Capital Budgeting

Capital Budgeting Chapter 11

Learning Objective 1 • Describe capital budgeting • decisions and use the net- • present-value (NPV) • method to make • such decisions.

Capital Budgeting Capital budgeting describes the long-term planning for making and financing major long-term projects. 1. Identify potential investments. 2. Choose an investment. 3. Follow-up or “postaudit.”

Discounted-Cash-FlowModels (DCF) These models focus on a project’s cash inflows and outflows while taking into account the time value of money. DCF models compare the value of today’s cash outflows with the value of the future cash inflows.

Net Present Value Model The net-present-value (NPV) method computes the present value of all expected future cash flows using a minimum desired rate of return.

Net Present Value Model The minimum desired rate of return depends on the risk of a proposed project – the higher the risk, the higher the rate. The required rate of return (also called hurdle rate or discount rate) is the minimum desired rate of return based on the firm’s cost of capital.

Cost of Capital • A company’s cost of capital is determined by summing the weighted average returns offered by each of the sources of capital (Bonds, preferred stock, common stock and retained earnings. • To illustrate let’s do the handout problem

Cost of Capital • To illustrate, assume the Foxborough Corporation has the following financing structure: • 10% Bonds $150,000 • 8% Preferred stock 50,000 • Common stock offering a 12% return 200,000 • Retained earnings with a 14% return 100,000 • Total $500,000 • To compute the weighted average cost of capital, find the relative percentages for each type of securities and multiply these percentage by the return offer and sum the result

Prepare a diagram of relevant expected cash inflows and outflows. 1 Find the present value of each expected cash inflow or outflow. 2 Sum the individual present values. 3 Applying the NPV Method

NPV Example Original investment (cash outflow): $6,075 Useful life: four years Annual income generated from investment (cash inflow): $2,000 Minimum desired rate of return: 10%

NPV Example YearsAmountPV FactorPresent Value 0 ($6,075) 1.0000 ($6,075) 1 2,000 .9091 1,818 2 2,000 .8264 1,653 3 2,000 .7513 1,503 4 2,000 .6830 1,366 Net present value $ 265

NPV Example YearsAmountPV FactorPresent Value 0 ($6,075) 1.0000 ($6,075) 1-4 2,000 3.1699 6,340 Net present value $ 265

Predicted cash flows occur timely. Money can be borrowed or loaned at the same interest rate. Assumptions of the NPV Model There is a world of certainty. There are perfect capital markets.

Decision Rules Managers determine the sum of the present values of all expected cash flows from the project. If the sum of the present values is positive, the project is desirable. If the sum of the present values is negative, the project is undesirable.

Internal Rate of Return Model The IRR determines the interest rate at which the NPV equals zero. If IRR > minimum desired rate of return, then NPV> 0 and accept the project. If IRR < minimum desired rate of return, then NPV< 0 and accept the project.

Real Option Model This model recognizes the value of contingent investments. Contingent investments are investments that a company can adjust as it learns more about their potential for success.

Learning Objective 2 • Evaluate projects using • sensitivity analysis.

Sensitivity Analysis Sensitivity analysis shows the financial consequences that would occur if actual cash inflows and outflows differ from those expected.

Sensitivity Analysis Example Suppose that a manager knows that the actual cash inflows in the previous example could fall below the predicted level of $2,000. How far below $2,000 must the annual cash inflow drop before the NPV becomes negative?

Sensitivity Analysis Example NPV = 0 (3.1699 × Cash flow) – $6,075 = 0 Cash flow = $6,075 ÷ 3.1699 = $1,916 If the annual cash flow is less than $1,916, the NPV is negative, and the project should be rejected.

Learning Objective 3 • Calculate the NPV difference • between two projects using • both the total project and • differential approaches.

Comparison of Two Projects Two common methods for comparing alternatives are: Total project approach Differential approach

Total Project Approach The total project approach computes the total impact on cash flows for each alternative and then converts these total cash flows to their present values. The alternative with the largest NPV of total cash flows is best.

Differential Approach The differential approach computes the differences in cash flows between alternatives and then converts these differences to their present values. This method cannot be used to compare more than two alternatives.

Learning Objective 4 • Identify relevant cash • flows for NPV analyses.

Relevant Cash Flows for NPV The four types of inflows and outflows should be considered when the relevant cash flows are arrayed: • Initial cash inflows and outflows at time zero • Investments in receivables and inventories • Future disposal values • Operating cash flows

Operating Cash Flows The only relevant cash flows are those that will differ among alternatives. Depreciation and book values should be ignored. A reduction in cash outflow is treated the same as a cash inflow.

Cash Flows for Investmentin Technology Suppose a company has a $10,000 net cash inflow this year using a traditional system. Investing in an automated system will increase the net cash inflow to $12,000. Failure to invest will cause net cash inflows to fall to $8,000.

Cash Flows for Investmentin Technology What is the benefit from the investment? $12,000 – $8,000 = $4,000

Learning Objective 5 • Compute the after-tax net • present values of projects.

Income Taxes andCapital Budgeting What is another type of cash flow that must be considered when making capital-budgeting decisions? Income taxes

Marginal Income Tax Rate In capital budgeting, the relevant tax rate is the marginal income tax rate. This is the tax rate paid on additional amounts of pretax income.

Effects of Depreciation Deductions U.S. tax authorities allow accelerateddepreciation. The focus is on the tax reporting rules, not those for public financial reporting. The recovery periodis the number of years over which an asset is depreciated for tax purposes.

TAX Effects of Depreciation Deductions Depreciation expense is a noncash expense and so is ignored for capital budgeting, except that it is an expense for tax purposes and so will provide a cash inflow from income tax savings.

Tax Deductions, Capital Effects, and Timing Assume the following: Cash inflow from operations: $60,000 Tax rate: 40% What is the after-tax inflow from operations? $60,000 × (1 – tax rate) = $60,000 × .6 = $36,000

Tax Deductions, Capital Effects, and Timing What is the after-tax effect of $25,000 depreciation? $25,000 × 40% = $10,000 tax savings

Modified Accelerated Cost Recovery System Under U.S. income tax laws, companies depreciate most assets using the Modified Accelerated Cost Recovery System (MACRS). This system specifies a recovery period and an accelerated depreciation schedule for all types of assets.

Learning Objective 6 • Explain the after-tax effect on • cash of disposing of assets.

Gains or Losses on Disposal Suppose a 5-year piece of equipment purchased for $125,000 is sold at the end of year 3 after taking three years of straight-line depreciation. What is the book value? $125,000 – (3 × $25,000) = $50,000

Gains or Losses on Disposal If it is sold for bookvalue, there is no gain or loss and so there is no tax effect. If it is sold for more than $50,000, there is a gain and an additional tax payment. If it is sold for less than $50,000, there is a loss and a tax savings.

Gains or Losses on Disposal Assume that it is sold for $70,000 and the tax rate is 40%. What is the cash inflow? ($70,000 – $50,000) × 40% = $8,000 $70,000 – $8,000 = $62,000

Learning Objective 7 • Use the payback model and • the accounting rate-of-return • model and compare them • with the NPV model.

Payback Model Payback time, or payback period, is the time it will take to recoup, in the form of cash inflows from operations, the initial dollars invested in a project. P = I ÷ Incremental inflow

What is the payback period Payback Model Example Assume that $12,000 is spent for a machine with an estimated useful life of 8 years. Annual savings of $4,000 in cash outflows are expected from operations. P = $12,000 ÷ $4,000 = 3 years

= Increase in expected average annual operating income ÷ Initial required investment Accounting Rate-of-Return Model The accounting rate-of-return (ARR) model expresses a project’s return as the increase in expected average annual operating income divided by the required initial investment. ARR

Accounting Rate-of-Return Example Assume the following: Investment is $6,075.  Useful life is four years.  Estimated disposal value is zero.  Expected annual cash inflow from operations is $2,000. What is the annual depreciation?

Accounting Rate-of-Return Example $6,075 ÷ 4 = $1,518.75 (rounded to $1,519) What is the ARR? ARR = ($2,000 – $1,519) ÷ $6,075 = 7.9%

Learning Objective 8 • Reconcile the conflict between • using an NPV model for making a • decision and using accounting • income for evaluating the • related performance

Performance Evaluation Many managers are reluctant to accept DFC models as the best way to make capital-budgeting decisions. Why? Their superiors evaluate them using a non-DCF model.

Reconciliation of Conflict Use DCF for both capital-budgeting decisions and performance evaluation. Economic Value Added (EVA) Follow-up evaluation of capital decisions

Capital Budgeting