The Capital Budgeting Decision Chapter 12 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline The Capital budgeting decision Cash flows in Capital budgeting Payback method Net Present Value and Internal rate of Return Discount or cutoff rate as Cost of Capital

Capital Budgeting Decision – Administrative Considerations Involves planning of expenditures for a project with a minimum period of a year or longer Capital expenditure decision requires: Extensive planning Coordination of different departments These decisions would be affected because of uncertainties involved in: Annual costs and inflows Product life Interest rates Economic conditions Technological changes

Capital Budgeting Decision – Administrative Considerations (cont’d) Steps in the decision-making process: Search for and discovery of investment opportunities Collection of data Evaluation and decision making Reevaluation and adjustment

Capital Budgeting Procedures

Accounting Flows versus Cash Flows In capital budgeting decisions, emphasis is on cash flows rather than earnings Depreciation (noncash expenditure) is added back to profit to determine the amount of cash flow generated Example provided in the following slide Emphasis is on use of proper evaluation techniques to make best economic choices and assure long term wealth maximization

Cash Flow and Revised Cash Flow for Alston Corporation Net earnings before and after taxes are zero, but the company has $20,000 cash in the bank

Methods of Ranking Investment Proposals Three methods used: Payback method Internal rate of return Net present value

Payback Method Time required to recoup initial investment from Table 12-3: Investment A is better Investment A recoups $10,000 Initial Investment at the end of the second year, while Investment B takes longer

Payback Method (cont’d) Advantages: Easy to understand Emphasizes liquidity Useful in industries characterized by dynamic technological developments Shortcomings: Does not consider Time Value of Money Ignores cash-flows after the cutoff period Fails to discern optimum or most economic solution to capital budgeting problem

Internal Rate of Return (Even Cash-Flows) Requires the determination of the yield on an investment that equates the cash outflows (cost) of an investment with subsequent cash inflows Assuming that a $1,000 investment returns an annuity of $244 per annum for five years Provides an internal rate of return of 7% as indicated: (Investment) = $1,000 = 4.1 (PVIFA) (Annuity) $244 The present value of an annuity (given in Appendix D) shows that the factor of 4.1 for five years indicates a yield of 7%

Internal Rate of Return - Uneven Cash-Flows Cash Inflows (of $10,000 investment) Year Investment A Investment B 1……………… $5,000 $1,500 2……………… 5,000 2,000 3……………… 2,000 2,500 4……………… 5,000 5……………… 5,000 To find a beginning value to start the first trial, the inflows are averaged out as though annuity was really being received $5,000 5,000 2,000 $12,000 ÷ 3 = $4,000

Internal Rate of Return - Uneven Cash-Flows (cont’d) Dividing the investment by the ‘assumed’ annuity value in the previous step, we have: (Investment) = $10,000 = 2.5 (PVIFA) (Annuity) $4,000 The first approximation (derived from Appendix D) of the internal rate of return using: PVIFA factor = 2.5 n (period) = 3 The factor falls between 9 and 10 percent Averaging would either understate or overstate the IRR by moving the cash-flows either to the end or beginning of the project Cash flows in early years are worth more and increase the return

Internal Rate of Return - Uneven Cash-Flows (cont’d) Using the trial and error approach, we use both 10% and 12% to arrive at the answer: Year 10% 1…….$5,000 X 0.909 = $4,545 2…….$5,000 X 0.826 = 4,130 3…….$2,000 X 0.751 = 1,502 $10,177 At 10%, the present value of the inflows exceeds $10,000 – we therefore use a higher discount rate Year 12% 1…….$5,000 X 0.893 = $4,464 2…….$5,000 X 0.797 = 3,986 3…….$2,000 X 0.712 = 1,424 $9,874 At 12%, the present value of the inflows is less than $10,000 – thus the discount rate is too high

Interpolation of the Results The internal rate of return is determined when the present value of the inflows (PVI) equals the present value of the outflows (PVO) The total difference in present values between 10% and 12% is $303 $10,177…… PVI @ 10% $10,177…….PVI @ 10% - 9,874…....PVI @ 12% - 10,000……(cost) $ 303 $ 177 The solution is ($177/$303) percent of the way between 10 and 12 percent. Due to a 2% difference, the fraction is multiplied by 2% and the answer is added to 10% for the final answer of: 10% + ($177/$303) (2%) = 11.17% IRR In Investment B the same process will yield an answer of 14.33 percent.

Interpolation of the Results (cont’d) Use of internal rate of return requires calculated selection of Investment B in preference to Investment A, the conclusion being exactly the opposite under the payback method The final selection of any project will also depend on yield exceeding some minimum cost standard, such as cost of capital to the firm Investment A Investment B Selection Payback method……. 2 years 3.8 years Quicker payback: “A” Internal Rate of Return……… 11.17% 14.33% Higher yield: ”B”

Net Present Value Discounting back the inflows over the life of the investment to determine whether they equal or exceed the required investment Basic discount rate is usually the cost of the capital to the firm Inflows must provide a return that at least equals the cost of financing those returns

Net Present Value (cont’d) $10,000 Investment, 10% Discount Rate Year Investment A Year Investment B 1……… $5,000 X 0.909 = $4,545 1………. $1,500 X 0.909 = $1,364 2……… $5,000 X 0.826 = 4,130 2………. $2,000 X 0.826 = 1,652 3……… $2,000 X 0.751 = 1,502 3………. $2,500 X 0.751 = 1,878 $10,177 4………. $5,000 X 0.683 = 3,415 5………. $5,000 X 0.621 = 3,105 $11,414 Present value of inflows…..$10,177 Present value of inflows…..$11,414 Present value of outflows - 10,000 Present value of outflows - 10,000 Net present value………… $ 177 Net present value…………...$1,414

Comparison of Capital Budgeting Results A summary of the various conclusions reached under the three methods is presented in the following table:

Selection Strategy For a project to be potentially accepted: Profitability must equal or exceed cost of capital Projects that are mutually exclusive: Selection of one alternative will preclude selection of any other alternative Projects that are not mutually exclusive: Alternatives that provide a return in excess of cost of capital will be selected

Selection Strategy (cont’d) In the case of prior Investment A and B, assuming a capital of 10%, Investment B would be accepted if the alternatives were mutually exclusive, while both would clearly qualify if they were not so, as depicted below: The IRR and NPV methods will call for the same decision with some exceptions Two rules: If an investment has a positive NPV, its IRR will be in excess of the cost of capital In certain limited cases, however, the two methods may give different answers in selecting the best investment

Reinvestment Assumption IRR All inflows from a given investment can be reinvested at the Internal Rate of Return (IRR) May be unrealistic to assume that reinvestment can occur at a equally high rate NPV Makes the more conservative assumption that each inflow can be reinvested at the cost of capital or discount rate Allows for certain consistency as inflows from each project are assumed to have the same investment opportunity

The Reinvestment Assumption – IRR and NPV

Modified Internal Rate of Return (MIRR) Combines reinvestment assumption of the NPV method with the IRR method MIRR is the discount rate that equates the terminal (final) value of the inflows with the investment In terms of a formula :

Modified Internal Rate of Return (cont’d) Assuming $10,000 produces the following inflows for the next three years: The cost of capital is 10% Determining the terminal value of the inflows at a growth rate equal to the cost of capital: To determine the MIRR: PVIF = PV = $10,000 = .641 (Appendix B) FV $15,610

Modified Internal Rate of Return (cont’d) Appendix B shows: For a tabular value of .641, the Yield or MIRR is 16 percent The conventional IRR computed would have been 21 percent MIRR uses a more realistic assumption of re-investment at the cost of capital

Capital Rationing Artificial constraint set on the usage of funds that can be invested in a given period by Management Only those projects with the highest positive NPV are accepted. Reasons for capital rationing: Fear of too much growth Hesitation to use external sources of financing Capital rationing can hinder a firm from achieving maximum profitability

Net Present Value Profile A graphical representation of net present value of a project at different discount rates To apply the NPV profile, the following aspects need to be considered: NPV at a zero discount rate NPV as determined by a normal discount rate (such as cost of capital) IRR for the project

Net Present Value Profile – Graphic Representation Investment B is preferred as both NPV and IRR are higher in case of Investment B as compared to Investment A

Net Present Value Profile with Crossover Below the crossover point of 8.7% Investment B is preferred Above the crossover point of 8.7% Investment C is preferred

The Rules of Depreciation Assets are classified into nine categories to determine allowable depreciation Each class is referred to as Modified Accelerated Cost Recovery System (MACRS) category Some references are also made to Asset Depreciation Range (ADR), or the expected physical life of the asset or class of assets

Categories for Depreciation Write-Off

Depreciation Percentages (Expressed in Decimals) Table 12–9

Depreciation Schedule Table 12–10

Actual Investment Decision - Example Assumption: $50,000 depreciation (Table 12–10) of machinery with a six-year productive life Produces an income of $18,500 for first three years before deductions for depreciation and taxes In the last three years, income before depreciation and taxes will be $12,000 Corporate tax rate taken at 35% and cost of capital 10% For each year: The depreciation is subtracted from “Earnings before depreciation and taxes” to arrive at Earnings before Taxes Taxes then subtracted to determine Earnings after Taxes Depreciation is added to earnings to arrive at Cash Flows

Actual Investment Decision – Example (cont’d)

Actual Investment Decision – Example (cont’d) Net present value analysis

The Replacement Decision Investment decision for new technology Includes several additions to the basic investment situation The sale of the old machine Tax consequences Decision can be analyzed by: Total analysis of both old and new machines An incremental analysis of changes in cash-flows between old and new machines

Sale of Old Asset The cash inflow from the sale of an old asset is based on the sales price as well as the related tax factors To determine these tax factors, the book value of the old asset is compared with the sales price to determine if there is a taxable gain or loss If there is a loss, it can be written off against other income for the corporation If there is a gain, it would be taxed at the corporation’s normal tax rate

Book Value of Old Asset and Net Cost of New Asset

Incremental Depreciation Benefits Cash flow analysis on the basis of: Incremental gain in depreciation Related tax shield benefits Cost savings Table 12–15

Cost Savings Benefits Table 12–16

Present Value of the Total Incremental Benefits

Elective Expensing Businesses can write-off certain tangible properties in the purchased year for up to $250,000 under the 2008 Economic Stimulus Act Beneficial to small businesses: Allowance is phased out dollar for dollar when total property purchases exceed $800,000 in a year