cumulative Cash Flow (A ‘000) -700 -1073 -833 191 1396 2761
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Illustration – Calculation of MIRR
An investment of A 1, 36,000 yields the following cash inflows (profits before depreciation but after tax). Determine MIRR considering 8% Cost of Capital. Year 1 2 3 4 5 (in A) 30,000 40,000 60,000 30,000 20,000 1,80,000
Solution Year 0 Year 1 2 3 4 5 Cash flows (A) 30,000 40,000 60,000 30,000 20,000 Cash Flow 1,36,000 @ 8% reinvestment rate factor 1.3605 1.2597 1.1664 1.0800 1.0000 (A) 40,815 50,388 69,984 32,400 20,000
The net cash flows from the Investment shall be compounded to the terminal year at 8% as follows;
MIRR of the Investment based on a single cash inflow of A 2,13,587 and a zeroth year cash outflow of A 1,36,000 is 9.4% (approx.)
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COMPARISON OF NET PRESENT VALUE AND INTERNAL RATE OF RETURN METHODS
A]. Similarities ? Both consider the time value of money. ? Both consider all cash flows over the expected useful life of the project. ? Both are consistent with the objective of maximizing the wealth of owners. ? Both are equivalent as regards the acceptance/rejection of conventional investments. B] Differences There are circumstances/scenarios under which the net present value method and the internal rate of return methods will reach different conclusions. These scenarios are as follows:Scenario 1 – Large initial investment
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NPV: The net present value method will favour a project with a large initial investment because the project is more likely to generate large net cash inflows. IRR: Because the internal rate of return method uses percentages to evaluate the relative profitability of an investment, the amount of the initial investment has no effect on the outcome. Conclusion: Therefore, the internal rate of return method is more appropriate in this scenario.
Scenario 2 – Difference in the timing and amount of net cash inflows
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NPV: The net present value method assumes that all net cash inflows from an investment earn the desired rate of return used in the calculation. The desired rate of return used by the net present value method is usually the organization’s weighted-average cost of capital, a more conservative and more realistic expectation in most cases. IRR: Differences in the timing and amount of net cash inflows affect a project’s internal rate of return. This results from the fact that the internal rate of return method assumes that all net cash inflows from a project earn the same rate of return as the project’s internal rate of return. Conclusion: In this scenario choosing NPV is a better choice.
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Scenario 3 – Projects with long useful life
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NPV: Both methods favour projects with long useful lives as long as a project earns positive net cash inflow during the extended years. As long as the net cash inflow in a year is positive, no matter how small, the net present value increases, and the projects desirability improves. IRR: Likewise, the internal rate of return method considers each additional useful year of a project another year that its cumulative net cash inflow will earn a return equal to the project’s internal rate of return. Conclusion: Both NPV and IRR suitable.
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Scenario 4 – Varying cost of capital As an organization’s financial condition or operating environment changes, its cost of capital could also change. A proper capital budgeting procedure should incorporate changes in the organization’s cost of capital or desired rate of return in evaluating capital investments.
? ? ?
NPV: The net present value method can accommodate different rates of return over the years by using the appropriate discount rates for the net cash inflow of different periods. IRR: The internal rate of return method calculates a single rate that reflects the return of the project under consideration and cannot easily handle situations with varying desired rates of return. Conclusion: NPV is a better method in these circumstances.
Scenario 5 – Multiple Investments
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NPV: The net present value method evaluates investment projects in cash amounts. The net present values from multiple projects can be added to arrive at a single total net present value for all investment. IRR: The internal rate of return method evaluates investment projects in percentages or rates. The percentages or rates of return on multiple projects cannot be added to determine an overall rate of return. A combination of projects requires a recalculation of the internal rate of return. Conclusion: NPV is a better method in these circumstances.
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doc_823019227.pdf