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Discover the importance of capital budgeting decisions in project planning for optimal economic choices. Learn about cash flows, ranking methods, payback calculations, and more in this comprehensive guide.
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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.
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.
Administrative Considerations • Steps in the decision-making process: • Search for and discovery for investment opportunities. • Collection of data-Accctg./Fin./Engineering • Evaluation and decision making. • Reevaluation and adjustment.
Accounting Flows vs 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 besteconomic choices and assure long term wealth.
Methods of Ranking Investment Proposals • 3 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.
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 Early Returns Late Returns 1……….. $9,000 $1,000 2……….. $1,000 $9,000 3……….. $1,000 $1,000
Payback Method (cont’d) • Advantages: • Easy to understand and 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.
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%.
Determining Internal Rate of Return Cash Inflows (of $10,000 investment) Year Investment A Investment B 1……………… $5,000 $1,500 2……………… $5,000 $2,000 3……………… $2,000 $2,500 4……………… $5,000 5……………… $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 $5,000 $2,000 $12,000 ÷ 3 = $4,000
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; PVIFA 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 under- stated.
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).
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% $10,177…….PVI @ 10% - $9,874…....PVI @ 12% - $10,000……(cost) $303 $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%).
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 Investment B Selection Payback method……..2 years 3.8 years Quicker payback: Investment A Internal Rate of Return………11.17% 14.33% Higher yield: Investment B
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.
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 $11,414 Present value of inflows…..$10,177 Present value of inflows…..$11,414 Present value of outflows -$10,000 Present value of outflows -$10,000 Net present value……………..$177 Net present value…………...$1,414
Capital Budgeting • End of the Lecture
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.
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.
Example - 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.
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.
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.
