4 C H A P T E R Capital Investment Decisions

Learning Objective 1 Understand the importance of capital budgeting and the concepts underlying strategic and capital investment decisions.

Define Capital Budgeting and Capital Systematic planning for long-term investments in operating assets. Capital The total amount of money or other resources owned or used to acquire future income or benefits.

Capital Investment Decisions What three aspects of capital investment decisions are critical to long-run profitability? Large capital outlays are required. There is a long-term impact on earnings. There is a lack of liquidity (they cannot be readily disposed of).

Capital Budgeting Analysis Requires What Two Processes? Screening Determining whether a capital investment meets a minimum standard of financial acceptability. Ranking The ordering of acceptable investment alternatives from the most to least desirable.

What is the Time Value of Money? - The concept that a dollar to be received now is worth more than a dollar to be received far in the future. - Interest is the payment (cost) for the use of the money. Because of the time value of money, a difference in the timing of cash flows can make one investment more attractive than another. 8

Example: Discounting Cash Flows Project A $90,910 Discounted at 10% $100,000 Discounted value at beginning of Year 1 Year 1 Project B Discounted at 10% per year $41,320 45,455 $86,775 $50,000 $50,000 Discounted value at beginning of Year 1 Year 1 Year 2

What are Cash Outflows? All investment opportunities have an initial cost plus other expected outlays or cash outflows associated with an investment. Investment opportunity Cash outflows

Example: Cash Outflows Cash PV PV of Cash Outflows Factor Outflows Initial cash outlay. . . . . . . $20,000 1.0000 $20,000 Future cash outlay. . . . . . 5,000 0.6302 3,151 Total present value of cash outflows. . . . . . . $23,151

Example: Internal Rate of Return Method George’s Power Tools wants to purchase a wood lathe for $5,000. The machine will save $1,200 a year for the next 5 years. Determine the internal rate of return. Calculate the present value factor by dividing the investment cost by annual net cash inflows. Using applicable present value tables and the life of the investment, find the present value factor closest to the number derived in step 1. Using interpolation, if necessary, find the exact internal rate of return represented by the present value factor in step 1. Remember the 3 steps: 34

Example: Internal Rate of Return Method Steps 1: Present value factor = Investment cost Annual net cash inflows = $5,000 $1,200 = 4.1667 35

Example: Internal Rate of Return Method Steps 1: Present value factor = 4.1667 Using the table, we find the yield for the machine is between 6 and 7 percent. 4% 5% 6% 7% 8% 4 3.6299 3.5460 3.4651 3.3872 3.3121 5 4.4518 4.3295 4.2124 4.1002 3.9927 6 5.2421 5.0757 4.9173 4.7665 4.6229 2: 35

Example: Internal Rate of Return Method Steps Present value factor = 4.1667 1: 5 4.4518 4.3295 4.2124 4.1002 3.9927 2: 3: Find the exact rate of return. Rate Present Value Factors High factor 6% 4.2124 4.2124 True factor 4.1667 Low factor 7% 4.1002 Difference 1% 0.0457 0.1122 Internal rate 0.0457 of return 0.1122 = 0.06 + 0.01 x = 0.0641 35

What are Cash Inflows? Cash inflows are any current or expected revenues or savings directly associated with an investment. Investment opportunity Cash outflows Cash inflows

Example: Cash Inflows Cash PV PV of Cash Inflows Factor Inflows Revenues . . . . . . . . . . . . . . $3,000 7.7160 $23,148 Salvage value . . . . . . . . . . . 5,000 0.3855 1,928 Total present value of cash inflows. . . . . . . . . $25,076 11

Learning Objective 2 Describe and use two nondiscounted capital budgeting techniques: the payback method and the unadjusted rate of return method.

Capital Budgeting Techniques Non-discounted capital budgeting techniques do not take into account the time value of money. What are two common techniques? Payback Method Unadjusted Rate of Return Method 13

Define Payback Method and Provide the Formula A capital budgeting technique that determines the amount of time it takes the net cash inflows of an investment to repay the investment costs. Payback period = Investment cost Annual net cash inflows 15

Example: Payback Method John wants to determine the payback period for an investment with an initial cost of $2,500. He estimates the net cash flows from the investment to be $800 per year. Estimate the payback period. Payback period = = = 3.1 years Investment cost Annual net cash inflows $2,500 $800 16

Define Unadjusted Rate of Return and Provide the Formula A capital budgeting technique in which management can quickly estimate a simple rate of return to evaluate an investment opportunity. Increase in future average annual net income Initial investment cost Unadjusted rate of return = 15

Example: Unadjusted Rate of Return Method Paul’s new investment is estimated to increase net income by $25,000 each year. The initial investment is $150,000. Determine the unadjusted rate of return. Increase in future average annual net income Initial investment cost = $25,000 $150,000 = 16.67% Unadjusted rate of return = 16

Learning Objective 3 Describe and use two discounted capital budgeting techniques: the net present value method and the internal rate of return method.

Define Capital Budgeting Techniques Discounted capital budgeting techniques take into account the time value of money by comparing discounted cash flows. What are two common techniques? Net Present Value Method Internal Rate of Return Method 14

Selecting a Discount Rate In order to evaluate investments using discounted cash flows, a firm must first establish a cost of capital, or acceptable rate of return. Define Cost of Capital The average cost of a firm’s debt and its equity; equals the rate of return that a company must earn in order to satisfy the demands of its owners and creditors. 21

What are the Three Steps to Do the Net Present Value Method? Using a predetermined interest rate or discount factor, compute the present values of all expected cash inflows and outflows of an investment. Subtract the total present value of the cash outflows from the total present value of the cash inflows. The difference is the investment’s net present value. If the net present value of the investment is positive, or at least zero, the project is acceptable from a financial standpoint. 24

What is the Decision Rule for the Net Present Value Method? Accept If the NPV is zero or greater, the investment is generating a rate of return that is equal to or greater than the required rate of return. NPV $0 25

What is the Decision Rule for the Net Present Value Method? Reject If the NPV is less than zero, the investment is generating a rate of return that is lower than the required rate of return. NPV $0 25

Example: Net Present Value Method George’s Power Tools wants to purchase a wood lathe for $5,000. The machine will save $1,200 a year for the next 5 years. The wood lathe can then be sold at the end of 5 years for $1,000. If the required rate of return is 12 percent, should the company invest in the new equipment? PV Present Cash Flows Amount Factor Value Purchase price . . . . . . . . $(5,000) 1.0000 $(5,000) Cost savings. . . . . . . . . . 1,200 3.6050 4,326 Salvage value. . . . . . . . . 1,000 0.5674 567 Net present value. . . . $ (107) 27

What is a Least-Cost Decision? In cases where investments must be made, managers should use a least-cost decision. Least-cost decision: A decision to undertake the project with the smallest negative net present value. Such a decision satisfies certain requirements at the lowest possible cost to the firm. 21

Define the Internal Rate of Return Method The discount rate that yields a net present value of zero when applied to cash flows of an investment—both inflows and outflows. What are the three steps? 1. Calculate the present value factor by dividing the investment cost by the annual net cash inflows. 2. Using applicable present value tables and the life of the investment, find the present value factor closest to the number derived in step 1. 3. Using interpolation, if necessary, find the exact internal rate of return represented by the present value factor in step 1. 21

Internal Rate of Return Method The “true” discount rate that will produce a net present value of zero when applied to the cash flows of investment inventory goods held for resale. What is Interpolation? A method of determining the internal rate of return when the factor for that rate lies between the factors given in the present value table. Its purpose is to determine the “true” rate of interest indicated by the present value factor. 31

What is a Hurdle Rate? The minimum rate of return that an investment must provide in order to be acceptable. Hurdle rate: To determine the value of an investment, management must compare the project’s internal rate of return with the company’s usual discount or hurdle rate. 21

What Is the Decision Rule for Internal Rate of Return Method? Accept Management should undertake the investment if the IRR is greater than the hurdle rate, or required rate of return. IRR Hurdle Rate 25

What Is the Decision Rule for Internal Rate of Return Method? Reject Management should not accept the investment if the IRR is lower than the hurdle rate, or required rate of return. IRR Hurdle Rate 25

Learning Objective 4 Understand the need for evaluating qualitative factors in strategic and capital investment decisions.

Qualitative Factors in Decisions An investment’s effect on the quality of products and services offered. An investment’s effect on the time with which products and services can be produced and delivered to customers. Other qualitative factors: - Consumer safety - Government regulations - Pollution control and environmental protection - Worker safety - Company image and prestige - Preferences of owners and management - Community welfare 43

Expanded Material Learning Objective 5 Use sensitivity analysis to assess the potential effects of uncertainty in capital budgeting.

Define Sensitivity Analysis A method of assessing the reasonableness of a decision that was based upon estimates; involves calculating how far reality can differ from an estimate without invalidating the decision. Used to determine whether the conclusions still seem reasonable under modified circumstances. 45

Example: Sensitivity Analysis Beatles Inc. wants to purchase a new belt buckle press for $9,000. The press will save $2,000 a year for the next 10 years. The press can then be sold at the end of 10 years for $1,000. Beatles Inc. has established a rate of 8 percent as the hurdle rate. Should the company invest in the new equipment? PV Present Cash Flows Amount Factor Value Purchase price . . . . . . . . . $(9,000) 1.0000 $(9,000) Cost savings. . . . . . . . . . . 2,000 6.1446 12,289 Salvage value. . . . . . . . . . 1,000 0.3855 386 Net present value. . . . . $ 3,675 46

Example: Sensitivity Analysis If expected cash flows are uncertain, what is the minimum cash flow needed to still meet the required 10 percent hurdle rate, which has a present value factor of 6.1146? Initial cost. . . . . . . . . . . . . . . . . . . . . . . $9,000 Discounted disposal value. . . . . . . . . . 386 Net cost of investment . . . . . . . . . . . $8,614 Present value factor . . . . . . .. . . . .  6.1146 Minimum cash flows needed. . . . . . . $1,409 27

Example: Sensitivity Analysis If the expected useful life is uncertain, how long does the press need to last in order for the investment to still be acceptable? 10% 4 3.1669 5 3.7908 6 4.3553 7 4.8684 Present value factor = 4.301 27

Example: Sensitivity Analysis According to the present value tables, the internal rate of return is between 18 and 20 percent. Internal Rate of Return Method Present value factor = $8,614 $2,000 = 4.307 27

Expanded Material Learning Objective 6 Explain how to use capital budgeting techniques in ranking capital investment projects.

What Is Capital Rationing? Allocating limited resources among ranked acceptable investments. Enables management to select the most profitable investments first. Helps a company use limited resources to the best advantage by investing only in the projects that offer the highest return. Either the internal rate of return method or the net present value method may be used in ranking investments. 51

Example: Capital Rationing The Ono Company needs to rank the following investment opportunities. The company requires a hurdle rate of 16 percent. Use the capital rationing techniques to determine the appropriate investments. Expected Project Rate of Return A 16% B 13% C 22% D 18% Ranking Order Decision 3 Accept — Reject 1 Accept 2 Accept 27

How Do You Rank by Net Present Value? Profitability index In order to rank projects using net present value, a profitability index must be used to rank different investments. Equal to the present value of net cash inflows divided by the investment cost. Profitability index = Present value of net cash inflows Investment cost 54

Example: Ranking by Net Present Value The Ono Company has the following two possible investments. Rank them using a profitability index. A B Present value of cash inflows. . . . $6,000 $11,000 Investment cost. . . . . . . . . . . . . . . . 5,000 10,000 Net present value . . . . . . . . . . . . . .$1,000 $ 1,000 Profitability index. . . . . . . . . . . . . 1.20 1.10 Rank . . . . . . . . . . . . . . . . . . . . . . . . 1 2 27

Expanded Material Learning Objective 7 Explain how income taxes affect capital budgeting decisions.

Income Tax Considerations Examples of income tax effects: A capital investment may allow a company to take an expense deduction for the cost of the asset and expense deductions for repairs and depreciation. The resulting income from operations and any gain on the eventual sale of an asset are affected by taxes. Such tax effects can be so significant that the net present value of the cash flows changes from positive to negative, or vice versa.

Income Tax Considerations Cash inflows and outflows of capital budgeting decisions must be converted to after-tax amounts before the present values are computed. They are converted to after-tax amounts by including such amounts as: Expense deduction for the cost of the asset. Expense deduction for repairs to the asset. Expense deduction for depreciation (MACRS). Income from operations. Gain on sale of disposal of asset.