LECTURE 5: LONG-TERM INVESTMENT DECISION PROCESS AND RELEVANT CASH FLOWS 5.

0 INTRODUCTION
Long-term investment decisions are important and take up a considerable amount of a financial managers attention because of two reasons: (1) They consume quite a sizable amount of a firms funds (2) The decisions determine the future viability and competitiveness of the firm. Objectives At the end of this lecture you should be able to: 1. Explain the motives for capital expenditure and the steps followed in the capital budgeting process. 2. Define and explain the basic terminologies used to describe projects, funds availability, decision approaches and cash flow patterns. 3. Discuss and compute the major components of relevant cash flows. 4. Calculate, interpret and evaluate the pay back period, the net present value, the profitability index and the internal rate of return of investment proposals. 5. discuss difficulties and conflicts in using discounted cash flow methods . In this lecture we shall discuss the motives, terminologies and procedures in the capital budgeting process. We will also explain the major components of the cash flows employed in making the long-term investment decision. The next lecture will complete

the discussion by examining the specific techniques employed in making the long-term investment decision.

5.1 THE BASICS OF CAPITAL BUDGETING PROCESS

Capital budgeting is the process of evaluating and selecting long term investments consistent with the firms goal of owner wealth maximization. For a manufacturing firm, capital investment are mainly to acquire fixed assets-property, plant and equipment. Note that typically, we separate the investment decision from the financing decision: first make the investment decision then the finance manager chooses the best financing method.

5.1.1

Capital Expenditure Motives

A capital expenditure is an outlay of funds by the firm that is expected to provide benefits over a period of time greater than one year (In contrast, operating expenditures benefits are received within one year). The basic motives for capital expenditures are to expand replace, or renew fixed assets, or obtain some other less tangible benefit over a long period of time. These key motives for making capital expenditures are briefly outlined below. 1. Expansion: The most common motive for capital expenditure is to expand the cause of operations usually through acquisition of fixed assets. Growing firms need to acquire new fixed assets rapidly. 2. Replacements As a firms growth slows down and it reaches maturity, most capital expenditure will be made to replace obsolete or worn out assets. Outlays of repairing an old machine should be compared with net benefit of replacement. 3. Renewal An alternative to replacement may involve rebuilding, overhauling or refitting an existing fixed asset.. A physical facility could be renewed by rewiring and adding air conditioning.

4. Other purposes Some expenditure may involve long-term commitments of funds in expectations of future return i.e. advertising, R&D, management consulting and development of view products. Other expenditures include installation of pollution control and safety devises mandated by the government.

5.1.2

Steps in Capital Budgeting Process

The capital budgeting process consists of five distinct but interrelated steps. It begins with proposal generation, followed by review and analysis, decision making, implementation and follow-up. These six steps are briefly outlined below. 1. Proposal generation: Proposals for capital expenditure are made at all levels within a business organization. Many items in the capital budget originate as proposals from the plant and division management. Project recommendations may also come from top management, especially if a corporate strategic move is involved ( for example , a major expansion or entry into a new market). A capital budgeting system where proposals originate with top management is referred to a top-down system, and one where proposals originate at the plant or division level is referred to as bottom-up system. In practice many firms use a mixture of the two systems, though in modern times has seen a shift to decentralization and a greater use of the bottoms-up approach. Many firm offer cash rewards for proposal that are ultimately adopted. 2. Review and analysis: Capital expenditure proposals are formally reviewed for two reasons. First, to assess their appropriateness in light of firms overall objectives, strategies and plans and secondly, to evaluate their economic viability. Review of a proposed project may involve lengthy discussions between senior management and those members of staff at the division and plant level who will be involved in the project if it is adopted. Benefits and costs are estimated and converted into a series of cash flows and various capital budgeting techniques applied to assess economic viability. The risks associated with the projects are also evaluated. 3. Decision making: Generally the board of directors reserves the right to make final decisions on the capital expenditures requiring outlays beyond a certain amount. 3

Plant manager may be given the power to make decisions necessary to keep the production line moving (when the firm is constrained with time it cannot wait for decision of the board. 4. Implementation: One approval has been received and funding availed implementation commences. For minor outlays the expenditure is made and payment is rendered: For major expenditures, payment may be phased, with each phase requiring approval of senior company officer. 5. Follow-up: involves monitoring results during the operation phase of the asset. Variances between actual performance and expectation are analyzed to help in future investment decision. Information on the performance of the firms past investments is helpful in several respects. It pinpoints sectors of the firms activities that may warrant further financial commitment; or it may call for retreat if a particular project becomes unprofitable. The outcome of an investment also reflects on the performance of those members of the management involved with it. Finally, past errors and successes provide clues on the strengths and weaknesses of the capital budgeting process itself.

5.1.3

Basic Terminology

Before we develop the concept, lecturing and practices of capital budget some basic terminology need to be explained. Independent versus Mutually Exclusive Projects Independent projects are those whose cash flows are unrelated or independent of one another; the acceptance of one does not eliminate the others from further considerations (if a firm has unlimited funds to invest, all independent project that meet it minimum acceptance criteria will be implemented i.e. installing a new computer system, purchasing a new computer system, and acquiring a new limousine for the CEO. Mutually exclusive projects are projects that compete with one another, no that the acceptance of one eliminates the acceptance of one eliminates the others from further consideration. For example, a firm in need of increased production capacity could either,

(1) Expand it plant (2) Acquire another company, or (3) contract with another company for production of required items.

Unlimited Funds versus Capital Rationing Unlimited funds This is the financial situation in which a firm is able to accept all independent projects that provide an acceptable return (Capital budgeting decisions are simply a decision of whether or not the project clears the hurdle rate). Capital rationing This is the financial situation in which the firm has only a fixed number of shillings to allocate among competing capital expenditures. A further decision as to which of the projects that meet the minimum requirements is to be invested in has to be taken. Conventional versus Non-Conventional Cash flows Conventional cash flow pattern consists of an initial outflow followed by only a series of inflows. ( For example a firm spends Sh.10 million and expects to receive equal annual cash inflows of Sh.2 million in each year for the next 8 years) Cash inflows 2m 0 Cash 10m Outflow End of year 1 2 2m 3 2m 4 2m 5 2m 6 2m 7 2m 8

The cash inflows could be unequal Non-conventional cash flows This is a cash flow pattern in which an initial outflow is not followed only by a series of inflows, but with at least one cash outflow. For example the purchase of a machine may require Sh.20 million and may generate cash flows of Sh.5 million for 4 years after which in the 5th year an overhaul costing Sh.8million may be required. The machine would then generate Sh.5 million for the following 5 years.

Inflows 5m Outflows 10m

5m

5m

5m

5m

5m

5m

5m

5m

5m

5m

8m

Evaluating projects with unconventional patterns poses challenges that require an analysts special attention Relevant versus Incremental Cash flows To evaluate capital expenditure alternatives, the firm must determine the relevant cash flows which are the incremental after-tax initial cash flow and the resulting subsequent inflows associated with a proposed capital expenditure. Incremental cash flows represent the additional cash flows (inflowing and outflows) expected to result from a proposed capital expenditure. Sunk Costs versus Opportunity Cost Sunk costs are cash outlays that have already been made (past outlays) and therefore have no effect on the cash flows relevant to a current decision. Therefore sunk costs should not be included in a projects incremented cash flows. Opportunity costs are cash flows that could be realized from the best alternative use of an owned asset. They represent cash flows that can therefore not be realized, by employing that asset in the proposed project. Therefore, any opportunity cost should be included as a cash outflow when determining a projects incremental cash outflows.

5.2 CASH FLOW COMPONENTS

The cash flows of any project can include three basic components: (1) An initial investment (2) Operating cash flows (3) Terminal cash flows. All projects will have the first two; some however, lack the final components. We will discuss these components in following sections.

5.2.1

Initial Investment

The initial investment is the relevant cash outflow for a proposed project at time zero. It is found by subtracting all cash inflows occurring at time zero from all cash outflows occurring at time zero. Atypical format used to determine initial cash flow is shown below. Cost on new asset Installation cost Installed cost of new asset Proceeds from sale of old assets + Tax on sale of old assets After-tax proceeds from sale of old asset + Change in Net working capital Initial Investment XX (XX) XX XX XX XX XX XX

We will elaborate some of the items appearing in the above determination. The installed cost of new asset = cost of new asset (acquisition cost) + installation cost (additional cost necessary to put asset into operation) +After-tax proceeds from sale of old asset. The last variable in the equation is explained as follows. After tax proceeds from sale of old asset =
The difference between old assets sale proceeds and any applicable taxes or tax refunds resulting from the sale of existing assets

Proceeds from sale of old assets +

Cash inflows net of any removal or cleanup cost resulting from the sale of an existing asset(** by the co)

Tax on sale of old asset

Tax that depends upon the relationship between old assets sale proceeds and its written down value(Capital Gains Tax)

Change in networking capital (NWC) Net working capital is the difference between current assets (CA) and current liabilities (CL) i.e. NWC = CA CL. Changes in NWC often accompany capital expenditure decisions. If a company acquires a new machinery to expand its levels of operation, levels of cash, accounts receivables, inventories, accounts payable, accruals will increase. Increases in current assets are uses of cash while increases in current liabilities are sources of cash. As long as the expanded operations continue, the increased investment in current assets (cash, accounts receivables and inventory) and increased current liabilities (accounts payables and accruals) would be expected to continue. Generally, current assets increase by more than the increase in current liabilities, resulting in an increase in NWC which would be treated as an initial outflow (This is an internal build up of accounts with no tax implications, and a tax adjustment is therefore unnecessary).

5.2.2
-

Operating Cash Flows

These are incremental after tax cash during its lifetime. Three points should be noted:Benefits should be measured on after tax basis because the firm will not have the use of any benefits until it has satisfied the governments tax claims. All benefits must be measured on a cash flow basis by adding back any non-cash charges (depreciation) Concern is only with the incremental (relevant) cash flows. Focus should be only on the change in operating cash flows as a result of proposed project. The following income statement format is useful in the determination of the operating cash flows.

Shs Revenue Expenses Profits before depreciation Depreciation Profit before tax Taxes Profit after taxes Add back depreciation Operating Cash flows XX (XX) XX (XX) XX (XX) XX XX XX

5.2.3

Terminal Cash Flows

The cash flows resulting from the termination and liquidation of a project at end of its economic life are its terminal cash flow. Terminal cash flow is determined as incremental after tax proceeds from sale or termination of a new asset or project. The format below can be used to determine terminal cash flows. Proceeds from sale of new assets Project Tax on sale of new asset Proceeds from sale of old asset Tax on sale of old asset Change in NWC Terminal Cash Flow XX XX XX XX XX XX XX XX

Note that for a replacement decision both the sale proceeds of the old asset and the new asset are considered. In the case of other decision (other than replacement), the proceeds of an old asset would be zero. Note also that with the termination of the project the need for the increased working capital is assumed to end. This will be shown as a cash inflow due to the release of the working capital to be used business needs. The amount recovered 9

at termination will be equal to the amount shown in the calculation of the initial investment.

5.3 CAPITAL INVESTMENT TECHNIQUES

The preferred technique should time value procedures, risk and return considerations and valuation concepts to select capital expenditures that are consistent with the firms goals of maximizing owners wealth. The three most popular techniques are the payback period, net present value, and internal rate of return. We will use one basic problem to illustrate all the techniques. Example The problem concerns MALI Limited, a medium sized metal fabricator that is currently contemplating two projects: project A requires an initial investment of Sh.42million and project B requires an initial investment of Sh.45million. The projected relevant cash flows for the two projects are shown below. PROJECT A Sh.42 million Sh.14 million Sh.14 million Sh.14 million Sh.14 million Sh.14 million Sh.14 million PROJECT B Sh.45 million Sh.28 million Sh.12 million Sh.10 million Sh.10 million Sh.10 million Sh.14 million

Initial Investment (yr 0) Operating cash flows Year 1 Year 2 Year3 Year 4 Year 5 Average

5.3.1

Payback Period

The payback period is the exact amount of time required for the firm to recover its initial investment in a project as calculated from cash inflows. In case off an annuity the pay back period can be found by dividing initial investment by annual cash inflow. For a mixed stream of inflows the yearly cash inflow must be accumulated until the initial investment is recovered.

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Decision Criteria When pay back period is used to make accept/reject decision, the decision criteria are as follows: If the Pay back period is less than the maximum acceptable Pay back period set by management accepts the project. If the pay back period is greater than the maximum acceptable pay back period, reject the project The length of the maximum acceptable pay back period is subjectively determined by management based on factors such as the type of project (i.e. replacement or expansion), the risk of the project, and the perceived relationships between pay back period and share values, past experiences and future prospects. It will be the length of time management feels results in good value-creating investment decisions. Calculating Pay Back Period for MALI Limited For project a (annuity Stream) Pay back period = 42 = 3.0 years 14

For project B (a mixed stream), the initial investment of Sh.45million will be recovered between the 2nd and 3rd year-ends. Year 1 2 3 4 5 2+ Cash flow (Sh) 28million 12million 10million 10million 10million 5 = 2.5 years 10 Cumulative cash flow (Sh.) 28million 40million 50million 60million 70million

Pay back period

Only 50% of year 3 cash inflows of Sh.10million are needed to complete the pay back period of the initial investment ofSh.45million. Therefore pay back period of project B is 2.5 years.

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If MALI Ltd.s maximum acceptable Pay back period was 2.75 years, Project A would be rejected and project B would be accepted. If projects were being ranked, Project B would be preferred. 5.3.1.1 Strengths and Weaknesses of the Pay Back Period Method The Pay back period is widely used by (1) large firms to evaluate small projects; (2) small firms to evaluate most projects. Advantages of the pay back period. The pay back period boasts the following strengths: Is simple and has intuitive appeal It considers cash flows rather than accounting projects Can be viewed as a measure of risk exposure can be used as a supplement to other sophisticated techniques

Weaknesses of the pay back period. The method suffers from the following shortcomings: 1. The benchmark Pay back period used is merely a subjectively set number y management (the maximum number of years management decides cash flows must breakeven no link to wealth maximization). 2. Fails to take fully into account time factor in the value of money. This weakness can be demonstrated using the following example.

Example A company is considering two projects, Project Gold and Project Silver, whose relevant cash flows are given below. Project GOLD Project SILVER Initial Investment _Year 1 Sh. 50million Sh.50 million

_______________________________________________________________________ Cash flows (Sh.) 5 million 80 million

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2 3 4 5 Pay back period

5 million 40 million 10 million 10 million 3 years

2 million 8 million 10 million 10 million 3 years

Both projects have 3-year Pay back periods but more of the Sh.50million of the initial investment in project Silver is received sooner than is recovered for project Gold within the 3-year Pay back periods. 3. Failure to recognize cash flows after the pay back period. Example Take the following data for two projects, X and Y. X Initial Investment Year 1 2 3 4 5 Pay back period Sh.5million 5 million 1 million 0.1 million 0.1 million 2 years Sh.10million Cash flow Sh.3 million 4million 3million 4million 3 million 3 years Y Sh. 10million

Strict adherence to pay back period suggests that project X be preferred. But we looked beyond Pay back period we see that Project X returns a paltry Sh.1.2million while project Y would bring in Sh.7million.

5.3.2

Net Present Value (NPV)

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A sophisticated capital budgeting technique; found by subtracting a projects initial investment from present value of its cash inflows discounted at a rate equal to the firms cost of capital. NPV = PV of cash inflows Initial Investment (II)

NPV =
n

CF (1+ k )
n t t =1

II ( Initial Investment )

(6.1)

= CF t * PVIF k ,t II
t =1

Decision Criteria When NPV is used to make accept reject decisions, the decision criteria are as follows: If the NPV is greater than 0, accept the project If the NPV is less than 0, reject the project.

If NPV > 0, the firm will earn a return greater than its cost of capital, thereby enhancing the market value of the firm and shareholders wealth. Calculating NPV for MALI Limited. Project A Annual Cash inflow (annuity) PVIFA 10%, 5 years (table A-4) PV Less initial Investment Net Present Value Sh.14million * 3.791 53.074million 42.million 11.074million

Project B Year Cash Inflows PVIF PV 14

1 2 3 4 5

28million 12m 10m 10m 10m Present Value

.909 .826 .751 .683 .621

25.452m 9.912m 7.510m 6.830m 6.210m 55.914m 45.000m 10.912m

Less initial investment NPV

5.3.3

The Internal Rate of Return (IRR)

Probably the most sophisticated capital budgeting technique, the internal rate of return (IRR) is the discount rate that equates the PV of cash inflows with the initial investment associated with the project (thereby causing NPV = 0). In other words, it is the compound annual rate of return , which would cause the investor to be indifferent between investing in the project and not investing in it.the firm will earn if it invests in the project and received the given cash flows. Mathematically, the IRR is found by solving the following equation for k

CF (1+ k )
n t t =1

= II ( Initial Investment )

Decision Criteria The IRR is used to make accept-reject decision as follows: If the IRR is greater than the cost of capital, accept the project. If the IRR is less than the cost of capital, reject the project. The decision rule guarantees that the firm earns at least its required return (cost of capital) which should enhance its market value and the wealth of its owners. Calculating the IRR

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It is not usually a simple matter to determine the internal rate of return of an investment without a financial calculator, a computer, or solving high order equations. In practice, a method of approximation (Trial and error) which gives answers accurate to two decimal places in the percentage figure is employed. Trial and Error Approach For an annuity calculating the IRR is considerably easier than calculating it for a mixed stream of operating cash inflows. The steps of the trial and error process are as follows: (1) Calculate Pay back period for the project (2) Find, from PVIFA, tables for the life of the project, the PVIFA closest to the Pay back period calculated in (1) above. (3) The discount rate associated with the factor is the projects IRR For Mali Company Project A has an annuity stream Payback period = 42,000,000/14,000,000 = 3.000. According to table of PVIFAs (Table A4), the PVIFA closest to 3.000 for 5years, is 3.058 (for 19%) and 2.991(for 20%). The value closest to 3.000 is 2.991; therefore, the IRR of the project A, to the nearest 1%, is 20%. Interpolating = 20 of 19.86%. Since the cost of capital for Mali Ltd is 11% the project is acceptable. For Mixed cash flow Stream Steps. Project B has a mixed operating cash flow stream. Having already worked out the projects NPV at the discount rate of 11% to be Sh.10.922 million, the discount rate that should result to zero NPV would have to be considerably higher than 11%.The trial and error steps proceed as follows, and are summarized in Table 5.4 below. We try first a discount rate of 20%, which gives an NPV of Sh.1,282,000. We have to try a higher rate, say, 21%. The NPV is Sh.+494,000. A higher discount rate of 22% makes the NPV to turn negative to Sh. -256,000. The IRR lies between 21% and 22%: to the nearest 1% it is 22% 3.000 2.991 * 1%(20% 19%) , will give a more accurate IRR 3.058 2.99

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We can interpolate to get a more accurate rate. 22 +

0 256 = 21.66% 494 256

Table 5.4: determining IRR through trial and error process Try 20% Try 21% Year CFs PVIF PV PVIF PV 0 -45m 1.000 -45m 1.000 -45m 1 +28m .833 +23.324m ..826 +23.128m 2 12m .694 +8.328m .683 +8.196m 3 +10m .579 +5.79m .564 +5.640m 4 +10m .482 +4.82m .467 +4.670 5 +10m .402 +4.02m .386 +3.860 +1.282 +.494

Try 22% PVIF 1.000 .820 .672 .551 .451 .370

PV -45m +22.96m +8.064m +5.510 +4.410m +3.700 -.256

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5.3.4 NPV Profile

In general the NPV and the IRR methods lead to the same accept reject decision. The graph

NP V

IRR

Discount rate

Shows the relationship between NPV and discount k.. When discount rate is zero NPV is simply total cash inflows less total cash outflows. (The highest NPV will occur with 0% discount rate). As the discount rate increases, the NPV falls and the graph slopes

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downwards to the right. When the curve intersects the horizontal axis NPV is zero and the discount rate at this point, by definitions, represents the IRR.. For discount rates higher than the IRR, the NPV is negative. It is clear from the profile that the NPV rule will be consistent with the IRR decision rule: If the cost of capital (required rate of return) is less than the IRR, the project will be accepted because NPV is positive. For required rates greater than the IRR we would reject project because the NPV would be negative.

5.3.5

Profitability Index

The profitability index (PI) or benefit cost ratio of a project is the ratio of the PV of future net cash flows to the initial cash outlay. It can be expressed as PI =
t =1 n

CF / II , where II is the initial outlay. (1+ k )

t t

Acceptance Criterion. As long as the PJ is 1.00 or greater the investment proposal is acceptable. For most projects, the NPV method and the PI method give the same accept/reject signals. Using Mali Ltd examples the PIs of the two projects are: Project A, PI = Project B, PI = PV (CFs ) 53,074,000 = = 1.26 . InitialInvestment 42,000,000 PV (CFs ) 55,914,000 = = 1.24 . InitialInvestment 45,000,000

Both projects are acceptable as their Profitability indexes are greater than 1.0. However, Project A is marginally better than Project B.

5.4 POTENTIAL DIFFICULTIES IN USING

DISCOUNTED CASH FLOW METHODS

For a single conventional, independent projects, the IRR, NPV and PI methods lead us to make similar accept/reject decision. Various types of circumstances and projects differences can cause ranking difficulties. Four situations that could cause inconsistencies arise: (1) when funds are limited necessitating capital rationing and, 19

(2) when ranking two or more project proposals with varied lives, (3) when ranking two or more projects with different Investment scales, and (4) when projects have opposite cash flow patterns.

5.4.1

Capital Rationing

Occurs any time there is a budget constraint or ceiling on the amount of money that can be invested during a specific period of time (For example, the company has to depend on internally-generated funds because of borrowing difficulties, or a division can make capital expenditures only up to a certain ceiling). With capital rationing, the firm attempts to select the combination of investments that will provide the greatest increase in the firm of the value subject to the constraining limit. Example Assume your firm faces the following investment opportunities: Project A B C D E F G H Initial Cash Flows Shs.000 50,000 35,000 30,000 25,000 15,000 10,000 10,000 1,000 15% 19 28 26 20 37 25 18 IRR NPV Sh.000 12,000 15,000 42,000 1,000 10,000 11,000 13,000 100 1.24 1.43 2.40 1.04 1.67 2.10 2.30 1.10 PI

If the budget ceiling for initial cash flows during the present period is Shs.65,000,000 and the proposals are independent of each other, your aim should be to select the combination projects that provide the highest in firm value the Shs.65 m can deliver. Selecting projects in descending order of profitability according to various discounted cash flows methods, which exhausts Sh.65 million reveals the following: Using the IRR Project IRR NPV Sh 000 Initial outlay Shs.000 Using the NPV Project NPV Sh 000 Initial flow Sh.000 20

A B C

37% 28 26

11,000 30,000 25,000 54,000

10,000 30,000 25,000 65,000

C B

42,000 15.000 57,000

30,000 35,000 65,000

Using the PI Project PI C G F E 2.40 2.30 2.10 1.67 NPV Sh000 42,000 13,000 11,000 10,000 76,000 Initial outlay Sh000 30,000 10,000 10,000 15,000 65,000

With capital rationing you would accept projects C, E, F and G which deliver an NPV of Sh.76million. The universal rule to follow is When operating under a constraint, select the projects that deliver the highest return per shilling of the constraint (the initial investment outlay). Put another way, select that mix of projects that gives you the biggest bang for the buck. We achieve this buy employing the profitability index which ranks projects on the basis of the return per shilling of initial investment outlay. Under conditions of capital rationing it is evident that the investment policy is less than optimal Optimal policy requires that no positive NPV projects be rejected.

5.4.2

Scale Differences

Example Suppose a firm has two mutually exclusive projects that are expected to generate following Cash flows End of Year 0 1 Project A Cash flows (Sh) -1000,000 0 Project B Cash flows (Sh) -100,000,000 0

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400,000 IRR NPV Sh000 231 29,132

156,250,000 PI 3.31 1.29

If the required rate of return is 10% the NPV, IRR and PI of the projects are as below:

Project A Project B

100% 25%

Ranking of projects based on our results RANKING 1st 2nd IRR A B NP B A PI A B

Using the IRR and PI shows preference for project A, while NPV indicates preference for Project B. Because IRR and PI are expressed as a proportion the scale of the project is ignored. In contrast results of NPV are expressed in absolute shilling increases in value of the firm. With regard to absolute increase in value of the firm, NPV is preferable.

5.4.3 IRR)
patterns. End of year

Differences in Cash Flow Patterns (Multiple

Example Assume a firm is facing two mutually exclusive projects with following cash flow Project C Cash flows Sh000 0 1 2 3 -1,200 1,000 500 100 Project D Cash flows Sh000 -1,200 100 600 1,080

Note that project Cs cash flows decrease while those of project D increase over time. The IRR for projects are as follows 22

Project C - 33% Project D - 17% For every discount rate> 10% project Cs NPV and PI will be> than project Ds. For every discount rate < 10% project Ds NPV and PI will > project Cs. K<10% RANKING 1st 2nd IRR C D NPV D C PI D C K>10% NPV C D PI C D

When we examine the NPV profiles of the two projects, 10% represents the discount rate at which the two projects have identical NPVs. This discount rate is referred to as Fishers rate of intersection. On one side of the Fishers rate it will happen that the NPV and PI on one hand, and the IRR on the other give conflicting rankings. We observed conflict is due to the different implicit assumption with respect to the reinvestment rate on intermediate cash flows released from the project. The IRR implicitly assumes that funds can be reinvested at the IRR over the remaining life of the project. With the IRR the implicit reinvestment rate will differ from project to project unless their IRRs are identical. For the NPV and PI methods assume reinvestment at a rate equal to the required rate of return as the discounts factor. The rate will be the same for all projects. Since the reinvestment rate represents the minimum return on opportunities available to the firm, the NPV ranking should be used. In this way, we identify the project that contributes most to shareholder wealth.

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5.4.4

Differences in Project Lives

When projects have different lives, a key question is what happens at the end of the shortlived project? Two alternatives assumptions can be considered. (1) Replace with (a) identical project or (b) a different project. (2) Do not replace. The Do not replace alternative is considered first. Example Suppose you are faced with choosing between 2 mutually exclusive investments X and Y that have the following Cash flows. End of year Project X Cash flows Sh. 000 0 1 2 3 follows: IRR X Y RANKING Rank 1st 2nd IRR Y X NPV X Y PI X Y 50% 100% NPV Sh000 1536 818 2.54 1.82 PI - 1000 0 0 3,375 Project Y Cash flows Sh. 000 - 1000 2000 0 0

If the required rate of return is 10% we can summarize our investment appraisal results as

Once again a conflict in ranking arises. Both the NPV and the PI prefer project X to Y, while The IRR criterion choose Y over X. Again, in this case of no replacement, the NPV method should be used because it will choose projects that add the greatest absolute increment in value to the firm.

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Replacement Chain When faced with a chose between mutually exclusive investments having unequal life that will require replacement, we can view the decision as one involving a series of replications or a replacement chain of respective alternatives over some common investment horizon. Repeating each project until the earliest rate that we can terminate each project in the same year results in a multiple like-for-like replacement chains covering the shortest common life. We solve the NPV for each replacement chain as follows: NPV chain = Where n = single replication project life in years NPV= singe replication NPV for a project with n- year R = umber of replications needed K= discount rate The value of each replacement chain therefore is simply the PV of the sequenced of NPV , generated by the replacement chain. Example Assume the following regarding mutually exclusive investments alternatives A and B, both of which requires future replacement Project A Single replication life (n) Single replication PV calculated at project specific required rate of return (NPVn) Number of replication to provide shortest common life Project specific discount rate Sh. 5,328 2 10% Sh. 8000 1 10% 5 years project B 10 years

At first glance project B looks better than project A (8000 Vs 5328). However the need to make future replacements dictates that we consider values provided over same common life i.e. 10 years. The NPV can then be re-worked as follows

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NPV for first 5 years NPV for replicated project=5328* NPV of chain

= 5328

PVIF

10%, 5 yrs

= 3303 8638

The NPV of project B is already known i.e. Sh. 8000. Comparing with Sh. 8638 present value of the replacement chain, project A is preferred.

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REVIEW QUESTIONS 1. Define, and differentiate between each of the following sets of capital budgeting terms; (a) independent vs. mutually exclusive projects (b) unlimited funds vs. capital rationing (c ) accept/reject vs. ranking approaches (d) conventional vs. non conventional cash flow patterns. (e) annuity vs. mixed stream cash flows (f) Bank vs. opportunity cost (g) incremental cash flows vs. irrelevant cash flows. 2. Describe each of the following input to the initial investment, and show how the initial investment is calculated by using them. (a) cost of new assets (b) installation cost (c) proceeds from sale of old asset (d) tax on sale of old asset; and (e) change in net working capital. 3. 4. 5. 6. 7. 8. What is the terminal cash flow? Explain its determination in a replacement decisions. What is the internal rate of return (IRR) on an investment? How is it determined? Do the net present value (NPV) and internal rate of return (IRR) always agree with respect to talking decisions? Explain. What is capital budgeting? What are the key motives for making capital expenditure? Why does capital budgeting rely for analysis purposes on cash flows rather than net income.

PROBLEMS 5.1 The Mbuni Glass Company uses a process of capital rationing in its decision making .The firms cost of capital is 13% . The company will only invest Sh. 60 million this year. It has determined the internal rates of return for the following projects. Project Project Size(Shs millions) Internal rate of return A 10 15% B 30 14% C 25 16.5% 27

D 10 17% E 10 23% F 20 11% G 15 16% Required (a) Pick the projects that the firm should accept. (b) If projects D and E were mutually exclusive, how would that affect your overall answer in (a) above. 5.2 Maringo Ltd.'s chief financial officer (CFO) expects the firms profits after taxes for the next 5 five years to be as follows. Year Net profits after taxes (Shs millions) 2008 100 2009 150 2010 200 2011 250 2012 320 The CFO is beginning to develop the relevant cash flows needed to analyze whether to renew or replace the companys only depreciable asset, a machine that originally cost Sh.30 million, has a current book value of zero, and can now be sold for Sh.20 million. He estimates that at the end of 5 years the existing machine can be sold to net Sh.2 million before taxes. The CFO plans to use the following information to develop the relevant cash flows for each of the alternatives. Alternative I: Renew the existing machine at a total depreciable cost of Sh.90 million. The renewed machine will have a 5 year useful life and be depreciated on straight line basis with a salvage value of Sh.10 million. The renewal decision could result in the following projected revenues and expenses (excluding taxes). Year Revenue (millions) Expenses (excldg. Depn) (millions 200 1,000 801 8 200 1,175 884 9 201 1,300 918 0 201 1,425 943 1 201 1,550 968 2 The renewed machine would result in an increased investment of Sh.15 million in net working capital. Alternative II: Replace the existing machine with a new machine costing Sh.100 million and requiring installation cost of Sh.10 million. The new machine would have a usable life of 5 years and a salvage value after 5 years of Sh.20 million before taxes. The firms

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projected revenues and expenses (excluding depreciation) if it acquires the machine, would be as follows: Year Revenue ( Shs millions) Expenses (Shs millions) 2008 1,000 764 2009 1,175 839 2010 1,300 914 2011 1,425 989 2012 1,550 998 The new machine would result in an n increased investment of Sh.22 millions in net working capital. The firm is subject to 40% tax on both ordinary income and capital gains> Required a. Calculate the initial investment associated with each alternative b. Calculate the incremental operating cash flows associated with each alternative c. Calculate the terminal cash flows at the end of year 5 associated with each alternative. d. Based solely on the cash flows (without discounting) which alternative appears to be better? Why? 5.3 Pima Watch Company Ltd. is considering an investment of Sh.1,500,000, which produces the following inflows. Cash flow 1 Sh.800,000 2 700,000 3 400,000 You are going to use the net present value profile to approximate the value for the internal rate of return. Follow the following steps. (a) Determine the net present value of the project based on a zero discount rate. (b) Determine the net present value of the project based on a 10% discount rate. (c) Determine the net present value of the project based on a 20% discount rate. (d) Draw the NPV profile of the project and observe the discount rate at which the NPV is zero. This is an approximation of the IRR of the project. (e) Actually compute the IRR by interpolation and compare your answer to the answer to part (d). 5.4 Waziri Industries is currently analyzing the purchase of a new machine costing Sh.16,000,000 and requiring Sh. 2,000,000 in installation costs. The use of this machine is expected to result in an increase in net working capital of Sh.3,000,000 to support the expanded level of operations. The firm will write down the installed cost of the machine at a rate of 20% per annum for tax purposes and expects to sell the machine to net Sh.1,000,000 before taxes at the end of its usable life. The firm is subject to 30% tax rate on both ordinary income and capital gains. Required Year

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(a) Calculate the terminal cash flow for a usable life of (1) 3 years (2) 5 years, and (3) 7years. (b) Discuss the effect of usable life on terminal cash flows using your findings in (b). (c) Assuming a 5 year usable life, calculate the terminal cash flows if the machine were sold to net (1) Sh.900,000 (2) Sh.17,000,000 before taxes at the end of 5 years. (d) Discuss the effect of sale price on terminal cash flows using your findings in (c). 5.5 A machine currently in use was purchased two years ago for Sh.4 million. The machine is being depreciated on a straight line basis to write off the cost over a 5 year usable life. The current machine can be sold today to net Sh.3.6 million. After removal and cleanup costs. A new machine with a three year usable life can be purchased today at a price of Sh.14 million. It requires Sh.1 million to install and has a usable life of 3 years. If the new machine were acquired the investment in accounts receivable will increase by Sh.1 million and inventory investment will rise by Sh 2.5 million., and accounts payable would increase by Sh.1.5 million. Profits before depreciation and taxes are expected to be Sh.7 million for each of the next 3 years with the old machine and Sh.12 million in the first year and Sh.13 million for each of the next 2 years with the new machine. At the end of the next 3 years the market value of the old machine will equal to zero, but the new machine will be sold to net Sh.3.5 million before taxes. Both ordinary corporate income and capital gains are taxed at the rate of 30%. Required (a) Determine the initial investment associated with the proposed replacement. (b) Calculate the incremental cash flows associated with the replacement decision for the next 3 years. (c) Calculate the terminal cash flows associated with the replacement decision. (d) Depict on a time line the relevant cash flows found in (a), (b) and (c) associated with the proposed replacement decision. 5.6 Molo Limited is developing the relevant cash flows associated with the proposed replacement of an existing machine tool with a technologically advanced one. Given the following costs associated with the replacement decision explain whether each could be treated as a sunk or opportunity cost. (a) Molo would be able to use the same tooling it had used on the old machine (which has a book value of Sh.4 million) for the new machine. (b) Molo would be able to use its existing computer system to develop programs for operating the new machine tool. The old machine tool did not require these programs. Although the firms computer system has excess capacity the capacity could be leased to another firm for an annual fee of Sh.1.7 million. (c) Molo would have to acquire additional space to accommodate the new larger machine tool. The space that would be used is currently being leased to another company for Sh.1 million.

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(d) Molo would use a small storage facility to store the increased output of the new machine tool. The storage facility was built by Molo at a cost of Sh.12 million 3 years ago. Because of its unique configuration and location, it is currently of no use to either Molo or any other company. (e) Molo would retain an existing overhead crane which it had planned to sell for its Sh. 18 million market value. Although the crane was not needed with the old machine it will be used to position raw materials on the new machine tool. 5.7 Bidii Limited is in the process of choosing the better of two equal risk, mutually exclusive, capital expenditure projects. The relevant cash flows for each project are shown below. The firms cost of capital is 14%. Year Project M Project N 0 (Initial investment) -Sh.28,500,000 -Sh.27,000,000 1 (Operating cash flows) +Sh.10,000,000 +Sh.11,000,000 2 . +Sh.10,000,000 +Sh.10,000,000 3 +Sh.10,000,000 +Sh.9,000,000 4 +Sh.10,000,000 +Sh.8,000,000 Required (a) (b) (c) (d) (e) Each projects pay back period The NPV for each project The IRR for each project Summarize the decision criterion for each measure calculated above. Draw the NPV profiles for each project on the same axes and explain circumstances under which conflicts in ranking may arise. 5.8 Magarini Limited is considering two mutually exclusive projects. The firm which has a cost of capital of 12% t\has estimated the following cash flows. Year Project A Project B 0 (Initial investment) -130 million -85 million 1 (Operating cash flows) 25 million +40 million 2 35 million +35 million 3 45 million +30 million 4 50 million +10 million 5 55 million +5 million Required (a) NPV of each project (b) IRR of each project (c) Draw NPV profile of each project on same axes. (d) Evaluate and discuss the ranking of the projects based on your findings above. (e) Explain your findings in (d) in light of the pattern of cash flows associated with each project. 5.9 Mzima Limited is considering the purchase of a new printing press. The total installed cost of the printing press is Sh 22 million. This outlay could be partially offset by the sale of an existing press, which has a book value of nil, was purchased at Sh.10 million10 years ago and could be sold to fetch Sh. 12 million currently before taxes. As a result of the new press sales for each of the next 5 years are expected to increase by Sh. 16 million, but product costs (excluding

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depreciation) will represent 50% of the sales. The new press will not affect the firms working capital requirements. The new press will be write-down on declining balance for a period of 5 Years. Assume a tax rate of 40%. Required (a) Determine the initial investment (b) Operating cash flows attributable to the new press (c) The pay back period. The NPV and the IRR related to the proposed new press. (d) Make a recommendation to accept or reject the new press and justify your answer. 5.10 Mugoya Limited, a large machine shop, is considering replacing one of its lathes with either of two new lathes, Bingwa or Hodari. Bingwa is highly automated , computer controlled lathe; Hodari is a less expensive lathe that uses standard technology. A financial analyst has prepared estimates of the initial investment and incremental cash flows associated with the two lathes as shown below. Year Bingwa (Shs, millions) Hodari (Shs. millions) 0 (Initial investment) -660 -360 1 (Operating Cash flows) +128 +88 2 +182 +120 3 +166 +96 4 +168 +86 5 +450 +207 Fifth year cash flows include the salvage value of the lathes. Mogayas cost of capital is 13% and is in the 40% tax bracket and requires all project to have a maximum payback period of 4 years. Required a. Determine the pay back period for each lathe b. Assess the acceptability and ranking using (1) NPV and (2) IRR c. Summarize project rankings according to the 3 techniques above. Is there any conflicts d. Which lathe should ultimately be accepted? Why?

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