Chapter 6 Principles of Capital Investment

Administrative Framework Involves Generation of investment proposals Estimation of cash flows Evaluation of cash flows Selection of projects based on an acceptance criterion Continual reevaluation of investment projects after acceptance Chapter 6 Chapter 7

Project Classification New products or expansion of existing products Replacement of equipment or buildings Research and development Exploration Others

Multiple Screens Board President Committee VP operations Plant manager Section chiefs

Level and Type of Capital Expenditure As the capital outlay increases, the number of screens generally increases Important to investors Convey information about expected future growth

Cash-Flow Forecasts Incremental cash flows Differences between cash flows of the firm with and without the project Ignore sunk cost Patterns of cash flow Annuity Salvage value

Replacement Decisions and Depreciation Cash flow information Purchase price of new machine Installation cost Sale of old machine Cash savings for new machine Depreciation effect Income tax Incremental, after-tax cash flow

Methods for Evaluation Average rate of return Payback Internal rate of return Net present value Economic worth of a project Discounted cash flow method

Average Rate of Return (ARR) Compared with required rate of return Principal virtue is its simplicity Principal shortcomings Based on accounting information Time value of money is ignored

Payback (PB) Number of years to recover initial cash investment Shortcomings Fails to consider Cash flows after the PB period Magnitude or timing of cash flows during the payback period Does not measure profitability Popularity of PB Limited insight Into the risk of a project Into the liquidity of a project

Internal Rate of Return (IRR) Discounted cash flow method The rate of discount which equates the PV of cash inflows with the PV of cash outflows Takes account of cash flows Magnitude Timing Acceptance criterion IRR > required rate

Required Rare of Return (RRR) Systematic risk is higher for capital-expending projects Replacement projects Produce benefits across more states of the economy Possess lower systematic risk Require a lower return

Net Present Value (NPV) What remains after discounting all cash flows by the RRR Acceptance criterion PV of the cash inflows > PV of the cash outflows Absolute measure of the contribution

Profitability Index (PI) PV of future net cash flows over the initial cash outlay Acceptance criterion PI  1.00 NPV and PI Give the same accept-reject signals Expresses relative profitability

Mutual Exclusive and Dependency Acceptance of one precludes the acceptance of another project Contingent proposal Depends on the acceptance of one or more other proposals

NPV Versus IRR Compounding rate differences Investment proposals are mutually exclusive IRR method implies that funds are compounded at the IRR PV method implies compounding at the RRR Scale of investment Mutually exclusive investment proposals having different initial cash outlays IRR ignores the scale of investment Multiple IRR’s Cash-flow stream changes sign more than once

Depreciation and Other Refinements in Cash-Flow Information Method of depreciation Setting up the cash flows Salvage value and taxes Working capital requirement

Method of Depreciation Straight-line depreciation Accelerated depreciation PV advantage in postponing taxes MACRS Eight property classes 200% declining-balance method (1-4) Half-year convention 150% declining-balance (5&6) Straight-line depreciation (7&8)

Setting Up the Cash Flows Cost Annual savings Depreciation Income Taxes NCF

Salvage Value and Taxes Sale of a fully depreciated asset is subject to taxation Sold > depreciated book value < cost Pay full corporate tax rate Sold > cost Capital-gains tax treatment

Working Capital Requirement Cash outflow at the time of occurrence Additional cash Additional receivables Additional inventories End of project’s life Treated as a cash inflow Can occur at any time

What Happens When Capital is Rationed? Capital rationing Budget ceiling Selection criterion Combination of proposals with highest NPV Consider more than one period Problems incurred Reject positive NPV projects Less than optimal investment policy

Inflation and Capital Budgeting Real cash flows do not keep up with inflation Inflation effect on results Lower real rates of return Disincentive to undertake capital expenditures Invest less Seek investments with faster PBs Become less capital intensive Bias in cash-flow estimates

Information to Analyze an Acquisition Same as any other investment proposal Initial outlay of cash or stock Followed by expected future benefits Major differences Initial cost may be subject to bargaining Synergism

Measuring Free Cash Flows (FCF) EBITDA - Taxes - Capital expenditures - Working-capital additions = Incremental free cash flow FCFs determine an acquisition’s value

Noncash Payments and Liability Assumptions Overriding valuation principle Value of the incremental FCFs Cash-equivalent price Convert to market value Securities Liabilities Separate investing from financing