Introduction
This week’s summary has been a little slow coming as I have been having a wonderful time writing a spreadsheet for all the calculations involved in this subject. I had forgotten how much I enjoyed this type of work and it has been a great experience rediscovering the power of spreadsheets.
Irrespective of the organisation’s size, there will always be the need to make decisions around investments and spending. The term Capital Budgeting applies to the assessment of varying options to provide the data on which sound decisions can be based [1].
The steps involved in making decisions on Capital Budgeting are to:-
- Make a list of all possible projects considered profitable
- Assess each project using sound standards and benchmarks
- Make your decision on the best project
Essentially, there are three types of capital investment projects:-
- Projects that will enhance revenue and profits
- Projects that will reduce costs and therefore increase profits
- Projects that are required by law such as reduction in emissions. These projects neither enhance income or reduce costs.
Net Present Value Method
Net Present Value (NPV) is commonly used by organisations when assessing capital projects. NPV considers the time value of money looked at in the previous module. In addition, when considering projects, it’s the incremental value of cash flows that is important and not profit. Profit is only an accounting measure, not a cash measure. So NPV is basically the difference between the cash inflows and the cash outflows as a result of investing in the project. For example, cash inflows from investing in a new rental property would be the inflows of rent. Cash outflows would be repayments, maintenance and interest on borrowings.
In order that the project be worthy of consideration, the NPV must be greater than zero. Another way of putting this is that the total of the discounted cash flows (in and out), must be greater than, or equal to, the original investment.
NPV Formulae
$$NPV\ =\ (rate ,\ Cash\ Flow\ Year\ 1 ,\ …(Insert\ all\ payments))$$
This formula is missing the initial investment. Consequently, it does not calculate the true NPV, only that of the payment stream.
$$NPV\ =\ (i,\ Cash\ Flow\ Period\ 1,\ + Cash\ Flow\ Period\ 2$$
$$+ …(Insert\ all\ subsequent\ cash\ flows))$$
$$ -\ Initial\ Investment/Expenditure/Cost$$
Profitability Index (PI)
The profitability index measures the relationship between the costs of a project and the benefits of a project. The higher the result, the more value a project can be considered to have.
$$Profitability\ Index\ =\frac{PV\ of\ Future\ Cash\ Flows}{Initial\ Investment}$$
Internal Rate of Return (IRR)
The internal rate of return sums the discounted cash flows of an investment and then returns a rate of return when the project value equals zero. The formula to calculate the internal rate of return starts out by using a guess value usually based on the organisation’s desired rate of return. If this is calculated on a spreadsheet such as Excel, then no guess value is required for the formula to work.
$$IRR\ =\ Initial\ Investment\ +\ \frac{Year\ 1\ Return}{1\ +\ Guessed\ Rate}$$
$$+\ \frac{Year\ 2\ Return}{1\ +\ Guessed\ Rate}\ +\ ……$$
The formula works by adding all the future discounted cash flows. The initial investment is entered as a negative amount as it is an outflow.
Payback Period (PP)
The payback period is the amount of time it will take to recover the initial investment. There are two ways to calculate the payback period. The first is the time to recover the initial investment using the cash flows each period. The second method is to discount the cash flows which probably provides a more accurate result because you are dealing with the real values. Both methods are calculated with my spreadsheet.
Like anything, the PP has its pros and cons.
Pros
- Quick indicator of how long it will take to recover investment
- The quicker the payback period the lower the risk
Cons
- The simple method doesn’t recognise the time value of money
- The calculation determines the amount when the investment is paid back but ignores cash flows after that.
Cost of Capital
The cost of capital is dynamic and dependent on how an organisation is funding its operations. Whatever the rate may be, it is this rate that must be exceeded by any investment decisions or they will be providing a negative return. This can also be known as the Required Rate of Return (RRR)
The source of capital can be by way of:-
- Debt and bonds
- Preference Shares (Company only)
- Ordinary Shares (Company only), Owner contribution (Sole trader and partnership)
The decision regarding the type of capital sourcing in influenced by a number of factors including:-
- The current debt to equity ratio. How highly geared is the business
- Debt requires regular repayments irrespective of economic times or profit levels
- Shares can pay dividends dependent on profit
- Preference shares often have a fixed rate or return
- Interest rates can be volatile at times
The discount rate or cost of capital rate applied to a potential project is representative of all the factors an organisation incurs as costs when acquiring capital. Calculation of these costs results in the Weighted Average Cost of Capital (WACC). The more risky the company is perceived by external investors, the higher its WACC will be.
Easy Spreadsheet Calculations
The spreadsheet I mentioned in last week’s post has been upgraded. It now contains all the formulae mentioned in this post and some other modifications. Some of my peers have downloaded the spreadsheet and confirmed that the formulae are working accurately. More importantly, it is a very easy way to get the answers required for an investment project.
Feel free to download from the Resources link in the menu.
Summary
This module introduced some calculations and ratios with which I wasn’t familiar. It was an interesting journey exploring them though. It was also a steep learning curve on Excel writing formulae I had never used before. Despite that and the amount of time spent on this module as a result, it has been extremely enjoyable. The week also saw the lodgment of Assessment 1 but results won’t be out until at least next week I imagine.
References- Course: 8006FMGT Financial Management 2022 Term 5, Topic: Week 5 Capital budgeting 2022, Aib.edu.au, viewed 26 September 2022, <https://learning.aib.edu.au/course/view.php?id=1265§ion=7>[↩]
