1. Copyright © 2014 Nelson Education Ltd. 11–1 PowerPoint Presentations for Finance for Non-Financial Managers: Seventh Edition Prepared by Pierre Bergeron University of Ottawa

2. Copyright © 2014 Nelson Education Ltd. 11–2 CHAPTER 11 Capital Budgeting

3. Copyright © 2014 Nelson Education Ltd. 11–3 1.Explain the importance of capital projects. 2.Differentiate between compulsory investments and opportunity investments. 3.Explain the capital budgeting process. 4.Comment on the key elements used to judge capital projects. 5.Evaluate capital investment decisions by using time- value-of-money yardsticks. 6.Assess capital investments by measuring risk. 7.Explain what can stop a capital project from being approved. Learning Objectives

4. Copyright © 2014 Nelson Education Ltd. 11–4 Importance of Capital Projects LO 1

5. Copyright © 2014 Nelson Education Ltd. 11–5 Compulsory and Opportunity Investments LO 2

6. Copyright © 2014 Nelson Education Ltd. 11–6 Capital Budgeting Process LO 3

7. Copyright © 2014 Nelson Education Ltd. 11–7 Cash Outflows Key Elements to Assess Capital Projects Cash Inflows Economic life of project Sunk costs Non-current assets Working capital Normal non-current assets additions Profit for the year Non-cash expenses (depreciation) Residual value LO 4

8. Copyright © 2014 Nelson Education Ltd. 11–8 Evaluating a Capital Expenditure Project Assumptions:1. A $1.5-million investment to modernize a plant. 2. The economic life of the project is 10 years. 3. The annual savings are $300,000. 4. The cost of capital is 14%. Year Outflow Inflows Discount factorsPresent value 0($1,500,000) --- ---($1,500,000) 1 --$ 300,0000.87719 263,157 2 -- 300,0000.76947 230,841 3 -- 300,0000.67497 202,491 4 -- 300,0000.59208 177,624 5 -- 300,0000.51937 155,810 6 -- 300,0000.45559 136,676 7 -- 300,0000.39964 119,891 8 -- 300,0000.35056 105,167 9 -- 300,0000.30751 92,252 10 -- 300,0000.26974 80,921 Total inflows$3,000,000 $1,564,830 Net present value $ 64,830 LO 5

9. Copyright © 2014 Nelson Education Ltd. 11–9 A Capital Project Inflows $300,000 X 5.2161 Outflow Net present value @ 14% $ 1,564,830 (1,500,000) $ 64,830 Inflows $300,000 X 5.018 Outflow Net present value @ 15% $ 1,505,640 (1,500,000) $ 5,640 Inflows $300,000 X 5.000 Outflow Net present value @ 15.1% $ 1,500,000 (1,500,000) $ --- Discounted payback 9th year Undiscounted payback 5 years IRR LO 5

10. Copyright © 2014 Nelson Education Ltd. 11–10 Payback or IRR? Project A 30% 4 years Project B 25% 2 years IRR Payback Difference in the timing of the cash flows Difference in the length of the project’s life span Years 0 1 2 3 4 5 6 7 8 9 10 Cash flows ($100,000) 20,000 30,000 40,000 50,000 60,000 $ 430,000 Cash flows ($100,000) 50,000 30,000 ---- $ 160,000 Difference ---- - $30,000 - 30,000 ---- + 40,000 + 50,000 + 60,000 + 270,000 LO 5

11. Copyright © 2014 Nelson Education Ltd. 11–11 Project’s Yearly Cash Outflow and Inflows Expected cash inflows In 000’s Cost of project Present value of inflows Present value of expected annual cash inflows Loss of value due to time $1,5 1,2,9,6,3 0 1 2 3 4 5 6 7 8 9 10 LO 5

12. Copyright © 2014 Nelson Education Ltd. 11–12 Net Present Value and Internal Rate of Return In 000’s ($1,500) 0% 1.000 3,000 $1,500 $3,000 2,500 2,000 1,500 1,000 500 0 Project cost Discount rate Factor Present value NPV Inflow Outflow ($1,500) 4% 8.1109 2,433 $ 933 Inflow Outflow ($1,500) 10% 6.1446 1,843 $ 343 Inflow Outflow ($1,500) 15% 5.0188 1,506 $ 6 ($1,500) 18% 4.4941 1,348 $ (152) Inflow Outflow ($1,500) 15.1% 5.0000 1,500 $ 0 Inflow Outflow LO 5

13. Copyright © 2014 Nelson Education Ltd. 11–13 Quantitative Yardsticks Use Number of 25 companies using each criteria Accounting rates of return Payback - Regular - Bailout Discounted cash flow Internal rate of return Net present value Net present value index At least one DCF method 19 21 14 3 22 25 1 Total Degree of emphasis Major Minor 10 20 8 2 21 9 -- 9 16111611 16 1 LO 5

14. Copyright © 2014 Nelson Education Ltd. 11–14 Accounting Methods What they are: Also referred to as “traditional yardsticks,” the “financial statement method,” the “accountant’s method,” and the “book value rate of return” make use of data presented on financial statements to express the economic results of a capital project. What they do: They give a rate of return on a capital project at a particular point in time (year) based on book profit and book investment. How they work: A. Based on investment 1. Return on original investment 2. Return on average investment 3. Return on depreciated investment B. Based on capital employed C. Based on average profit D. Based on equity LO 5

15. Copyright © 2014 Nelson Education Ltd. 11–15 Calculating the Return on Investment Non-current assets............ $1, 500,000 Net working capital............ 500,000 Total capital employed.......... $2,000,000 Profit for the year Year 1........................... $ 50,000 Year 2........................... $200,000 Year 3............................ $375,000 Year 4............................ $510,000 Year 5............................ $690,000 C.E. 2.5 10.0 18.7 25.5 34.5 C.A. 3.3 13.3 25.0 34.0 46.0 Average profit 18.2 24.3 C.A. 6.7 26.7 50.0 68.0 92.0 Average investment C.E. 4.0 16.0 30.0 41.0 55.2 C.A. 4.2 22.2 66.6 170.0 +1000.0 Depreciated assets C.E. 2.9 14.3 34.0 63.7 138.0 LO 5

16. Copyright © 2014 Nelson Education Ltd. 11–16 Calculating the Return on Investment Assets R&D.................... $150,000 Equipment/machinery....... 850,000 Other assets............... 500,000 $1,500,000 Net working capital 500,000 Total capital employed $2,000,000 Profit for the year Year 1........................... $ 50,000 Year 2........................... $200,000 Year 3........................... $375,000 Year 4........................... $510,000 Year 5........................... $690,000 Trade receivables $600.0 Inventories $300.0 Total $900.0 Acc. pay. $400.0 Net working capital $500.0 LO 5

17. Copyright © 2014 Nelson Education Ltd. 11–17 Projected Statements of Income and Cash Flows Years 1 2 34 5 Revenue$1,300.0 $1,700.0 $2,415.0 $3,000.0$3,700.0 Cost of sales (600.0) (700.0) (990.0) (1,240.0) (1,560.0) Gross profit 700.0 1,000.0 1,425.0 1,760.0 2,140.0 Distribution and administrative expenses* (350.0) (400.0) (500.0) (600.0) (650.0) Profit before CCA 350.0 600.0 925.0 1,160.0 1,490.0 CCA (250.0) (200.0) (175.0) (140.0) 110.0 Profit before taxes 100.0 400.0 750.0 1,020.0 1,380.0 Income tax expense (50%) (50.0) (200.0) (375.0) (510.0) (690.0) Profit for the year 50.0 200.0 375.0510.0 690.0 Add back CCA 250.0 200.0 175.0140.0 110.0 Cash Flow $300.0 $400.0 $550.0 $650.0 $800.0 * Excludes financing charges LO 5

18. Copyright © 2014 Nelson Education Ltd. 11–18 Projected Cash Flows Years 0 1 2 3 4 5 Non-current assets ( 1,500.0) --- --- --- --- --- Working capital --- ( 250.0) ( 250.0) --- --- --- Pro-forma cash flow --- 300.0 400.0 550.0 650.0 800.0 Sale of non-current assets --- --- --- --- --- 300.0 Recovery of working capital --- --- --- --- --- 500.0 Total cash flow (1,500.0) 50.0 150.0 550.0 650.0 1,600.0 LO 5

19. Copyright © 2014 Nelson Education Ltd. 11–19 The Payback Period What it does:It appraises time risk (not risk conditions or uncertainties). How it works:Years Annual net cash flows Cumulative cash flows 0($1,500,000)($1,500,000) 1 50,000( 1,450,000) 2 150,000( 1,300,000) 3 550,000( 750,000) 4 650,000( 100,000) 5 1,600,000 $1,500,000 Also known as the “cash recovery period,” the “payoff method,” or the “payout method” measures the period of time it takes for the cash outflow of a project to be totally recovered by the anticipated cash inflows; it measures how soon the initial funds disbursed are recovered by the project. What it is: LO 5

20. Copyright © 2014 Nelson Education Ltd. 11–20 Net Present Value How it works: Annual net 10% Years cash flows discount factorsPresent value 0($1,500.0) 1.000 ($1,500.0) 1 50.0 0.909 45.4 2 150.0 0.826 123.9 3 550.0 0.751 413.1 4 650.0 0.683 444.0 5$ 1,600.0 0.621 993.6 2,020.0 Net present value (NPV) $ 520.0 Measures the difference between the sum of all cash inflows discounted at a pre-determined interest rate (the hurdle rate), which sometimes reflects the company’s weighted cost of capital, and all cash outflows. Shows whether or not the use of borrowed funds for a project has greater financial merit than the cost of borrowing. What it is: What it does: LO 5

21. Copyright © 2014 Nelson Education Ltd. 11–21 Internal Rate of Return What it is:Also known as the “discounted cash flow,” the “true yield,” or the “investor’s method” can be described as the specific interest rate used to discount all future cash inflows, so that their present value equals the initial cash outflows. What it does:Shows the economic merits of independent projects, and of mutually exclusive ones, and compares their returns to other financial indicators, such as the weighted cost of capital and the company’s weighted rate of return. How it works:Years Cash flows 17% 18%19% 0($1,500.0) ($1,500.0) ($1,500.0) ($1,500.0) 1 50.0 42.7 42.4 42.0 2 150.0 109.6 107.7 105.9 3 550.0 343.4 334.7 326.4 4 650.0 346.8 335.3 324.1 5$ 1,600.0$729.8 $699.4$670.4 Net present value (NPV) $72.3 $19.5 ($31.2) IRR 18.4% LO 5

22. Copyright © 2014 Nelson Education Ltd. 11–22 The Profitability Index What it is: How it works: What it does: Also known as the present value index, or benefit- cost ratio, shows the ratio of the present value of cash inflow to the present value of the cash outflow, discounted at a predetermined rate of interest. Helps to rank capital projects by the ratio of the net present value for each dollar to the cash outflow and to select the projects with the highest index until the budget is depleted. Present value of cash inflows = Cash outflow $ 2,020.0 = 1.347 $ 1,500.0 LO 5

23. Copyright © 2014 Nelson Education Ltd. 11–23 Sensitivity Analysis How it works:Factors % variation in factor Internal rate of return Base case ------ 18.4% Selling price -10% 14.2% Cost of construction + 5% 17.3% Sales volume -10% 16.6% Involves the identification of profitability variations as a result of one or more changes in the base case regarding certain key elements of a project, such as the purchase of land, buildings, equipment, sales volume, selling price, cost of materials, or labour and even the length of the economic life of a project. Gives a range of results based on patterns of variation on the use of one single set of factors generating the best possible results. What it is: What it does: LO 6

24. Copyright © 2014 Nelson Education Ltd. 11–24 Measuring Risk Through Analysis How it works:Sales volume (000’s units)100200300400 Probabilities.05.15.65.15 Selling price ($)1.501.701.90 2.10 Probabilities.05.15.70.10 Cost of labour ($).75.80.85.90 Probabilities.05.15.65.15 Project cost ($000’s)200250300 350 Probabilities.05.10.75.10 Life of project (years)101112 13 Probabilities.05.10.80.05 Process of attaching probabilities to individual estimates in the base case. Shows the full spectrum of return outcomes, from the most pessimistic to the most optimistic, by weighing the uncertainty factors. What it is: What it does: LO 6

25. Copyright © 2014 Nelson Education Ltd. 11–25 Risk Analysis IRR range Occurrences % of total % cumulative 5-8 4.4.4 8-11 30 3.0 3.4 11-14 133 13.3 16.7 14-17 323 32.3 49.0 17-20 283 28.3 77.3 20-23 167 16.7 94.0 23-26 43 4.3 98.3 26-29 17 1.7 100.0 1,000100.0 Output document would read as follows: Minimum rate of return 5.3% Maximum rate of return29.3% Mean18.1% Probability 68.3% that the return will fall between 15.6% and 22.0% 95.5% that the return will fall between 9.0% and 23.9% 99.7% that the return will fall between 5.9% and 29.0% LO 6

26. Copyright © 2014 Nelson Education Ltd. 11–26 Capital Constraints Cash insufficiency –Not enough cash generated by project to pay for fixed charges (interest charges) Hurdle rate –Method used for ranking capital projects LO 7