Capital Budgeting

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CAPITAL BUDGETINGLONG-RANGE PLANNING

Capital Budgeting • It is the process of considering alternative capital

projects and selecting those alternatives that provide the most profitable return on available funds.

• Examples of capital projects include land, buildings, equipment and other major fixed asset items.

I will choose theproject with the mostprofitable return on

available funds.

?

?

?Limited

InvestmentFunds

PlantExpansion

NewEquipment

OfficeRenovation

Alternatives:

Capital Budgeting

Capital Budgeting Implementation of a capital project involves . . .

• a large commitment of money inthe decision period.

• a large increase in fixed costsfor a number of years.

• potential returns in future years.• an opportunity cost because of

the rejection of other projects.

Project Selection:A General View

• Analysis of cash inflows and cash outflows• Net cash inflow is the net cash benefit expected from a

capital project in a period.

• Time value of money• Cash received today is

worth more than thesame amount receivedin the future.

.

Capital BudgetingCash Flow Analysis

InitialInvestment

IncreasedWorking Capital

Repairsand

Maintenance

IncrementalOperating

CostsTypical

Cash Outflows

Capital BudgetingCash Flow Analysis

TypicalCash Inflows

ReducedOperating

Costs

ReleasedWorkingCapital

IncrementalRevenues

SalvageValue .

Capital BudgetingTerminology

Interest rateindicating thecost of debtand equityinvestment

funds

Cost of capital

Out-of-pocketcosts

Avoided by not selecting

a project

Future cashoutflows

Sunkcosts

Not avoidedby currentdecision

Past cashoutflows

Depreciation and Taxes Depreciation itself is not a cash flow.

However, depreciation results in a reduction of cash outflows by reducing federal income taxes.


Depreciation and TaxesExample

Apex Company is considering the purchase ofnew equipment. Given the following information,

and a tax rate of 40 percent, compute the: Tax savings due to depreciation. After-tax net cash inflow.

Asset cost 72,000$ Asset life 10 yearsAsset salvage value 12,000$ Straight-line depreciation 6,000 Annual cash inflows 90,000 Annual cash outflows 70,000


With WithoutDepreciation Depreciation

Net cash inflow from project 20,000$ 20,000$ Depreciation 6,000 - Amount subject to tax 14,000$ 20,000$

Tax at 40% 5,600$ 8,000$

Tax savings

Tax savings = $2,400 (.40 × $6,000 depreciation = $2,400)



.

Income Cash FlowNet cash inflow from project 20,000$ 20,000$ Depreciation 6,000 - Income subject to tax 14,000$ 20,000$ Tax at 40% 5,600 5,600 After-tax amount 8,400$ 14,400$

After-tax net cash inflow

After-tax net Before-tax net Tax Depreciation Tax cash inflow cash inflow rate expense rate+1 - = [ ]

] [ ×( ) ×

[$20,000 (1 - .4)] + [$6,000 .4] = $14,400 × ×

Alternatively, reducing this analysis to a formula yields:


Project Selection MethodsPayback PeriodUnadjusted Rate of ReturnNet Present Value (NPV)Profitability IndexTime Adjusted Rate of Return

i.e., Internal Rate of Return (IRR)

Project Selection Method 1:Payback Period

Time required for the sumof the annual net cash

inflows to equal theinitial cash outlay.


Payback Period

When the annual net cash inflows are equal, use the following formula:

Initial cash outlay Annual net cash inflowPayback period =

Payback PeriodExample

Gators wants to install a separate seafood bar in its pub.

The seafood bar will . . . cost $150,000 and has a 10-year life with zero

salvage value. generate net annual cash inflows of $30,000.

Gators requires a payback period of 6 years or less on all investments.Should Gators invest in the seafood bar?



Payback period = $150,000$30,000 per year = 5.0 years

Gators should invest in the seafood bar because the payback period is less than 6 years.

Payback PeriodExample


Payback Period Limitations

Ignores the time valueof money.

Ignores cashflows after the payback

period.

Payback Period LimitationsExample

Consider two projects, each with a five-year life and each costing $6,000.

Project One Project TwoNet Cash Net Cash

Year Inflows Inflows1 2,000$ 1,000$ 2 2,000 1,000 3 2,000 1,000 4 2,000 1,000 5 2,000 1,000,000

Which project has the better payback period?

• Project one returns the $6,000 investment faster -- shorter payback period of three years ($6,000 ÷ $2,000 per year = 3 years).

• Project two is clearly superior because of the large cash inflow in the last year.

• Can you see the limitations of the payback period?

Payback Period LimitationsExample

Project Selection Method 2:Unadjusted Rate of Return

The unadjusted rate of return focuses on annual income instead of cash flows.

Unadjusted Average annual incomerate of return Average amount of investment=

Beginning balance + Ending balance2


Unadjusted Rate of ReturnExample

What is the the unadjustedrate of return on the seafood bar?

The seafood bar will . . . cost $150,000 and has a 10-year life with zero salvage

value. generate net annual cash inflows of $30,000.

Gators requires a payback period of 6 years or less on all investments and pays tax at 40%.

Reconsider the Gators example:


.

Unadjusted (30,000 - 15,000) x (1 - .40)rate of return (150,000 + 0) ÷ 2= = 12.0%

Unadjusted Rate of ReturnExample

Annual net cash inflows 30,000$ Depreciation ($150,000 ÷ 10 years) 15,000 Annual income before tax 15,000$

Unadjusted Average annual income after taxrate of return Average amount of investment=

Unadjusted Average annual before- Average annual TaxRate of tax net cash inflow depreciation rate return Average amount of investment=

( - ) × (1 - )

• Depreciation may be calculated several ways thereby giving different results.

• Time value ofmoney is ignored.

Unadjusted Rate of ReturnLimitations

Project Selection Method 3:Net Present Value (NPV) Method

A comparison of the present value of cash inflows with the present value of cash outflows

Chose a minimum rate of return (cost of capital).

Calculate the present value of cash inflows.Calculate the present value of cash outflows.NPV = –

Net Present ValueProcedure

• If NPV is positive, the investment yields a higher return than the cost of capital.

• Decision rule: Invest if NPV is positive.

Net Present ValueInterpretation

Net Present ValueQuestion

Savak Company can buy a new machine for $96,000 which will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s

required return is 12 percent, what is the NPV (rounded)?

a. $ 4,306b. $12,721c. $11,553d. $17,004


Savak Company can buy a new machine for $96,000 which will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is

12 percent, what is the NPV (rounded)?

a. $ 4,306b. $12,721c. $11,553d. $17,004

Use present value of annuity table (A.4)PV of inflows = $20,000 × 5.65022 = $113,004NPV = $113,004 - $96,000 = $17,004



Calculate the NPV if Savak Company’s required return is 14 percent instead of 12 percent.



Calculate the NPV if Savak Company’s required return is 14 percent instead of 12 percent.

Use present value of annuity table (A.4)PV of inflows = $20,000 × 5.21612 = $104,322NPV = $104,322 - $96,000 = $8,322


Note that the NPV is smallerusing the larger interest rate.


Net Present ValueNow that you have mastered the basic concept of net present value, it’s time

for a more sophisticated checkup!

Net Present Value Example Harper Co. has been offered a five-year contract to provide

parts for a large manufacturer, requiring an investment in new equipment.

• The new equipment will . . .• cost $160,000, have a five-year useful life, and

a $5,000 salvage value.• need an overhaul at the end of three years costing $30,000.

• Initial working capital requirement is $100,000.

The contract is expected to produce the following annual cash flows:

Revenues 750,000$Less: Cost of goods sold 400,000 Gross margin 350,000$Less: Other cash expenses 270,000 Annual net cash inflow 80,000$

Harper uses a 10 percent discount rate. Ignoring income taxes, compute the net

present value of the contract.

Net Present Value Example


Harper Company Net Present Value Analysis


Year(s) Cash Flow PV factor PV(rounded)Equipment Now (160,000)$ 1.00000 (160,000)$




Year(s) Cash Flow PV factor PV(rounded)Equipment Now (160,000)$ 1.00000 (160,000)$ Working capital Now (100,000) 1.00000 (100,000)


Year(s) Cash Flow PV factor PV(rounded)Equipment Now (160,000)$ 1.00000 (160,000)$ Working capital Now (100,000) 1.00000 (100,000) Annual inflow 1-5 80,000 3.79079 303,263



Present value of an annuity of $1 factor for 5 years at 10%.


Year(s) Cash Flow PV factor PV(rounded)Equipment Now (160,000)$ 1.00000 (160,000)$ Working capital Now (100,000) 1.00000 (100,000) Annual inflow 1-5 80,000 3.79079 303,263



$80,000 × 3.79079 = $303,263


Year(s) Cash Flow PV factor PV(rounded)Equipment Now (160,000)$ 1.00000 (160,000)$ Working capital Now (100,000) 1.00000 (100,000) Annual inflow 1-5 80,000 3.79079 303,263 Overhaul 3 (30,000) 0.75131 (22,539)



Present value of $1 factor for 3 years at 10%.


Year(s) Cash Flow PV factor PV(rounded)Equipment Now (160,000)$ 1.00000 (160,000)$ Working capital Now (100,000) 1.00000 (100,000) Annual inflow 1-5 80,000 3.79079 303,263 Overhaul 3 (30,000) 0.75131 (22,539) Working capital 5 100,000 0.62092 62,092 Salvage value 5 5,000 0.62092 3,105 NPV 85,921$



Present value of $1 factor for 5 years at 10%.



Since the contract has positive NPV, we know the rate of return is greater than the 10 percent discount rate.


Year(s) Cash Flow PV factor PV(rounded)Equipment Now (160,000)$ 1.00000 (160,000)$ Working capital Now (100,000) 1.00000 (100,000) Annual inflow 1-5 80,000 3.79079 303,263 Overhaul 3 (30,000) 0.75131 (22,539) Working capital 5 100,000 0.62092 62,092 Salvage value 5 5,000 0.62092 3,105 NPV 85,921$

Project Selection Method 4: Profitability Index

• Provides a means of ranking projects that have different initial investments.

• Decision rule: consider only those projects with a profitability index of 1.00 or more.

Present value of net cash inflows Present value of cash outflowsProfitability index =

.

The interest rate that makes . . .

Project Selection Method 5:Time Adjusted Rate of Return

Presentvalue of

cash inflows

Presentvalue of

cash outflows

=

Also known as the internal rate of return.

The net present value equal zero.

For projects with equal annual cash flows (i.e., annuities)

Determine the payback period.Use the present value of annuity table to determine

the IRR.

Internal Rate of Return (IRR)Procedure


Project life = 4 yearsInitial cost = $42,523

Annual net cash inflows = $14,000Determine the IRR for this project.

1. Determine the payback period. ($42,523 ÷ $14,000 per year = 3.03736 years)

Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308

Locate the rowwhose numberequals the lifeof the project.



2. Using present value of annuity table . . .

Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308




In that row,locate the

interest factorclosest in

amount to thepayback period.

Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308




IRR is theinterest rate

of the columnin which the

interest factoris found.

Internal Rate of ReturnExample

Decker Company can purchase a new machine at a cost of $104,322 that will save $20,000 per year in cash operating costs. The machine will have a

10-year life.What is the internal rate of return on this

investment project?


In Table A-4 in the appendix of your textbook, look across the 10-period row until you find an interest factor of 5.21610 in the 14 percent column. The internal rate of

return is 14 percent.

If 14 percent is greater than Decker’s required rate of return, Decker should purchase the new machine.


$104,322 $20,000 per yearPayback period = = 5.21610


Here’s the proof . . .

Year Amount14%

FactorPresent Value

Investment required Now (104,322)$ 1.00000 (104,322)Annual cost savings 1-10 20,000 5.21610 104,322 Net present value $ 0


Internal Rate of ReturnComplication #1

If the exact interest rate is not found in the present value table, an estimate of the interest rate is

required.

Periods 10% 11% 12%1 0.90909 0.90090 0.89286 2 1.73554 1.71252 1.69005 3 2.48685 2.44371 2.40183 4 3.16987 3.10245 3.03735 5 3.79079 3.69590 3.60478

For a project with a five-year life and a payback periodof 3.65000, the IRR would be approximately 11.5 percent.

Internal Rate of ReturnComplication #2

If cash inflows involve both annuities and one-time amounts, a trial and error solution will result if

present value tables are used.

Sophisticated business calculators and electronic spreadsheets can be used to easily solve these

problems.


Internal Rate of Return Compare the cost of capital

to the internal rate of return on a project.

To be acceptable, a project’s rate of return cannot be less than the cost of capital.

Net Present Value The cost of capital is used

as the actual discount rate.

Any project with a negative net present value is rejected.

Net Present Value vs.Internal Rate of Return


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Capital Budgeting