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Lecture 3:Capital investment appraisal 2- Inflation, Taxation and capital rationing

Lecture 3:Capital investment appraisal 2- Inflation, Taxation and capital rationing. Objectives: Understand the influences of inflation and taxation on investment decisions Undertake investment appraisal when inflation and taxes are present

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Lecture 3:Capital investment appraisal 2- Inflation, Taxation and capital rationing

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  1. Lecture 3:Capital investment appraisal 2- Inflation, Taxation and capital rationing Objectives: • Understand the influences of inflation and taxation on investment decisions • Undertake investment appraisal when inflation and taxes are present • Apply profitability index to arrive at best decision if investment capital is rationed

  2. Inflation and Investment Decisions • Inflation: • is an increase in the price unaccompanied by any other changes (such as quantity and quality). • With inflation, one must pay more money across time to acquire the same goods and services. • E.g. inflation 5% goods costing £100 at the beginning will cost £105 at the end.

  3. Nominal and Real measures • Nominal cash flow • the actual number of £s that would change hands at the time the purchase is made. • A real cash flow • the number of pounds that would have been exchanged to purchase something before the inflation took place (inflation-free return is the real rate).

  4. Inflation and Investment Decisions • Inflation creates two problems for project appraisal: • a) the estimation of future cash flows is made more troublesome; • b) the rate of return required by the firm’s security holders, such as shareholders will rise with inflation.

  5. Methods of Adjusting Inflation • Approach 1: • estimate the cash flows in money terms and use a money discount rate. • Approach 2: • estimate the cash flows in real terms and use a real discount rate.

  6. Converting Nominal return to Real return • Assume the real return is 10% and inflation is expected to be 5%. • What is the nominal rate of return? • (1+nominal return) = (1+real return)(1+inf) • (1+N) = (1+0.10)(1+0.05) = 1.155 • N = 1.155 – 1 = 0.155 = 15.5%

  7. Nominal return and Real return Example 3.2 Channel Ltd is evaluating a proposal to begin operating at a new location. The real cash flows are(in millions): yr0 yr1 yr2 yr3 (2000) 500 900 1300 Real cost of capital is 10%, what is the NPV?

  8. Solution 3.2 Channel ltd (Real and real) • NPV=-2,000 + 500 + 900 + 1,300 (1.10) (1.10)² (1.10)³ = 175

  9. Example 3.3 Suppose the expectations are that inflation will certainly be 5%, use example 3.2 to calculate the NPV

  10. Solution 3.3 (Nominal and nominal) NPV=-2,000 + 525 + 992 + 1,505 ( 1.155) (1.155)² (1.155)³ = 175

  11. Example 3.4 (Real and nominal) Use the information in examples 3.2 and 3.3 to calculate the NPV using the real cash flows and nominal discount rate and comment on your answer.

  12. Solution 3.4 NPV=-2,000 + 500 + 900 + 1,300 (1.155) (1.155)2 (1.155)³= - 49

  13. Nominal return and Real return • Never: • discount nominal cash flow with the real discount rate. This gives an apparent NPV much larger than the true rate NPV and so will result in wrong decisions to accept projects which are not shareholder wealth enhancing.

  14. Nominal return and Real return Never • discount real cash flow with the nominal discount rate. This will reduce the NPV from its true value which causes the rejection of projects which will be shareholder wealth enhancing.

  15. Taxation and Capital investment decisions The key issues • Depreciation • Accounting profit • Taxable profit • Capital allowances

  16. Example 3.5 Blake Ltd is considering buying a machine costing £200,000 which would generate the following pre-tax profits from the sale of goods produced. Year Pre-tax profit 1 £85,000 2 £65,000 3 £75,000 4 £65,000 Blake pays a corporation tax at a rate of 30 percent one year in arrears and also receives capital allowances on a 25 per cent reducing balance basis following a 40 per cent first year allowance. The expected life of the machine is four years, at the end of which it will be sold for 20,000. If Blake Ltd’s after-tax cost of capital is 10 per cent, should the company buy the machine in the first place?

  17. Solution 3.5

  18. Solution 3.5 (Workings)

  19. Alternative approach to 3.5

  20. Alternative approach to 3.5 (Workings)

  21. Capital Rationing Capital rationing • occurs when funds are not available to finance all wealth enhancing projects. Types: • Soft capital rationing is internal management-imposed limits on investment expenditure. Such limits may be linked to the firm’s financial control policy, e.g.family business

  22. Capital Rationing • Hard capital rationing relates to capital from external sources. For example, the external market may disagree with the company as to the desirability of the investment. In finance, capital rationing is used to deal with such situations.

  23. Technique for dealing with Capital Rationing Profitability index (PI) is the ratio of the cumulated present values of future cash flows to the present cash flow at time 0. OR PI = NPV/Initial investment

  24. Capital Rationing –Example 3.6 Suppose that your company had the following opportunities: Project Outlay Yr1 Yr2 A (10,000) 30,000 5,000 B (5,000) 5,000 20,000 C (5,000) 5,000 15,000 Only£10,000 is available to undertake investments appropriate discount rate is 10%. Which project should be selected?

  25. Capital Rationing – Solution 3.6 Profitability index = net present value/investment Project Outlay PV NPV PI Ranking A (10,000) 31,405 21,405 3.1 3rd B (5,000) 21,074 6,074 4.2 1st C (5,000) 16,942 11,942 3.38 2nd We must pick the projects that offer the highest NPV value per pound of initial outlay. This is called the Profitability index. As the spending is limited to £10,000 projects B and C should be chosen.

  26. Example 3.7 (Capital Rationing) Suppose that you were the financial analyst in a company that had the investment opportunities below: BUDGET 37,000 outlay at year 0 PVs NPV PI Rank H 5,000 8000 3000 1.6 1 I 10,000 15000 5000 1.5 2 J 20,000 26000 6000 1.3 3 K 4,000 4560 560 1.14 4

  27. Solution 3.7 (Optimal Investment Schedule) Project Outlay NPV Cumulative Inv H 5,000 3,000 5,000 I 10,000 5,000 15,000 J 20,000 6,000 35,000 K 2,000 280 37,000 Note: Assumed that project is divisible

  28. Example 3.7 What should be the optimum project selection if the projects are none divisible?

  29. Which cash flow to include? Relevant and irrelevant cash flows • Depreciation- Not relevant • Allocated fixed cost is not relevant unless if incurred as a result of the project • Sunk costs not relevant • Interest and dividend not relevant

  30. Further reading (article) Drury, Colin and Tayles, Mike (1997), “The misapplication of capital investment appraisal techniques” Management Decision, Vol 35, no 2, pp. 86-93.

  31. Self assessment questions After reading the above article, Drury, Colin and Tayles, Mike (1997), please answer the three questions at the end (on page 93 of the article)

  32. End of lecture 3 Any questions please

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