1 Capital Budgeting: Financial Appraisal of Investment Projects Yousef ElMudalal Chapter 1
2 Introduction Chapter 1 introduces the concept of capital budgeting, and sets out the structure of the book. The important points are: Capital budgeting is the most significant financial activity of the firm. Capital budgeting determines the core activities of the firm over a long term future. Capital budgeting decisions must be made carefully and rationally.
3 Capital Budgeting Within The Firm
4 Examples of Long Term Assets
5 Classification of investment projects a)Independent Projects: The acceptance or rejection of one does not directly eliminate other projects from consideration or cause the likelihood of their selection. Examples would include: (i)The introduction of a new product line (soap) and at the same time the replacement of a machine, which is currently producing a different product (plastic bottles). (ii)The installation of a new air conditioning system and the commissioning of a new advertising campaign for a product currently sold by the firm.
6 Classification of investment projects b) Mutually Exclusive Projects : The acceptance of one prevents the acceptance of an alternative proposal. That is, two or more projects cannot be pursued simultaneously. Examples would include: (i) A firm may own a block of land, which is large enough to establish a shoe manufacturing business or a steel fabrication plant. The selection of one will exclude the acceptance of the other. (ii) A car manufacturing company considering to establish one of its manufacturing complexes can locate it in Sydney, Brisbane or Adelaide. If the company chooses Sydney, the other two locations are ruled out.
7 c) Contingent Projects : The acceptance or rejection of one is dependent on the decision to accept or reject one or more other projects. Contingent projects may be complementary or substitute. Example of each would include: i.Complementary: The decision to start a pharmacy may be contingent upon a decision to establish a doctors surgery in an adjacent building. The cash flows of the pharmacy will be enhanced by the existence of a nearby surgery and vice versa. ii.Complementary: The introduction of a water recycling plant may increase the profitability of several other projects. Classification of investment projects
8 Example of Substitutes i.Substitutes: customers visiting a shopping complex may treat Chinese and Thai food as close substitutes. Consequently if the firm establishes both restaurants, none of the restaurants may be profitable due to the distribution of a given number of customers between the two restaurants. However, if only one restaurant is established, it may generate net present value. Therefore, the acceptance of one is contingent upon the non- acceptance of the other project. ii.Substitutes: two different brands of butter as two different projects. The success of one project may depend on the non-acceptance of the other project. Classification of investment projects
9 Aspects of Capital Budgeting Capital Budgeting involves: Committing significant resources. Planning for the long term: 5 to 50 years. Decision making by senior management. Forecasting long term cash flows. Estimating long term discount rates. Analyzing risk.
10 The capital budgeting process.
11 Strategic planning A strategic plan is the grand design of the firm and clearly identifies the business the firm is in and where it intends to position itself in the future. It reviews strengths, weaknesses, threats and opportunities; presents a series of statements relating to firms vision, mission, values and objectives; and sets out its proposed strategies and goals
12 Identification of investment opportunities The identification of investment opportunities and generation of investment project proposals is an important step in the capital budgeting process. Some investments are mandatory. Other investments are discretionary and are generated by growth opportunities, competition, cost reduction opportunities and so on. The firm should ensure that it has searched and identified potentially lucrative investment opportunities and proposals, because the remainder of the capital budgeting process can only assure that the best of the proposed investments are evaluated, selected and implemented.
13 Preliminary screening of projects The identified investment opportunities have to be subjected to a preliminary screening process by management to isolate the marginal and unsound proposals. The preliminary screening may involve some preliminary quantitative analysis and judgments based on intuitive feelings and experience.
14 Financial appraisal of projects Other names: Quantitative analysis Economic and financial appraisal Project evaluation Project analysis. Projects which pass through the preliminary screening phase become candidates for rigorous financial appraisal to ascertain if they would add value to the firm.
15 Financial appraisal of projects This project analysis contain predict the expected future cash flows of the project Analyze the risk associated with those cash flows Develop alternative cash flow forecasts Examine the sensitivity of the results to possible changes in the predicted cash flows Subject the cash flows to simulation and prepare alternative estimates of the projects net present value. If the projects identified within the current strategic framework of the firm repeatedly produce negative NPVs in the analysis stage, these results send a message to the management to review its strategic plan.
16 Qualitative factors in project evaluation Qualitative factors are those which will have an impact on the project, but which are virtually impossible to evaluate accurately in monetary terms such as: The societal impact of employee numbers The environmental impact of the project Possible positive or negative governmental political attitudes towards the project. The strategic consequences of consumption of scarce raw materials Positive or negative relationships with labor unions Possible legal difficulties with respect to the use of patents, copyrights and trade or brand names Impact on the firms image if the project is socially questionable.
17 The accept/reject decision NPV results from the quantitative analysis combined with qualitative factors form the basis of the decision support information Management considers this information and other relevant prior knowledge using their routine information sources, experience, expertise, gut feeling and, of course, judgment to make a major decision
18 Project implementation and monitoring Once investment projects have passed through the decision stage, they then must be implemented by management. An integral part of project implementation is the constant monitoring of project progress Deviations from the estimated cash flows need to be monitored on a regular basis with a view to taking corrective actions when needed.
19 Post-implementation audit An evaluation of the performance of past decisions, however, can contribute greatly to the improvement of current investment decision-making by analyzing the past rights and wrongs.
20 Review questions 1. In finance theory, what is the most widely accepted goal of the firm? How does the net present value of a project relate to this goal? The most widely accepted goal of the firm is to maximise shareholder wealth or market value of the firm. This goal incorporates both the profitability and risk into one objective. The firm can maximise shareholder wealth by investing in only those projects that generate positive net present values (NPV). Net present value refers to the discounted sum of the expected net cash flows. The discount rate takes into account the timing and risk of the future cash flows that are available from an investment. The NPV represents the amount of wealth or value added to the firm from the project. Thus, the selection of projects on the basis of NPV criterion directly relates to the achievements of the firms goal.
21 Review questions 2. Discuss the relationships between the firms goal, financial management and capital budgeting.
22 Aspects of Capital Budgeting Capital Budgeting: Emphasize the firms goal of wealth maximization, which is expressed as maximizing an investments Net Present Value: Ch 1 Requires calculating a projects relevant cash flows: Ch 2
23 Aspects of Capital Budgeting Time series analysis by the application of simple and multiple regression, and moving averages:Ch 3 Capital Budgeting Uses: Sophisticated forecasting techniques:- Qualitative forecasting by the application of various techniques, such as the Delphi method:Ch 4.
24 Aspects of Capital Budgeting Capital Budgeting requires: Application of time value of money formulae: Ch 5 Application of NPV analysis to forecasted cash flows: Ch 6
25 Aspects of Capital Budgeting Application of Sensitivity and Brea