Chapter 8 Capital Asset Selection and Capital Budgeting

Learning Objectives 1. How do managers choose which capital projects to fund? 2. Why do most capital budgeting methods rely on analysis of cash flows? 3. What are the differences among payback period, the net present value method, profitability index, and internal rate of return? C 8

Continuing. . . Learning Objectives 4. How do the underlying assumptions and limitations of each capital project evaluation method affect its use? 5. How do taxes and depreciation methods affect cash flows? C 8

Continuing. . . Learning Objectives 6. Why are quality management, training, and research and development controlled largely by capital budget analyses? 7. Why do managers occasionally need to quantify qualitative information in making capital budgeting decisions? C 8

Continuing. . . Learning Objectives 8. Why are environmental issues becoming an increasingly important influence on the capital budget? 9. How and why should management conduct a post-investment audit of a capital project? C 8

Continuing. . . Learning Objectives 10. What calculations are necessary to control for the time value of money? (Appendix 1) 11. How is the accounting rate of return for a project determined? (Appendix 2) C 8

Capital Assets Lease Nuclear Power Plant Copy Machine

Capital Budgeting Is Capital budgeting is the process of evaluating long-range investment proposals for the purpose of allocating limited resources effectively and efficiently.

Capital Budgeting Questions • Is the activity worth the investment? • Which assets can be used for the activity? • Of the suitable assets, which are the best investments? – Screening decision – Preference decision • Which of the best investments should the company choose? – Mutually exclusive projects – Independent projects – Mutually inclusive projects

Cash Flows • Cash receipts and disbursements that arise from the purchase, operation, and disposition of capital assets • Cash receipts – Project revenues that have been earned and collected – Savings generated by reduced project operating costs – Inflows from asset’s sale and release of working capital at end of asset’s useful life • Cash disbursements – Expenditures to acquire asset – Additional working capital investments – Amounts paid for related operating costs

Interest is a cash flow created by the method of financing a project. It should not be considered in project evaluation.

Return of Capital vs. Return on Capital Return of Capital Recovery of original investment Return on Capital Income for each investment period = Interest included in receipt or payment

Use a Timeline to Determine Cash Flows Time Point t 0 t 1 t 2 t 3 t 4 $500 Cash In Cash Out Net Cash Flow

Payback Period A measure of the time it will take a project’s cash inflows to equal the original investment • The longer it takes to recover the initial investment, the greater is the project’s risk • Management sets a maximum acceptable payback period • Often used as a screening technique

Assumptions of Payback Period • Speed of investment recovery is the key consideration • Timing and size of cash flows are accurately predicted • Risk (uncertainty) is lower for a shorter payback project

Purchase of Machine Example • Machine costs $60, 000 • Will be used to produce and sell 3, 000 units per year at $14 for the next 5 years • Variable costs are $5 per unit • Annual fixed costs are $5, 000 • Cutoff rate of 12 percent • All revenues and costs are in cash amounts

Annual Incremental Cash Inflows

Payback Period = Investment required Annual cash returns = $60, 000 $22, 000 = 2. 7 years

Limitations of Payback Period • Ignores cash flows after payback • Basic method treats cash flows and project life deterministically without explicit consideration of probabilities • Ignores time value of money • Cash flow pattern preferences are not explicitly recognized

Discounted Cash Flow Methods • Net present value (NPV) • Profitability index (PI) • Internal rate of return (IRR)

Net Present Value Method Determines whether the rate of return (ROR) on a project is equal to, higher than, or lower than the desired ROR • Accept if: – If NPV = 0, actual ROR = desired ROR – If NPV > 0, actual ROR > desired ROR • Reject if: – If NPV < 0, actual ROR < desired ROR • Does not determine expected ROR

Remember! • Changing discount rate affects NPV • Changing timing and size of cash flows affects NPV • NPV can be used to select the best project when choosing among investments that can perform the same task or achieve the same objective • NPV should not be used to compare independent investment projects that do not have approximately the same original asset cost or asset life

Net Present Value Example

Assumptions of Net Present Value • Discount rate used is valid • Timing and size of cash flows are accurately predicted • Life of project is accurately predicted • If the shorter-lived of two projects is selected, the proceeds of that project will continue to earn the discount rate of return through theoretical completion of the longer-lived project

Limitations of Net Present Value • Basic method treats cash flows and project life deterministically without explicit consideration of probabilities • NPV does not measure expected rates of return on projects being compared • Cash flow pattern preferences are not explicitly recognized • IRR of project is not reflected

Profitability Index Ratio that compares present value of net cash inflows with present value of net investment • • Compares projects with different costs PI should be at least equal to 1. 0 Gauges the firm’s efficiency at using its capital Does not indicate expected ROR

Continuing. . . Profitability Index (PI) = = PV of Cash Flows -------------Investment required $79, 310 -----$60, 000 = 1. 3

Assumptions of Profitability Index • Same as NPV • Size of PV of net inflows relative to size of PV of investment measures efficient use of capital

Limitations of Profitability Index • Same as NPV • Gives a relative answer but does not reflect dollars of NPV

Internal Rate of Return • Is the project’s expected rate of return • The discount rate where PV of net cash flows = cost of project – Discount rate where NPV = 0 • IRR compared with hurdle rate(which is the lowest acceptable return on investment) • Acceptable if IRR > hurdle rate

Internal Rate of Return Discount factor = PV of future flows/Annual cash flows Discount factor = $60, 000/$22, 000 = 2. 7 The factor of 2. 7 corresponds to an interest rate between 24 and 25 percent when the number of periods is five. The IRR is between 24 and 25 percent.

Assumptions of IRR • Hurdle rate is valid • Timing and size of cash flows are accurately predicted • Life of project is accurately predicted • If the shorter-lived of two projects is selected, the proceeds of that project will continue to earn the IRR through theoretical completion of the longer-lived project

Limitations of IRR • Projects are ranked for funding based on IRR rather than dollar size • Does not reflect dollars of NPV • Basic method treats cash flows and project life deterministically without explicit consideration of probabilities • Cash flow pattern preferences are not explicitly recognized • It is possible to calculate multiple rates of return on the same project

The Effect of Taxation On Cash Flows • Managers should use after-tax cash flows to determine project’s acceptability • Depreciation expense is a tax shield for revenues – Tax benefit equal to depreciation amount multiplied by tax rate • Type of depreciation method affects amount of annual taxable income • Tax laws can change every year; use most current regulations • Tax rates and tax related asset lives may also change; use most current information

Annual Incremental After-Tax Cash Inflows

Payback Period = Investment required Annual cash returns = $60, 000 $18, 000 = 3. 3 years

Net Present Value of After-Tax Example

Profitability Index (PI) = = PV of Cash Flows -------------Investment required $64, 890 -----$60, 000 = 1. 1

Internal Rate of Return Discount factor = PV of future flows/Annual cash flows Discount factor = $60, 000/$18, 000 = 3. 333 The factor of 3. 333 corresponds to an interest rate between 14 and 16 percent when the number of periods is five. The IRR is between 14 and 16 percent.

Uneven Cash Flows Now, assume that the salvage value in the example is $5, 000 at the end of the fifth year.

Summary of Present Value of Investment

Net Present Value of Salvage Value Example

High-Tech Investments The decision is more a question of “how much” and “when” than “whether” Generally requires massive monetary investment

Possible Reasons for Not Investing – Worker displacement – Morale problems – Implementation problems – Computers not considered competitive assets – Difficult to justify investment using traditional analyses

Considerations in High-Tech Investment Analysis • Discount or hurdle rate may need to be set lower • Both quantitative and qualitative benefits need to be considered – Quality improvements – Shortened delivery time – Improved competitive position • High-tech investments are not “free-standing” • Opportunity cost of not acquiring automated equipment is often critical

Post-Investment Audit Compare actual project results with expected results • Complete after project has stabilized • Use same analysis techniques as used for original decision to accept project • Used to pinpoint areas of operation not in line with expectations • Helps evaluate accuracy of original cost/benefit predictions

Accounting Rate of Return (ARR) Measures the expected rate of earnings obtained on the average capital investment over a project’s life • Not based on cash flows • Compared with hurdle rate which may be higher than the discount rate • Compared with ARR of other projects

Continuing. . . Accounting Rate of Return (ARR) ARR = Average Annual Income from Project ------------------------Average Investment in Project Before Taxes After Taxes = $22, 000 - ($60, 000/5) ------------($60, 000 - $0)/2 = 33. 3% = $18, 000 - ($60, 000/5) ------------($60, 000 - $0)/2 = 20. 0%

Assumptions of ARR • Effect on company accounting earnings relative to average investment in a project is a key consideration • Size and timing of investment cost, project life, salvage value, and increases in earnings can be accurately predicted

Limitations of ARR • Ignores cash flows • Ignores time value of money • Treats earnings, investment, and project life deterministically without explicit consideration of probabilities