1. Capital Budgeting Decisions
Module 25
Capital Budgeting Decisions
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2. Explain the role of capital budgeting in long-range planning.1
Explain the role of capital budgeting in long-range planning.
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3. Capital Expenditures Investments of financial resources in projects
To develop or introduce new products or services
To expand current production or service capacity, or
To change current production or service facilities
Made with the expectation that the new product, process, or service will generate future financial inflows that exceed initial costs
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4. Capital Budgeting A process that involves
The identification of potentially desirable projects for capital expenditures
The subsequent evaluation of capital expenditure proposals, and
The selection of proposals that meet certain criteria
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5. Effective Capital Budgeting
Long-range planning is necessary since models involve cash flows over several years
Well-defined business strategy guides a company’s capital expenditure decisions
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6. Capital Budgeting Procedures
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7. Management of Capital Budgeting
Management should develop procedures for review, evaluation, approval, and post-audit of capital expenditure proposals
Capital budgeting committee
Provides management guidance in formulation of capital expenditure proposals
May preauthorize certain types and amounts of proposals with guidelines
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8. Post-Audit of Capital Budgeting
Involves the development of project performance reports comparing planned and actual results
Reports should be provided to those involved with the proposal
To help keep the project on target
To help identify the need to reevaluate the project if the initial analysis is in error or significant changes occur
To improve investment proposal quality
To help the capital budgeting committee better evaluate proposals
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9. 2
Analyze capital budgeting decisions, using models that consider the time value of money, such as net present and internal rate of return.
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10. Capital Budgeting Models
Net present value
Internal rate of return
Payback period
Accounting rate of return
Time Value of Money methods
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11. Three Phases of a Project’s Cash Flows
Includes all cash expenditures necessary to begin operations
Initial Investment
Includes all cash operating receipts and expenditures during operations
Operation
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
Disinvestment
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12. Predicted Cash Flow Analysis Example
Bates’ Limo is considering the purchase of a new limo with these predicted cash flows:
Initial investment (time 0):
Limo purchase
$84,000
Working capital
2,500
Total
$86,500
Operations (per year for 4 years):
Sales
$105,000
Cash operating costs:
Fuel and maintenance
$21,600
Insurance
2,300
Driver's salary
53,000
76,900
Net annual cash flows
$28,100
Disinvestment (end of 4 years):
Sale of limo
$12,000
Recovery of working capital
1,000
Total disinvestment
$13,000
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13. Calculating Net Present Value
Present value of the project’s net cash inflows from operations
+ Present value of the disinvestment cash flows
– Amount of the initial investment
NET PRESENT VALUE
Cash flows are adjusted for time value of money, using a discount rate (the minimum rate of return required for the project to be acceptable).
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14. Net Present Value Assumptions
Initial investment occurs at time 0
All other cash flows occur at end of each year
Initial Investment
Treated as a lump-sum amount
Operations
Treated as an annuity (if equal in amount each year)
Disinvestment
Treated as a lump-sum amount
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15. Net Present Value Approaches
Table Approach
Select factors from Tables 25A.1 and 25A.2 in Appendix 25A
Spreadsheet Approach
Use built in NPV function
Input required for the discount rate and cash flow amounts for each period
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16. Net Present Value Table Approach Example
Assume Bates Limo uses an 8% discount rate.
Predicted Cash Inflows (Outflows)
Years(s) of
Cash Flows 8%
Present Value Factor
Present Value of
Initial investment
$(86,500)
Operations
28,100
1-4
93,071.
Disinvestment
13,000 4
9,555.
Net present value of all cash flows
$ 16,126.
Table 12A.2
Table 12A.1
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17. Net Present Value Spreadsheet Approach Example
Assume Bates Limo uses an 8% discount rate.
$28,100 + $13,000
NPV function: =NPV(0.08, B2:B5)
Because the NPV is positive, this is an acceptable project.
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18. Caution in Using the Spreadsheet Approach
NPV spreadsheet formula assumes that the first cash flow occurs at time “1” rather than at time “0,” i.e., omit time 0 cash flow in the formula.
Arrange operating cash flows from top to bottom in a column, or left to right in a row.
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19. Internal Rate of Return (IRR)
Also called the time-adjusted rate of return
The discount rate that equates the present value of the cash inflows with the present value of the cash outflows
The minimum rate that could be paid for the money invested in a project without losing money
The discount rate that results in a project’s net present value equaling zero
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20. Spreadsheet Approach to Internal Rate of Return (IRR)
Sometimes requires an initial guess of the project’s rate of return
IRR function: =IRR(B2:B6, 0.08)
The investment will generate an internal rate of return of 15.6%. The IRR should be compared to the required rate of return.
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21. Cost of Capital
The average cost an organization pays to obtain resources necessary to make investments
Considers items such as
Effective interest rate on debt
Effective dividend rate on preferred stock
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 company’s common stock
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22. Computing the Cost of Equity Capital
The cost of capital for a company that has no debt or preferred stock:
Current annual dividend per common share
Current market price per common share +
Expected dividend growth rate
Cost of equity capital =
Investing in a project that has an IRR greater than the cost of capital should increase the market value of a firm’s securities.
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23. 3
Analyze capital budgeting decisions using methods that do not consider the time value of money, such as payback period and accounting rate of return.
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24. Does not consider the time value of money.
Payback Period
Indicates the time required to recover the initial investment in a project from operations
Acceptable projects must have less than some maximum payback period designated by management
Does not consider the time value of money.
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25. Calculating Payback Period
For projects with equal annual operating cash flows
Initial investment
Annual operating cash inflows
Payback period =
Payback period for Bates Limo =
$86,500
$28,100
= years
Bates Limo will recover all of its initial cash investment in 3.08 years.
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26. Calculating Payback Period
For projects with unequal annual operating cash flows
Assume Bates Limo’s net operating cash inflow is $26,000, $27,000, $28,000, and $29,000 in Years 1 through 4, respectively.
Payback period for Bates Limo:
Year
Net Cash Inflow
Unrecovered Investment $
$86,500 1
26,000
60,500 2
27,000
33,500 3
28,000
5,500 4
29,000
Three full years plus a portion of year 4:
$5,500 / $29,000 = 0.19
Recovery period = 3.19 years
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27. Accounting Rate of Return
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
Focuses on net income, not cash flows
Determining Net Income:
Annual net cash inflow from operations
– Average annual depreciation
Average annual increase in net income
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28. Accounting Rate of Return Example
Bates Limo is considering the purchase of a new limo for $84,000 with an estimated disposal value of $12,000 at the end of its useful life of 4 years. The annual operating cash flows total $28,100.
Average annual increase in net income =
Annual net cash inflow from operations
$ ,100
Less average annual depreciation:
($84,000 - $12,000) / 4 years
(18,000)
Average annual increase in net income
$ ,100
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29. Accounting Rate of Return Example
Bates Limo is considering the purchase of a new limo for $84,000 with an estimated disposal value of $12,000 at the end of its useful life of 4 years. The average annual increase in net income is $10,100.
Accounting rate of return on initial investment:
$10,100
$84,000 =
Average annual increase in net income
Initial investment =
Accounting rate of return on average investment:
$10,100
($84,000 + $12,000) / 2 =
Avg. annual increase in net income
Avg. investment =
Management will reject investments that do not exceed the minimum required return.
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30. 4
Evaluate the strengths and weaknesses of alternative capital budgeting models.
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31. Evaluating Payback Period
Disadvantages when used solely to evaluate investments
Ignores time value of money
Ignores profit
Ignores cash flows after the payback period
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32. Evaluating Accounting Rate of Return
Superior to payback period method for total life evaluations as it considers the proposals’ profitability
Fails to consider the timing of cash flows
Treats all cash flows equally
Early period cash flows are worth more than later cash flows
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33. Evaluating Accounting Rate of Return
Predicted net cash inflow from operations
Project 1
Project 2
Year 1
$ 30,000.
$ 5,000.
Year 2
30,000.
5,000.
Year 3
Year 4
Total
70,000.
Total depreciation
(48,000)
Net income
22,000.
Project life
÷ 4 years.
Average annual increase in income
$ 5,500.
Increase in investment
÷ 48,000.
Accounting rate of return on initial investment
Preferable cash flows
While both investments have the same accounting rate of return, receiving cash flows earlier (as in Project 1) is preferable to the timing of the cash flows in Project 2, due to the time value of money.
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34. Evaluating Net Present Value
Predicted net cash inflow from operations
Project 1
Project 2
Years 1 and 2
$ 30,000.
$ 5,000.
Years 3 and 4
5,000.
30,000.
Initial investment
48,000.
Project 1
Predicted Cash Inflows (Outflows)
Years(s) of Cash Flows
8% Present
Value Factor
Present Value
of Cash Flows
Initial investment
$ (48,000)
$(48,000)
Operations
30,000
1-2
53,498.
5,000
3-4 –
7,644.
Net present value of all cash flows
$ 13,142.
Project 2
Predicted Cash Inflows (Outflows)
Years(s) of Cash Flows
8% Present
Value Factor
Present Value
of Cash Flows
Initial investment
$ (48,000)
1.000
$(48,000)
Operations
5,000
1-2
8,916.
30,000
3-4 –
45,866.
Net present value of all cash flows
$ 6,782.
Project 1 generates the higher net present value.
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35. Comparing NPV and the Internal Rate of Return Methods
Net Present Value
Gives explicit consideration to investment size
Assumes all net cash inflows are reinvested at the discount rate
Internal Rate of Return
Gives no consideration to investment size
Assumes all net cash inflows are reinvested at the project’s internal rate of return
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36. 5
Examine the impact of judgment, attitudes toward risk, and relevant cash flow information on capital budgeting decisions.
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37. Using Multiple Investment Criteria
Investment models aid managers in making investment decisions
Management considerations
Reduce risk
Ensure an adequate return to investors
Availability of resources
Nonquantitative factors
Market position
Operational performance improvement
Strategy implementation
Top management’s attitudes and confidence in decision makers
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38. Evaluating Capital Expenditure Risk
Risks are often related to…
Cost of the initial investment
Time required to complete the initial investment and begin operations
Whether the new facilities will operate as planned
Life of the facilities
Customers’ demand for the product or service
Final selling price
Operating costs
Disposal values
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39. Risk Analysis Techniques
Suggested approaches to assist in capital budgeting risk…
Adjust the discount rate for individual projects based on management’s perception of a project’s risks
Compare several internal rates of return and/or net present values for a project
Subject a capital expenditure proposal to sensitivity analysis
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40. Differential Analysis of Cash Flows
Some capital expenditure proposals create no cash inflows, such as
Not-for-profit and government units providing services
For-profit firms maintaining product quality or improving safety standards
Cannot calculate payback period, accounting rate of return and internal rate of return
Solution
Compute the present value of all life cycle costs
Select the investment with the least negative net present value
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41. Differential Analysis Example
Yater College wants to replace its 3 year old fitness equipment in its student fitness center. The equipment has a remaining useful life of 1 year, a current book value of $43,600, and a current market value of $35,000.
The new equipment will cost $88,000 and will have an estimated useful life of 4 years and a $5,000 salvage value. The new equipment will reduce annual utility costs from $75,000 to $72,800 due to improved energy efficiency.
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42. Differential Analysis Example
Keep Old Equipment
Replace with New Equipment
Difference
Initial investment
Cost of new equipment
$88,000.
Disposal value of old machine
(35,000)
Net initial investment
$53,000.
Annual operating cash savings
Utility costs on old equipment
$75,000
Utility costs on new equipment
$72,800.
Net annual cost savings
$ 2,200.
Disinvestment at end of life
Old equipment $
New equipment
$ 5,000.
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43. Differential Analysis Example
Predicted Cash Inflows (Outflows)
Year(s) of
Cash Flows
8% Present Value
Factor
Present Value of
Initial investment, net
$(53,000)
1.000
Operations
2,200
1-4
3.312
7,286
Disinvestment of new equipment
5,000 1
0.735
3,675
Net present value of all cash flows
$(42,039)
The proposal provides no net incremental cash flows, though it still may be accepted since it is a replacement of older equipment.
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44. High-Tech Investments
Includes such innovations such as flexible manufacturing systems and computer integrated manufacturing
Care must be taken when evaluating
Potential errors in evaluating
Investing in unnecessary or overly complex equipment
Overestimating cost savings
Underestimating incremental sales
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45. Investing in Unnecessary or Overly Complex Equipment
Common error
Comparing the cost associated with the current inefficient way of doing things with the predicted cost of performing the identical operations with modern equipment
Potential outcome
Generation of costly non-value-added activities
Careful evaluation of situations will help mitigate problems of this type of error.
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46. Other Problems with High-Tech Investments
Overestimating cost savings
Common error
Basing estimates on a single activity cost driver
Underestimating incremental sales or cost savings
Common errors
Assuming that the baseline for comparison is the current sales level
Forgetting that investments in manufacturing technologies increase rapid, low-cost switching to new products
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47. 6
Determine the net present value of investment proposals with consideration of taxes.
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48. Taxes in Capital Budgeting Decisions
Cost of asset is depreciated over the operating life of an asset
Depreciation reduces income taxes but does not cause cash outflows
Two assumptions in dealing with taxes in capital budgeting decisions
Revenues and operating cash receipts are the same each year
Depreciation is the only noncash expense of an organization
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49. Depreciation Tax Shield
Depreciation provides a “tax shield”
Reduces cash payments for income taxes
Depreciation tax shield = Depreciation x Tax rate
EXAMPLE
Depreciation tax shield for Bates Limo, assuming a 30% tax rate: =
$84,000 – $12,000
4 years
x 30% = $5,400
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50. Effect of Depreciation Example
If Bates Limo purchases the new limo for $84,000, incremental sales and cash operating expenses will be $132,100 and $104,000, respectively.
How much are net annual cash inflows assuming a 30% income tax rate?
Depreciation expense = =
$84,000 – $12,000
4 years
= $18,000 per year
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51. Effect of Depreciation Example
Annual Taxes and Income without Depreciation:
Sales
$132,100.
Operating expenses (except depreciation)
(104,000)
Depreciation 0.
Income before taxes without depreciation
28,100.
Income taxes
(8,430)
Net income
$ 19,670.
Annual Taxes and Income with Depreciation:
Sales
$132,100.
Operating expenses (except depreciation)
(104,000)
Depreciation
18,000.
Income before taxes with depreciation
10,100.
Income taxes
(3,030)
Net income
$ 7,070.
Tax difference = Depreciation Tax Shield = $5,400
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52. Effect of Depreciation Example
Annual Taxes and Cash Flow without Depreciation:
Sales
$132,100.
Operating expenses (except depreciation)
(104,000)
Income taxes
(8,430)
Net annual cash inflow
$ 19,670.
Tax difference = $5,400
Cash flow difference = $5,400
Annual Taxes and Cash Flow with Depreciation:
Sales
$132,100.
Operating expenses (except depreciation)
(104,000)
Income taxes
(3,030)
Net annual cash inflow
$ 25,070.
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53. Investment Tax Credit
A government tax incentive for the purpose of stimulating investment and economic growth
A reduction of taxes in the year a new asset is placed in service
Reduces cash payments for taxes
Treated as a cash inflow for capital budgeting purposes
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54. Net Present Value with Taxes
Predicted Cash Inflows (Outflows)
Year(s) of
Cash Flows
8% Present Value Factor
Present Value of Cash Flows
Initial investment
Limo purchase
$(84,000) —
Working capital
(2,500)
Operations
Annual taxable income without
depreciation
28,100.
1-4
93,071.
Taxes on income ($28,100 × 30%)
(8,430)
(27,921)
Depreciation tax shield ($18,000 × 30%)
5,400.
17,886.
Disinvestment
Sale of limo*
12,000. 4
8,820.
Recovery of working capital
1,000.
735.
Net present value of all cash flows
$ 6,091.
*No gain recognized:
Sale price at end of life, $12,000
Less book value at end of life, $12,000
Equals $0 gain.
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55. Compute basic present value cash flow amounts.7
Appendix 25A
Compute basic present value cash flow amounts.
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56. Time Value of Money
Money is worth more if received today rather than received in the future
Two reasons
The time value of money
Risk
If invested, money will earn interest and grow in value over time
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57. Future Value
The amount that a current sum of money earning a stated rate of interest will accumulate to at the end of a future period
Calculating future value
fv = pv(1 + i)n
How much will a deposit of $800 in the bank that pays 8% annual interest accumulate in 1 year?
fv of $800 = $800( )1 = $864
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58. Present Value
The current worth of a sum of money to be received at some future date at a stated rate of interest
Calculating present value
pv = fv
(1 + i)n
How much is the current value of $864 to be received one year in the future at an 8% annual interest rate?
pv of $864 =
$864
( )1
= $800
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59. Annuities
A series of equal cash flows received or paid over equal intervals of time
Example: Suppose that $300 will be received at the end of each of the next 3 years. The discount rate is 8%.
How much is the present value the cash flows?
Year 1
$300 × $1 ÷ ( )1
$278
Year 2
$300 × $1 ÷ ( )2
257
Year 3
$300 × $1 ÷ ( )3
238
Present value
$773
OR: pva = 1
( )3
= $773
x 1 –
300
0.08
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60. Unequal Cash Flows
A series of unequal cash flows received or paid over equal intervals of time
Example: Suppose that $300 will be received at the end of Year 1, with $200 received at the end of Year 2, and $100 received at the end of 3 years. The discount rate is 8%.
How much is the present value the cash flows?
Year
Annual
Cash Flow
Present Value
at 8%
Present Value Amount 1
$300
$277.78 2
200
171.47 3
100
79.38
$528.63
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61. Determine internal rate of return using present value tables.8
Appendix 25B
Determine internal rate of return using present value tables.
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62. Internal Rate of Return
Equal cash flows
A single investment is followed by a series of equal annual net cash flows
Present value factor for an annuity of $1
Initial investment
Annual net cash inflows =
$84,000
$28,100 =
Bates Limo Example =
Locate this factor in the row for 4 periods in the Present Value of an Annuity of $1 table.
The factor is found between 12% and 14%, at approximately 12.8%.
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63. Internal Rate of Return
Unequal cash flows
A single investment is followed by a series of unequal annual net cash flows
Trial and error must be used
First, select a discount rate estimated to be close to the proposal’s IRR
Calculate the net present value
If net present value is positive, select a higher rate
If net present value is negative, select a lower rate
Recalculate the net present value until an approximate IRR is found
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