1. Chapter 6 Principles of Capital Investment

2. Administrative Framework Involves
Generation of investment proposals
Estimation of cash flows
Evaluation of cash flows
Selection of projects based on an acceptance criterion
Continual reevaluation of investment projects after acceptance
Chapter 6
Chapter 7

3. Project Classification
New products or expansion of existing products
Replacement of equipment or buildings
Research and development
Exploration
Others

4. Multiple Screens Board President Committee VP operations Plant manager
Section chiefs

5. Level and Type of Capital Expenditure
As the capital outlay increases, the number of screens generally increases
Important to investors
Convey information about expected future growth

6. Cash-Flow Forecasts Incremental cash flows
Differences between cash flows of the firm with and without the project
Ignore sunk cost
Patterns of cash flow
Annuity
Salvage value

7. Replacement Decisions and Depreciation
Cash flow information
Purchase price of new machine
Installation cost
Sale of old machine
Cash savings for new machine
Depreciation effect
Income tax
Incremental, after-tax cash flow

8. Methods for Evaluation
Average rate of return
Payback
Internal rate of return
Net present value
Economic worth of a project
Discounted cash flow method

9. Average Rate of Return (ARR)
Compared with required rate of return
Principal virtue is its simplicity
Principal shortcomings
Based on accounting information
Time value of money is ignored

10. Payback (PB) Number of years to recover initial cash investment
Shortcomings
Fails to consider
Cash flows after the PB period
Magnitude or timing of cash flows during the payback period
Does not measure profitability
Popularity of PB
Limited insight
Into the risk of a project
Into the liquidity of a project

11. Internal Rate of Return (IRR)
Discounted cash flow method
The rate of discount which equates the PV of cash inflows with the PV of cash outflows
Takes account of cash flows
Magnitude
Timing
Acceptance criterion
IRR > required rate

12. Required Rare of Return (RRR)
Systematic risk is higher for capital-expending projects
Replacement projects
Produce benefits across more states of the economy
Possess lower systematic risk
Require a lower return

13. Net Present Value (NPV)
What remains after discounting all cash flows by the RRR
Acceptance criterion
PV of the cash inflows > PV of the cash outflows
Absolute measure of the contribution

14. Profitability Index (PI)
PV of future net cash flows over the initial cash outlay
Acceptance criterion
PI  1.00
NPV and PI
Give the same accept-reject signals
Expresses relative profitability

15. Mutual Exclusive and Dependency
Acceptance of one precludes the acceptance of another project
Contingent proposal
Depends on the acceptance of one or more other proposals

16. NPV Versus IRR Compounding rate differences
Investment proposals are mutually exclusive
IRR method implies that funds are compounded at the IRR
PV method implies compounding at the RRR
Scale of investment
Mutually exclusive investment proposals having different initial cash outlays
IRR ignores the scale of investment
Multiple IRR’s
Cash-flow stream changes sign more than once

17. Depreciation and Other Refinements in Cash-Flow Information
Method of depreciation
Setting up the cash flows
Salvage value and taxes
Working capital requirement

18. Method of Depreciation
Straight-line depreciation
Accelerated depreciation
PV advantage in postponing taxes
MACRS
Eight property classes
200% declining-balance method (1-4)
Half-year convention
150% declining-balance (5&6)
Straight-line depreciation (7&8)

19. Setting Up the Cash Flows
Cost
Annual savings
Depreciation
Income
Taxes
NCF

20. Salvage Value and Taxes
Sale of a fully depreciated asset is subject to taxation
Sold > depreciated book value < cost
Pay full corporate tax rate
Sold > cost
Capital-gains tax treatment

21. Working Capital Requirement
Cash outflow at the time of occurrence
Additional cash
Additional receivables
Additional inventories
End of project’s life
Treated as a cash inflow
Can occur at any time

22. What Happens When Capital is Rationed?
Capital rationing
Budget ceiling
Selection criterion
Combination of proposals with highest NPV
Consider more than one period
Problems incurred
Reject positive NPV projects
Less than optimal investment policy

23. Inflation and Capital Budgeting
Real cash flows do not keep up with inflation
Inflation effect on results
Lower real rates of return
Disincentive to undertake capital expenditures
Invest less
Seek investments with faster PBs
Become less capital intensive
Bias in cash-flow estimates

24. Information to Analyze an Acquisition
Same as any other investment proposal
Initial outlay of cash or stock
Followed by expected future benefits
Major differences
Initial cost may be subject to bargaining
Synergism

25. Measuring Free Cash Flows (FCF)
EBITDA
- Taxes
- Capital expenditures
- Working-capital additions
= Incremental free cash flow
FCFs determine an acquisition’s value

26. Noncash Payments and Liability Assumptions
Overriding valuation principle
Value of the incremental FCFs
Cash-equivalent price
Convert to market value
Securities
Liabilities
Separate investing from financing