1. Capital Budgeting Integrative Case Analysis: Lasting Impressions
Dr. C. Bulent Aybar
Professor of International Finance

2. Capital Budgeting Process
Proposal Generation
Review & Analysis
Decision Making
Implementation and
Follow-up
is the formal process of assessing the appropriateness and economic viability of the project in light of the firm’s overall objectives. This is done by estimating cash flows arising from the project and evaluating them through capital budgeting techniques. Risk factors are also incorporated into the analysis phase.
Decision making is the step where the proposal is compared against predetermined criteria and either accepted or rejected.
Implementation of the project begins after the project has been accepted and funding is made available.
Follow-up is the post-implementation audit of expected and actual costs and revenues generated from the project to determine if the return on the proposal meets pre-implementation projections
Proposal Generation
is the origination of proposed capital projects for the firm by individuals at various levels of the organization.

3. Integrative Capital Budgeting Case
Lasting Impressions (LI) Company is a medium- sized commercial printer of promotional advertising brochures, booklets, and other direct- mail pieces.
The firms' major clients are ad agencies based in New York and Chicago. The typical job is characterized by high quality and production runs of more than 50,000 units. LI has not been able to compete effectively with larger printers because of its existing older, inefficient presses. The firm is currently having problems in meeting demand cost effectively and quality requirements of the industry.
The general manager has proposed the purchase of one of two large, six- color presses designed for long, high- quality runs. The purchase of a new press would enable LI to reduce its cost of labor and therefore the price to the client, putting the firm in a more competitive position.

4. Existing Equipment (Old Equipment)
Old press Originally purchased 3 years ago at an installed cost of $ 400,000, it is being depreciated under MACRS using a 5- year recovery period.
The old press has a remaining economic life of 5 years. It can be sold today to net $ 420,000 before taxes; if it is retained, it can be sold to net $ 150,000 before taxes at the end of 5 years.
5 Year MACRS – 20% 32% 19% 12% 12% 5%

5. Alternative-1: Press-A
This highly automated press can be purchased for $ 830,000 and will require $ 40,000 in installation costs.
It will be depreciated under MACRS using a 5- year recovery period. At the end of the 5 years, the machine could be sold to net $ 400,000 before taxes.
If this machine is acquired, it is anticipated that the following current asset changes would result:
Cash
$25,400
A/R
$120,000
Inventories
($20,000)
A/P
$35,000

6. Alternative-2: Press-B
This press is not as sophisticated as press A. It costs $640,000 and requires $20,000 in installation costs.
It will be depreciated under MACRS using a 5- year recovery period.
At the end of 5 years, it can be sold to net $ 330,000 before taxes.
Acquisition of this press will have no effect on the firm’s net working capital investment.

7. Earning Projections Before Depreciation Interest and Taxes
EBITDA
Year
Old Press
Press A
Press B 1
$120,000
$250,000
$210,000 2
$270,000 3
$300,000 4
$330,000 5
$370,000
The firm is subject to a 40% tax rate. The firm’s cost of capital, r, applicable to the proposed replacement is 14%.

8. Tasks For each of the two proposed replacement presses, determine:
( 1) Initial investment. ( 2) Operating cash inflows ( 3) Terminal cash flow
Using the data developed in part a, find and depict on a time line the relevant cash flow stream associated with each of the two proposed replacement presses, assuming that each is terminated at the end of 5 years.
Using the data developed in part b, apply each of the following decision techniques:
( 1) Payback period (2) Discounted Payback Period (3) NPV (4) IRR (5) MIRR (6) Profitability Index
Draw net present value profiles for the two replacement presses on the same set of axes, and discuss conflicting rankings of the two presses, if any, resulting from use of NPV and IRR decision techniques.
Recommend which, if either, of the presses the firm should acquire if the firm has
( 1) unlimited funds ( 2) capital rationing.
What is the impact on your recommendation of the fact that the operating cash inflows associated with press A are characterized as very risky in contrast to the low- risk operating cash inflows of press B?

9. Initial Investment Outlay
Item
Press A
Press B
Cost of Old Machine
$400,000
Cost of New Machine
$870,000
$660,000
Proceeds from Old Machine
$420,000
Book Value of Old Machine
$116,000
Gains from Sale
$304,000
Tax Liability
$121,600
NWC Investment
$90,400 $0
Net Initial Outlay
$662,000
$361,600
Book value of the old machine: 400,000-(80, ,000+76,000)=116,000
400,000x0.2=80,000
400,000 x0.32=128,000
400,000x0.19=76,000
Cumulative Depreciation=284,000

10. Depreciation of The New and Old Equipment
MACR-5Yr
Press A
Press B
Existing Press 1
20%
$174,000
$132,000
$48,000 2
32%
$278,400
$211,200 3
19%
$165,300
$125,400
$20,000 4
12%
$104,400
$79,200 $0 5 6 5%
$43,500
$33,000

11. Net Operating Cash Flows: Old Machine
Existing Machine 1 2 3 4 5
EBITDA
120000
Depreciation
$48,000
$20,000 $0
EBT
$72,000
$100,000
$120,000
Taxes
$28,800
$40,000
Net Income
$43,200
$60,000
NOCF
$91,200
$80,000

12. Net Operating Cash Flows: Press-A1 2 3 4 5
EBITDA
$250,000
$270,000
$300,000
$330,000
$370,000
Depreciation
174000
278400
165300
104400
EBT
$76,000
-$8,400
$134,700
$225,600
$265,600
Taxes
30400
-3360
53880
90240
106240
Net Income
$45,600
-$5,040
$80,820
$135,360
$159,360
NOCF
$219,600
$273,360
$246,120
$239,760
$263,760

13. Net Operating Cash Flows: Press-B1 2 3 4 5
EBITDA
$210,000
Depreciation
132000
211200
125400
79200
EBT
$78,000
-$1,200
$84,600
$130,800
Taxes
31200
-480
33840
52320
Net Income
$46,800
-$720
$50,760
$78,480
NOCF
$178,800
$210,480
$176,160
$157,680

14. Incremental Operating Cash Flows for Press A & B
IOCF=Incremental Operating Cash Flows
Column1 1 2 3 4 5
Existing Machine
$91,200
$80,000
$72,000
Press-A
$219,600
$273,360
$246,120
$239,760
$263,760
Press-B
$178,800
$210,480
$176,160
$157,680
Press A IOCF
$128,400
$182,160
$166,120
$167,760
$191,760
Press B IOCF
$87,600
$119,280
$96,160
$85,680

15. Terminal Cash Flows Proceeds from Liquidation BV at Liquidation
Press A
Press B
Old Mach.
Proceeds from Liquidation
$400,000
$330,000
$150,000
BV at Liquidation
$43,500
$33,000 $0
Profit from Sale
$356,500
$297,000
Tax Liability
$142,600
$118,800
$60,000
Net Proceeds from Sale
$257,400
$211,200
$90,000
Recall NWC Investment
$90,400
Net Terminal Cash Flows
$347,800
Net Incremental TCF
$257,800
$121,200
211,200-90,000=121,200
347,800-90,000=257,800

16. Relevant Cash Flow for the Projects
Year
Press A
Press B
-$662,000
-$361,600 1
$128,400
$87,600 2
$182,160
$119,280 3
$166,120
$96,160 4
$167,760
$85,680 5
$449,560
$206,880
Year 5 cash flows include terminal cash flows

17. Cash Flows on a Time Line

18. Pay Back Period Analysis
Cumulative Cash Flows
PAYBACK PERIOD ANALYSIS
Press A
Press B 1
$128,400
$87,600 2
$310,560
$206,880 3
$476,680
$303,040 4
$644,440
$388,720 5
$1,094,000
$595,600
In calculation of the payback period, we consider only the operating cash flows for a given year. For instance, in this particular case we did not include terminal cash flows of the project in year 5 cash flows.
Note that the cost for Press A (662,000) can be recovered only sometime
between 4th and 5th year. The portion recovered in the 5th year is
(662, ,440)/449,560= Therefore payback period for the
Press A is 4 years Years or 4.04 years. The recovery for press B is faster as initial investment of 361,600 can be recovered in 3.68 years.

19. Discounted Payback Period
Year
Press A
Press B
Cumulative Cash Flows A
Cumulative
Cash Flows B
(662,000)
(361,600) 1
112,632
76,842 2
140,166
91,782
252,798
168,624 3
112,126
64,905
364,924
233,529 4
99,327
50,729
464,251
284,259 5
233,487
107,447
697,739
391,706
Discounted Payback Period
4.85
4.72
Discounted Payback period requires discounted value of each cash flow. Each cash flow is discounted to time 0 at the cost of capital, and payback period is calculated by using these discounted cash flows. In this particular case, method favors project “B” as in the standard Payback Period method.

20. NPV Analysis NPVPress-A=35,738.82>NPVPress-B=30,105.88
Year
Press A
Press B
-$662,000
-$361,600 1
$128,400
$87,600 2
$182,160
$119,280 3
$166,120
$96,160 4
$167,760
$85,680 5
$449,560
$206,880
NPVPress-A=35,738.82>NPVPress-B=30,105.88
Since both projects have 5 year life spans there is no need to consider
Annualized NPV, but have we had done it, ANPV-A would have been higher than ANPV-B.

21. IRR Project A’s IRR is 15.8, Project B’s IRR is 17.06.
Both projects have IRR above cost of Capital. If we used IRR to choose the projects, Press B would be favored by the IRR method. Note that IRR assumes that cash flows can be reinvested at the IRR.
A consideration of reinvestment at cost of capital (MIRR) suggest that ranking does not change. MIRR-A=15% MIRR-B=16%

22. Cost of Capital and NPV
Cost of Capital
NBV Press A
NPV Presss B
0.11
$100,287
$63,653.89
0.12
$77,808
$51,988.82
0.13
$56,309
$40,814.89
0.14
$35,739
$30,105.88
0.15
$16,046
$19,837.23
0.16
-$2,816
$9,985.92
0.17
-$20,891
$530.34
0.18
-$38,221
-$8,549.78
0.19
-$54,843
-$17,273.48
As the above table shows, when cost of capital is approximately
Below 15%, press A has higher NPV than Press B.
But this changes when the cost of capital Increases to 15% and
Beyond. This suggest a cross-over point between 14 and 15% (14.59)
cost of capital.

23. NPV and Cost of Capital
Cross-over point=14.59%
Project A
Project B

24. Profitability Index
Profitability index reflects the benefit cost ratio of a project. It is the ratio of PV of project cash flows to the project cost.
LI’s two projects have PIA=1.05 and PIB= While profitability index suggests that project B generates more value per dollar invested, the total value created by project A is higher.

25. Impact of Capital Rationing on the Decision
In this case we are considering mutually exclusive projects. It does not make sense for the firm to implement both projects simultaneously.
However, if had we considered projects that are not necessarily mutually exclusive, we could use two methods:
IRR Method
Rank Projects wrt their IRR, select the projects with IRRs exceeding cost of capital up to a point where the capital budget is consumed. If the last qualified project partially exceeds capital budget, drop that project as well.
NPV Method
Rank Projects wrt their NPV, select all the positive NPV projects in order until the capital budget is consumed

26. Mutually Exclusive Projects and Capital Rationing
When investments are independent and decision is simply to adopt or abandon, decision rules like NPV, IRR and Profitability Index provide competent guidance.
However when investments are mutually exclusive, the guidance provided by these decision rules should be carefully considered.
One reason for possible conflicting recommendations is the insensitivity of PI and IRR to the scale of investment.
This may lead to decisions that are not consistent with value maximization objective.

27. Example
Consider the two projects above with different initial outlays and cash flow structures. The company in question should choose one of these two service station projects. Which one should company adopt? Since these are mutually exclusive projects, it does not make sense to adopt both.
NPV at 10%
PI at 10%
IRR
Inexpensive Project
92,500
1.18
14%
Expensive Project
98,200
1.09
12%

28. Mutually Exclusive Projects and NPV
NPV at 10%
PI at 10%
IRR
Inexpensive Project
92,500
1.18
14%
Expensive Project
98,200
1.09
12%
While the expensive project’s direct contribution to shareholder wealth is larger, inexpensive project earns higher return on each dollar invested, and has a higher return. The impressive performance of inexpensive project documented in PI and IRR obviously in conflict with the value maximization objective.
What should company do? If company invests $1.1m it creates $7,700 more value! However, investing $522,000 makes $578,000 available. If the company had an opportunity to deploy this amount to create NPV in excess of $7,700 by taking same level of risk, inexpensive project would be viable. Otherwise, the firm should go for the expensive project. Scale insensitivity of PI and IRR confirms the use of NPV as appropriate figure or merit.

29. Capital Rationing
Under capital rationing, the company has a fixed investment budget that it may not exceed.
Capital rationing requires us to rank investments rather than simply accept or reject them.
In mutually exclusive alternatives, capital is available but, for technical reasons, the company cannot make all investments.
Under capital rationing, it may be technically possible to make all investments, but there is limited capital. This has a fundamental impact on the ranking processes.
When capital is constrained, the objective is to get best possible benefit per dollar.

30. Example: Mutually Exclusive Projects
Investment A B C
Initial Cost
$ 5,500,000
$ 3,000,000
$ 2,000,000
Expected Life (yr) 10
$ ,000
$ ,000
$ ,000
15%
1.06
1.10
IRR
20%
30%
40%
If the company can raise large amounts of money at an annual cost of 15%, and if the investments are mutually exclusive, which project should the company undertake?
Answer:
Undertake investment A because it has the highest NPV, and NPV is a direct measure of the increase in wealth from undertaking the investment

31. Example: Capital Rationing
Investment A B C
Initial Cost
$ 5,500,000
$ 3,000,000
$ 2,000,000
Expected Life (yr) 10
$ ,000
$ ,000
$ ,000
15%
1.06
1.10
IRR
20%
30%
40%
Considering only these three investments, if the company has a fixed capital budget of $5.5 million, and if the investments are in­dependent of one another, which projects should the company undertake?
If the capital budget is fixed at $5.5 million, invest in C and B, and put the remaining $500,000 in A if possible. This is the bundle of investments with the highest total NPV. One can select this bundle by ranking investments by their IRR, or occasionally more accurately by their PI (or Benefit Cost Ratio or BCR)