12 The Capital Budgeting Decision Prepared by: Michel Paquet SAIT Polytechnic ©2009 McGraw-Hill Ryerson Limited

Chapter 12 - Outline Definition of Capital Budgeting Methods of Evaluating Investment Proposals Accept/Reject Decision Capital Rationing Cash Flow Analysis and Capital Cost Allowance (CCA) Making Investment Decisions Summary and Conclusions

Learning Objectives Define capital budgeting decisions as long-run investment decisions. (LO1) Explain that cash flows rather than accounting earnings are evaluated in the capital budgeting decision. (LO2) Evaluate investments by the average accounting return, the payback period, the internal rate of return, the net present value and the profitability index. (LO3)

Learning Objectives Discuss the use of the cost of capital as the discount rate in capital budgeting analysis. (LO4) Identify the cash flows that result from an investment decision, including the aftertax operating benefits and the tax shield benefits of capital cost allowance (amortization). (LO5) Perform NPV analysis to assist in the decision-making process concerning long-run investments. (LO6)

What is Capital Budgeting? LO1 What is Capital Budgeting? Capital Budgeting: represents a long-term investment decision for example, buy a new computer system or build a new plant involves the planning of expenditures for a project with a life of 1 or more years emphasizes amounts and timing of cash flows and opportunity costs and benefits investment usually requires a large initial cash outflow with the expectation of future cash inflows considers only those cash flows that will occur as a result of the investment (resultant cash flows) all cash flows are calculated aftertax

LO1 FIGURE 12-1 Capital budgeting procedures

Accounting Flows Versus Cash Flows Table 12-1 Cash flow for Alston Corporation Earnings before amortization and taxes (cash inflow) . . . $20,000 Amortization (non-cash expense) . . . . . . . . 5,000 Earnings before taxes . . . . . . . . . . . . 15,000 Taxes (cash outflow) 40% . . . . . . . . . . . 6,000 Earnings aftertaxes . . . . . . . . . . . . 9,000 Amortization . . . . . . . . . . . . . . + 5,000 Cash flow . . . . . . . . . . . . . . . $14,000 Alternative method of cash flow calculation Cash inflow (EBAT) . . . . . . . . . . . . $20,000 Cash outflow (taxes) . . . . . . . . . . . . - 6,000

Table 12-2 Revised cash flow for Alston Corporation Earnings before amortization and taxes . . . . . $20,000 Amortization . . . . . . . . . . . . . 20,000 Earnings before taxes . . . . . . . . . . 0 Taxes . . . . . . . . . . . . . . . 0 Earnings aftertaxes . . . . . . . . . . . 0 Amortization . . . . . . . . . . . . . + 20,000 Cash flow . . . . . . . . . . . . . $20,000

5 Methods of Evaluating Investment Proposals LO3 5 Methods of Evaluating Investment Proposals Average Accounting Return (AAR) Payback Period (PB) Internal Rate of Return (IRR) Net Present Value (NPV) Profitability Index (PI)

Average Accounting Return (AAR) LO3 Average Accounting Return (AAR) AAR Equals: Average Earnings Aftertax Average Book Value of Investment Advantage: Relatively easy to calculate Disadvantages: Uses accounting earnings, not cash flows Ignores the timing of the earnings Uses book value, not market value of investment Does not suggest an objective evaluation yardstick

Average Accounting Return: An Example LO1 Average Accounting Return: An Example Earnings Aftertax Amortized Capital Cost Capital Cost $30,000* Year 1 $2,000 22,500 Year 2 4,000 15,000 Year 3 8,000 7,500 Year 4 2,000 0 Average $16,000/4 = $4,000 $75,000/5 = $15,000** Average Accounting Return $4,000/$15,000 = 26.7% *Straight-line depreciation **Also, Average Book Value = ($15,000 + $0)/2 = $15,000

Payback Period Payback Period (PB): LO3 computes the amount of time required to recoup the initial investment a cutoff period is arbitrarily established Advantages: easy to use (“quick and dirty” approach) emphasizes liquidity one measure of the risk of an investment Disadvantages: ignores inflows after the cutoff period and fails to consider the time value of money does not have an objective yardstick not a good measures of risk

Net Present Value Net Present Value (NPV): LO3 Net Present Value Net Present Value (NPV): the present value of the cash inflows minus the present value of the cash outflows the future cash flows are discounted back over the life of the investment the basic discount rate is usually the firm’s cost of capital (WACC) (assuming similar risk)

Internal Rate of Return LO3 Internal Rate of Return Internal Rate of Return (IRR): represents a yield on an investment or a rate of return requires calculating the discount rate that equates the initial cash outflow (cost) with the future cash inflows (benefits) is the discount rate where the cash outflows equal the cash inflows (or NPV = 0)

Profitability Index Profitability Index (PI) = LO3 Profitability Index Profitability Index (PI) = – an alternative presentation of the NPV method – used to compare investments of different sizes especially in a capital rationing situation Present value of the inflows Present value of the outflows

Capital Budgeting: An Example LO3 Capital Budgeting: An Example TABLE 12-3 Investment alternatives

Evaluating These 2 Investments LO3 Evaluating These 2 Investments Payback Period: Investment A: $5,000 + $5,000 = $10,000 (2 years) Investment B: $1,500 + $2,000 + $2,500 + $4,000 ( = 0.8 of $5,000) = $10,000 (3.8 years) Net Present Value: Investment A: $5,000 $5,000 $2,000 0 1 2 3 |----------------|-----------------|-------------------| PV = -$10,000 n = 3 %i = 10% Using the NPV function in a financial calculator: CF0= -10000; C01 = 5000; F01 = 2; C02 = 2000; F02 = 1; I = 10; Compute NPV = 180.32

Evaluating These 2 Investments LO3 Evaluating These 2 Investments Net Present Value: Investment B: $1,500 $2,000 $2,500 $5,000 $5,000 0 1 2 3 4 5 |---------------|---------------|---------------|----------------|---------------| PV= -$10,000 n = 5 i% = 10 Using the NPV function in a financial calculator: CF0= -10000; C01 = 1500; F01 = 1; C02 = 2000; F02 = 1; C03 = 2500; F03 = 1; C04 = 5000; F04 = 2; I = 10; Compute NPV = 1414.49

Evaluating These 2 Investments LO3 Evaluating These 2 Investments Internal Rate of Return: Investment A: Investment B: Profitability Index: A: PI = $10,180/$10,000 = 1.0180; B: PI = $11,414/$10,000 = 1.1414 Using the IRR function in a financial calculator: CF0= -10000; C01 = 5000; F01 = 2; C02 = 2000; F02 = 1; Compute IRR = 11.16(%) Using the IRR function in a financial calculator: CF0= -10000; C01 = 1500; F01 = 1; C02 = 2000; F02 = 1; C03 = 2500; F03 = 1; C04 = 5000; F04 = 2; Compute IRR = 14.33 (%)

Table 12-4 Capital budgeting results LO3 Table 12-4 Capital budgeting results Investment A Investment B Selection Payback period . . . . 2 years 3.8 years Quickest payback: Investment A Net present value . . . $180 $1,414 Highest net present value: Investment B Internal rate of return . 11.16% 14.33% Highest yield: Investment B Profitability Index . . 1.0180 1.1414 Highest relative profitability: Investment B

Accept/Reject Decision LO3 Payback Method (PB): – if PB period < cutoff period, accept the project – if PB period > cutoff period, reject the project Internal Rate of Return (IRR): – if IRR > cost of capital, accept the project – if IRR < cost of capital, reject the project Net Present Value (NPV): – if NPV > 0, accept the project – if NPV < 0, reject the project Profitability Index (PI): – if PI > 1, accept the project – if PI < 1, reject the project

Comparing Methods PI is a variation of NPV method. LO3 Comparing Methods PI is a variation of NPV method. IRR and NPV methods are superior to PB and AAR methods, because – IRR and NPV evaluate all the resultant cash flows – they employ the time value of money – they have an objective yardstick – the cost of capital IRR method has some flaws: – inconsistency with NPV for some mutually exclusive projects – discounting considerations – multiple IRRs NPV is the best methodology.

LO4 Table 12-5 Internal rate of return and net present value ($10,000 investment) Investment A (11.16% IRR) Investment A Year Cash Flow Year Cash Flow 1 . . . $5,000 1 . . . $5,000 10% 2 . . . 5,000 2 . . . 5,000 11% 3 . . . 2,000 3 . . . 2,000 12% discounted at discounted 11.16% at various rates if desired NPV = 0 NPV = $27

Modified Internal Rate of Return LO3 Modified Internal Rate of Return The reinvestment assumption of the IRR method may be unrealistic. To remedy this flaw, the more realistic reinvestment assumption of the NPV method is combined with the IRR method, producing the modified internal rate of return (MIRR). MIRR is the discount rate that will equate the initial investment with the future value of inflows. Each of these inflows grows at the cost of capital.

Modified Internal Rate of Return LO3 Modified Internal Rate of Return Cost of capital = 10% $6,000 FV = $7,260 $5,000 FV = $5,500 $2,850 FV = $2,850 0 1 2 3 FV = $15,610 PV = -$10,000 Using the PV function in a financial calculator N= 3; PV= -10000; PMT= 0; FV=15,610; Compute I = 16(%) MIRR = 16%

LO3 Table 12-6 Multiple IRRs

LO3 Capital Rationing A limit or constraint on the amount of funds that can be invested Firm must rank investments based on their NPVs Those with positive NPVs are accepted until all funds are exhausted

Table 12-7 Capital rationing LO3 Table 12-7 Capital rationing Net Total Present Project Investment Investment Value Capital A $2,000,000 $400,000 rationing B 2,000,000 380,000 solution C 1,000,000 $5,000,000 150,000 D 1,000,000 100,000 Best E 800,000 6,800,000 40,000 solution F 800,000 (30,000.)

Net Present Value Profile LO4 Net Present Value Profile – a graph of the NPV of a project at 3 different discount rates: a zero discount rate the normal discount rate (or cost of capital) the IRR for the investment – allows an easy way to visualize whether or not an investment should be undertaken

Figure 12-2 Net Present Value Profile LO4 Figure 12-2 Net Present Value Profile 6,000 4,000 2,000 Net present value ($) 5% 10% 15% 20% 25% IRRB = 14.33% IRRA = 11.16% Discount rate (percent) Investment B Investment A B A A B

Figure 12-3 Net Present Value Profile With Crossover LO4 Figure 12-3 Net Present Value Profile With Crossover 6,000 4,000 2,000 Net present value ($) 5% 10% 15% 20% 25% IRRC = 22.49% IRRB = 14.33% Discount rate (percent) Crossover point Investment C Investment B B C B C

Capital Cost Allowance Amortization for income tax purposes Capital Cost Allowance (CCA) is the maximum amount of amortization allowable under the tax act Capital assets are divided into a number of classes (pools) Each class is assigned a CCA rate; ex. Class 8 is Machinery with a rate of 20% CCA is calculated on the Un-depreciated Capital Cost (UCC) in the pool (declining balance) CCA provides a tax shield over the life of the investment A formula provides the present value of the CCA tax shield

Capital Cost Allowance: tax savings Before CCA Expense After CCA Expense Income (cash flow) . . $12,000 Income (cash flow) . . $12,000 CCA . . . . . . . . . . . . . . 5,000 Taxable income . . . . . 7,000 Tax @ 40% . . . . . . . . 4,800 Tax @ 40% . . . . . . . . 2,800 Income (cash flow) Income aftertaxes $4,200 aftertaxes . . . . . 7,200 Add back CCA 5,000 Income/cash flow aftertax $9,200 Aftertax expense $5,000 (1 - T) = $3,000 Tax savings $5,000 (T) = $2,000 Before-tax expense $5,000

Table 12-8 Some declining balance CCA classes LO5 Table 12-8 Some declining balance CCA classes

Table 12-9 Capital Cost Allowance for investment A or B Year 1: Net original cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000 Less: capital cost allowance 1/2($10,000 x .20) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Undepreciated capital cost* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . $ 9,000 Year 2: Less: capital cost allowance ($9,000 x .20) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800 Undepreciated capital cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,200 Year 3: Less: capital cost allowance ($7,200 x .20) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,440 Undepreciated capital cost . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,760 Year 4: Less capital cost allowance $(5,760 x .20) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,152 Undepreciated capital cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . $ 4,608 Year n: Undepreciated capital cost (for year n - 1) Less capital cost allowance (UCC in year n - 1 x .20) Equals: undepreciated capital cost (for year n) *UCC for short UCCn = (1-d/2)(1 - d)n-1

Table 12-10 Liquidation of Asset Pool LO5 Table 12-10 Liquidation of Asset Pool

Making Investment Decisions LO6 Making Investment Decisions When estimating cash flows for an investment proposal, remember that only those cash flows resulting from the potential acceptance decision are relevant and should be included in your estimation. For example, a proposal of purchasing a new van to replace an old van should only include the net cost of the new van, that is, the difference between the cost of the new van and the sale price of the old van. The present value of CCA tax shield =

Table 12-13 Net present value of resultant cash flows at 12%

Table 12-14 IRR solution framework using 25% LO6 Table 12-14 IRR solution framework using 25%

Making Investment Decisions LO6 Making Investment Decisions To make the actual investment decision: (1) determine the net cash outflow arising from the initial investment (2) estimate the amounts and timing of net future cash inflows (aftertax) (3) discount the future cash flows back to the present (4) add the present value of the Capital Cost Allowance shield, using the formula and appropriate CCA rate (5) determine whether the machine should be purchased (if NPV > 0)

Table 12-15 Net price of the new computer LO6 Table 12-15 Net price of the new computer Price of the new computer . . . . . . . . . . . . . . . . . . . . . . . . $150,000 - Investment tax credit (15%) or $22,500 . . . . . . . . . . . . 19,737* Net price of new computer . . . . . . . . . . . . . . . . . . . . . . . . 130,263 - Cash inflow from sale of old computer . . . . . . . . . . . . . 40,000 Net cost of new computer . . . . . . . . . . . . . . . . . . . . . . . . . $ 90,263 *Our assumption about cash flows (revenues, expenses) and tax-initiated cash flows is that they occur at the end of the year. Therefore, the tax credit of $22,500 is discounted one year. The CCA pool is affected in the year after acquisition. The CCA tax shield formula is constructed assuming tax savings effects occur at the end of the year

Table 12-16 Differential analysis of new computer LO6 Table 12-16 Differential analysis of new computer Present (1- After-tax Value Year Cash Flow Amount (tax rate) Cash Flow (@14%) 0 . . . New computer –$90,623 — — –$90,623 0 . . . Working capital investment –5,000 — — –5,000 1 . . . Cost savings 20,000 .61 12,200 10,702 2 . . . Cost savings 38,000 .61 23,180 17,836 3 . . . Cost savings 40,000 .61 24,400 16,469 4 . . . Cost savings 45,000 .61 27,450 16,253 5 . . . Cost savings 45,000 .61 27,450 14,257* 5 . . . Salvage 30,000 — — 15,581 5 . . . Working capital recovery 5,000 — — 2,597 Present value of CCA tax shield benefits. . . (from calculation) 20,490 Net present value $18,922 *The present value of all the cost savings may be handled in one output from the calculator, particularly if it is an annuity

Summary and Conclusions The capital budgeting decision deals with the planning of expenditures for a project with a life of at least one year. Five methods are used to analyze capital investment proposals: average accounting return (AAR), payback period (PB), net present value (NPV), internal rate of return (IRR), and profitability index (PI). NPV, IRR and PI are more complete methods for assessing capital budgeting decision, because they consider timing and overall amount of cash flows and have an objective yardstick.

Summary and Conclusions A capital budgeting decision should consider cash flows on an aftertax basis not accounting flows and should only consider those cash flows as a direct result of the decision. Capital cost allowance (CCA) would affect the cash flows from a project because it may save a firm some tax dollars. A positive NPV project will increase the shareholders’ wealth by that amount.