Chapter 23 Capital Investment Decisions Albrecht Stice Swain

Chapter 23 Capital Investment Decisions Albrecht, Stice, & Swain COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. 1

The Time Value of Money • Concept: A dollar to be received now is worth more than a dollar to be received in the future. – The dollar received now can be put to use— invested, used to pay off loans, etc. • Because of the time value of money, a difference in the timing of cash flows can make one investment more attractive than another. 2

Discounting Cash Flows • Future cash inflows and outflows must be discounted to their present value using an appropriate discount rate. • Example: Investment A will return $100, 000 at the end of one year, and Investment B will return $50, 000 at the end of each year for two years. – At a discount rate of 10%, the discounted cash flow from Investment A is $90, 910. For Investment B, it is $86, 775. $90, 910 A: $100, 000 Year 1 B: $86, 775 { $41, 320 $45, 455 $50, 000 Year 1 $50, 000 Year 2 3

Non-discounted Capital Budgeting Techniques • Payback method – Determines the amount of time it takes the net cash inflows of an investment to repay the investment cost. Investment cost Payback period = Annual net cash inflows • Unadjusted rate of return method – A rate of return is calculated by dividing the increase in the average annual net income a project will generate by the initial investment cost. Unadjusted rate of return = Increase in future average net income Initial investment cost 4

Payback Method – Example • Jeff wants to determine the payback period for an investment with an initial cost of $30, 000. He estimates the net cash flows from the investment to be $6, 000 per year. Estimate the payback period. Investment cost Payback period = Annual net cash inflows = $30, 000 $6, 000 = 5 years 5

Unadjusted Rate of Return Method – Example • Paul’s new investment is estimated to increase net income by $25, 000 each year. The initial investment is $150, 000. Determine the unadjusted rate of return. Unadjusted rate of return = = Increase in future average net income Initial investment cost $25, 000 $150, 000 = 16. 67% 6

Discounted Capital Budgeting Techniques • Net present value method – Uses discounted cash flows to compare the present values of an investment’s expected cash inflows and outflows. • Internal rate of return method – Uses discounted cash flows to find the “true” discount rate of an investment; this true rate produces a net present value of zero. 7

Net Present Value Method In general, the net present value method involves the following three steps: 1. Using a predetermined interest rate or discount factor, compute the present values of all expected cash inflows and outflows of an investment. 2. Subtract the total present value of the cash outflows from the total present value of the cash inflows. The difference is the investment’s net present value. 3. If the net present value of the investment is positive, or at least zero, the project is acceptable from a financial standpoint. NPV ≥ 0 Accept NPV < 0 Reject 8

Net Present Value Method – Example George’s Carpentry wants to purchase a wood lathe for $5, 000. The machine will save $1, 200 a year for the next 5 years. The wood lathe can then be sold at the end of 5 years for $1, 000. If the required rate of return is 12 percent, should the company invest in the new equipment? PV Cash Flows Present Amount Purchase price. . . . Cost savings. . Salvage value. . Net present value. . Factor Value $(5, 000) 1. 0000 $(5, 000) 1, 200 3. 6050 4, 326 1, 000 0. 5674 567 $ (107) The company should not purchase the wood lathe. 9

Internal Rate of Return • The discount rate that yields a net present value of zero when applied to all the cash flows of an investment—both inflows and outflows. • Three steps of the internal rate of return method: 1. Calculate the present value factor by dividing the investment cost by the annual net cash inflows. 2. Using applicable present value tables and the life of the investment, find the present value factor closest to the number derived in Step 1 (using interpolation, if necessary). 3. Compare the project’s internal rate of return with the company’s usual discount or hurdle rate. 10

Internal Rate of Return Method - Example Returning to our previous example, George’s Carpentry wants to purchase a wood lathe for $5, 000. The machine will save $1, 200 a year for the next 5 years. Now, assume it is worthless after five years, and the hurdle rate is now 8%. Determine the internal rate of return. 1. Present value factor = = = Investment cost Annual net cash inflows $5, 000 $1, 200 4. 1667 11

Internal Rate of Return Method - Example 2. Using the table, we find the yield for a PV factor of 4. 1667 is between 6% and 7%, which we then calculate exactly: 4% 5% 6% 7% 8% 4 3. 6299 3. 5460 3. 4651 3. 3872 3. 3121 5 4. 4518 4. 3295 4. 2124 4. 1002 3. 9927 6 5. 2421 5. 0757 4. 9173 4. 7665 4. 6229 Rate High factor True factor Low factor Difference Internal rate of return 6% 7% 1% Present Value Factors 4. 2124 4. 1667 4. 1002 0. 0457 0. 1122 0. 06 + 0. 01 x 0. 1122 0. 0457 = 0. 0641 = 6. 4% 3. As the IRR is lower than the hurdle rate, George’s shouldn’t buy the lathe 12

Qualitative Factors in Capital Budgeting Decisions 1. An investment’s effect on the quality of products and services offered. 2. An investment’s effect on the time with which products and services can be produced and delivered to customers. 3. Other qualitative factors: – – – – Consumer safety Government regulations Pollution control and environmental protection Worker safety Company image and prestige Preferences of owners and management Community welfare 13

Uncertainty in Capital Budgeting and Sensitivity Analysis • As capital budgeting decisions are based upon the future, applicable numbers are only estimates. • When making decisions based on estimates, sensitivity analysis is a useful tool. – A sensitivity analysis is a method of assessing the reasonableness of a decision that was based upon estimates; it involves calculating how far reality can differ from an estimate without invalidating the decision. 14

Uncertainty in Capital Budgeting and Sensitivity Analysis • Sensitivity analysis is used to address such questions as: – What level of cash operating inflows will give the project an NPV of at least zero? What are the chances that this level of cash inflows will be achieved? – What salvage value amount is large enough to give the project an NPV of at least zero? What are the chances that the salvage value will be at least this much? – How long must the project last in order to have an NPV of at least zero? What are the chances that the project will last this long? 15

Sensitivity Analysis – Example Beatles Inc. wants to purchase a new belt buckle press for $9, 000. The press will save $2, 000 a year for the next 10 years. The press can then be sold at the end of 10 years for $1, 000. Beatles Inc. has established a rate of 10 percent as the hurdle (discount) rate. Should the company invest in the new equipment? PV Cash Flows Present Amount Factor Purchase price. . Cost savings. . . Salvage value. . Net present value. . . Value $(9, 000) 1. 0000 $(9, 000) 2, 000 6. 1446 12, 289 1, 000 0. 3855 386 $ 3, 675 With current estimates, Beatles should make the investment. But what if the yearly savings of $2, 000 is uncertain? 16

Sensitivity Analysis – Example If Beatles’ expected yearly savings are uncertain, what is the minimum annual savings needed to still meet the required 10 percent hurdle rate (which has a present value factor of 6. 1446)? Initial cost. . . Discounted disposal value. . Net cost of investment. . . Present value factor. . . Minimum cash flows needed. . . . $9, 000 386 $8, 614 6. 1446 $1, 402 The new belt buckle press must yield annual savings of at least $1, 402 to meet Beatles’ hurdle rate. 17

Capital Rationing • Because resources are limited, capital projects should be ranked to select the most profitable first. This can be done in two ways: 1. If the internal rate of return is used, the projects should be ranked in the order of their IRR from highest to lowest. 2. If the net present value method is used, a profitability index must be calculated: Profitability index = Present value of net cash inflows Investment cost Projects can then be ranked from highest to lowest in terms of their respective profitability indexes. 18

Income Tax Considerations in Capital Budgeting Decisions • Income tax effects must also be taken into consideration, so cash inflows and outflows must be converted to after-tax amounts before capital budgeting calculations: – After-tax cash flow = Before-tax cash flow × (1 – Tax Rate) • Examples of tax effects on cash flow include: – – Depreciation expense (MACRS) Asset repair expense Income/loss from operations Gain/loss on sale of asset 19