Student lecture notes

CHAPTER 25

CAPITAL BUDGETING

Capital budgeting is a process of management accounting which assists management

decision making by providing …………………………….. in a project and the
…………………………….. from that project, and by ………………………………
of the project subsequent to its implementation.

The assumptions adopted

 No taxes
 No inflation
 Certainty in predicting future events

Three methods of capital budgeting

 Payback method
 Accounting rate of return
 Net present value method

Data

A haulage company has three potential projects planned. Each will

require investment in two refrigerated vehicles at a total cost of £120,000.
The vehicle has a three-year life. The three projects are:

(A) Expected cash inflows, after deducting all expected cash outflows,
are £60,000 per annum.

(B) Expected cash inflows, after deducting all expected cash outflows,
are £45,000 per annum.

(C) Expected cash inflows, after deducting all expected cash outflows,
are £40,000 in Year 1, £70,000 in Year 2 and £80,000 in Year 3.

Financial and Management Accounting, Third Edition Student notes 25.1

P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Payback method

The payback period is the length of time required for a stream of cash inflows from
a project to equal the original cash outlay.

Cash flows Project A Project B Project C

£ £ £
Outlay 120 120 120
Net cash flows
Year 1 60 45 40
Year 2 60 45 70
Year 3 60 45 80
Payback period
Workings

Usefulness and limitations of the payback approach

Concentrating on projects which give ……………… of cash flow.

………………… approach.

Ignores the ………………………………………..

Cash flows earned should ……………… the capital sum invested plus interest.

Ignores any …………… arising after …………………...

Financial and Management Accounting, Third Edition Student notes 25.2

P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Accounting rate of return

The accounting rate of return is calculated by taking the ………………………….….

as a percentage of ………………….

Profit is not the same as cash flow.

Expense associated with using a fixed asset is the reduction in the value of the asset
due to depreciation.

Depreciation

A straight-line method of depreciation is applied, assuming a zero residual value.

Annual depreciation (£120,000/3 years) = £40,000 per annum deducted from cash
flows to arrive at annual profit.

Calculations: Accounting rate of return

Cash flows Project A Project B Project C

£ £ £
Outlay (a) 120,000 120,000 120,000
Profits (cash flows minus depreciation)
Year 1 20,000 5,000 nil
Year 2 20,000 5,000 30,000
Year 3 20,000 5,000 40,000

Average annual profit (b)

Accounting rate of return ((b)  100/(a))

Project …….…..……. is the most desirable project.

Project ………….…… is next in rank.

Project ………………..is the least desirable.

Usefulness and limitations of accounting rate of return

Based on the familiar accounting measure of profit.

Takes into the calculation ………………….

Ignores the …………………………………….

Depends on profit, including a …………………….. accounting estimate of

depreciation.

Financial and Management Accounting, Third Edition Student notes 25.3

P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Net present value method

It takes into account all cash flows over the life of the project and makes allowance
for the time value of money.

Time value of money

If £100 is invested at 10% per annum then it will grow to £110 by the end of the year.
If the £100 is spent on business machinery the interest is lost.

Lost opportunity of earning interest on an investment.

Time value of money recognising that a project needs to compensate the business for
the lost opportunity.

Question

You are given a written promise of £100 to be received in one year’s time. Interest
rates are 10%.

What is the price for which you could sell that promise?

Answer is £………………...

(The amount which, invested now at 10%, would grow to £100 in one year’s time.)

Both the buyer and the seller would be equally satisfied.

You are given a promise of £100 for payment in two years’ time.

What is the price for which you could sell that promise now?

Answer is £………………

(£…………. would grow at 10% to £……………… at the end of one year

and to £100 at the end of two years.)

Mathematical representation as follows:

The present value of a sum of £1 receivable at the end of n years when the rate of
interest is r% per annum equals
 1 
 
 (1  r ) n 
 

where r =represents the annual rate of interest (discount rate),

and n represents the time period when the cash flow will be received.

Financial and Management Accounting, Third Edition Student notes 25.4

P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Assuming a rate of interest of 10%:

The present value of a sum of £100, due one year hence:

 100 
  = ……………
 (1  0.1) 1 
 

The present value of a sum of £100, due two years hence:

 100 
  = …………….
 (1  0.1) 2 
 

A full table of discount factors is set out in the supplement at the end of Chapter 25.

The column for the discount rate of 10% has the following discount factors:

At end of period Present value of £1

1
2
3

Net present value calculation

The net present value of a project is equal to the present value of the ………………..
minus the present value of the …………………., all discounted at the cost of capital.
Calculation of net present value

Using the formula approach the net present value is calculated as:

£60,000 + £60,000 + £60,000  £120,000

(1.10) (1.10)2 (1.10)3

= £54,550 + £49,590 + £45,080 - £120,000 = £………………

Using the discount tables the net present value is calculated as follows:

End of year Cash flow Discount factor Present value

£ £
1 60,000 0.909
2 60,000 0.826
3 60,000 0.751

Less initial outlay (120,000)

Net present value
The NPV decision rule is as follows:

Financial and Management Accounting, Third Edition Student notes 25.5

P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Where the NPV of the project is ………………………………. the project.

Where the NPV of the project is …………………………………. the project.

Where the NPV of the project is ……………………………………….. in meeting the

cost of capital but gives no surplus to its owners.

If an organisation seeks to maximise the wealth of its owners, then it should accept
any project which has a ………………………. net present value.

Based on the above decision rule Project A will be accepted as it gives a

………………. net present value.

Project B Cash flow patterns

Using the discount tables the net present value is calculated as follows:

End of year Cash flow Discount Present value

factor
£ £
1 45,000 0.909
2 45,000 0.826
3 45,000 0.751

Less initial outlay (120,000)

Net present value

Project C Cash flow patterns

Using the discount tables the net present value is calculated as:

End of year Cash flow Discount Present value

factor
£ £
1 40,000 0.909
2 70,000 0.826
3 80,000 0.751

Less initial outlay (120,000)

Net present value

Project …………… is the most desirable project.

Project ……………. is next in rank.

Financial and Management Accounting, Third Edition Student notes 25.6

P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Project …………….. would be rejected as it gives a negative net present value.

Financial and Management Accounting, Third Edition Student notes 25.7

P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
 Internal rate of return

The internal rate of return is another method in capital budgeting which uses the time
value of money but results in an answer expressed in percentage form. It is a discount
rate which leads to a …………………………………………, where the present value
of the cash inflows exactly equals the cash outflows.

The internal rate of return is the discount rate at which the present value of the cash
flows generated by the product is equal to the …………………. of the capital
invested, so that the net present value of the project is ……………..

Method of calculation

The calculation of the internal rate of return involves a process of repeated guessing at
the discount rate until the present value of the cash flows generated is equal to the
capital investment.

Initial investment =

C1 C2 C3 Cn
+ + +…+
(1  d ) (1  d ) 2 (1  d ) 3
(1  d ) n

Non-computerised process of estimation by use of discount tables, with the

aim of arriving at a reasonably close answer.

Illustration: Project A

Find two values of NPV using discount rates lying either side of the actual IRR.

A first guess of 20% produces a net present value which is positive.

A higher discount rate of, say, 24% is used for the second guess.

Calculation of net present value at 20% and at 24%

End of year Cash Discount rate 20% Discount rate 24%

flows
£ £ £
1 60,000 0.833 0.806
2 60,000 0.694 0.650
3 60,000 0.579 0.524

Outlay (120,000) (120,000)

Net present value

Financial and Management Accounting, Third Edition Student notes 25.8

P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Financial and Management Accounting, Third Edition Student notes 25.9
P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Locating the IRR between two discount rates of known NPV

The precise discount rate which gives a zero NPV may now be found by assuming a
linear interval between 20% and 24%.

The difference between the two net present values is £6,360  (£1,200), i.e. £7,560.

The difference between the two discount rates is 4%. Using simple proportion
calculations the net present value of zero lies at:

 6,360 
20% + 
  4
 = 23.365%
 7 ,560 

The process of estimation shown here is called ………………………………………..

Formula

lower of the pair of discount rates +

 NPV at lower rate 

 Difference between the NPVs  Difference in rates 
 
 

Financial and Management Accounting, Third Edition Student notes 25.10

P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Graph of net present value against discount rate showing IRR

The Internal Rate of Return decision rule

Where the IRR of the project is ……………… the cost of capital, ………… the
project.

Where the IRR of the project is …………………. the cost of capital, ………. the
project.

Where the IRR of the project …………… the cost of capital, the project is
……………… in meeting the required rate of return of those investing in the business
but gives no surplus to its owners.

When the net present value and the internal rate of return criteria are applied to an
isolated project, they will lead to the same accept/reject decision because they both
use the discounting method of calculation applied to the same cash flows.

Mutually exclusive projects

An organisation may need to make a choice between two projects which are mutually
exclusive (perhaps because there is only sufficient demand in the market for the
output of one of the projects, or because there is a limited physical capacity which
will not allow both).

Financial and Management Accounting, Third Edition Student notes 25.11

P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Case example: Whisky distillery

A distillery is planning to invest in a new still. There are two plans, one of which
involves continuing to produce the traditional mix of output blends and the second of
which involves experimentation with new blends. The second plan will produce
lower cash flows in the earlier years of the life of the still but it is planned that these
cash flows will overtake the traditional pattern within a short space of time. The cost
of capital is 12% per annum.

Two mutually exclusive projects: Cash flows, NPV and IRR

Project Initial Cash flows

investment Year 1 Year 2 Year 3
£ £ £ £
A 120,000 96,000 48,000 12,000
B 120,000 12,000 60,000 108,000

Project NPV at 12% IRR

£
A 12,521 20.2%
B 15,419 17.6%

It may be seen that, looking at the net present value at the cost of capital,
Project B appears the more attractive with the higher net present value.
Looking at the internal rate of return, Project A appears more attractive.

Profitability index

The profitability index is the present value of cash flows (discounted at the cost of
capital) divided by the present value of the investment intended to produce those cash
flows.

The project with the highest profitability index will give the highest net present value
for the amount of investment funding available:

Project A
132,521
Profitability index = 120,000 = 1.10

Project B
135,419
Profitability index = 120,000 = 1.13

This confirms that, of the two, Project B is preferable at a cost of capital of 12%.

Financial and Management Accounting, Third Edition Student notes 25.12

P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Sensitivity to changes in the discount rate

Graph of net present value of competing projects using a range of discount rates

For both projects, the net present value ……………. as the discount rate …………..
but the net present value of Project B ………………… more rapidly.

The net present value of Project B is …………… than that of Project A at all discount
rates above the point M (around 14.2%). In particular Project B has a ……………
net present value than Project A at the cost of capital 12% (point N on the graph).

For discount rates above 14.2%, the net present value of Project B is always ………..
than that of Project A.

The internal rate of return for Project B is at point ……….. (around …………..%).

The internal rate of return for Project A is at point ………….(around …………%).

If it is certain that the cost of capital will remain at 12%, then Project ………is more
desirable than Project ………..

If there is a chance that the cost of capital will in reality be substantially higher than
the 12% then it might be safer to choose Project A.

Financial and Management Accounting, Third Edition Student notes 25.13

P Weetman and P Gordon. Copyright © Pearson Education Limited 2003