Chapter 6 Principles of Capital Investment

1®2002 Prentice Hall Publishing

Chapter 6Principles of Capital

Investment


Administrative Framework Involves

• Generation of investment proposalsGeneration of investment proposals

• Estimation of cash flowsEstimation of cash flows

• Evaluation of cash flowsEvaluation of cash flows

• Selection of projects based on an acceptance Selection of projects based on an acceptance criterioncriterion

• Continual reevaluation of investment projects Continual reevaluation of investment projects after acceptanceafter acceptance

Chapter 6

Chapter 7


Project Classification

• New products or expansion of existing New products or expansion of existing productsproducts

• Replacement of equipment or buildingsReplacement of equipment or buildings

• Research and developmentResearch and development

• Exploration Exploration

• OthersOthers


Multiple Screens

Board Board

PresidentPresident

CommitteeCommittee

VP operationsVP operations

Plant manager Plant manager

Section chiefsSection chiefs


Level and Type of Capital Expenditure

• As the capital outlay increases, the number As the capital outlay increases, the number of screens generally increasesof screens generally increases

• Important to investorsImportant to investors

– Convey information about expected Convey information about expected future growthfuture growth


Cash-Flow Forecasts

• Incremental cash flowsIncremental cash flows

– Differences between cash flows of the Differences between cash flows of the firm with and without the projectfirm with and without the project

• Ignore sunk costIgnore sunk cost

• Patterns of cash flowPatterns of cash flow

– AnnuityAnnuity

– Salvage valueSalvage value


Replacement Decisions and Depreciation

• Cash flow informationCash flow information– Purchase price of new machinePurchase price of new machine– Installation costInstallation cost– Sale of old machineSale of old machine– Cash savings for new machineCash savings for new machine

• Depreciation effectDepreciation effect• Income taxIncome tax• Incremental, after-tax cash flowIncremental, after-tax cash flow


Methods for Evaluation

• Average rate of returnAverage rate of return

• PaybackPayback

• Internal rate of returnInternal rate of return

• Net present valueNet present value

Economic worth of a project

Discounted cash flow method


Average Rate of Return (ARR)

• Compared with required rate of returnCompared with required rate of return

• Principal virtue is its simplicityPrincipal virtue is its simplicity

• Principal shortcomingsPrincipal shortcomings

– Based on accounting informationBased on accounting information

– Time value of money is ignoredTime value of money is ignored


Payback (PB)• Number of years to recover initial cash investmentNumber of years to recover initial cash investment• ShortcomingsShortcomings

– Fails to considerFails to consider• Cash flows after the PB periodCash flows after the PB period• Magnitude or timing of cash flows during the payback periodMagnitude or timing of cash flows during the payback period

– Does not measure profitabilityDoes not measure profitability• Popularity of PBPopularity of PB

– Limited insightLimited insight• Into the risk of a projectInto the risk of a project• Into the liquidity of a projectInto the liquidity of a project


Internal Rate of Return (IRR)• Discounted cash flow methodDiscounted cash flow method• The rate of discount which equates the PV of The rate of discount which equates the PV of

cash inflows with the PV of cash outflowscash inflows with the PV of cash outflows• Takes account of cash flowsTakes account of cash flows

– MagnitudeMagnitude– TimingTiming

• Acceptance criterionAcceptance criterion– IRR > required rate IRR > required rate


Required Rare of Return (RRR)

• Systematic risk is higher for capital-Systematic risk is higher for capital-expending projectsexpending projects

• Replacement projectsReplacement projects

– Produce benefits across more states of the Produce benefits across more states of the economyeconomy

• Possess lower systematic riskPossess lower systematic risk

• Require a lower returnRequire a lower return


Net Present Value (NPV)

• What remains after discounting all cash What remains after discounting all cash flows by the RRRflows by the RRR

• Acceptance criterionAcceptance criterion

– PV of the cash inflows > PV of the cash PV of the cash inflows > PV of the cash outflows outflows

• Absolute measure of the contributionAbsolute measure of the contribution


Profitability Index (PI)• PV of future net cash flows over the initial cash outlayPV of future net cash flows over the initial cash outlay

• Acceptance criterionAcceptance criterion– PI PI 1.00 1.00

• NPV and PI NPV and PI – Give the same accept-reject signalsGive the same accept-reject signals

• Expresses relative profitabilityExpresses relative profitability

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Mutual Exclusive and Dependency

• Mutual exclusiveMutual exclusive

– Acceptance of one precludes the Acceptance of one precludes the acceptance of another projectacceptance of another project

• Contingent proposalContingent proposal

– Depends on the acceptance of one or Depends on the acceptance of one or more other proposalsmore other proposals


NPV Versus IRR

• Compounding rate differencesCompounding rate differences– Investment proposals are mutually exclusiveInvestment proposals are mutually exclusive– IRR method implies that funds are compounded at the IRR method implies that funds are compounded at the

IRRIRR– PV method implies compounding at the RRRPV method implies compounding at the RRR

• Scale of investmentScale of investment– Mutually exclusive investment proposals having Mutually exclusive investment proposals having

different initial cash outlaysdifferent initial cash outlays• IRR ignores the scale of investmentIRR ignores the scale of investment

• Multiple IRR’sMultiple IRR’s– Cash-flow stream changes sign more than onceCash-flow stream changes sign more than once


Depreciation and Other Refinements in Cash-Flow

Information• Method of depreciationMethod of depreciation

• Setting up the cash flowsSetting up the cash flows

• Salvage value and taxesSalvage value and taxes

• Working capital requirementWorking capital requirement


Method of Depreciation• Straight-line depreciationStraight-line depreciation• Accelerated depreciationAccelerated depreciation

– PV advantage in postponing taxesPV advantage in postponing taxes• MACRSMACRS

– Eight property classesEight property classes– 200% declining-balance method (1-4)200% declining-balance method (1-4)– Half-year conventionHalf-year convention– 150% declining-balance (5&6)150% declining-balance (5&6)– Straight-line depreciation (7&8)Straight-line depreciation (7&8)


Setting Up the Cash Flows

• CostCost

• Annual savingsAnnual savings

• DepreciationDepreciation

• IncomeIncome

• TaxesTaxes

• NCFNCF


Salvage Value and Taxes

• Sale of a fully depreciated asset is subject to Sale of a fully depreciated asset is subject to taxationtaxation

• Sold > depreciated book value < costSold > depreciated book value < cost

– Pay full corporate tax ratePay full corporate tax rate

• Sold > costSold > cost

– Capital-gains tax treatmentCapital-gains tax treatment


Working Capital Requirement

• Cash outflow at the time of occurrenceCash outflow at the time of occurrence

– Additional cashAdditional cash

– Additional receivablesAdditional receivables

– Additional inventoriesAdditional inventories

• End of project’s lifeEnd of project’s life

– Treated as a cash inflowTreated as a cash inflow

• Can occur at any timeCan occur at any time


What Happens When Capital is Rationed?

• Capital rationingCapital rationing– Budget ceilingBudget ceiling

• Selection criterionSelection criterion– Combination of proposals with highest NPVCombination of proposals with highest NPV– Consider more than one periodConsider more than one period– Problems incurredProblems incurred

• Reject positive NPV projectsReject positive NPV projects• Less than optimal investment policyLess than optimal investment policy


Inflation and Capital Budgeting

• Real cash flows do not keep up with inflationReal cash flows do not keep up with inflation• Inflation effect on resultsInflation effect on results

– Lower real rates of returnLower real rates of return– Disincentive to undertake capital expendituresDisincentive to undertake capital expenditures

• Invest lessInvest less• Seek investments with faster PBsSeek investments with faster PBs• Become less capital intensiveBecome less capital intensive

• Bias in cash-flow estimatesBias in cash-flow estimates


Information to Analyze an Acquisition

• Same as any other investment proposalSame as any other investment proposal

– Initial outlay of cash or stockInitial outlay of cash or stock

– Followed by expected future benefitsFollowed by expected future benefits

• Major differencesMajor differences

– Initial cost may be subject to bargainingInitial cost may be subject to bargaining

• SynergismSynergism


Measuring Free Cash Flows (FCF)

• EBITDAEBITDA

- Taxes- Taxes

- Capital expenditures- Capital expenditures

- Working-capital additions- Working-capital additions

= Incremental free cash flow= Incremental free cash flow

• FCFs determine an acquisition’s valueFCFs determine an acquisition’s value


Noncash Payments and Liability Assumptions

• Overriding valuation principleOverriding valuation principle

– Value of the incremental FCFsValue of the incremental FCFs

– Cash-equivalent priceCash-equivalent price

– Convert to market valueConvert to market value

• SecuritiesSecurities

• LiabilitiesLiabilities

• Separate investing from financingSeparate investing from financing

Documents

Chapter 6 Principles of Capital Investment