2 Outline Projects with Unequal Lives Equivalent Annual Costs Capital Budgeting and Inflation Capital Rationing Assessed Tax Losses Optimal Economic Lives Strategic Options Theory and Practice 3 Projects with Unequal Lives How do we choose between alternatives with unequal economic lives?
It may not be possible to compare Net
Present Values.
Need a universal measure to ensure
comparability. 4 Example Projects with unequal lives
Should we select Project Y with the higher NPV?
If there is an opportunity to reinvest in a similar project X in 3 years, then the NPV for Project X will be:
5 Projects with Unequal Lives We should compare 2 X with 1 Y.
X X
Y PV Factor Equivalent Annual Annuities Project X – 13.01/2.3216 = R5.604m Project Y – 17.22/3.8887 = R4.428m Not applicable for independent projects and if projects cannot be repeated. What are inflation and currency effects on the cost of new equipment? Changes in technology Risk minimised by investing in smaller project? 6 Equivalent Annual Costs We can convert capital costs into Equivalent Annual costs. Project X - 52m/2.3216 = 22.4m Project Y - 80m/3.8887 = 20.57m If the annual cash flows were the same, Project Y would be selected as it minimises the annual cost of the investment. Further adjustments required for capital tax allowances, which will reduce the real cost of investments in fixed assets. 7 Capital Budgeting and Inflation No adjustment for inflation may result in material errors in capital budgeting decisions. Why? Inflation is included implicitly in the discount rate Nominal rate (1+ Real rate)(1+Inflation rate) – 1 If the expected inflation rate is 7% and the real rate is 4%, then the nominal (quoted) rate is 11.3%. 8 Capital Budgeting and Inflation Discount nominal cash flows at a nominal discount rate Discount real cash flows at a real discount rate
Example: future cash flows stated in today’s prices
discounted at a nominal discount rate of 11%.
NPV is negative – do not accept the project.
9 Capital Budgeting and Inflation Adjust future cash flows by inflation of 4.72% per year and NPV becomes positive.
Tax excluded in above example. Depreciation deductions do
not increase with inflation as tax allowances are based on historical cost. Refer to example in textbook to see what happens. 10 Capital Rationing Used when a lack of capital prevents a company from selecting all positive NPV projects. Projects 1 – 4: IRR > WACC Should be accepted.
Project 5: IRR < WACC Should be rejected.
Capital constraint of R70m means only Project 1 and 2 can be accepted. 11 Why Does Capital Rationing Occur? Hard Capital Rationing Capital Markets. Does this mean capital markets are not efficient? Soft Capital Rationing Use of capital limits to ensure subsidiaries prioritise investments. Capital limits ensures discipline in relation to investments by lower level management.
12 Profitability Index (Benefit-Cost Ratio)
A project’s PI measures the return of a
project relative to cost
PI = Present Value/Cost
If PI > 1 = Accept the project
If PI < 1 = Reject the project
13 Capital Rationing Rules Maximise the total NPV subject to the capital constraint. Use the Profitability Index to rank projects if projects are divisible Why? The PI measures the return relative to cost.
14 Capital Rationing & PI Example:
15 Reasons for Capital Rationing Smaller firms have limited ability to raise debt and equity finance Smaller firms may find it difficult to raise long- term debt at fixed rates Firms with a short lifespan have difficulty raising finance Firms may be unwilling to issue equity to finance projects if the share price is unfavourable
16 Capital rationing: use of a hurdle rate In order to manage capital rationing, firms may set a hurdle rate that is higher than the cost of capital In figure 9.3, if we use a hurdle rate of 20%, then only projects 1 and 2 would be accepted What the disadvantages with using a hurdle rate?
17 Assessed Tax Losses Assume: New project results in a cash inflow of R5m per year. That existing product lines are currently also producing income of R5m per year. Assume tax rate = 30%.
? 18 Assessed Tax Losses Answer to: “?”
19 Optimal Economic Lives Abandonment Value & Continuing evaluation of projects Compare a project’s economic value (PV of future cash flows) to its abandonment value Replacement timing Use EAC to determine the optimal time to replace assets
20 Replacement Timing By comparing Equivalent Annual Costs over time, the firm can determine the optimal time to replace the asset. In this example, the firm should replace the asset at the end of 4 years.
21 Real (Strategic) Options Real NPV = NPV of original project + NPV of Strategic options
Examples: Flexibility of Process: Different mixes of inputs to produce same output The Option to abandon the project - exit values The Option to expand the project The ability to delay the project Temporary Closure Termination Leasing structures Research & Development Exploration Sequencing of Investments 22 Taxation Capital Budgeting Theory vs Practice
24 What information is required? An Example: Capital Budgeting in the Hotel Industry Economic Overview [ demography, tourism, data of occupancy and room rates, hotel types] Site Evaluation [size,nature of area, transport, distance to attractions/draws, climate and location of competitors] Competitive market supply [review of local hotels, tourist boards, hotel tariffs, market reports, tour operators] Total hotel supply [hotels, rooms, grade] Potential changes in the supply Primary competitive hotel supply [facilities, tariffs, conference facilities, occupancy rates] Revenue from restaurants / bar facilities /functions Input costs (electricity, laundry services, reception, cleaning etc) Demand for accommodation Corporate/conferences/tourist/airline crew Taxation ( building and plant depreciation allowances) Terminal value (may be significant if hotel is in prime area. There are cases of older hotels being redeveloped into prime residential units or a head office)
