1. 10 C Strategy Management of Capital Expenditures hapter
Prepared by Douglas Cloud Pepperdine University 1 1 1 1

2. After studying this chapter, you should be able to:
Objectives
1. Discuss the role of capital budgeting in long-range planning.
2. Apply capital budgeting models, such as the net present value and the internal rate of return, that consider that the time value of money.
3. Apply capital budgeting models, such as the payback period and the accounting rate of return, that do not consider the time value of money.
After studying this chapter, you should be able to:
Continued

3. Objectives
4. Evaluate the strengths and weaknesses of alternative capital budgeting models.
5. Discuss the importance of judgment, attitude toward risks, and relevant cash flow information in making capital budgeting decisions.
6. Determine the net present value of investment proposals with consideration of the effects of taxes.

4. Capital budgeting is a process that involves the identification of potentially desired projects for capital expenditures, the subsequent evaluation of capital expenditure proposals and the selection of proposals that meet certain criteria.

5. Capital Budgeting Procedures
A precondition for effective capital budgeting requires having a clearly defined mission, long-range goals, and a well-defined business strategy.

6. Capital Budgeting Procedures
Identify possible capital expenditure.
Determine if proposed expenditures fit mission, goals, and business strategy.
Perform preliminary data gathering and analysis using appropriate financial models.
Continued

7. Develop implementation plans for approved projects.
Increase analytical rigor and required level of approval as importance and size of project increases.
Develop implementation plans for approved projects.
Monitor implementation and revise implementation of project as appropriate.
Conduct a post audit review to fix responsibility and improve future planning.

8. The Three Phases of a Project’s Cash Flows
Includes all cash expenditures necessary to begin operations.
Initial investment
Operation
Disinvestment
Occurs at the end of the project’s life when assets are disposed of for their salvage value and any initial investment of working capital is recovered.

9. Analysis of a Project’s Predicted Cash Flows
Initial investment:
Vehicle and equipment $90,554
Inventories and other working capital 4,000
Total $94,554
Mobile Yogurt Shoppe

10. Analysis of a Project’s Predicted Cash Flows
Operation (per year for 5 years)
Sales $175,000 Cash expenditures:
Food $47,000
Labor 65,000
Supplies 9,000
Fuel and utilities 8,000
Advertising 4,000
Miscellaneous 12, ,000
Net annual cash flow $ 30,000

11. Analysis of a Project’s Predicted Cash Flows
Disinvestment (at the end of 5 years)
Sale of vehicle and equipment $ 8,000
Recovery of investment in inventories
and other working capital ,000
Total $12,000
Assume management uses a 12 percent discount rate

12. …and disinvestment less the amount of the initial investment.
Net Present Value
Net present value is the present value of the project’s net cash inflows from operations...
…and disinvestment less the amount of the initial investment.

13. NPV Analysis of a Project
Table Approach
Predicted % Present
Cash Year(s) Present Value
Inflows of Cash Value of Cash
(Outflows) Flows Factor Flows
(A) (B) (C) (A) x (C)
Initial investment -$94, $94,554
Operation 30, ,150
Disinvestment 12, ,804
Net present value of all cash flows $20,400

14. NPV Analysis of a Project
Spreadsheet Approach
1. Input
A B
1 Year of cash flow Cash flow
2 1 $30,000
, ,000
,000
,000
7 Present value =NPV(0.12,B2:B6)
8 Initial investment -94,554
9 Net present value =B7+B8

15. NPV Analysis of a Project
Spreadsheet Approach
2. Output
A B
1 Year of cash flow Cash flow
2 1 $30,000
, ,000
,000
,000
7 Present value $114,952.41
8 Initial investment -94,554
9 Net present value $20,398.41

16. Cautional Notes in Using the Spreadsheet Approach
1. The spreadsheet formula for the net present value assumes that the first cash flow occurs at time “one,” rather than at time “zero.”
2. Be sure to arrange the cash flows subsequent to the initial investments from top to bottom in a column.

17. Internal Rate of Return (IRR)
1. Also called the time-adjusted rate of return.
2. It is the minimum rate that could be paid for the money invested in a project without losing money.
3. It is also described as the discount rate that results in a project’s net present value equaling zero.

18. Internal Rate of Return (IRR)
Spreadsheet Approach
1. Input
A B
1 Year of cash flow Cash flow
2 0 $-94,554
, ,000
,000
,000
,000
8 IRR =IRR(B2:B7,0.08)

19. Internal Rate of Return (IRR)
Spreadsheet Approach
2. Output
A B
1 Year of cash flow Cash flow
2 0 $-94,554
, ,000
,000
,000
,000
8 IRR

20. Cost of Capital
The cost of capital is the average cost of obtaining the resources needed to make investments.
The cost of capital is the average rate an organization must pay for invested funds.
The cost of capital is the minimum return that is acceptable for investment purposes.

21. Cost of Capital The effective interest rate on notes or bonds,
The average rate takes into account such items as:
The effective interest rate on notes or bonds,
The effective dividend rate on preferred stock, and
The discount rate that equates the present value of all dividends expected on common stock over the life of the organization to the current market value of the organization’s common stock.

22. Cost of Capital
The cost of capital for a company that has no debt or preferred stock is simply the cost of equity capital, computed as follows: =
Current annual dividend per common share
Current market price per common share
Cost of equity capital +
Expected dividend growth rate

23. Payback Period
The Payback period is the time required to recover the initial investment in a project from operations.

24. Annual operating cash inflows
Payback Period
Payback period =
Initial investment
Annual operating cash inflows
Payback period =
$94,554
$30,000
Mobile Yogurt Shoppe
Payback period =

25. $10,000 is needed in Year 3 to complete the recovery.
Payback Period
Alderman Company is evaluating a capital expenditure proposal that requires an initial investment of $50,000.
Net Cash Unrecovered
Year Inflow Investment
0 $ $50,000
1 15,000 35,000
2 25,000 10,000
3 40,000
$10,000 is needed in Year 3 to complete the recovery.

26. Accounting Rate of Return
The accounting rate of return is the average annual increase in net income that results from acceptance of a capital expenditure proposal divided by the initial investment or the average investment in the project.
Mobile Yogurt Shoppe purchased a vehicle and equipment costing $90,554. It has a disposal value of $8,000 at the end of 5 years.
Mobile Yogurt Shoppe

27. Accounting Rate of Return
Annual net cash inflow from operations $30,000
Less average annual depreciation:
[$90,554 – $8,000]/5) 16,511
Average annual increase in net income $13,489
Click here to refresh your memory about Mobile Yogurt Shoppe. Reexamine Slides 9-11, then click the circle on Slide 11 to return to this slide.

28. Accounting Rate of Return
Accounting rate of return on initial investment
Average annual increase in net income
Initial investment =
Accounting rate of return on initial investment =
$13,489
$94,554 =

29. Accounting Rate of Return
Accounting rate of return on average investment
Average annual increase in net income
Average investment =
Accounting rate of return on initial investment =
$13,489
$53,277 =
([$94,554 + $12,000])/2

30. Evaluation of Capital Budgeting Models
Predicted net cash
inflow from operations:
Year 1 $ 50,000 $ 10,000
Year 2 50,000 10,000
Year 3 10,000 50,000
Year , ,000
Total $120,000 $120,000
Total depreciation -100, ,000
Total net income $ 20,000 $ 20,000
Project life  4 years  4 years
Average annual increase in income $ 5,000 $ 5,000
Project A Project B
Accounting Rate of Return
on Initial Investment
Project B:
$5,000/$100,000 = 0.05
Accounting Rate of Return
on Initial Investment
Project A:
$5,000/$100,000 = 0.05

31. Evaluation of Capital Budgeting Models
Net present value analysis of Project A:
Predicted % Present
Cash Year(s) Present Value
Inflows of Cash Value of Cash
(Outflows) Flows Factor Flows
Initial investment -$100, $100,000
Operation 50, ,800
10, – ,340
Net present value of all cash flows $ 1,140

32. Evaluation of Capital Budgeting Models
Net present value analysis of Project B:
Predicted % Present
Cash Year(s) Present Value
Inflows of Cash Value of Cash
(Outflows) Flows Factor Flows
Initial investment -$100, $100,000
Operation 10, ,360
50, – ,700
Net present value of all cash flows -$ 10,940

33. Evaluation of Risk
All capital expenditures proposals involve many sources of risk, including risk related to:
The cost of the initial investment
The time required to complete the initial investment and begin operations
Whether or not the new facilities will operate as planned
The life of the facilities
The customers’ demand for the product or service
The final selling price
Operating costs
Disposal values

34. Differential Analysis of Cash Flows
Model II, a new welding machine to replace an older welding machine, costs $80,000 and has a useful life of four years and a predicted salvage value of zero at the end of its useful life. The use of Model II welding machine would reduce operating costs.
The Ace Welding Company uses a Model I welding machine to produce 10,000 bicycle frames per year. The Model I is 2 years old and has a remaining useful life of 4 years. Its current book value is $60,000 and its current market value is $35,000.

35. Differential Analysis of Cash Flows
Replace with New Model II Machine)
Difference (Effect of Replacement on Income)
Initial investment:
Cost of new machine $80,000 $80,000
Disposal value of old machine -35, ,000
Net initial investment $45,000

36. Difference (Effect of Replacement on Income)
Differential Analysis of Cash Flows
Difference (Effect of Replacement on Income)
Summary
Annual operating cash savings:
Conversion $10,000
Inspection and adjustment 3,500
Machine maintenance 2,200
Net annual cost savings $15,700

37. NPV Analysis of Differential Cash Flows
Predicted 12% Present
Cash Year(s) Present Value
Inflows of Cash Value of Cash
(Outflows) Flow Factor Flows
Initial -$45, $45,000 15, ,681
Disinvestment
Net present value
of all cash flows $ 2,681

38. Ranking Capital Budgeting Proposals
Proposal A Proposal B Proposal C
Predicted cash flows (in 000):
Initial investment $26,900 $55,960 $30,560
Operation:
Year 1 10, , ,000
Year 2 10, , ,000
Year 3 10, ,000 0
Year 4 10, ,000 0
Disinvestment

39. Ranking Capital Budgeting Proposals
Proposal A
Predicted cash flows (in 000):
Initial investment -$26,900 Operation:
Year 1 10,000
Year 2 10,000
Year 3 10,000
Year 4 10,000
Disinvestment 0
Net present value (in 000) at 12% $3,470
Internal rate of return 18 %
Present value index 1.129

40. Ranking Capital Budgeting Proposals
Proposal B
Predicted cash flows (in 000):
Initial investment -$55,960 Operation:
Year 1 20,000
Year 2 20,000
Year 3 20,000
Year 4 20,000
Disinvestment 0
Net present value (in 000) at 12% $4,780
Internal rate of return 16 %
Present value index 1.085

41. Ranking Capital Budgeting Proposals
Proposal C
Predicted cash flows (in 000):
Initial investment -$30,560 Operation:
Year 1 20,000
Year 2 20,000
Year 3 0
Year 4 0
Disinvestment 0
Net present value (in 000) at 12% $3,240
Internal rate of return 20 %
Present value index 1.106

42. Ranking Capital Budgeting Proposals
Ranking by investment criterion:
Net present value 2 1 3
Internal rate of return 2 3 1
Present value index 1 3 2

43. Present Value Index
Now, we can determine the present value index for the three proposals.
Present value index =
Present value of subsequent cash flows
Initial investment
Present value index =
$30,370,000
$26,900,000
Present value index =
1.129
Proposal A

44. Present value of subsequent cash flows
Present Value Index
Present value index =
Present value of subsequent cash flows
Initial investment
Present value index =
$60,675,000
$55,960,000
Present value index =
1.080
Proposal B

45. Present value of subsequent cash flows
Present Value Index
Present value index =
Present value of subsequent cash flows
Initial investment
Present value index =
$33,800,000
$30,560,000
Present value index =
1.110
Proposal C

46. Depreciation Tax Shield
Depreciation provides a “tax shield” because it reduces cash payments for income taxes.
Depreciation
tax shield
= Depreciation x Tax rate

47. Annual Taxes and Income without Depreciation
Effect of Depreciation on Taxes, Income, and Cash Flows
Annual Taxes and Income without Depreciation
Sales $175,000
Operating expenses (except depreciation) -145,000
Depreciation
Income before taxes without depreciation $ 30,000 Income taxes (34%) -10,200
Net income $ 19,800
Continued

48. Annual Taxes and Income with Depreciation
Effect of Depreciation on Taxes, Income, and Cash Flows
Annual Taxes and Income with Depreciation
Sales $175,000
Operating expenses (except depreciation) -145,000
Depreciation ,111
Income before taxes without depreciation $ 11,889
Income taxes (34%) ,042
Net income $ 7,847
Continued

49. Annual Taxes and Cash Flow without Depreciation
Effect of Depreciation on Taxes, Income, and Cash Flows
Annual Taxes and Cash Flow without Depreciation
Sales $175,000
Operating expenses (except depreciation) -145,000
Income taxes (34%) ,200
Net annual cash inflow $ 19,800
Continued

50. Annual Taxes and Cash Flow with Depreciation
Effect of Depreciation on Taxes, Income, and Cash Flows
Annual Taxes and Cash Flow with Depreciation
Sales $175,000
Operating expenses (except depreciation) -145,000
Income taxes (34%) ,042
Net annual cash inflow $ 25,958

51. C 10
hapter
The End