Chapter 6 Principles of Capital Investment

1. Chapter 6Principles of Capital Investment

2. Administrative Framework Involves • Generation of investment proposals • Estimation of cash flows • Evaluation of cash flows • Selection of projects based on an acceptance criterion • Continual reevaluation of investment projects after acceptance Chapter 6 Chapter 7

3. Project Classification • New products or expansion of existing products • Replacement of equipment or buildings • Research and development • Exploration • Others

4. Multiple Screens Board President Committee VP operations Plant manager Section chiefs

5. Level and Type of Capital Expenditure • As the capital outlay increases, the number of screens generally increases • Important to investors • Convey information about expected future growth

6. Cash-Flow Forecasts • Incremental cash flows • Differences between cash flows of the firm with and without the project • Ignore sunk cost • Patterns of cash flow • Annuity • Salvage value

7. Replacement Decisions and Depreciation • Cash flow information • Purchase price of new machine • Installation cost • Sale of old machine • Cash savings for new machine • Depreciation effect • Income tax • Incremental, after-tax cash flow

8. Methods for Evaluation • Average rate of return • Payback • Internal rate of return • Net present value Economic worth of a project Discounted cash flow method

9. Average Rate of Return (ARR) • Compared with required rate of return • Principal virtue is its simplicity • Principal shortcomings • Based on accounting information • Time value of money is ignored

10. Payback (PB) • Number of years to recover initial cash investment • Shortcomings • Fails to consider • Cash flows after the PB period • Magnitude or timing of cash flows during the payback period • Does not measure profitability • Popularity of PB • Limited insight • Into the risk of a project • Into the liquidity of a project

11. Internal Rate of Return (IRR) • Discounted cash flow method • The rate of discount which equates the PV of cash inflows with the PV of cash outflows • Takes account of cash flows • Magnitude • Timing • Acceptance criterion • IRR > required rate

12. Required Rare of Return (RRR) • Systematic risk is higher for capital-expending projects • Replacement projects • Produce benefits across more states of the economy • Possess lower systematic risk • Require a lower return

13. Net Present Value (NPV) • What remains after discounting all cash flows by the RRR • Acceptance criterion • PV of the cash inflows > PV of the cash outflows • Absolute measure of the contribution

14. Profitability Index (PI) • PV of future net cash flows over the initial cash outlay • Acceptance criterion • PI  1.00 • NPV and PI • Give the same accept-reject signals • Expresses relative profitability

15. Mutual Exclusive and Dependency • Mutual exclusive • Acceptance of one precludes the acceptance of another project • Contingent proposal • Depends on the acceptance of one or more other proposals

16. NPV Versus IRR • Compounding rate differences • Investment proposals are mutually exclusive • IRR method implies that funds are compounded at the IRR • PV method implies compounding at the RRR • Scale of investment • Mutually exclusive investment proposals having different initial cash outlays • IRR ignores the scale of investment • Multiple IRR’s • Cash-flow stream changes sign more than once

17. Depreciation and Other Refinements in Cash-Flow Information • Method of depreciation • Setting up the cash flows • Salvage value and taxes • Working capital requirement

18. Method of Depreciation • Straight-line depreciation • Accelerated depreciation • PV advantage in postponing taxes • MACRS • Eight property classes • 200% declining-balance method (1-4) • Half-year convention • 150% declining-balance (5&6) • Straight-line depreciation (7&8)

19. Setting Up the Cash Flows • Cost • Annual savings • Depreciation • Income • Taxes • NCF

20. Salvage Value and Taxes • Sale of a fully depreciated asset is subject to taxation • Sold > depreciated book value < cost • Pay full corporate tax rate • Sold > cost • Capital-gains tax treatment

21. Working Capital Requirement • Cash outflow at the time of occurrence • Additional cash • Additional receivables • Additional inventories • End of project’s life • Treated as a cash inflow • Can occur at any time

22. What Happens When Capital is Rationed? • Capital rationing • Budget ceiling • Selection criterion • Combination of proposals with highest NPV • Consider more than one period • Problems incurred • Reject positive NPV projects • Less than optimal investment policy

23. Inflation and Capital Budgeting • Real cash flows do not keep up with inflation • Inflation effect on results • Lower real rates of return • Disincentive to undertake capital expenditures • Invest less • Seek investments with faster PBs • Become less capital intensive • Bias in cash-flow estimates

24. Information to Analyze an Acquisition • Same as any other investment proposal • Initial outlay of cash or stock • Followed by expected future benefits • Major differences • Initial cost may be subject to bargaining • Synergism

25. Measuring Free Cash Flows (FCF) • EBITDA - Taxes - Capital expenditures - Working-capital additions = Incremental free cash flow • FCFs determine an acquisition’s value

26. Noncash Payments and Liability Assumptions • Overriding valuation principle • Value of the incremental FCFs • Cash-equivalent price • Convert to market value • Securities • Liabilities • Separate investing from financing