Capital Budgeting Cash Flows and Capital Budgeting Techniques

Capital Budgeting Cash Flows and Capital Budgeting Techniques
Chapters 12 &13 Capital Budgeting Cash Flows and Capital Budgeting Techniques

Learning Goals Understand the motives for key capital budgeting expenditures and the steps in the capital budgeting process. Define basic capital budgeting terminology. Discuss relevant cash flows, expansion versus replacement decisions, sunk costs and opportunity costs, and international capital budgeting.

Learning Goals (cont.) Calculate the initial investment associated with a proposed capital expenditure. Find the relevant operating cash inflows associated with a proposed capital expenditure. Determine the terminal cash flow associated with a proposed capital expenditure.

The Capital Budgeting Decision Process
Capital Budgeting is the process of identifying, evaluating, and implementing a firm’s investment opportunities. It seeks to identify investments that will enhance a firm’s competitive advantage and increase shareholder wealth. The typical capital budgeting decision involves a large up-front investment followed by a series of smaller cash inflows. Poor capital budgeting decisions can ultimately result in company bankruptcy.

Table 8.1 Key Motives for Making Capital Expenditures

Steps in the Process Proposal Generation Review and Analysis
Decision Making Implementation Follow-up Our Focus is on Step 2 and 3

Basic Terminology: Independent versus Mutually Exclusive Projects
Independent Projects, on the other hand, do not compete with the firm’s resources. A company can select one, or the other, or both—so long as they meet minimum profitability thresholds. Mutually Exclusive Projects are investments that compete in some way for a company’s resources—a firm can select one or another but not both.

Basic Terminology: Conventional versus Nonconventional Cash Flows
Figure 8.1 Conventional Cash Flow

Figure 8.2 Nonconventional Cash Flow
Basic Terminology: Conventional versus Nonconventional Cash Flows (cont.) Figure 8.2 Nonconventional Cash Flow

The Relevant Cash Flows
Incremental cash flows: are cash flows specifically associated with the investment, and their effect on the firms other investments (both positive and negative) must also be considered. For example, if a kindergarten decides to open another facility, the impact of customers who decide to move from one facility to the new facility must be considered.

Relevant Cash Flows: Major Cash Flow Components
Figure 8.3 Cash Flow Components Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Relevant Cash Flows: Expansion Versus Replacement Decisions
Estimating incremental cash flows is relatively straightforward in the case of expansion projects, but not so in the case of replacement projects. With replacement projects, incremental cash flows must be computed by subtracting existing project cash flows from those expected from the new project.

Figure 8.4 Relevant Cash Flows for Replacement Decisions
Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Relevant Cash Flows: Sunk Costs Versus Opportunity Costs
Note that cash outlays already made (sunk costs) are irrelevant to the decision process. However, opportunity costs, which are cash flows that could be realized from the best alternative use of the asset, are relevant.

Relevant Cash Flows: International Capital Budgeting
International capital budgeting analysis differs from purely domestic analysis because: cash inflows and outflows occur in a foreign currency, and foreign investments potentially face significant political risks Despite these risks, the pace of foreign direct investment has accelerated significantly since the end of WWII.

Finding the Initial Investment
Table 8.2 The Basic Format for Determining Initial Investment Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Finding the Initial Investment (cont.)
Table 8.3 Tax Treatment on Sales of Assets Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Hudson Industries, a small electronics company, 2 years ago acquired a machine tool with an installed cost of $100,000. The asset was being depreciated under MACRS using a 5-year recovery period. Thus 52% of the cost (20% + 32%) would represent accumulated depreciation at the end of year two. Book Value = $100,000 - $52,000 = $48,000 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Finding the Initial Investment
Sale of the Asset for More Than Its Purchase Price If Hudson sells the old asset for $110,000, it realizes a gain of $62,000 ($110,000 - $48,000). Technically, the difference between the cost and book value ($52,000) is called recaptured depreciation and the difference between the sales price and purchase price ($10,000) is called a capital gain. Under current corporate tax laws, the firm must pay taxes on both the gain and recaptured depreciation at its marginal tax rate.

Sale of the asset for more than its book value but less than its purchase price If Hudson sells the old asset for $70,000, it realizes a gain in the form of recaptured depreciation of $22,000 ($70,000–$48,000) which is taxed at the firm’s marginal tax rate.

Sale of the asset for its book value If Hudson sells the old asset for its book value of $48,000, there is no gain or loss and therefore no tax implications from the sale.

Sale of the asset for less than its book value If Hudson sells the old asset for $30,000 which is less than its book value of $48,000, it experiences a loss of $18,000 ($48,000 - $30,000). If this is a depreciable asset used in the business, the loss may be used to offset ordinary operating income. If it is not depreciable or used in the business, the loss can only e used to offset capital gains.

Change in Net Working Capital Danson Company, a metal products manufacturer, is contemplating expanding operations. Financial analysts expect that the changes in current accounts summarized in Table 8.4 on the following slide will occur and will be maintained over the life of the expansion.

Powell Corporation, a large diversified manufacturer of aircraft components, is trying to determine the initial investment required to replace an old machine with a new, more sophisticated model. The machine’s purchase price is $380,000 and an additional $20,000 will be necessary to install it. It will be depreciated under MACRS using a 5-year recovery period. The firm has found a buyer willing to pay $280,000 for the present machine and remove it at the buyers expense. The firm expects that a $35,000 increase in current assets and an $18,000 increase in current liabilities will accompany the replacement. Both ordinary income and capital gains are taxed at 40%. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Finding the Operating Cash Inflows
Powell Corporation’s estimates of its revenues and expenses (excluding depreciation and interest), with and without the new machine described in the preceding example, are given in Table Note that both the expected usable life of the proposed machine and the remaining usable life of the existing machine are 5 years. The amount to be depreciated with the proposed machine is calculated by summing the purchase price of $380,000 and the installation costs of $20,000. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Finding the Operating Cash Inflows (cont.)
Table 8.5 Powell Corporation’s Revenue and Expenses (Excluding Depreciation and Interest) for Proposed and Present Machines Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Table 8.6 Depreciation Expense for Proposed and Present Machines for Powell Corporation

Table 8.7 Calculation of Operating Cash Inflows Using the Income Statement Format

Table 8.9 Incremental (Relevant) Operating Cash Inflows for Powell Corporation

Finding the Terminal Cash Flow
Table The Basic Format for Determining Terminal Cash Flow Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Finding the Terminal Cash Flow (cont.)
Continuing with the Powell Corporation example, assume that the firm expects to be able to liquidate the new machine at the end of its 5-year useable life to net $50,000 after paying removal and cleanup costs. The old machine can be liquidated at the end of the 5 years to net $10,000. The firm expects to recover its $17,000 net working capital investment upon termination of the project. Again, the tax rate is 40%. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Finding the Terminal Cash Flow (cont.)

Summarizing the Relevant Cash Flows

Capital Budgeting Techniques Learning Goals
Understand the role of capital budgeting techniques in the capital budgeting process. Calculate, interpret, and evaluate the payback period. Calculate, interpret, and evaluate the net present value (NPV).

Learning Goals (cont.) Calculate, interpret, and evaluate the internal rate of return (IRR). Use net present value profiles to compare NPV and IRR techniques. Discuss NPV and IRR in terms of conflicting rankings and the theoretical and practical strengths of each approach.

Capital Budgeting Techniques
Problem Bennett Company is a medium sized metal fabricator that is currently contemplating two projects: Project A requires an initial investment of $42,000, project B an initial investment of $45,000. The relevant operating cash flows for the two projects are presented in Table 9.1 and depicted on the time lines in Figure 9.1.

Capital Budgeting Techniques (cont.)
Table 9.1 Capital Expenditure Data for Bennett Company Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Capital Budgeting Techniques (cont.)
Figure 9.1 Bennett Company’s Projects A and B Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Payback Period The payback method simply measures how long (in years and/or months) it takes to recover the initial investment. The maximum acceptable payback period is determined by management. If the payback period is less than the maximum acceptable payback period, accept the project. If the payback period is greater than the maximum acceptable payback period, reject the project.

Pros and Cons of Payback Periods
The payback method is widely used by large firms to evaluate small projects and by small firms to evaluate most projects. It is simple, intuitive, and considers cash flows rather than accounting profits. It also gives implicit consideration to the timing of cash flows and is widely used as a supplement to other methods such as Net Present Value and Internal Rate of Return.

Pros and Cons of Payback Periods (cont.)
One major weakness of the payback method is that the appropriate payback period is a subjectively determined number. It also fails to consider the principle of wealth maximization because it is not based on discounted cash flows and thus provides no indication as to whether a project adds to firm value. Thus, payback fails to fully consider the time value of money.

Net Present Value (NPV)
Net Present Value (NPV): Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows.

Net Present Value (NPV) (cont.)
Net Present Value (NPV): Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows. Decision Criteria If NPV > 0, accept the project If NPV < 0, reject the project If NPV = 0, technically indifferent

Using the Bennett Company data from Table 9.1, assume the firm has a 10% cost of capital. Based on the given cash flows and cost of capital (required return), the NPV can be calculated as shown in Figure 9.2 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. The IRR is the project’s intrinsic rate of return.

Internal Rate of Return (IRR) (cont.)
The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. The IRR is the project’s intrinsic rate of return. Decision Criteria If IRR > cost of capital, accept the project If IRR < cost of capital, reject the project If IRR = cost of capital, technically indifferent

Figure 9.3 Calculation of IRRs for Bennett Company’s Capital Expenditure Alternatives

Internal Rate of Return (IRR) (cont.)

Net Present Value Profiles
NPV Profiles are graphs that depict project NPVs for various discount rates and provide an excellent means of making comparisons between projects. To prepare NPV profiles for Bennett Company’s projects A and B, the first step is to develop a number of discount rate-NPV coordinates and then graph them as shown in the following table and figure.

Conflicting Rankings Conflicting rankings between two or more projects using NPV and IRR sometimes occurs because of differences in the timing and magnitude of cash flows. This underlying cause of conflicting rankings is the implicit assumption concerning the reinvestment of intermediate cash inflows—cash inflows received prior to the termination of the project. NPV assumes intermediate cash flows are reinvested at the cost of capital, while IRR assumes that they are reinvested at the IRR.

Conflicting Rankings (cont.)
A project requiring a $170,000 initial investment is expected to provide cash inflows of $52,000, $78,000 and $100,000. The NPV of the project at 10% is $16,867 and it’s IRR is 15%. Table 9.5 on the following slide demonstrates the calculation of the project’s future value at the end of it’s 3-year life, assuming both a 10% (cost of capital) and 15% (IRR) interest rate. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

If the future value in each case in Table 9.5 were viewed as the return received 3 years from today from the $170,000 investment, then the cash flows would be those given in Table 9.6 on the following slide. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Bennett Company’s projects A and B were found to have conflicting rankings at the firm’s 10% cost of capital as depicted in Table If we review the project’s cash inflow pattern as presented in Table 9.1 and Figure 9.1, we see that although the projects require similar investments, they have dissimilar cash flow patterns. Table 9.7 on the following slide indicates that project B, which has higher early-year cash inflows than project A, would be preferred over project A at higher discount rates. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Which Approach is Better?
On a purely theoretical basis, NPV is the better approach because: NPV assumes that intermediate cash flows are reinvested at the cost of capital whereas IRR assumes they are reinvested at the IRR, Certain mathematical properties may cause a project with non-conventional cash flows to have zero or more than one real IRR. Despite its theoretical superiority, however, financial managers prefer to use the IRR because of the preference for rates of return.

Table 9.8 Summary of Key Formulas/Definitions and Decision Criteria for Capital Budgeting Techniques

Capital Budgeting Cash Flows and Capital Budgeting Techniques

Similar presentations

Presentation on theme: "Capital Budgeting Cash Flows and Capital Budgeting Techniques"— Presentation transcript:

Similar presentations

About project

Feedback

Log in

Auth with social network:

Capital Budgeting Cash Flows and Capital Budgeting Techniques

Similar presentations

Presentation on theme: "Capital Budgeting Cash Flows and Capital Budgeting Techniques"— Presentation transcript:

Similar presentations

About project

Feedback