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CHAPTER 26. C APITAL B UDGETING LONG-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.

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slide1

CHAPTER 26

CAPITALBUDGETING

LONG-RANGE PLANNING

capital budgeting
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.
capital budgeting3

I will choose theproject with the mostprofitable return onavailable funds.

Alternatives:

PlantExpansion

?

LimitedInvestmentFunds

NewEquipment

?

?

OfficeRenovation

Capital Budgeting
capital budgeting4
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 ofthe rejection of other projects.
project selection a general view
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 isworth more than thesame amount receivedin the future.

.

capital budgeting cash flow analysis

InitialInvestment

IncrementalOperatingCosts

RepairsandMaintenance

IncreasedWorking Capital

Capital BudgetingCash Flow Analysis

TypicalCash Outflows

capital budgeting cash flow analysis7

IncrementalRevenues

ReducedOperatingCosts

ReleasedWorkingCapital

SalvageValue

Capital BudgetingCash Flow Analysis

TypicalCash Inflows

.

capital budgeting terminology

Out-of-pocketcosts

Cost of capital

Sunkcosts

Futurecashoutflows

Interest rateindicating thecost of debtand equityinvestmentfunds

Past cashoutflows

Avoided by not selectinga project

Not avoidedby currentdecision

Capital BudgetingTerminology
depreciation and taxes
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 taxes example
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.
slide11

Tax savings

Tax savings = $2,400

(.40 × $6,000 depreciation = $2,400)

Depreciation and TaxesExample

slide12

[

(

)

]

[

]

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

Depreciation and TaxesExample

After-tax net cash inflow

Alternatively, reducing this analysis to a formula yields:

.

project selection methods
Project Selection Methods
  • Payback Period
  • Unadjusted Rate of Return
  • Net Present Value (NPV)
  • Profitability Index
  • Time Adjusted Rate of Return i.e., Internal Rate of Return (IRR)
project selection method 1 payback period
Project Selection Method 1:Payback Period

Time required for the sumof the annual net cashinflows to equal theinitial cash outlay.

slide15

Initial cash outlay Annual net cash inflow

Payback period =

Payback Period

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

payback period example
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 Gatorsinvest in the seafood bar?
slide17

Initial cash outlay Annual net cash inflow

Payback period =

$150,000$30,000 per year

Payback period =

= 5.0 years

Payback PeriodExample

Gators should invest in the seafood bar

because the payback period is less than 6 years.

payback period limitations

Ignores the

time value

of money.

Ignores cash

flows after

the payback

period.

Payback Period Limitations
payback period limitations example
Payback Period LimitationsExample

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

Which project has the better payback period?

payback period limitations example20
Payback Period LimitationsExample
  • 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?
project selection method 2 unadjusted rate of return

Unadjusted Average annual incomerate of return Average amount of investment

=

Beginning balance + Ending balance2

Project Selection Method 2:Unadjusted Rate of Return

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

slide22

Unadjusted Rate of ReturnExample

Reconsider the Gators example:

  • 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%.

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

slide23

(

)×(1 - )

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

-

=

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

=

Unadjusted Rate of ReturnExample

Annual net cash inflows

$

30,000

Depreciation ($150,000 ÷ 10 years)

15,000

Annual income before tax

$

15,000

.

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

=

= 12.0%

slide24

Unadjusted Rate of ReturnLimitations

  • Depreciation may be calculated several ways thereby giving different results.
  • Time value ofmoney is ignored.
project selection method 3 net present value npv method
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

net present value procedure
Net Present ValueProcedure
  • 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 value interpretation
Net Present ValueInterpretation
  • If NPV is positive, the investment yields a higher return than the cost of capital.
  • Decision rule: Invest if NPV is positive.
net present value question
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. $ 4,306

b. $12,721

c. $11,553

d. $17,004

slide29

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. $ 4,306

b. $12,721

c. $11,553

d. $17,004

Use present value of annuity table (A.4)

PV of inflows = $20,000 × 5.65022 = $113,004

NPV = $113,004 - $96,000 = $17,004

slide30

Net Present ValueQuestion

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

slide31

Net Present ValueQuestion

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 = $104,322

NPV = $104,322 - $96,000 = $8,322

Note that the NPV is smallerusing the larger interest rate.

net present value
Net Present Value

Now that you have mastered the basic concept of net present value, it’s time for a more sophisticated checkup!

net present value example
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, anda $5,000 salvage value.
    • need an overhaul at the end of three years costing $30,000.
  • Initial working capital requirement is $100,000.
net present value example34
Net Present Value Example

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

Harper uses a 10 percent discount rate. Ignoring income taxes, compute the net present value of the contract.

net present value example35
Net Present Value Example

Harper Company Net Present Value Analysis

net present value example36
Net Present Value Example

Harper Company Net Present Value Analysis

net present value example37
Net Present Value Example

Harper Company Net Present Value Analysis

Present value of an annuity of $1

factor for 5 years at 10%.

net present value example38
Net Present Value Example

Harper Company Net Present Value Analysis

$80,000 × 3.79079 = $303,263

net present value example39
Net Present Value Example

Harper Company Net Present Value Analysis

Present value of $1

factor for 3 years at 10%.

net present value example40
Net Present Value Example

Harper Company Net Present Value Analysis

Present value of $1

factor for 5 years at 10%.

slide41

Net Present Value Example

Harper Company Net Present Value Analysis

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

project selection method 4 profitability index

Present value of net cash inflows Present value of cash outflows

Profitability index =

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.

.

project selection method 5 time adjusted rate of return

Presentvalue ofcash inflows

Presentvalue ofcash outflows

=

Also known as theinternal rate of return.

Project Selection Method 5:Time Adjusted Rate of Return

The interest rate that makes . . .

  • The net present value equal zero.
internal rate of return irr procedure
Internal Rate of Return (IRR)Procedure

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 procedure45
Internal Rate of Return (IRR)Procedure

Say that:

Project life = 4 yearsInitial cost = $42,523Annual net cash inflows = $14,000

Determine the IRR for this project.

1. Determine the payback period.

($42,523 ÷ $14,000 per year = 3.03736 years)

internal rate of return irr procedure46
Internal Rate of Return (IRR)Procedure

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

2. Using present value of annuity table . . .

Locate the rowwhose numberequals the lifeof the project.

internal rate of return irr procedure47
Internal Rate of Return (IRR)Procedure

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

2. Using present value of annuity table . . .

In that row,locate theinterest factorclosest inamount to thepayback period.

internal rate of return irr procedure48
Internal Rate of Return (IRR)Procedure

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

2. Using present value of annuity table . . .

IRR is theinterest rateof the columnin which theinterest factoris found.

internal rate of return example
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?

slide50

Initial cash outlay Annual net cash inflow

Payback period =

$104,322 $20,000 per year

Payback period =

= 5.21610

Internal Rate of ReturnExample

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.

internal rate of return example51
Internal Rate of ReturnExample

Here’s the proof . . .

internal rate of return complication 1
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.

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 return complication 2
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.

net present value vs internal rate of return
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
the end
THE END

I’m telling you, that’s the end. There isn’t any more of thisvirtual lecture.