1. Longer-Run Decisions: Capital Budgeting27
Longer-Run Decisions: Capital Budgeting

2. Chapter Highlights
Addresses alternative choice decisions with following characteristics:
Longer term commitment of funds, i.e. capital investments.
Major difference from previous chapter: alternative choices affect a longer-term horizon and therefore time value of money must be considered.

3. Nature of Problem
Similar to investment of cash in a bank or a bank lending money to a customer.
Time value of money must be considered.
An investment is the purchase of an expected future stream of cash inflows.

4. Types of Capital Budgeting Problems
Replace existing equipment with new equipment.
Expand by building or acquiring new facilities.
Buy equipment to replace manual operations.
Which of several equipment should we buy?
Should we add a new product to our line?

5. General Approach
Lump sum is paid out at the beginning of the project, i.e. at time zero.
A stream of cash inflows is expected to result from investment.

6. Net Present Value Approach
Equate all cash outflows and inflows to a monetary value at same point in time, usually at time zero.
This process is called discounting.
Can be done with calculators or by multiplying future amounts by factors indicated in Table A (or Table B) in back of text.
Rate at which the cash flows are discounted is called cost of capital, required rate of return, discount rate, or hurdle rate.

7. Net Present Value (NPV)
Difference between present value of cash outflows and inflows.
If NPV is a nonnegative amount, proposal is acceptable.
The decision rule is a general rule. Similar to last chapter, in addition to quantitative analysis other factors should be considered.

8. Elements Involved with Capital Budgeting Calculations
Required rate of return.
Economic life (number of years for which cash inflows are anticipated).
Amount of cash inflow in each year.
Amount of investment.
Terminal value.

9. Required Rate of Return
Trial and error approach: management intuitively decides on rates based on number of projects it wants to approve.
Cost of capital.

10. Definition of Cost of Capital
Weighted average of: cost of debt capital + cost of equity capital.
Cost of debt capital is adjusted for income tax effect.
Cost of equity capital is an estimate and is imprecise.
CAPM may be used.
Management may decide to discount higher risk investments with a higher rate.
Some projects are necessity, i.e. nondiscretionary, and may not result in cash inflows, e.g. safety devices, pollution control equipment.
Therefore, discretionary projects must earn a higher rate of return than company’s average cost of capital to make up for lack of return on nondiscretionary projects.

11. Economic Life
Number of years over which cash inflows are expected as a consequence of making investment.
Management usually will set a maximum number of years, say 15.
Can rarely be estimated accurately.
Obsolescence and market uncertainty.

12. Cash Inflows Accrual accounting numbers are not necessarily relevant.
Differential costs/cash flows are relevant.

13. Inflation
In general, cash flows should not be restated for anticipated inflation
Discount rate, interest rates and stock market returns include an inflation component.

14. Depreciation Not an item of differential cost.
Cash flow associated with acquisition of equipment is an outflow at time zero.
Accrual accounting capitalizes initial cost of asset and then depreciates, i.e. writes off asset over its life.
To treat depreciation as a differential cost would result in double counting the cost.

15. Income Tax Impact
Income tax is a cash outflow (or a reduction of cash inflows).
Therefore, tax effect should be considered in analysis.

16. Interest Expense
Ordinarily interest expense is not considered in analysis. It is already considered in discount rate.
Interest may be considered if it is an integral part of investment (such as investing in real estate largely financed by mortgage).

17. Investment
Amount of funds an entity risks if it accepts an investment proposal.
Relevant costs are differential costs made if project is undertaken but will not be made if it is not undertaken.
Investment includes differential funds needed to acquire new assets and increase working capital (e.g. increases in receivables and inventories less increase in payables).
If existing assets are sold as a result of new investment, net proceeds from sale reduce amount of differential investment.

18. Investment Tax Credit
A tax credit granted by congress when a company purchases certain types of assets under certain conditions.
Currently, there is no provision in tax law for investment tax credits.

19. Terminal Value = cash inflow at end of investment’s time horizon.
For NPV, calculations must be discounted to PV.
Types of terminal value:
Residual value. May be insignificant.
Assumed investment is sold as of terminal date.
Assume current assets remain same throughout life of investment.

20. Non-monetary Considerations
Necessity projects: safety, pollution.
Difficult to quantify: to protect market share, to improve quality of existing products or services.

21. Summary of NPV Method (1 of 3)
Select a required rate of return.
Estimate economic life of proposed project.
Estimate differential cash inflows for each year.
Determine net investment made at time zero (and at later periods).

22. Summary of NPV Method (2 of 3)
Estimate terminal values at end of economic life.
Find present value of all inflows (and outflows) by discounting.
Determine present value by subtracting net investment (i.e. outflows) from PV of inflows.

23. Summary of NPV Method (3 of 3)
If NPV is zero or positive (and capital is available) accept project.
If NPV is negative, reject project.
Take into account non-monetary factors and reach a decision.

24. Internal Rate of Return (IRR) Method
Determine rate of return that equates PV of cash inflows with PV of cash outflows.
This rate is the IRR or discounted cash flow (DCF) rate of return.
Accept project if management is satisfied with IRR.
IRR can be found by trial and error.

25. Payback Period
Number of years over which investment outlay will be recovered (paid back) from cash inflows if estimates turn out to be correct.
Does not consider time value of money.
Longer economic life bigger drawback.

26. Discounted Payback Period
= year in which discounted value of cash inflows equals or exceeds amount of investment.
Same as payback method except uses discounted cash flows.

27. Unadjusted Return on Investment Method (1 of 2)
Also called: accounting rate of return method.
Compute accrual net income expected to be earned from project each year.
Divide annual net income by amount of original investment or by ½ of original investment.
½ of original investment equals approximately average book value of investment over life of investment.

28. Unadjusted Return on Investment Method (2 of 2)
Unadjusted return method based on gross amount of investment will always understate true return.
Unadjusted return method based on ½ of gross amount of investment will always overstate true return.
Shortcoming: doesn’t consider time value of money.

29. Multiple Decision Criteria
Most companies use 2 or more methods to analyze a potential capital investment.
The larger the company’s capital budget, the greater the variety of techniques used.
DCF methods are conceptually superior, but non-DCF methods (pay back and unadjusted return method) are still popular.

30. Why Use Non-DCF Methods
Concern about short-run impact that a proposed project would have on profitability.
Managers concerned about short-term performance measurement.
Belief that security analysts use historical ROI to make investment decisions.

31. Preference Problems
Screening problems: whether or not we should accept a proposal.
Preference (= ranking = capital rationing) problems: allocate limited capital among acceptable projects.
More acceptable projects than capital for investment and need to rank the projects.

32. Criteria to Rank Capital Projects
IRR (provided projects are of equal risk).
Profitability index: Divide present value of cash inflows by amount of investment. The higher the profitability index, the better the project.
Often results in same ranking.

33. Nonprofit Organizations
Same analytical techniques.
Rate of return required for equity capital determined by comparison to alternative possible investments.

34. 27
End of Chapter 27