Capital Budgeting Decisions Module 25 Capital Budgeting Decisions © Cambridge Business Publishers, 2018

Explain the role of capital budgeting in long-range planning. 1 Explain the role of capital budgeting in long-range planning. © Cambridge Business Publishers, 2018

Capital Expenditures Investments of financial resources in projects To develop or introduce new products or services To expand current production or service capacity, or To change current production or service facilities Made with the expectation that the new product, process, or service will generate future financial inflows that exceed initial costs © Cambridge Business Publishers, 2018

Capital Budgeting A process that involves The identification of potentially desirable projects for capital expenditures The subsequent evaluation of capital expenditure proposals, and The selection of proposals that meet certain criteria © Cambridge Business Publishers, 2018

Effective Capital Budgeting Long-range planning is necessary since models involve cash flows over several years Well-defined business strategy guides a company’s capital expenditure decisions © Cambridge Business Publishers, 2018

Capital Budgeting Procedures © Cambridge Business Publishers, 2018

Management of Capital Budgeting Management should develop procedures for review, evaluation, approval, and post-audit of capital expenditure proposals Capital budgeting committee Provides management guidance in formulation of capital expenditure proposals May preauthorize certain types and amounts of proposals with guidelines © Cambridge Business Publishers, 2018

Post-Audit of Capital Budgeting Involves the development of project performance reports comparing planned and actual results Reports should be provided to those involved with the proposal To help keep the project on target To help identify the need to reevaluate the project if the initial analysis is in error or significant changes occur To improve investment proposal quality To help the capital budgeting committee better evaluate proposals © Cambridge Business Publishers, 2018

2 Analyze capital budgeting decisions, using models that consider the time value of money, such as net present and internal rate of return. © Cambridge Business Publishers, 2018

Capital Budgeting Models Net present value Internal rate of return Payback period Accounting rate of return Time Value of Money methods © Cambridge Business Publishers, 2018

Three Phases of a Project’s Cash Flows Includes all cash expenditures necessary to begin operations Initial Investment Includes all cash operating receipts and expenditures during operations Operation Occurs at the end of the project’s life when assets are disposed of for their salvage value and any initial investment of working capital is recovered Disinvestment © Cambridge Business Publishers, 2018

Predicted Cash Flow Analysis Example Bates’ Limo is considering the purchase of a new limo with these predicted cash flows: Initial investment (time 0): Limo purchase $84,000 Working capital 2,500 Total $86,500 Operations (per year for 4 years): Sales $105,000 Cash operating costs: Fuel and maintenance $21,600 Insurance 2,300 Driver's salary 53,000 76,900 Net annual cash flows $28,100 Disinvestment (end of 4 years): Sale of limo $12,000 Recovery of working capital 1,000 Total disinvestment $13,000 © Cambridge Business Publishers, 2018

Calculating Net Present Value Present value of the project’s net cash inflows from operations + Present value of the disinvestment cash flows – Amount of the initial investment NET PRESENT VALUE Cash flows are adjusted for time value of money, using a discount rate (the minimum rate of return required for the project to be acceptable). © Cambridge Business Publishers, 2018

Net Present Value Assumptions Initial investment occurs at time 0 All other cash flows occur at end of each year Initial Investment Treated as a lump-sum amount Operations Treated as an annuity (if equal in amount each year) Disinvestment Treated as a lump-sum amount © Cambridge Business Publishers, 2018

Net Present Value Approaches Table Approach Select factors from Tables 25A.1 and 25A.2 in Appendix 25A Spreadsheet Approach Use built in NPV function Input required for the discount rate and cash flow amounts for each period © Cambridge Business Publishers, 2018

Net Present Value Table Approach Example Assume Bates Limo uses an 8% discount rate. Predicted Cash Inflows (Outflows) Years(s) of Cash Flows 8% Present Value Factor Present Value of Initial investment $(86,500) 1.00000 Operations 28,100 1-4 3.31213 93,071. Disinvestment 13,000 4 0.73503 9,555. Net present value of all cash flows $ 16,126. Table 12A.2 Table 12A.1 © Cambridge Business Publishers, 2018

Net Present Value Spreadsheet Approach Example Assume Bates Limo uses an 8% discount rate. $28,100 + $13,000 NPV function: =NPV(0.08, B2:B5) Because the NPV is positive, this is an acceptable project. © Cambridge Business Publishers, 2018

Caution in Using the Spreadsheet Approach NPV spreadsheet formula assumes that the first cash flow occurs at time “1” rather than at time “0,” i.e., omit time 0 cash flow in the formula. Arrange operating cash flows from top to bottom in a column, or left to right in a row. © Cambridge Business Publishers, 2018

Internal Rate of Return (IRR) Also called the time-adjusted rate of return The discount rate that equates the present value of the cash inflows with the present value of the cash outflows The minimum rate that could be paid for the money invested in a project without losing money The discount rate that results in a project’s net present value equaling zero © Cambridge Business Publishers, 2018

Spreadsheet Approach to Internal Rate of Return (IRR) Sometimes requires an initial guess of the project’s rate of return IRR function: =IRR(B2:B6, 0.08) The investment will generate an internal rate of return of 15.6%. The IRR should be compared to the required rate of return. © Cambridge Business Publishers, 2018

Cost of Capital The average cost an organization pays to obtain resources necessary to make investments Considers items such as Effective interest rate on debt Effective dividend rate on preferred stock Discount rate that equates the present value of all dividends expected on common stock over the life of the organization to the current market value of the company’s common stock © Cambridge Business Publishers, 2018

Computing the Cost of Equity Capital The cost of capital for a company that has no debt or preferred stock: Current annual dividend per common share Current market price per common share + Expected dividend growth rate Cost of equity capital = Investing in a project that has an IRR greater than the cost of capital should increase the market value of a firm’s securities. © Cambridge Business Publishers, 2018

3 Analyze capital budgeting decisions using methods that do not consider the time value of money, such as payback period and accounting rate of return. © Cambridge Business Publishers, 2018

Does not consider the time value of money. Payback Period Indicates the time required to recover the initial investment in a project from operations Acceptable projects must have less than some maximum payback period designated by management Does not consider the time value of money. © Cambridge Business Publishers, 2018

Calculating Payback Period For projects with equal annual operating cash flows Initial investment Annual operating cash inflows Payback period = Payback period for Bates Limo = $86,500 $28,100 = 3.08 years Bates Limo will recover all of its initial cash investment in 3.08 years. © Cambridge Business Publishers, 2018

Calculating Payback Period For projects with unequal annual operating cash flows Assume Bates Limo’s net operating cash inflow is $26,000, $27,000, $28,000, and $29,000 in Years 1 through 4, respectively. Payback period for Bates Limo: Year Net Cash Inflow Unrecovered Investment $ 0 $86,500 1 26,000 60,500 2 27,000 33,500 3 28,000 5,500 4 29,000 Three full years plus a portion of year 4: $5,500 / $29,000 = 0.19 Recovery period = 3.19 years © Cambridge Business Publishers, 2018

Accounting Rate of Return Average annual increase in net income that results from acceptance of a capital expenditure proposal divided by the initial investment or the average investment in the project Focuses on net income, not cash flows Determining Net Income: Annual net cash inflow from operations – Average annual depreciation Average annual increase in net income © Cambridge Business Publishers, 2018

Accounting Rate of Return Example Bates Limo is considering the purchase of a new limo for $84,000 with an estimated disposal value of $12,000 at the end of its useful life of 4 years. The annual operating cash flows total $28,100. Average annual increase in net income = Annual net cash inflow from operations $ 28,100 Less average annual depreciation: ($84,000 - $12,000) / 4 years (18,000) Average annual increase in net income $ 10,100 © Cambridge Business Publishers, 2018

Accounting Rate of Return Example Bates Limo is considering the purchase of a new limo for $84,000 with an estimated disposal value of $12,000 at the end of its useful life of 4 years. The average annual increase in net income is $10,100. Accounting rate of return on initial investment: $10,100 $84,000 = 0.1202 Average annual increase in net income Initial investment = Accounting rate of return on average investment: $10,100 ($84,000 + $12,000) / 2 = 0.2104 Avg. annual increase in net income Avg. investment = Management will reject investments that do not exceed the minimum required return. © Cambridge Business Publishers, 2018

4 Evaluate the strengths and weaknesses of alternative capital budgeting models. © Cambridge Business Publishers, 2018

Evaluating Payback Period Disadvantages when used solely to evaluate investments Ignores time value of money Ignores profit Ignores cash flows after the payback period © Cambridge Business Publishers, 2018

Evaluating Accounting Rate of Return Superior to payback period method for total life evaluations as it considers the proposals’ profitability Fails to consider the timing of cash flows Treats all cash flows equally Early period cash flows are worth more than later cash flows © Cambridge Business Publishers, 2018

Evaluating Accounting Rate of Return Predicted net cash inflow from operations Project 1 Project 2 Year 1 $ 30,000. $ 5,000. Year 2 30,000. 5,000. Year 3 Year 4 Total 70,000. Total depreciation (48,000) Net income 22,000. Project life ÷ 4 years. Average annual increase in income $ 5,500. Increase in investment ÷ 48,000. Accounting rate of return on initial investment 0.1146. Preferable cash flows While both investments have the same accounting rate of return, receiving cash flows earlier (as in Project 1) is preferable to the timing of the cash flows in Project 2, due to the time value of money. © Cambridge Business Publishers, 2018

Evaluating Net Present Value Predicted net cash inflow from operations Project 1 Project 2 Years 1 and 2 $ 30,000. $ 5,000. Years 3 and 4 5,000. 30,000. Initial investment 48,000. Project 1 Predicted Cash Inflows (Outflows) Years(s) of Cash Flows 8% Present Value Factor Present Value of Cash Flows Initial investment $ (48,000) 1.00000 $(48,000) Operations 30,000 1-2 1.78326 53,498. 5,000 3-4 3.31213 – 1.78326 7,644. Net present value of all cash flows $ 13,142. Project 2 Predicted Cash Inflows (Outflows) Years(s) of Cash Flows 8% Present Value Factor Present Value of Cash Flows Initial investment $ (48,000) 1.000 $(48,000) Operations 5,000 1-2 1.78326 8,916. 30,000 3-4 3.31213 – 1.78326 45,866. Net present value of all cash flows $ 6,782. Project 1 generates the higher net present value. © Cambridge Business Publishers, 2018

Comparing NPV and the Internal Rate of Return Methods Net Present Value Gives explicit consideration to investment size Assumes all net cash inflows are reinvested at the discount rate Internal Rate of Return Gives no consideration to investment size Assumes all net cash inflows are reinvested at the project’s internal rate of return © Cambridge Business Publishers, 2018

5 Examine the impact of judgment, attitudes toward risk, and relevant cash flow information on capital budgeting decisions. © Cambridge Business Publishers, 2018

Using Multiple Investment Criteria Investment models aid managers in making investment decisions Management considerations Reduce risk Ensure an adequate return to investors Availability of resources Nonquantitative factors Market position Operational performance improvement Strategy implementation Top management’s attitudes and confidence in decision makers © Cambridge Business Publishers, 2018

Evaluating Capital Expenditure Risk Risks are often related to… Cost of the initial investment Time required to complete the initial investment and begin operations Whether the new facilities will operate as planned Life of the facilities Customers’ demand for the product or service Final selling price Operating costs Disposal values © Cambridge Business Publishers, 2018

Risk Analysis Techniques Suggested approaches to assist in capital budgeting risk… Adjust the discount rate for individual projects based on management’s perception of a project’s risks Compare several internal rates of return and/or net present values for a project Subject a capital expenditure proposal to sensitivity analysis © Cambridge Business Publishers, 2018

Differential Analysis of Cash Flows Some capital expenditure proposals create no cash inflows, such as Not-for-profit and government units providing services For-profit firms maintaining product quality or improving safety standards Cannot calculate payback period, accounting rate of return and internal rate of return Solution Compute the present value of all life cycle costs Select the investment with the least negative net present value © Cambridge Business Publishers, 2018

Differential Analysis Example Yater College wants to replace its 3 year old fitness equipment in its student fitness center. The equipment has a remaining useful life of 1 year, a current book value of $43,600, and a current market value of $35,000. The new equipment will cost $88,000 and will have an estimated useful life of 4 years and a $5,000 salvage value. The new equipment will reduce annual utility costs from $75,000 to $72,800 due to improved energy efficiency. © Cambridge Business Publishers, 2018

Differential Analysis Example Keep Old Equipment Replace with New Equipment Difference Initial investment Cost of new equipment $88,000. Disposal value of old machine (35,000) Net initial investment $53,000. Annual operating cash savings Utility costs on old equipment $75,000 Utility costs on new equipment $72,800. Net annual cost savings $ 2,200. Disinvestment at end of life Old equipment $ 0 New equipment $ 5,000. © Cambridge Business Publishers, 2018

Differential Analysis Example Predicted Cash Inflows (Outflows) Year(s) of Cash Flows 8% Present Value Factor Present Value of Initial investment, net $(53,000) 1.000 Operations 2,200 1-4 3.312 7,286 Disinvestment of new equipment 5,000 1 0.735 3,675 Net present value of all cash flows $(42,039) The proposal provides no net incremental cash flows, though it still may be accepted since it is a replacement of older equipment. © Cambridge Business Publishers, 2018

High-Tech Investments Includes such innovations such as flexible manufacturing systems and computer integrated manufacturing Care must be taken when evaluating Potential errors in evaluating Investing in unnecessary or overly complex equipment Overestimating cost savings Underestimating incremental sales © Cambridge Business Publishers, 2018

Investing in Unnecessary or Overly Complex Equipment Common error Comparing the cost associated with the current inefficient way of doing things with the predicted cost of performing the identical operations with modern equipment Potential outcome Generation of costly non-value-added activities Careful evaluation of situations will help mitigate problems of this type of error. © Cambridge Business Publishers, 2018

Other Problems with High-Tech Investments Overestimating cost savings Common error Basing estimates on a single activity cost driver Underestimating incremental sales or cost savings Common errors Assuming that the baseline for comparison is the current sales level Forgetting that investments in manufacturing technologies increase rapid, low-cost switching to new products © Cambridge Business Publishers, 2018

6 Determine the net present value of investment proposals with consideration of taxes. © Cambridge Business Publishers, 2018

Taxes in Capital Budgeting Decisions Cost of asset is depreciated over the operating life of an asset Depreciation reduces income taxes but does not cause cash outflows Two assumptions in dealing with taxes in capital budgeting decisions Revenues and operating cash receipts are the same each year Depreciation is the only noncash expense of an organization © Cambridge Business Publishers, 2018

Depreciation Tax Shield Depreciation provides a “tax shield” Reduces cash payments for income taxes Depreciation tax shield = Depreciation x Tax rate EXAMPLE Depreciation tax shield for Bates Limo, assuming a 30% tax rate: = $84,000 – $12,000 4 years x 30% = $5,400 © Cambridge Business Publishers, 2018

Effect of Depreciation Example If Bates Limo purchases the new limo for $84,000, incremental sales and cash operating expenses will be $132,100 and $104,000, respectively. How much are net annual cash inflows assuming a 30% income tax rate? Depreciation expense = = $84,000 – $12,000 4 years = $18,000 per year © Cambridge Business Publishers, 2018

Effect of Depreciation Example Annual Taxes and Income without Depreciation: Sales $132,100. Operating expenses (except depreciation) (104,000) Depreciation 0. Income before taxes without depreciation 28,100. Income taxes (8,430) Net income $ 19,670. Annual Taxes and Income with Depreciation: Sales $132,100. Operating expenses (except depreciation) (104,000) Depreciation 18,000. Income before taxes with depreciation 10,100. Income taxes (3,030) Net income $ 7,070. Tax difference = Depreciation Tax Shield = $5,400 © Cambridge Business Publishers, 2018

Effect of Depreciation Example Annual Taxes and Cash Flow without Depreciation: Sales $132,100. Operating expenses (except depreciation) (104,000) Income taxes (8,430) Net annual cash inflow $ 19,670. Tax difference = $5,400 Cash flow difference = $5,400 Annual Taxes and Cash Flow with Depreciation: Sales $132,100. Operating expenses (except depreciation) (104,000) Income taxes (3,030) Net annual cash inflow $ 25,070. © Cambridge Business Publishers, 2018

Investment Tax Credit A government tax incentive for the purpose of stimulating investment and economic growth A reduction of taxes in the year a new asset is placed in service Reduces cash payments for taxes Treated as a cash inflow for capital budgeting purposes © Cambridge Business Publishers, 2018

Net Present Value with Taxes Predicted Cash Inflows (Outflows) Year(s) of Cash Flows 8% Present Value Factor Present Value of Cash Flows Initial investment Limo purchase $(84,000) — 1.00000 Working capital (2,500) Operations Annual taxable income without depreciation 28,100. 1-4 3.31213 93,071. Taxes on income ($28,100 × 30%) (8,430) (27,921) Depreciation tax shield ($18,000 × 30%) 5,400. 17,886. Disinvestment Sale of limo* 12,000. 4 0.73503 8,820. Recovery of working capital 1,000. 735. Net present value of all cash flows $ 6,091. *No gain recognized: Sale price at end of life, $12,000 Less book value at end of life, $12,000 Equals $0 gain. © Cambridge Business Publishers, 2018

Compute basic present value cash flow amounts. 7 Appendix 25A Compute basic present value cash flow amounts. © Cambridge Business Publishers, 2018

Time Value of Money Money is worth more if received today rather than received in the future Two reasons The time value of money Risk If invested, money will earn interest and grow in value over time © Cambridge Business Publishers, 2018

Future Value The amount that a current sum of money earning a stated rate of interest will accumulate to at the end of a future period Calculating future value fv = pv(1 + i)n How much will a deposit of $800 in the bank that pays 8% annual interest accumulate in 1 year? fv of $800 = $800(1 + 0.08)1 = $864 © Cambridge Business Publishers, 2018

Present Value The current worth of a sum of money to be received at some future date at a stated rate of interest Calculating present value pv = fv (1 + i)n How much is the current value of $864 to be received one year in the future at an 8% annual interest rate? pv of $864 = $864 (1 + 0.08)1 = $800 © Cambridge Business Publishers, 2018

Annuities A series of equal cash flows received or paid over equal intervals of time Example: Suppose that $300 will be received at the end of each of the next 3 years. The discount rate is 8%. How much is the present value the cash flows? Year 1 $300 × $1 ÷ (1 + 0.08)1 $278 Year 2 $300 × $1 ÷ (1 + 0.08)2 257 Year 3 $300 × $1 ÷ (1 + 0.08)3 238 Present value $773 OR: pva = 1 (1 + 0.08)3 = $773 x 1 – 300 0.08 © Cambridge Business Publishers, 2018

Unequal Cash Flows A series of unequal cash flows received or paid over equal intervals of time Example: Suppose that $300 will be received at the end of Year 1, with $200 received at the end of Year 2, and $100 received at the end of 3 years. The discount rate is 8%. How much is the present value the cash flows? Year Annual Cash Flow Present Value at 8% Present Value Amount 1 $300 0.92593 $277.78 2 200 0.85734 171.47 3 100 0.79383 79.38 $528.63 © Cambridge Business Publishers, 2018

Determine internal rate of return using present value tables. 8 Appendix 25B Determine internal rate of return using present value tables. © Cambridge Business Publishers, 2018

Internal Rate of Return Equal cash flows A single investment is followed by a series of equal annual net cash flows Present value factor for an annuity of $1 Initial investment Annual net cash inflows = $84,000 $28,100 = 2.98932 Bates Limo Example = Locate this factor in the row for 4 periods in the Present Value of an Annuity of $1 table. The factor is found between 12% and 14%, at approximately 12.8%. © Cambridge Business Publishers, 2018

Internal Rate of Return Unequal cash flows A single investment is followed by a series of unequal annual net cash flows Trial and error must be used First, select a discount rate estimated to be close to the proposal’s IRR Calculate the net present value If net present value is positive, select a higher rate If net present value is negative, select a lower rate Recalculate the net present value until an approximate IRR is found © Cambridge Business Publishers, 2018