1 Chapter Nine Capital Budgeting

2 Capital Budgeting Decisions require sizable commitments of cash. are expected to generate returns that will last more than one year. involve time value of money.

3 Importance of Capital Budgeting Decisions Capital budgeting decisions commit companies to courses of action. The success or failure of a particular strategy, or even of the company itself, can hinge on one or a series of such decisions.

4 Importance of Capital Budgeting Decisions (continued) In addition, capital budgeting decisions are generally riskier than short-term ones for the following reasons:  The company expects to recoup its investment over a longer period.  Reversing a capital budgeting decision is much more difficult than reversing a short- term decision.

5 Types of Capital Budgeting Decisions Investments made to further strategic goals Investments made to increase capacity or reduce costs Investments made for non-financial reasons Investments mandated by law or policy

6 Cost of Capital Cost of capital is the cost, expressed as a percentage, of obtaining the money needed to operate the company. Capital is obtained from two sources, creditors and owners, corresponding to divisions of liabilities and owners’ equity on the balance sheet.

7 Weighted Average Cost of Capital Average costs of debt and equity components Example - debt with after tax cost of 5% is 40% of capital structure and equity with after cost of 15% is 60% of capital structure Cost of capital is: 40% * 5% = 2% 60% * 15% = 9% Total11%

8 Cutoff Rate Because of the practical difficulties of determining cost of capital, managers might simply use their judgment to set a minimum acceptable rate, called a cutoff rate, hurdle rate, or target rate.

9 The Capital Budgeting Decision Models Discounted Cash Flow (DCF) Techniques:  Net present value (NPV)  Internal rate of return (IRR) Nondiscounted Cash Flow Techniques  Payback period  Book rate of return

10 Net Present Value Method The net present value method (NPV) uses the minimum acceptable rate to find the present value (PV) of the future returns and compares that value with the cost of the investment.

11 Internal Rate of Return Method The internal rate of return method (IRR) finds the rate of return associated with the project and compares that rate with the minimum acceptable rate. NPV = PV of future returns - Cost of the investment

12 Decision Rules Under the NPV method, a project having a positive NPV should be accepted; others should be rejected. Under the IRR method, a project having an IRR greater than the company’s cost of capital should be accepted.

13 Purchase of Machine Example Machine costs $60,000 Sell 3,000 units per year at $14 for the next 5 years Variable costs are $5 per unit Annual cash fixed costs are $5,000 Cutoff rate of 12 percent

14 Annual Incremental Cash Inflows Annual Cash Flows Revenues ($14 x 3,000)$42,000 Variable costs ($5 x 3,000)15,000 Contribution margin ($9 x 3,000)$27,000 Cash fixed costs5,000 Expected increase in net cash$22,000

15 Net Present Value Example Expected increase in net cash$22,000 Present value factor (PVA 5 12%) x Present value of future cash flows$79,306 Investment required60,000 Net present value$19,306

16 Internal Rate of Return Factor = PV of future flows/Annual cash flows Factor = $60,000/$22,000 = The corresponds to an interest rate between 20 and 30 percent when the number of periods is five. The IRR is about 25%.

17 Taxes and Depreciation Additional information: Tax rate is 40 percent. Straight-line depreciation is used.

18 Annual After-Tax Cash Inflows IncomeCash Flow Revenues$42,000$42,000 Cash expenses20,00020,000 Cash inflow before taxes$22,000$22,000 Depreciation12,000 Increase in taxable income$10,000 Income taxes (40 percent)4,0004,000 Net Income$6,000 Depreciation12,000 Net increase in cash inflow$18,000$18,000

19 Net Present Value of After-Tax Example Expected increase in net cash inflows$18,000 Present value factorx Present value of future cash flows$64,887 Investment required60,000 Net present value$4,887

20 Internal Rate of Return Factor = PV of future flows/Annual cash flows Factor = $60,000/$18,000 = The corresponds to an interest rate between 15 and 16 percent when the number of periods is five. The IRR is between 15 and 16 percent.

21 Payback Period Payback Period = Investment /Annual cash return = $60,000/$18,000 = years

22 Book Rate of Return Average book rate of return= Net income/Average book investment = $6,000/($60,000/2) = 20 percent Net income is cash flow less depreciation Average investment is (investment +residual)/2 This is the only method discussed that does not use cash flows.

23 Tax Depreciation For Tax, depreciation is computed using either the Modified Accelerated Cost Recovery System (MACRS) or optional straight line. MACRS gives rapid depreciation according to tables published by the IRS Optional straight line uses a shorter life than the actual life and a half year convention Tax deprecation will almost always end up with uneven cash flows.

24 Cash Flow Problem Information - A company is offered an 8 year contract that will yield an annual gross cash flow of $450,000 with cash expenses of $261,500. Working capital investment is $90,000, and machinery costing $700,000 is required. The equipment is 5 year property for MACRS depreciation, and has a useful life of 9 years, but will be sold at the end of year 8 for $25,000. The tax rate is 30% and the cost of capital is 14%.

25 Calculating Annual Cash Flow

26 Calculating Cash Flows

27 Final Cash Flows

28 MACRS Example

29 Straight Line Example