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Capital Budgeting

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Capital Budgeting

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    1. Chapter 10 Capital Budgeting

    2. Capital Budgeting The process of making capital expenditure decisions is known as capital budgeting. Capital budgeting involves choosing among various capital projects to find one(s) that will maximize a company’s return on its financial investment.

    3. The Capital Budgeting Evaluation Process Many companies follow a carefully prescribed process in capital budgeting. The process usually includes the following steps: 1 Project proposals are requested from departments, plants, and authorized personnel. 2 Proposals are screened by a capital budget committee. 3 Officers determine which projects are worthy of funding. 4 Board of directors approves capital budget.

    4. Cash Flow Information Most capital budgeting decision methods employ cash flow numbers rather than accrual accounting revenues and expenses. Revenues and expenses often differ significantly from cash inflow and outflows. For purposes of capital budgeting, estimated cash inflows and outflows are preferred as inputs into capital budgeting decision tools.

    5. Capital Budgeting Considerations The capital budgeting decision, under any technique, depends in part on a variety of considerations: The availability of funds The relationships among proposed projects The company’s basic decision-making approach The risk associated with a particular project

    6. Illustrative Data The following data will be used in a continuing example. This will allow for comparison of the results of the various capital budgeting techniques.

    7. Cash Payback The cash payback technique identifies the time period required to recover the cost of the capital investment from the annual cash inflow produced by the investment.

    8. Cash Payback Example The cash payback period in the Stewart Soup example is 5.42 years, computed as follows: Assume that at Stewart Soup a project is unacceptable if the payback period is longer than 60% of the asset’s expected useful life. Thus, this project is acceptable. The 5.42-year payback period is just over 50% of the project’s 10-year expected useful life.

    9. Cash Payback: Advantages and Disadvantages The cash payback technique may be useful as an initial screening tool. It is easy to compute and understand. However, it should not normally be the only basis for a capital budgeting decision because it ignores the profitability of the project. It also ignores the time value of money.

    10. Discounted Cash Flow Techniques Capital budgeting techniques that take into account both the time value of money and the estimated total cash flows from an investment are called discounted cash flow techniques. They are generally recognized as the most informative and best conceptual approaches to making capital budgeting decisions.

    11. Discounted Cash Flow Techniques The primary capital budgeting method that uses discounted cash flow techniques is called net present value. A second method, to be discussed later, is the internal rate of return. Appendix C reviews the time value of money concepts upon which these methods are based. (All of the PV factors in the following examples come from Appendix C.)

    12. Net Present Value Method Under the net present value (NPV) method, cash inflows are discounted to their present value and then compared with the capital outlay required by the investment. The difference between these two amounts is referred to as the net present value. The interest rate to be used in discounting the future cash flows is the required minimum rate of return. A proposal is acceptable when the NPV is zero or positive. The higher the NPV, the more attractive the investment.

    13. Net Present Value Decision Criteria

    14. Equal Annual Cash Flows Example Stewart’s annual cash inflows are $24,000. If we assume this amount is uniform over the asset’s useful life, the present value of its annual cash flows can be computed as shown:

    15. Unequal Cash Flows Example When annual cash flows are unequal, it is not possible to use annuity tables to calculate their PV. Instead tables showing the PV of a single amount must be applied to each annual cash flow.

    16. Unequal Cash Flows Example

    17. Choosing a Discount Rate In most cases, a company uses a discount rate (also known as hurdle rate, cutoff rate, or required rate of return) that is equal to its cost of capital, which is the rate it must pay to obtain funds from creditors and stockholders. The cost of capital is a weighted average of the rates paid on borrowed funds and funds from investors in the company’s stock. A discount rate has two elements: a cost of capital element, and a risk element. Companies often assume the risk element is zero.

    18. Choosing a Discount Rate Using an incorrect discount rate can lead to incorrect capital budgeting decisions. Suppose Stewart Soup’s 12% discount rate did not take into account the fact that this project is riskier than most of the company’s investments. Given the risk, a 15% discount rate would have been more appropriate.

    19. Simplifying Assumptions In the examples of the NPV method, a number of simplifying assumptions have been made: All cash flows come at the end of each year. All cash flows are immediately reinvested in another project that has a similar return. All cash flows can be predicted with certainty. Because these assumptions are rarely all true in the “real world,” NPV provides estimated analysis. Some of these assumptions are relaxed in more advanced capital budgeting techniques.

    20. Comprehensive Example Best Taste Foods is considering investing in new equipment to produce fat-free snack foods. The following information was determined in consultation with various company departments:

    21. Comprehensive Example The computation of the net annual cash inflows for the project is shown below:

    22. Intangible Benefits Intangible benefits such as increased quality or safety or employee loyalty may also influence the decision. To avoid rejecting projects that should be accepted, two possible approaches are suggested: Calculate NPV ignoring intangible benefits and if NPV is negative, ask if intangible benefits are worth at least the negative NPV. Project rough, conservative estimates of the value of the intangible benefits and include those in NPV calculation.

    24. Mutually Exclusive Projects In theory, all projects with positive NPVs should be accepted. However, companies rarely are able to adopt all positive-NPV proposals. Proposals are often mutually exclusive because of limited resources. When choosing between alternatives, it is tempting to choose the project with the highest NPV, but the investment required by the projects should also be considered.

    25. Mutually Exclusive Projects: Profitability Index One relatively simple method of comparing alternative projects that takes into account both the size of the original investment and the discounted cash flows is the profitability index. The profitability index is computed with the following formula:

    26. Profitability Index Example A company must choose between two mutually exclusive projects. Each project has a 10-year life and a 12% discount rate can be assumed. Data related to the two projects is as shown:

    27. Profitability Index Example Data for the two projects is shown below in a slightly altered form:

    28. Internal Rate of Return Method The internal rate of return method results in finding the interest yield of the potential investment. The internal rate of return is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows (i.e., a NPV of zero).

    29. Internal Rate of Return Method Determining the internal rate of return involves three steps: (These steps assume that annual cash flows are equal; an alternative method of computing the internal rate of return must be used when cash flows are unequal.) Tampa Company will be used as an example. Tampa Company is considering a new project with an 8-year estimated life, an initial cost of $249,000, and a net annual cash inflow of $45,000.

    30. Internal Rate of Return Step 1: Compute the internal rate of return factor using the following formula:

    31. Internal Rate of Return Step 2: Use the factor and the present value of an annuity of 1 table to find the internal rate of return.

    32. Internal Rate of Return Decision Criteria

    33. Annual Rate of Return Method The annual rate of return technique is based on accrual accounting data. It indicates the profitability of a capital expenditure. The formula is:

    34. Annual Rate of Return Example Assume that Reno Company is considering an investment of $130,000 in new equipment. The new equipment is expected to last 5 years and have zero salvage value. The straight-line depreciation method is used for accounting purposes. The expected annual revenues and costs of the new product that will be produced from the investment are:

    35. Annual Rate of Return Example Average investment is computed as follows:

    36. Annual Rate of Return: Advantages & Disadvantages The principal advantages of this method are the simplicity of its calculation and management’s familiarity with the accounting terms it uses. A major limitation is that it does not consider the time value of money.

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