12 The Capital Budgeting Decision Chapter Mc GrawHillIrwin

Chapter Outline • Capital budgeting decision. • Cash flows and capital budgeting. • Methods for ranking investments – Payback methods – Internal rate of return – Net present value. • Discount or cutoff rate. • After-tax operating benefits and tax shield benefits of depreciation. 12 -2

Capital Budgeting Decision • Involves planning of expenditures for a project with a minimum period of a year or longer. • Capital expenditure decisions requires: – Extensive planning and coordination of different departments. • Uncertainties are common in areas such as: – Annual costs and inflows, product life, economic conditions, and technological changes. 12 -3

Administrative Considerations • Steps in the decision-making process: – Search for and discovery for investment opportunities. – Collection of data. – Evaluation and decision making. – Reevaluation and adjustment. 12 -4

Capital Budgeting Procedures 12 -5

Accounting Flows versus Cash Flows • Capital budgeting decisions - emphasis remains on cash flow. – Depreciation (non cash expenditure) is added back to profit to determine the amount of cash flow generated. • An example shown in the next slide. • The emphasis is on the use of proper evaluation techniques for to make best economic choices and assure long term wealth. 12 -6

Cash Flow for Alston Corporation 12 -7

Revised Cash Flow for Alston Corporation 12 -8

Methods of Ranking Investment Proposals • Three methods used: – Payback method – although not sound conceptually, is often used. – Internal rate of return - more acceptable and commonly used. – Net present value - more acceptable and commonly used. 12 -9

Payback Method • Time required to recoup the initial investment. – Table 12 -3, using Investment A: • There is no consideration of inflows after the cutoff period. • The method fails to consider the concept of the time value of money. Year 1………. . 2………. . 3………. . Early Returns $9, 000 $1, 000 Late Returns $1, 000 $9, 000 $1, 000 12 -10

Investment Alternatives 12 -11

Payback Method (cont’d) • Advantages: – Easy to understand emphasizes liquidity. – Must recoup the initial investment quickly or it will not qualify. – Rapid payback preferred in industries characterized by dynamic technological environment. • Shortcomings: – Fails to discern the optimum or most economic solution to a capital budgeting problem. 12 -12

Internal Rate of Return • Requires the determination of the yield on an investment with subsequent cash inflows. – Assuming that a $1, 000 investment returns an annuity of $244 per annum for five years, provides an internal rate of return of 7%: • Dividing the investment (present value) by the annuity: (Investment) = $1, 000 = 4. 1 (PVIFA) (Annuity) $244 • The present value of an annuity (given in Appendix D) shows that the factor of 4. 1 for five years indicates a yield of 7%. 12 -13

Determining Internal Rate of Return Year 1……………… 2……………… 3……………… 4……………… 5……………… Cash Inflows (of $10, 000 investment) Investment A Investment B $5, 000 $1, 500 $5, 000 $2, 500 $5, 000 • To find a beginning value to start the first trial, the inflows are averaged out as though annuity was really being received. $5, 000 $2, 000 $12, 000 ÷ 3 = $4, 000 12 -14

Determining Internal Rate of Return (cont’d) • Dividing the investment by the ‘assumed’ annuity value in the previous step, we have; (Investment) = $10, 000 = 2. 5 (PVIFA) (Annuity) $4, 000 • The first approximation (derived from Appendix D) of the internal rate of return using; the factor falls between 9 and 10 percent; PV IFA factor = 2. 5 n (period) = 3 • Averaging understates the actual IRR and the same method would overstate the IRR for Investment B. • Cash flows in the early years are worth more and increase the return, it is possible to gauge whether the first approximation is over- or understated. 12 -15

Determining Internal Rate of Return (cont’d) • Using the trial and error approach, we use both 10% and 12% to arrive at the answer: Year 10% 1……. $5, 000 X 0. 909 = $4, 545 2……. $5, 000 X 0. 826 = $4, 130 3……. $2, 000 X 0. 751 = $1, 502 $10, 177 • (At 10%, the present value of the inflows exceeds $10, 000 – we therefore use a higher discount rate). Year 12% 1……. $5, 000 X 0. 893 = $4, 465 2……. $5, 000 X 0. 797 = $3, 985 3……. $2, 000 X 0. 712 = $1, 424 $9, 874 • (At 12%, the present value of the inflows is less than $10, 000 – thus the discount rate is too high). 12 -16

Interpolation of the Results • The internal rate of return is determined when the present value of the inflows (PVI) equals the present value of the outflows (PVO). • The total difference in present values between 10% and 12% is $303. $10, 177…… PVI @ 10% - $9, 874…. . PVI @ 12% $303 $10, 177……. PVI @ 10% - $10, 000……(cost) $177 • The solution is ($177/$303) percent of the way between 10 and 12 percent. Due to a 2% difference, the fraction is multiplied by 2% and the answer is added to 10% of the final answer of: 10% + ($177/$303) (2%) = 11. 17% IRR. • The exact opposite of this conclusion is yielded for Investment B (14. 33%). 12 -17

Interpolation of the Results (cont’d) • The use of the internal rate of return requires the calculated selection of Investment B in preference to Investment A, the conclusion being exactly the opposite under the payback method. • The final selection of any project will also depend on the yield exceeding some minimum cost standard, such as the cost of capital to the firm. Investment A Payback method……. . 2 years Internal Rate of Return……… 11. 17% Investment B 3. 8 years 14. 33% Selection Quicker payback: Investment A Higher yield: Investment B 12 -18

Net Present Value • Discounting back the inflows over the life of the investment to determine whether they equal or exceed the required investment. – Basic discount rate is usually the cost of the capital to the firm. – Inflows must provide a return that at least equals the cost of financing those returns. 12 -19

Net Present Value (cont’d) $10, 000 Investment, 10% Discount Rate Year Investment A Year Investment B 1……… $5, 000 X 0. 909 = $4, 545 1………. $1, 500 X 0. 909 = $1, 364 2……… $5, 000 X 0. 826 = $4, 130 2………. $2, 000 X 0. 826 = $1, 652 3……… $2, 000 X 0. 751 = $1, 502 3………. $2, 500 X 0. 751 = $1, 878 $10, 177 4………. $5, 000 X 0, 683 = $3, 415 5………. $5, 000 X 0. 621 = $3, 105 $11, 41 4 Present value of inflows…. . $10, 177 Present value of outflows -$10, 000 Net present value……………. . $177 Present value of inflows…. . $11, 414 Present value of outflows -$10, 000 Net present value…………. . . $1, 414 12 -20

Capital Budgeting Results 12 -21

Selection Strategy • For a project to be potentially accepted: – Profitability must equal or exceed the cost of capital. – Projects that are mutually exclusive: • Selection of one alternative will preclude selection of any other alternative. – Projects that are not mutually exclusive: • Alternatives that provide a return in excess of cost of capital will be selected. 12 -22

Selection Strategy (cont’d) • In the case of the prior Investment A and B, assuming a capital of 10%, Investment B would be accepted if the alternatives were mutually exclusive, while both would clearly qualify if they were not so. 12 -23

Selection Strategy (cont’d) • Assumption used: – Internal rate of return and net present value methods call for the same decision. – Exceptions to this generally common scenario are: • Both methods will accept or reject the same investments. • The two methods may give different answers in selecting the best investment from a range of acceptable alternatives. 12 -24

Reinvestment Assumption • All inflows can be reinvested at the yield from a given investment. – Investments with very high IRR • May be unrealistic to assume that reinvestment can occur at a equally high rate. – Under the net present value method: • Allows for certain consistency. 12 -25

The Reinvestment Assumption – Net Present Value ($10, 000 Investment) 12 -26

Modified Internal Rate of Return (MIRR) • Combines reinvestment assumption of the net present value method with the internal rate of return. 12 -27

Modified Internal Rate of Return (MIRR) (cont’d) • Assuming $10, 000 produces the following inflows for the next three years; • The cost of capital is 10%. • Determining the terminal value of the inflows at a growth rate equal to the cost of capital: • To determine the MIRR: PVIF = PV = $10, 000 =. 641 (Appendix B) FV $16, 610 12 -28

Capital Rationing • Artificial restraint set on the usage of funds that can be reinvested in a given period. – May be adopted because of: • Fearful of too much growth. • Hesitation to use external sources of funding. – Hinders a firm from achieving maximum profitability. 12 -29

Capital Rationing 12 -30

Net Present Value Profile • Allows the graphical representation of the net present value of a project at different discount rates. • To apply the net present value profile, three characteristics need to be looked into: – The net present value at a zero discount rate. – The net present value as determined by a normal discount rate (such as cost of capital). – The internal rate of return for the investments. 12 -31

Net Present Value Profile – Graphic Representation 12 -32

Net Present Value Profile with Crossover 12 -33

The Rules of Depreciation • Assets are classified according to nine categories. – Determine the allowable rate of depreciation write-off. – Modified accelerated cost recovery system (MACRS) represent the categories. – Asset depreciation range (ADR) is the expected physical life of the asset or class of assets. 12 -34

Categories for Depreciation Write. Off 12 -35

Depreciation Percentages (Expressed in Decimals) 12 -36

Depreciation Schedule 12 -37

The Tax Rate • Corporate tax rates are subject to changes. – Maximum quoted federal corporate tax rate is now in the mid 30 percent range. – Smaller corporations and others may pay taxes only between 15 – 20%. – Larger corporations with foreign tax obligations and special state levies may pay effective taxes of 40% or more. 12 -38

Actual Investment Decision • Assumption: – $50, 000 depreciation analysis allows the purchase of a machinery with a 6 year productive life. – Produces an income of $18, 500 for the first three years before deductions for depreciation and taxes. – In the last three years, the income before depreciation and taxes will be $12, 000. – Corporate tax rate taken at 35% and cost of capital 10%. – For each year: • The depreciation is subtracted from earnings before depreciation and taxes to arrive at earnings before taxes. • The taxes are then subtracted to determine the earnings after taxes. • Depreciation is then added to earnings to arrive at the cash flow. 12 -39

Cash Flow Related to the Purchase of Machinery 12 -40

Net Present Value Analysis 12 -41

The Replacement Decision • Investment decision for new technology. • Includes several additions to the basic investment situation. – The sale of the old machine. – Tax consequences. • Decision can be analyzed by using a total or an incremental analysis. 12 -42

Book Value of Old Computer 12 -43

Net Cost of New Computer 12 -44

Analysis of Incremental Depreciation Benefits 12 -45

Analysis of Incremental Cost Savings Benefits 12 -46

Present Value of the Total Incremental Benefits 12 -47

Elective Expensing • Businesses can write off tangible property, in the purchased year for up to $100, 000. – Includes: equipment, furniture, tools, and computers etc. • Beneficial to small businesses: – Allowance is phased out dollar for dollar when total property purchased exceed $200, 000 in a year. 12 -48