Chapter 12 Mc GrawHillIrwin The Capital Budgeting Decision

Chapter Outline • • The Capital budgeting decision Cash flows in Capital budgeting Payback method Net Present Value and Internal rate of Return • Discount or cutoff rate as Cost of Capital 12 -2

Capital Budgeting Decision – Administrative Considerations • Involves planning of expenditures for a project with a minimum period of a year or longer • Capital expenditure decision requires: – Extensive planning – Coordination of different departments • These decisions would be affected because of uncertainties involved in: – – – Annual costs and inflows Product life Interest rates Economic conditions Technological changes 12 -3

Capital Budgeting Decision – Administrative Considerations (cont’d) • Steps in the decision-making process: – Search for and discovery of investment opportunities – Collection of data – Evaluation and decision making – Reevaluation and adjustment 12 -4

Capital Budgeting Procedures 12 -5

Accounting Flows versus Cash Flows • In capital budgeting decisions, emphasis is on cash flows rather than earnings – Depreciation (noncash expenditure) is added back to profit to determine the amount of cash flow generated • Example provided in the following slide • Emphasis is on use of proper evaluation techniques to make best economic choices and assure long term wealth maximization 12 -6

Cash Flow and Revised Cash Flow for Alston Corporation Net earnings before and after taxes are zero, but the company has $20, 000 cash in the bank 12 -7

Methods of Ranking Investment Proposals • Three methods used: – Payback method – Internal rate of return – Net present value 12 -8

Payback Method • Time required to recoup initial investment from Table 12 -3: – Investment A is better – Investment A recoups $10, 000 Initial Investment at the end of the second year, while Investment B takes longer 12 -9

Payback Method (cont’d) • Advantages: – Easy to understand – Emphasizes liquidity – Useful in industries characterized by dynamic technological developments • Shortcomings: – Does not consider Time Value of Money – Ignores cash-flows after the cutoff period • Fails to discern optimum or most economic solution to capital budgeting problem 12 -10

Internal Rate of Return (Even Cash. Flows) • Requires the determination of the yield on an investment that equates the cash outflows (cost) of 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% as indicated: (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 -11

Internal Rate of Return - Uneven Cash-Flows 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 -12

Internal Rate of Return - Uneven Cash-Flows (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: PVIFA factor = 2. 5 n (period) = 3 • The factor falls between 9 and 10 percent • Averaging would either understate or overstate the IRR by moving the cash-flows either to the end or beginning of the project • Cash flows in early years are worth more and increase the return 12 -13

Internal Rate of Return - Uneven Cash-Flows (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, 464 2……. $5, 000 X 0. 797 = 3, 986 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 -14

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% for the final answer of: 10% + ($177/$303) (2%) = 11. 17% IRR • In Investment B the same process will yield an answer of 14. 33 percent. 12 -15

Interpolation of the Results (cont’d) • Use of internal rate of return requires 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 yield exceeding some minimum cost standard, such as cost of capital to the firm Investment A Payback method……. 2 years Internal Rate of Return……… 11. 17% Investment B Selection 3. 8 years Quicker payback: “A” 14. 33% Higher yield: ”B” 12 -16

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 -17

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 -18

Comparison of Capital Budgeting Results A summary of the various conclusions reached under the three methods is presented in the following table: 12 -19

Selection Strategy • For a project to be potentially accepted: – Profitability must equal or exceed 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 -20

Selection Strategy (cont’d) • In the case of 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, as depicted below: • The IRR and NPV methods will call for the same decision with some exceptions • Two rules: – If an investment has a positive NPV, its IRR will be in excess of the cost of capital – In certain limited cases, however, the two methods may give different answers in selecting the best investment 12 -21

Reinvestment Assumption • IRR – All inflows from a given investment can be reinvested at the Internal Rate of Return (IRR) – May be unrealistic to assume that reinvestment can occur at a equally high rate • NPV – Makes the more conservative assumption that each inflow can be reinvested at the cost of capital or discount rate – Allows for certain consistency as inflows from each project are assumed to have the same investment opportunity 12 -22

The Reinvestment Assumption – IRR and NPV 12 -23

Modified Internal Rate of Return (MIRR) • Combines reinvestment assumption of the NPV method with the IRR method • MIRR is the discount rate that equates the terminal (final) value of the inflows with the investment • In terms of a formula : 12 -24

Modified Internal Rate of Return (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 $15, 610 12 -25

Modified Internal Rate of Return (cont’d) • Appendix B shows: – For a tabular value of. 641, the Yield or MIRR is 16 percent – The conventional IRR computed would have been 21 percent • MIRR uses a more realistic assumption of re -investment at the cost of capital 12 -26

Capital Rationing • Artificial constraint set on the usage of funds that can be invested in a given period by Management • Only those projects with the highest positive NPV are accepted. • Reasons for capital rationing: – Fear of too much growth – Hesitation to use external sources of financing • Capital rationing can hinder a firm from achieving maximum profitability 12 -27

Net Present Value Profile • A graphical representation of net present value of a project at different discount rates • To apply the NPV profile, the following aspects need to be considered: – NPV at a zero discount rate – NPV as determined by a normal discount rate (such as cost of capital) – IRR for the project 12 -28

Net Present Value Profile – Graphic Representation • Investment B is preferred as both NPV and IRR are higher in case of Investment B as compared to Investment A 12 -29

Net Present Value Profile with Crossover • Below the crossover point of 8. 7% Investment B is preferred • Above the crossover point of 8. 7% Investment C is preferred 12 -30

The Rules of Depreciation • Assets are classified into nine categories to determine allowable depreciation – Each class is referred to as Modified Accelerated Cost Recovery System (MACRS) category • Some references are also made to Asset Depreciation Range (ADR), or the expected physical life of the asset or class of assets 12 -31

Categories for Depreciation Write-Off 12 -32

Depreciation Percentages (Expressed in Decimals) Table 12– 9 12 -33

Depreciation Schedule Table 12– 10 12 -34

Actual Investment Decision Example • Assumption: – $50, 000 depreciation (Table 12– 10) of machinery with a six-year productive life – Produces an income of $18, 500 for first three years before deductions for depreciation and taxes – In the last three years, 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 • Taxes then subtracted to determine Earnings after Taxes • Depreciation is added to earnings to arrive at Cash Flows 12 -35

Actual Investment Decision – Example (cont’d) 12 -36

Actual Investment Decision – Example (cont’d) Net present value analysis 12 -37

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: – Total analysis of both old and new machines – An incremental analysis of changes in cashflows between old and new machines 12 -38

Sale of Old Asset • The cash inflow from the sale of an old asset is based on the sales price as well as the related tax factors – To determine these tax factors, the book value of the old asset is compared with the sales price to determine if there is a taxable gain or loss • If there is a loss, it can be written off against other income for the corporation • If there is a gain, it would be taxed at the corporation’s normal tax rate 12 -39

Book Value of Old Asset and Net Cost of New Asset 12 -40

Incremental Depreciation Benefits • Cash flow analysis on the basis of: – Incremental gain in depreciation – Related tax shield benefits – Cost savings Table 12– 15 12 -41

Cost Savings Benefits Table 12– 16 12 -42

Present Value of the Total Incremental Benefits 12 -43

Elective Expensing • Businesses can write-off certain tangible properties in the purchased year for up to $250, 000 under the 2008 Economic Stimulus Act • Beneficial to small businesses: – Allowance is phased out dollar for dollar when total property purchases exceed $800, 000 in a year 12 -44