Capital Budgeting

Typical Capital Budgeting Decisions

Capital budgeting tends to fall into two broad Capital budgeting tends to fall into two broad categories . . .categories . . .

Screening decisionsScreening decisions.. Does a proposed project Does a proposed project meet some present standard of acceptance?meet some present standard of acceptance?

Preference decisionsPreference decisions.. Selecting from among Selecting from among several competing courses of action. several competing courses of action.

Capital budgeting tends to fall into two broad Capital budgeting tends to fall into two broad categories . . .categories . . .

Screening decisionsScreening decisions.. Does a proposed project Does a proposed project meet some present standard of acceptance?meet some present standard of acceptance?

Preference decisionsPreference decisions.. Selecting from among Selecting from among several competing courses of action. several competing courses of action.

Four Capital Budgeting Methods

1. Net Present Value (NPV)

2. Internal Rate of Return (IRR)

3. Payback Period

4. Accrual Accounting Rate of Return (AARR)

Discounted Cash Flows

• Discounted Cash Flow (DCF) Methods measure all expected future cash inflows and outflows of a project, discounted back to the present point in time

• The key feature of DCF methods is the time value of money (interest), meaning that a dollar received today is worth more than a dollar received in the future

Discounted Cash Flows (continued)

• The reason is that $1 received today could be invested at, say, 10% per year so that it grows to $1.10 at the end of one year

• DCF methods use the Required Rate of Return (RRR), which is the minimum acceptable annual rate of return on an investment.

• RRR is internally set , usually by upper management, and is usually the Weighted Average Cost of Capital for a firm.

• RRR is also called the discount rate, hurdle rate, cost of capital or opportunity cost of capital.

Typical Cash Outflows

Repairs andRepairs andmaintenancemaintenance

IncrementalIncrementaloperatingoperating

costscosts

InitialInitialinvestmentinvestment

WorkingWorkingcapitalcapital

Typical Cash Inflows

ReductionReductionof costsof costs

SalvageSalvagevaluevalue

IncrementalIncrementalrevenuesrevenues

Release ofRelease ofworkingworkingcapitalcapital

Net Present Value (NPV) Method

• The NPV method calculates the expected monetary gain or loss from a project by discounting all expected future cash inflows and outflows to the present point in time, using the Required Rate of Return

• NPV is the arithmetic sum of the present value of the future cash flows

• Based on financial factors alone, only projects with a zero or positive NPV are acceptable

• We’ll use three steps for the NPV method

Three-Step NPV Method

1. Draw a sketch of the relevant cash inflows and outflows.

2. Discount the Cash Flows using the Correct Compound Interest Table (hand-out) and Sum Them.

3. Make the Project Decision on the Basis of the Calculated NPV (zero or positive should be accepted because the expected rate of return equals or exceeds the required rate of return.)

Relevant Cash Flows in NPV Analysis

• One of the biggest challenges in capital budgeting, particularly DCF analysis, is determining which cash flows are relevant in making an investment selection.

• Relevant cash flows are the differences in expected future cash flows as a result of making the investment.

• A capital investment project typically has three categories of cash flows:• Net initial investment.• After-tax cash flow from operations.• Recovery of working capital.

Net Initial Investment

The three components of net-initial investment cash flows are as follows:

1.Initial machine investment.

2.Initial working capital investment.

3.After-tax cash flow from current disposal of old machine.

Cash Flow from Operations

Two components of cash flow from operations are relevant:

1.Annual after-tax cash flow from operations (excluding the depreciation effect).

2.Income tax cash savings from annual depreciation deductions.

Recovery of Working Capital

Working Capital is recovered at the end of the project (liquidating receivables and inventory that was needed to support the project)

Lifetime Care Hospital

• Lifetime Care Hospital is a for-profit taxable company.

• One of Lifetime Care’s goals is to improve the productivity of its X-ray machine.

• As a first step to achieve this goal, the manager of Lifetime Care identifies a new state-of-the-art X-ray machine, XCAM8, as a possible replacement for the existing X-ray machine.

• The manager next acquires information to do more-detailed evaluation of XCAM8.

• Quantitative information for the formal analysis follows.

Lifetime Care Hospital (Cont)

1. Revenues will be unchanged regardless of whether the new X-ray machine is acquired. The only relevant financial benefit in purchasing the new X-ray machine is the cash savings in operating costs.

2. Lifetime Care is a profitable company. The income tax rate is 40% of operating income each year.

3. The operating cash savings from the new X-ray machine are $120,000 in years 1-4 and $105,000 in year 5.

Lifetime Care Hospital (Cont)

4. Lifetime uses straight-line depreciation method, which means an equal amount of depreciation is taken each year.

5. Gains or losses on the sale of depreciable assets are taxed at the same rate as ordinary income.

6. The tax effects of cash inflows and outflows occur at the same time that the cash inflows and outflows occur.

7. Lifetime Care uses an 8% required rate of return for discounting after-tax cash flows.

Summary Data for the X-Ray Machine

Old X-Ray Machine

New X-Ray Machine

Purchase Price --- $390,000

Current book value $40,000 ---

Current disposal value 6,500 Not applicable

Terminal disposal value

5 years from now 0 0

Annual depreciation 8,000a 78,000b

Working capital required 6,000 15,000

a $40,000 / 5 years = $8,000 annual depreciation

b $390,000 / 5 years = $78,000 annual depreciation

Effect on Year One Cash Flows from Operations – Net of Income Taxes

Annual After-Tax Cash Flow from Operations

• The 40% tax rate reduces the benefit of the $120,000 operating cash flow savings for years 1-4 with the new X-ray machine.

• After tax cash flow (excluding depreciation effects) is:

Annual cash flow from operations with new machine $120,000

Deduct income tax payments (0.40 X $120,000) 48,000

Annual after-tax cash flow from operations $72,000

Annual After-Tax Cash Flow from Operations (Cont)

• For year 5, the after-tax cash flow (excluding depreciation effects) is:

Annual cash flow from operations with new machine $105,000

Deduct income tax payments

(0.40 X $105,000)42,000

Annual after-tax cash flow from operations $63,000

Tax Consequences of Disposing of the Old Machine

Loss on disposal:

Current disposal value of old machine

$6,500

Deduct current book value of old machine

40,000

Loss on disposal of machine

$(33,500)

Tax Consequences of Disposing of the Old Machine (cont)

Any loss on sale of assets lowers taxable income and results in tax savings. The after-tax cash flow from disposal of the old machine equals:

Current disposal value of old machine

$6,500

Tax savings on loss

(0.40 X $33,500)13,400

After-tax cash inflow from current disposal of old machine

$19,900

Relevant Cash Inflows and Outflows for X-Ray Machine

NPV Method – X-Ray Machine

Preference Decisions - Net Present Value

The net present value of one project cannot be directly compared to the net present

value of another project unless the investments are equal.

Ranking Capital Investment Opportunities Using NPV

Present Value Index Present Value Index ==

Sum of PV of cash inflowsSum of PV of cash inflowsInitial InvestmentInitial Investment

Internal Rate of Return Method

• The The internal rate of returninternal rate of return is the true rate of is the true rate of returnreturn promised by an investment project over its promised by an investment project over its useful life. It is computed by finding the discount useful life. It is computed by finding the discount rate that will cause the rate that will cause the net present valuenet present value of a of a project to be project to be zerozero..

• It works very well if a project’s cash flows are It works very well if a project’s cash flows are identical every year. If the annual cash flows are identical every year. If the annual cash flows are not identical, a trial and error process must be not identical, a trial and error process must be used to find the internal rate of return.used to find the internal rate of return.

• A project is accepted only if the IRR equals or exceeds the RRR

Internal Rate of Return Method (cont)

• Managers or analysts solving capital budgeting problems typically use a calculator or computer program to determine the internal rate of return, but a more manual trial and error approach can also provide the answer.

• Trial and error approach:• Use a discount rate and calculate the project’s NPV. Goal:

find the discount rate for which NPV = 0• If the calculated NPV is greater than zero, use a higher

discount rate.• If the calculated NPV is less than zero, use a lower discount

rate.• Continue until NPV = 0.

IRR Method – X-Ray Machine

Preference Decisions - IRR

The higher the internal rate of return, the

more desirable the project.

When using the internal rate of return method to rank competing investment

projects, the preference rule is:

Payback Method• The Payback method measures the time it will

take to recoup, in the form of expected future cash flows, the net initial investment in a project

• Shorter payback periods are preferable• Organizations choose an acceptable project

payback period for them • The payback method is easy to understand• The two weaknesses of the payback method are:

– Fails to recognize the time value of money.– Doesn’t consider the cash flow beyond the

payback point

Payback Method Calculation

Payback Net Initial InvestmentPeriod Uniform Increase in Annual Future Cash Flows=

• With uniform cash flows:

• With non-uniform cash flows: add cash flows period-by-period until the initial investment is recovered; count the number of periods included for payback period

Pop Quiz

(Ignore income taxes in this problem.) Dumora Corporation is considering an investment project that will require an initial investment of $9,400 and will generate the following net cash inflows in each of the five years of its useful life:

Year 1 Year 2 Year 3 Year 4 Year 5 Net cash inflows $1,000 $2,000 $4,000 $6,000 $5,000

Dumora’s discount rate is 16%.

Dumora's payback period for this investment project is closest to:

A) 1.91 years

B) 2.61 years

C) 2.89 years

D) 3.40 years

Accrual Accounting Rate of Return Method (AARR)

• The AARR method divides the average annual [accrual accounting] income of a project by a measure of the investment in it.

• That “measure of the investment” in the project can vary company by company.

• Also called the accounting rate of return.

AARR Method Formula

Increase in Expected AverageAccrual Accounting Annual After-Tax Operating Income

Rate of Return Net Initial Investment=

AARR Method, Advantages and Disadvantages

• Firms vary in how they calculate AARR.

• Easy to understand, and uses numbers reported in financial statements.

• Does not track cash flows.

• Ignores time value of money.