Capital Asset Selection and Capital Budgeting

1. Capital Asset Selection and Capital Budgeting Chapter 13

2. Assessing the Profitability of Long-Term Strategic Investments The investment in capital assets often coincides with the execution of major strategies such as development of new product lines or acquisitions of other companies. Capital investments are also associated with major management initiatives to improve competitive position such as raising product or service quality through acquisition of new technology. Other capital investments are made to maintain and support existing operations. Capital asset acquisition decisions involve long-term commitments of large amounts of money. Making the most economically beneficial investments within resource constraints is critical to the organization's long-range well-being. Capital budgeting techniques are designed to enhance management's success in making capital investment decisions.

3. Learning Objectives How do managers choose which capital projects to fund? Why do most capital budgeting methods rely on analyses of cash flows? What are the differences among payback period, the net present value method, profitability index, and internal rate of return? Why are quality management, training, and research and development controlled largely by capital budget analysis?

4. Learning Objectives Why are environmental issues becoming an increasingly important influence on the capital budget? How and why should management conduct a post-investment audit of a capital project? How does ERP impact capital budgeting? What is the time value of money? (Appendix 13B) How is the accounting rate of return for a project determined? (Appendix 13B)

5. Learning Objectives How does capital cost allowance affect cash flows? (Appendix 13C)

6. Capital Assets Capital asset – an asset used to generate revenues or cost savings by providing production, distribution, or service capabilities for more than one year Copy Machine Lease

7. Capital Budgeting Project – future activity, such as the purchase, installation, and operation of capital asset Capital budgeting – the process of evaluating long-range investment proposals for the purpose of allocating limited resources effectively and efficiently.

8. The Investment Decision Despite technology and new tools, it is easy to make the wrong decision when analyzing a new project; assump- tions may be faulty, and different techniques will give different answers.

9. Capital Budgeting Questions • Is the activity worth the investment? • Which assets can be used for the activity? • Of the suitable assets, which are the best investments? • Screening decision • Preference decision • Which of the best investments should the company choose? • Mutually exclusive projects • Independent projects • Mutually inclusive projects

10. Capital Budgeting Questions Is the activity worth the investment? Management initially measures an activity's worth by monetary cost-benefit analysis. If an activity's financial benefits exceed its costs, the activity could be considered worthwhile. In some cases, benefits cannot be measured in terms of money. In other cases, it is known in advance that the financial benefits will not exceed the costs. In either of these situations an activity meeting either of these criteria may still be judged worthwhile for some qualitative reasons.

11. Capital Budgeting Questions Which assets can be used for the activity? Part of the decision process is a comparison of costs and benefits. Managers should gather monetary and nonmonetary information about each available and suitable asset. This includes initial cost, estimated life and salvage value, raw material and labour requirements, operating costs (fixed and variable), output capacity, service availability and cost, maintenance expectations, and revenues to be generated.

12. Capital Budgeting Questions Of the suitable assets, which are the best investments? There are two types of capital budgeting decisions: screening and preference. If the project does not meet the minimum standard requirement of the screening decision, it is excluded from further consideration. Once unacceptable projects have been screened out, a preference decision is made in which the remaining projects are ranked based on their contributions to the achievement of company objectives. Screening decision – a judgment regarding the desirability of a capital project based on some previously established minimum criterion or criteria Preference decision – a judgment regarding how projects are to be ranked based on their impact on the achievement of company objectives

13. Ranking Categories for Capital Projects Category 1 – Required by Legislation – Safety equipment and environmental protection equipment. They may not meet the company's minimum return criteria, but they are necessary Category 2 – Essential to Operations – without these assets the primary functions of the organization could not continue. Could include the purchase of new capital assets, or replacement of older capital assets Category 3 – Nonessential But Income Generating – Capital assets that would improve operations by providing cost savings or supplements to revenue. Examples – efficient technology to replace labour Category 4 – Optional Improvements – Capital assets that do not provide any cost savings or additional revenues, but would make operations run more smoothly or improve working conditions, for example, a covered parking lot Category 5 – Miscellaneous – Pet projects of managers, for example development of a new corporate logo or a new executive washroom

14. Which of the Best Should the Company Choose? Mutually exclusive projects – a set of proposed investments for which there is a group of available candidates that all perform essentially the same function or meet the same objective; from this group, one is chosen and all others are rejected Independent projects – an investment project that has no specific bearing on any other investment project Mutually inclusive project – a set of investment projects that must be chosen as a package

15. Which of the Best Should the Company Choose? Projects must be ranked in order to select the ones that yield the highest value to the company. Doing the analysis and ranking in the right way pays off. A recent poll determined that 27.5% of clients of the Institute of Management and Administration saw changing the way they conduct financial analysis of new projects as one of the top ways to enhance corporate value.

16. Cash Flows • Cash receipts and disbursements that arise from the purchase, operation, and disposition of capital assets. • Cash receipts • project revenues that have been earned and collected • savings generated by reduced project operating costs • inflows from asset’s sale and release of working capital at end of asset’s useful life • Cash disbursements • expenditures to acquire the asset • additional working capital investments • amounts paid for related operating costs Cash Flow – the receipt or disbursement of cash

17. Cash Flows Identify and include all cash flows relevant to the project -- even if you have to use best estimates. Only differential cash flows should be used (relevant costs).

18. Interest is a cash flow created by the method of financing a project. Interest It should not be considered in project evaluation.

19. Financing and Investing Financing decision – a judgment regarding how funds will be obtained to make an acquisition Investing decision – a judgment regarding which assets an entity will acquire to achieve its stated objectives

20. Return of Capital vs. Return on Capital Return of Capital – recovery of the original investment Return on Capital – income equals the discount rate times an investment amount

21. Comparing the Techniques Canada Oil Ltd. Truck Fleet Acquisition Decision Purchase price of 20 trucks, trailers and equipment $ 1,800,000 Cost of custom modifications 600,000 Total cash acquisition cost $ 2,400,000 Annual cash cost of hiring freight forwarder $ 3,200,000 Annual cash operating costs of company owned fleet (2,600,000) Annual cash operating savings $ 600,000 Expected life of the trucks is six years. At the end of the sixth year the trucks are expected to have a salvage (residual) value of $700,000.

22. Use a Timeline to Determine Cash Flows Capital cost allowance – tax depreciation Timeline – illustration of the timing of expected cash receipts and payments; cash inflows are shown as positive amounts and cash outflows are shown as negative amounts Annuity – a series of equal cash flows occurring at equal time intervals

23. Use a Timeline to Determine Cash Flows Time t0 t6 t1 t2 t3 t4 t5 Net cash flow ($2,400) $600 $600 $600 $600 $600 $1,300 t0 ($2,400) = acquisition and modification cost t1 to t5 $600 = annual operating savings t6 $1,300 = year 6 operating savings and inflow from sale of assets (residual value)

24. Payback Period Payback period – the time required to recoup the original investment in a project through its cash flows • The longer it takes to recover the initial investment, the greater is the project’s risk • Management sets a maximum acceptable payback period • Often used as a screening technique When a project provides an annuity, the payback period equals the investment cost divided by the amount of the projected annuity inflow. Canada Oil's payback is four years ($2,400,000 / $600,000). Annuity – a series of equal cash flows occurring at equal time intervals

25. Payback Period Company management typically sets a maximum acceptable payback period as part of its evaluation. Different categories of capital projects may have different payback criteria. Most companies use payback as only one of several ways of judging an investment project – usually as a screening technique. Normally, after being found acceptable in terms of payback period, a project is subjected to evaluation by another capital budgeting technique because of the limitations of payback period.

26. Assumptions of Payback Period • Speed of investment recovery is the key consideration • Timing and size of cash flows are accurately predicted • Risk (uncertainty) is lower for a shorter payback project

27. Limitations of Payback • Ignores cash flows after payback • Basic method treats cash flows and project life deterministically without explicit consideration of probabilities • Ignores time value of money • Cash flow pattern preferences are not explicitly recognized • Ignores the company's desired rate of return

28. Discounted Cash Flow Methods • Net present value (NPV) • Profitability index (PI) • Internal rate of return (IRR)

29. Discounted Cash Flow Methods -- Terminology Discounting – the process of removing the portion of a future cash flow that represents interest, thereby reducing that flow to a present value amount Present value (PV) – the amount that a future cash flow is worth currently, given a specified rate of interest Discount rate – the rate of return on capital investments required by the company; the rate of return used in present value computations Cost of capital (COC) – the weighted average rate that reflects the costs of the various sources of funds making up a firm's debt and equity structure Net present value method (NPV) – an investment evaluation technique that uses discounted cash flow to determine if the rate of return on a project is equal to, higher than, or lower than the desired rate of return Net present value (PV) – the difference between the present values of all the project's cash inflows and cash outflows Profitability index (PI) – a ratio that compares the present value of net cash flows with the present value of the investment Internal rate of return (IRR) – the discount rate at which the present value of the cash inflows minus the present value of the cash outflow equals zero

30. Discounted Cash Flow Methods Money has a time value because interest is paid or received on funds. $1,000 received today has greater value than $1,000 received one year from now. The $1,000 received today can be invested and earn interest causing it to be more than $1,000 by the end of one year. Discounting is based on two considerations: the timing of receipts or payments, and the assumed interest rate. After discounting, all future values are stated in a common base of current dollars, or present values (PVs). Using present values of future cash flows occurring at different points in time allows managers to view all project amounts in common terms (present values).

31. Discounted Cash Flow Methods To discount the future cash flows, managers must estimate the rate of return on capital required by the company. This rate of return is called the discount rate. It is used to determine the imputed interest portion of future cash flows. The discount rate should equal or exceed the company's cost of capital. Current expenditures (initial project investment) are undiscounted. Because of this it is extremely important for managers to obtain the best possible information about future cash flows. The amounts and timing of these future inflows and outflows must be carefully estimated. Managers need to consider ALL future cash flows – those that are obvious and those that are hidden.

32. Net Present Value Method A discount rate may be adjusted up or down to compensate for unique underlying factors in investment projects. Managers of multinationals may use a higher rate for international investments to compensate for the greater risks involved (foreign exchange fluctuations and political instability). Managers may also raise or lower the discount rate to compensate for qualitative factors. For instance, an investment in high-technology equipment that would provide a strategic advantage over competitors might be discounted at a rate lower than the COC.

33. Net Present Value Method The NPV of a project is estimated by forecasting the project's annual cash flows during its expected life, discounting them back to the present at a risk-adjusted rate, then subtracting the initial start-up capital expenditure. A project's net present value (NPV) is the difference between the present values of all the project's cash inflows and outflows. The NPV of Canada Oil Ltd.'s estimated cash flows (10% rate) is: Discount Present DescriptionTimeAmountFactorValue Investment t0 $(2,400,000) 1.0000 $(2,400,000) Cash savings t1-t5 600,000 3.7908 2,274,480 Cash savings and salvage t6 1,300,000 0.5645 733,850 Net present value $ 608,330

34. Net Present Value Method Determines whether the rate of return (ROR) on a project is equal to, higher than, or lower than the desired ROR. • May accept if: • If NPV = 0, actual ROR = desired ROR • If NPV > 0, actual ROR > desired ROR • May reject if: • If NPV < 0, actual ROR < desired ROR • Does not determine expected ROR

35. Net Present Value Method • Changing discount rate affects NPV • Changing timing and size of cash flows affects NPV • NPV can be used to select the best project when choosing among investments that can perform the same task or achieve the same objective • Like a roll of the dice, some cash flows, such as cost savings and revenue increases, are a gamble

36. Assumptions of Net Present Value • Discount rate used is valid • Timing and size of cash flows are accurately predicted • Life of project is accurately predicted • If the shorter-lived of two projects is selected, the proceeds of that project will continue to earn the discount rate of return through the theoretical completion of the longer-lived project

37. Limitations of Net Present Value • Basic method treats cash flows and project life deterministically without explicit consideration of probabilities • NPV does not measure expected rates of return on projects being compared • Cash flow pattern preferences are not explicitly recognized • IRR of project is not reflected

38. Profitability Index a ratio that compares present value of net cash inflows with the present value of the net investment • Compares projects with different costs • PI should be at least equal to 1.0 • Gauges the firm’s efficiency at using its capital • Does not indicate expected ROR

39. Profitability Index Profitability Index (PI) = NPV of future cash flows / Net investment For Canada Oil Ltd.'s project, PI is $3,009,330 / $2,400,000 = approximately 1.25 $3,009,330 = $2,274,480 + $733,850 (future cash flows)

40. Assumptions of Profitability Index • Same as NPV • Size of PV of net inflows relative to size of PV of investment measures efficient use of capital

41. Limitations of Profitability Index • Same as NPV • Gives a relative answer but does not reflect dollars of NPV

42. Internal Rate of Return Internal rate of return – the discount rate at which the present value of the cash inflows minus the present value of the cash outflows equals zero IRR is the project’s expected rate of return. • It is the discount rate where PV of net cash flows = the cost of the project. • Discount rate where NPV = 0 • IRR is compared with the hurdle rate (which is the lowest acceptable return on investment). • The project is acceptable if IRR > hurdle rate. Hurdle rate – the rate of return deemed by management to be the lowest acceptable return on investment

43. Internal Rate of Return Discount factor = Investment/Annuity Assume a project will cost $30,000 and will produce annual net cash flows of $4,600 (annuity) for eight years. Discount factor = $30,000/$4,600 = 6.5217 The present values of an ordinary annuity (Table 2, Appendix C) will provide the internal rate of return. The project's life is eight years. In the row where n = 8, look for the discount rate. The factor corresponds to an interest rate between 4 and 5 percent when the number of periods is eight. The IRR is between 4 and 5 percent. (Note: the factor at 4% is 6.7327 and the factor at 5% is 6.4632.)

44. Internal Rate of Return When a project does not have equal annual cash flows, finding the IRR involves an iterative trial-and-error process. An estimate is made of a rate believed to be close to the IRR, and the NPV is computed. If the NPV is negative, a lower rate is used and the process is repeated. If the NPV is positive, a higher rate is tried. Canada Oil Ltd. does not have equal annual cash flows. The project has an expected IRR of more than 10%, since discounting at that rate resulted in a positive NPV. Using 18% results in a negative NPV of $42,160. Using 17% results in a positive NPV of $26,380. The IRR is between 17 and 18 percent.

45. Assumptions of IRR • Hurdle rate is valid • Timing and size of cash flows are accurately predicted • Life of project is accurately predicted • If the shorter-lived of two projects is selected, the proceeds of that project will continue to earn the IRR through the theoretical completion of the longer-lived project

46. Limitations of IRR • Projects are ranked for funding based on IRR rather than dollar size • Does not reflect dollars of NPV • Basic method treats cash flows and project life deterministically without explicit consideration of probabilities • Cash flow pattern preferences are not explicitly recognized • It is possible to calculate multiple rates of return on the same project

47. Prevention and Appraisal Costs and Capital Budgeting Control of quality has been discussed in terms of managing four related costs: internal failure, external failure, appraisal, and prevention. Total quality cost is the sum of costs in these four categories. Management of quality costs requires analysis of tradeoffs among the categories. Spending greater amounts for prevention and appraisal is likely to lead to reduction in both failure cost categories. Prevention and appraisal costs are both partly managed in the capital budget. Quality problems can be prevented by acquiring more sophisticated technology and by training workers to use techniques that reduce errors. Statistical quality controls can be applied to monitor operations and determine when acceptable error tolerances are exceeded.

48. Prevention and Appraisal Costs and Capital Budgeting A project with a negative NPV may still be considered acceptable. If the new project would reduce defects, the savings from reduced defects should be included in the determination of NPV. These savings can be significant and could change the NPV to a positive figure. Investment in training results in an increase in prevention costs in the present, to be offset by future decreases in other quality cost categories – external and internal failure.

49. Research and Development and Capital Budgeting Research and development (R & D) activities are necessary to generate the innovative products and services that will produce future revenues. Life cycles of many products have decreased. Once an innovative product reaches the market, competitors can respond more quickly with products that meet or exceed the quality and features of the innovative product. In the race to be first to market with a new product, each week of delay can mean millions of dollars of lost revenue and profit. In this competitive game whose outcome depends on the pace of introducing new products, the generation of future profits critically depends on effective capital budget analysis. R & D requires a commitment of cash and other resources in the present to reap cash inflows in the future.

50. High-Tech Investments The decisions are more a question of “how much” and “when” than “whether” Generally require massive monetary investment