Chapter 11

1. Chapter 11 Capital Budgeting

2. Describe capital budgeting decisions and use the net present value (NPV) method to make such decisions. Learning Objective 1

3. Capital Budgeting Capital budgeting describes the long-term planning for making and financing major long-term projects. Identify potential investments. Choose an investment. Follow-up or “post audit.”

4. Discounted-Cash-Flow Models (DCF) These models focus on a project’s cash inflows and outflows while taking into account the time value of money. DCF models compare the value of today’s cash outflows with the value of the future cash inflows.

5. Net Present Value The net-present-value (NPV) method is a discounted-cash-flow approach to capital budgeting that computes the present value of all expected future cash flows using a minimum desired rate of return.

6. Net Present Value The minimum desired rate of return depends on the risk of a proposed project; the higher the risk, the higher the rate. The required rate of return (also called hurdle rate or discount rate) is the minimum desired rate of return based on the firm’s cost of capital.

7. Applying the NPV Method Prepare a diagram of relevant expected cash inflows and outflows. Find the present value of each expected cash inflow or outflow. Sum the individual present values.

8. NPV Example • Original investment (cash outflow): $6,075 • Useful life: four years • Annual income generated from investment (cash inflow): $2,000 • Minimum desired rate of return: 10%

9. NPV Example YearsAmountPV FactorPresent Value 0 ($6,075) 1.0000 ($6,075) 1 2,000 .9091 1,818 2 2,000 .8264 1,653 3 2,000 .7513 1,503 4 2,000 .6830 1,366 Net present value $ 265

10. NPV Example YearsAmountPV FactorPresent Value 0 ($6,075) 1.0000 ($6,075) 1-4 2,000 3.1699 6,340 Net present value $ 265

11. NPV Assumptions There is a world of certainty. Predicted cash flows occur timely. There are perfect capital markets. Money can be borrowed or loaned at the same interest rate.

12. Capital Budgeting Decisions Managers determine the sum of the present values of all expected cash flows from the project. If the sum of the present values is positive, the project is desirable. If the sum of the present values is negative, the project is undesirable.

13. Calculate the NPV difference between two projects using both the total project and differential approaches. Learning Objective 3

14. Comparison of Two Projects Two common methods for comparing alternatives are: Total project approach Differential approach

15. Total Project Approach • The total project approach computes the total impact on cash flows for each alternative and then converts these total cash flows to their present values. • The alternative with the largest NPV of total cash flows is best.

16. Differential Approach • The differential approach computes the differences in cash flows between alternatives and then converts these differences to their present values. • This method cannot be used to compare more than two alternatives.

17. Identify relevant cash flows for DCF analyses. Learning Objective 4

18. Relevant Cash Flows for NPV • Be sure to consider the four types of inflows and outflows: • Initial cash inflows and outflows at time zero • Investments in receivables and inventories (w/c) • Future disposal values • Operating cash flows (w/c) – working capital

19. Operating Cash Flows • Using relevant-cost analysis, the only relevant cash flows are those that will differ among alternatives. • Depreciation and book values should be ignored. • A reduction in cash outflow is treated the same as a cash inflow.

20. Compute the after-tax net present values of projects. Learning Objective 5

21. Income Taxes and Capital Budgeting What is an example of another type of cash flow that must be considered when making capital-budgeting decisions? Income taxes

22. Marginal Income Tax Rate • In capital budgeting, the relevant tax rate is the marginal income tax rate. • This is the tax rate paid on additional amounts of pretax income.

23. Tax Effect on Cash Inflows from Depreciation Deductions Depreciation expense is a noncash expense and so is ignored for capital budgeting, except that it is an expense for tax purposes and so will provide a cash inflow from income tax savings.

24. Tax Effect on Cash Inflows from Operations Assume the following: Cash inflow from operations $60,000 Tax rate 40% What is the after-tax inflow from operations? $60,000 × (1 – tax rate) = $60,000 × .6 = $36,000

25. Explain the after-tax effect on cash of disposing of assets. Learning Objective 6

26. Gains or Losses on Disposal Suppose an equipment with a 5-year life was purchased for $125,000 and is now sold at the end of year 3 after taking 3 three years of straight-line depreciation. What is the book value? $125,000 – (3 × $25,000) = $50,000

27. Gains or Losses on Disposal • If it is sold for bookvalue, there is no gain or loss and so there is no tax effect. • If it is sold for more than $50,000, there is a gain and an additional tax payment. • If it is sold for less than $50,000, there is a loss and a tax savings. TAX

28. Example 1 Sales = $50,000 Book Value = $50,000 Profit = 0 Taxes @30% = 0 Cash Flow from Sale = $50,000

29. Example 2 Sales = $70,000 Book Value = $50,000 Profit = $20,000 Taxes @30% = $6,000 Cash Flow from Sale = $64,000 (70,000-6,000)

30. Example 3 Sales = $30,000 Book Value = $50,000 Profit = ($20,000) Taxes @30% = ($6,000) (taxes saved) Cash Flow from Sale = $36,000 (30,000 - -6,000)

31. Comprehensive Example: • Machine Cost = $100,000 • Required increase in inventory $10,000 • Depreciation, straight-line for 5 years • Sold after 3 years for $65,000 and inventory fully recouped • Annual cash revenue is $50,000 • Annual cash expenses is $12,000 • Tax rate 30%, desired rate of return 10% Required - NPV ?

32. Year 0 $ Machine Cost 100,000 Increase in inventory 10,000 Initial Investment110,000

33. Year 1, 2 & 3 Cash Revenues $50,000 Cash Expenses 12,000 Net Operating Cash before tax 38,000 x (1- 0.30) Net Operating Cash after tax = 26,600 Tax savings from depreciation: 20,000 x 0.30 = 6,000 Total net cash flow =32,600

34. Also in Year 3 Sales = $65,000 Book Value = $40,000 Profit = $25,000 Taxes @30% = $7,500 Cash Flow from Sale = $57,500 (65,000- 7,500) Inventory recouped = $10,000 Terminal Cash Flow =$67,500

35. NPV Year 0 1 2 3 _ Initial Investment (110,000) Annual Cash Flow 32,600 32,600 32,600 Terminal Cash Flow 67,500 (110,000) 32,600 32,600 100,100 x (Pvif 10%,n) 1 0.9091 0.8264 0.7513 (110,000) 29,637 26,941 75,205  = 21, 783  NPV = $21,783  Go ahead and purchase machine

36. Compute the impact of inflation on a capital-budgeting project. Learning Objective 7

37. Inflation What is inflation? It is the decline in general purchasing power of the monetary unit. Simply put, one has to factor in inflation in estimating future cash flows

38. Use the payback model and the accounting rate-of-return model and compare them with the NPV model. Learning Objective 8

39. Payback Model • Paybacktime, or paybackperiod, is the time it will take to recoup, in the form of cash inflows from operations, the initial dollars invested in a project. (If the cash flows represent an annuity) The payback model has some deficiencies! P= I ÷ O

40. Payback Model Example • Assume that $12,000 is spent for a machine with an estimated useful life of 8 years. • Annual savings of $4,000 in cash outflows are expected from operations. • What is the payback period? P = I ÷ O = $12,000 ÷ $4,000 = 3 years

41. Accounting Rate-of-Return Model • The accounting rate-of-return (ARR) model expresses a project’s return as the increase in expected average annual operating income divided by the required initial investment. • We will NOT go any further in this because it is also has deficiencies!

42. Post Audit • A recent survey showed that most large companies conduct a follow-up evaluation of at least some capital-budgeting decisions, often called a post audit. • The post audit focuses on actual versus predicted cash flows.