1. 8-1 Capital Budgeting Decisions–Part II Prepared by Douglas Cloud Pepperdine University Prepared by Douglas Cloud Pepperdine University 8

2. 8-2  Analyze investments in working capital.  Analyze replacement decisions using two approaches.  Explain and apply sensitivity analysis.  Describe and analyze mutually exclusive investments.  Describe the Modified Accelerate Cost Recovery System and use it in evaluating investments. ObjectivesObjectives After reading this chapter, you should be able to: ContinuedContinued

3. 8-3  Explain how capital budgeting applies to not- for-profit entities and to social welfare. ObjectivesObjectives

4. 8-4 Investments in Working Capital Current assets -Current liabilities =Working capital

5. 8-5 Increases in Working Capital Investment  Companies strive to reduce working capital requirements to increase returns  Companies invest to reduce working capital Example Annual revenues$30,000 Annual cash costs$12,000 Investment$50,000 in equipment $35,000 in working capital Life5 years

6. 8-6 Annual Incremental After-Tax Cash Flows (Years 1-5) Revenues$30,000$30,000 Cash expenses (variable and fixed) 12,000 12,000 Cash inflow before taxes$18,000$18,000 Depreciation ($50,000 ÷ 5) 10,000 Increase in taxable income$8,000 Income taxes (40 percent)$3,200 3,200 Net increase in annual cash inflow$14,800 Tax Computation Cash Flow

7. 8-7 Summary of Net Present Value of Investment Operating cash inflows ($14,800 x 3.605)$ 53,354 Recovery of working capital ($35,000 x 0.567) 19,845 Total present value$ 73,199 Investment required ($50,000 + $35,000) 85,000 Net present value$(11,801) *Cost of Capital Used = 12%

8. 8-8  Inventory is the most common target of investments that focus on reducing working capital.  A company embarking on an inventory- reduction project will draw down existing inventory the first year of the project.  Delaying production or purchases in this first year frees up cash for other purposes. Decreases in Working Capital Investment

9. 8-9 Replacement Decisions Businesses frequently face the problem of whether to replace an asset currently in use. Such a question is called a replacement decision. Replacement decisions are made when economic or technological factors make it possible to perform tasks at lower cost.

10. 8-10 Two Approaches to Replacement Decisions The incremental approach focuses on the differences between the cash flows, given the alternatives of keeping the existing assets or replacing them. The total-project approach compares the present values of operating each way.

11. 8-11 Replacement Decision Example Cost$100,000 five years ago Remaining useful life 5 years Current book value $50,000 Annual depreciation $10,000 Expected sales value—now$20,000 —in 5 years$0 Annual cash operating costs $30,000

12. 8-12 Information on new machine: Cost is $60,000 Useful life is 5 years Annual cash operating costs is $15,000 Tax rate is 40 percent Straight-line depreciation Cut off rate is 16% Replacement Decision Example

13. 8-13 Purchase price of new asset$60,000 Book value of old machine$50,000 Sales price, which is cash inflow 20,000(20,000) Loss for taxes, which can be offset against regular income$30,000 Taxes saved (40% x $30,000)$12,000 (12,000) Net outlay for new asset$28,000 Replacement Decision Example Tax Computation Cash Flow

14. 8-14 Annual Incremental After-Tax Cash Inflows (Years 1-5) Pretax cash savings: Cash cost of using old machine$30,000 Cash cost of using new machine 15,000 Difference favoring replacement$15,000$15,000 Additional depreciation: Depreciation on new machine$12,000 Depreciation on old machine 10,000 Additional tax deduction for depreciation with replacement 2,000 Increase in taxable income $13,000 Tax Computation Cash Flow ContinuedContinued

15. 8-15 Annual Incremental After-Tax Cash Inflows (Years 1-5) Increase in taxable income $13,000 Additional tax ($13,000 x 40%) outflow 5,200$ (5,200) Additional net cash inflow favoring replacement$ 9,800 Present value factor, 5 years, 16% 3.274 Present value of savings$32,085 Investment 28,000 Net present value$ 4,085 Tax Computation Cash Flow The NPV is positive, so replacement is desirable

16. 8-16 Total-Project Approach Annual operating costs$30,000$30,000 Depreciation 10,000 Total tax-deductible expenses$40,000 Tax savings expected$16,000 16,000 Net cash outflow expected per year$14,000 Present value factor, 5 years at 16% x 3.274 Present value of future operating outflows$45,836 Decision: Operate Existing Machine Tax Cash Computation Flow

17. 8-17 Annual operating costs$15,000$15,000 Depreciation 12,000 Total tax-deductible expenses$27,000 Tax savings expected$10,800 10,800 Net cash outflow expected per year$ 4,200 Present value factor, 5 years at 16% x 3.274 Present value of future operating outflows$13,751 Net outlay required for the new machine 28,000 Present value to buy new machine$41,751 Total-Project Approach Decision: Sell Existing Machine, Buy New Machine Tax Cash Computation Flow

18. 8-18 Comparing the Two Alternatives Present value of using existing machine$45,836 Present value of buying new machine 41,751 Difference in favor of replacing old machine$ 4,085

19. 8-19 Insight: Know When to Fold Em  Set limits up front  Be skeptical of optimistic analyses  Consider alternatives  Question assumptions and projections

20. 8-20 Sensitivity Analysis Sensitivity analysis involves finding out how much the value of a variable can rise or fall before a different decision is indicated. Sensitivity analysis applies to all types of decisions, but is especially beneficial when applied to capital budgeting decisions.

21. 8-21 Sensitivity Analysis A company with a cost of capital of 14 percent and a 40 percent tax rate can bring out a product priced at $22. Managers estimate variable costs at $4 per unit, fixed costs of $100,000 annually, and 10,000 units annual sales volume. The product requires an investment of $200,000 for depreciable assets with a five-year life and no salvage value. Example

22. 8-22 Sensitivity Analysis Expected contribution margin (10,000 x $18)$180,000$180,000 Fixed costs: Cash100,000(100,000) Depreciation ($200,000/5) 40,000 $140,000 Increase in taxable income 40,000 Tax at 40%$ 16,000 (16,000) Net cash inflow per year$ 64,000 Present value factor, 5-years at 14% x 3.433 Present value of annual cash inflows$219,712 Investment required 200,000 Net present value$ 19,712 Tax Cash Computation Flow Accept the Project!

23. 8-23 Mutually Exclusive Alternatives Mutually exclusive alternatives happen when a company has two or more ways of accomplishing the same goal, so that selecting one alternative precludes selecting the others. The replacement decision discussed earlier fits the definition.

24. 8-24 Unequal Lives To illustrate this method, assume the following facts about two mutually exclusive investment opportunities involving a machine, versions Model G-40 and Model G-70, that is essential to the company’s operations Model G-40Model G-70 Purchase price$40,000$70,000 Annual cash operating costs$8,000$6,000 Expected useful life4 years8 years Neither machine has any expected salvage value at the end of its useful life. The cutoff rate is 14 percent.

25. 8-25 Present Value for Model G-70 Annual operating costs$ 6,000 Present value factor, 8 years, 14% x 4.639 Present value of operating costs$27,834 Investment required 70,000 Net present value$97,834 Unequal Lives

26. 8-26 Annual operating costs, years 1-8$ 8,000 Present value factor, 8 years, 14% x 4.639 Present value of operating costs, yrs 1-8$ 37,112 Present value of purchase of replacement Model G-40 at the end of Year 4 26,048 Present value of future cash outlays$ 63,160 Investment required 40,000 Net present value$103,160 Present Value for Model G-40 Unequal Lives

27. 8-27 Ranking Investment Opportunities Profitability index (PI) is the ratio of the present value of the future cash flows to the investment. PI = PV of future cash flows/Investment

28. 8-28 Investment required$50,000$10,000 Life of investment1 year1 year Cash flows, end of year 1$55,991$11,403 Net present value of project$896$365 Internal rate of return12%14% Profitability index1.0181.037 Ranking Investment Opportunities X Y Below are data for two mutually exclusive investment opportunities confronting a company with a 10 percent cost of capital.

29. 8-29 5-Year Class trucks typewriters copiers Personal computers

30. 8-30 7-Year Class office furniture and equipment most types of machinery Any property not designated by law as being in some other class

31. 8-31 10-Year Class Lives of at least 16 years and less than 20 years, including certain types of transportation equipment

32. 8-32 31.5-Year Class Nonresidential real property such as factory buildings

33. 8-33 Percentages of Cost Depreciated Under MACRS Year5-Year Class7-Year Class10-Year Class 120%14%10% 232%25%18% 319%18%14% 412% 5 9% 65%9%7% 79%7% 84%7% 9 106% 113%

34. 8-34 Discount Rate5-Year Class7-Year Class 8%0.811 0.766 10%0.774 0.722 12%0.738 0.681 14%0.706 0.645 16%0.675 0.611 18%0.647 0.580 20%0.621 0.552 22%0.597 0.526 24%0.574 0.502 Present Value of MACRS Tax Shields

35. 8-35 Example A company expects pretax cash flows of $3,000 per year from an asset costing $10,000. The asset is in the 5-year class and, to reduce calculations, has a useful life of six years. The tax rate is 40 percent and cost of capital is 12 percent

36. 8-36 Pretax inflow$3,000$3,000$3,000$3,000$3,000$3,000 MACRS deduction 2,000 3,200 1,900 1,2001,200 500 Taxable income$1,000$(200)$1,100$1,800$1,800$2,500 Tax at 40% 400 (80) 440 720 720 1,000 Net cash inflow$2,600$3,080$2,560$2,280$2,280$2,000 PV factor.893.797.712.636.567.507 Present values$2,322$2,455$1,823$1,450$1,293$1,014 Total present value $10,357 Example 1 2 3 4 5 6

37. 8-37 Present value of operating flows $3,000 x (1 – 0.40) x 4.11 (from Table B)$ 7,400 Present value of MACRS shield $10,000 x 0.40 x.738 (from Slide 8-34) 2,952 Total present value$10,352 Example

38. 8-38 Criticisms of DCF Methods  Companies downplay quantitative analysis because of overriding quantitative, or hard-to-quantify, concerns about particular investment.  High-tech investments often fail discounted cash flow tests yet such investments are clearly important.

39. 8-39 Social Consequences of Decision Making Social costs are not borne directly by the entity making a decision and taking an action. Social benefits (also called externalities) are benefits not accruing directly to the entity making a decision.

40. 8-40 The End Chapter 8

41. 8-41