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C APITAL B UDGETING LONG-RANGE PLANNING

CHAPTER 26. C APITAL B UDGETING LONG-RANGE PLANNING. Capital Budgeting . It is the process of considering alternative capital projects and selecting those alternatives that provide the most profitable return on available funds.

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C APITAL B UDGETING LONG-RANGE PLANNING

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  1. CHAPTER 26 CAPITALBUDGETING LONG-RANGE PLANNING

  2. Capital Budgeting • It is the process of considering alternative capital projects and selecting those alternatives that provide the most profitable return on available funds. • Examples of capital projects include land, buildings, equipment and other major fixed asset items.

  3. I will choose theproject with the mostprofitable return onavailable funds. Alternatives: PlantExpansion ? LimitedInvestmentFunds NewEquipment ? ? OfficeRenovation Capital Budgeting

  4. Capital Budgeting Implementation of a capital project involves . . . • a large commitment of money inthe decision period. • a large increase in fixed costsfor a number of years. • potential returns in future years. • an opportunity cost because ofthe rejection of other projects.

  5. Project Selection:A General View • Analysis of cash inflows and cash outflows • Net cash inflow is the net cash benefit expected from a capital project in a period. • Time value of money • Cash received today isworth more than thesame amount receivedin the future. .

  6. InitialInvestment IncrementalOperatingCosts RepairsandMaintenance IncreasedWorking Capital Capital BudgetingCash Flow Analysis TypicalCash Outflows

  7. IncrementalRevenues ReducedOperatingCosts ReleasedWorkingCapital SalvageValue Capital BudgetingCash Flow Analysis TypicalCash Inflows .

  8. Out-of-pocketcosts Cost of capital Sunkcosts Futurecashoutflows Interest rateindicating thecost of debtand equityinvestmentfunds Past cashoutflows Avoided by not selectinga project Not avoidedby currentdecision Capital BudgetingTerminology

  9. Depreciation and Taxes Depreciation itself is not a cash flow. However, depreciation results in a reduction of cash outflows by reducing federal income taxes.

  10. Depreciation and TaxesExample • Apex Company is considering the purchase ofnew equipment. Given the following information,and a tax rate of 40 percent, compute the: • Tax savings due to depreciation. • After-tax net cash inflow.

  11. Tax savings Tax savings = $2,400 (.40 × $6,000 depreciation = $2,400) Depreciation and TaxesExample

  12. [ ( ) ] [ ] After-tax net Before-tax net Tax Depreciation Tax cash inflow cash inflow rate expense rate × × = 1 - + × × [$20,000 (1 - .4)] + [$6,000 .4] = $14,400 Depreciation and TaxesExample  After-tax net cash inflow Alternatively, reducing this analysis to a formula yields: .

  13. Project Selection Methods • Payback Period • Unadjusted Rate of Return • Net Present Value (NPV) • Profitability Index • Time Adjusted Rate of Return i.e., Internal Rate of Return (IRR)

  14. Project Selection Method 1:Payback Period Time required for the sumof the annual net cashinflows to equal theinitial cash outlay.

  15. Initial cash outlay Annual net cash inflow Payback period = Payback Period When the annual net cash inflows are equal, use the following formula:

  16. Payback PeriodExample • Gators wants to install a separate seafood bar in its pub. • The seafood bar will . . . • cost $150,000 and has a 10-year life with zero salvage value. • generate net annual cash inflows of $30,000. • Gators requires a payback period of 6 years or less on all investments. • Should Gatorsinvest in the seafood bar?

  17. Initial cash outlay Annual net cash inflow Payback period = $150,000$30,000 per year Payback period = = 5.0 years Payback PeriodExample Gators should invest in the seafood bar because the payback period is less than 6 years.

  18. Ignores the time value of money. Ignores cash flows after the payback period. Payback Period Limitations

  19. Payback Period LimitationsExample Consider two projects, each with a five-year life and each costing $6,000. Which project has the better payback period?

  20. Payback Period LimitationsExample • Project one returns the $6,000 investment faster -- shorter payback period of three years ($6,000 ÷ $2,000 per year = 3 years). • Project two is clearly superior because of the large cash inflow in the last year. • Can you see the limitations of the payback period?

  21. Unadjusted Average annual incomerate of return Average amount of investment = Beginning balance + Ending balance2 Project Selection Method 2:Unadjusted Rate of Return The unadjusted rate of return focuses on annual income instead of cash flows.

  22. Unadjusted Rate of ReturnExample Reconsider the Gators example: • The seafood bar will . . . • cost $150,000 and has a 10-year life with zero salvage value. • generate net annual cash inflows of $30,000. • Gators requires a payback period of 6 years or less on all investments and pays tax at 40%. What is the the unadjustedrate of return on the seafood bar?

  23. ( )×(1 - ) Unadjusted Average annual before- Average annual TaxRate of tax net cash inflow depreciation rate return Average amount of investment - = Unadjusted Average annual income after taxrate of return Average amount of investment = Unadjusted Rate of ReturnExample Annual net cash inflows $ 30,000 Depreciation ($150,000 ÷ 10 years) 15,000 Annual income before tax $ 15,000 . Unadjusted (30,000 - 15,000) x (1 - .40)rate of return (150,000 + 0) ÷ 2 = = 12.0%

  24. Unadjusted Rate of ReturnLimitations • Depreciation may be calculated several ways thereby giving different results. • Time value ofmoney is ignored.

  25. Project Selection Method 3:Net Present Value (NPV) Method A comparison of the present value of cash inflows with the present value of cash outflows

  26. Net Present ValueProcedure • Chose a minimum rate of return (cost of capital). • Calculate the present value of cash inflows. • Calculate the present value of cash outflows. • NPV = –

  27. Net Present ValueInterpretation • If NPV is positive, the investment yields a higher return than the cost of capital. • Decision rule: Invest if NPV is positive.

  28. Net Present ValueQuestion Savak Company can buy a new machine for $96,000 which will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV (rounded)? a. $ 4,306 b. $12,721 c. $11,553 d. $17,004

  29. Net Present ValueQuestion Savak Company can buy a new machine for $96,000 which will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV (rounded)? a. $ 4,306 b. $12,721 c. $11,553 d. $17,004 Use present value of annuity table (A.4) PV of inflows = $20,000 × 5.65022 = $113,004 NPV = $113,004 - $96,000 = $17,004

  30. Net Present ValueQuestion Calculate the NPV if Savak Company’s required return is 14 percent instead of 12 percent.

  31. Net Present ValueQuestion Calculate the NPV if Savak Company’s required return is 14 percent instead of 12 percent. Use present value of annuity table (A.4) PV of inflows = $20,000 × 5.21612 = $104,322 NPV = $104,322 - $96,000 = $8,322 Note that the NPV is smallerusing the larger interest rate.

  32. Net Present Value Now that you have mastered the basic concept of net present value, it’s time for a more sophisticated checkup!

  33. Net Present Value Example Harper Co. has been offered a five-year contract to provide parts for a large manufacturer, requiring an investment in new equipment. • The new equipment will . . . • cost $160,000, have a five-year useful life, anda $5,000 salvage value. • need an overhaul at the end of three years costing $30,000. • Initial working capital requirement is $100,000.

  34. Net Present Value Example The contract is expected to produce the following annual cash flows: Harper uses a 10 percent discount rate. Ignoring income taxes, compute the net present value of the contract.

  35. Net Present Value Example Harper Company Net Present Value Analysis

  36. Net Present Value Example Harper Company Net Present Value Analysis

  37. Net Present Value Example Harper Company Net Present Value Analysis Present value of an annuity of $1 factor for 5 years at 10%.

  38. Net Present Value Example Harper Company Net Present Value Analysis $80,000 × 3.79079 = $303,263

  39. Net Present Value Example Harper Company Net Present Value Analysis Present value of $1 factor for 3 years at 10%.

  40. Net Present Value Example Harper Company Net Present Value Analysis Present value of $1 factor for 5 years at 10%.

  41. Net Present Value Example Harper Company Net Present Value Analysis Since the contract has positive NPV, we know the rate of return is greater than the 10 percent discount rate.

  42. Present value of net cash inflows Present value of cash outflows Profitability index = Project Selection Method 4: Profitability Index • Provides a means of ranking projects that have different initial investments. • Decision rule: consider only those projects with a profitability index of 1.00 or more. .

  43. Presentvalue ofcash inflows Presentvalue ofcash outflows = Also known as theinternal rate of return. Project Selection Method 5:Time Adjusted Rate of Return The interest rate that makes . . . • The net present value equal zero.

  44. Internal Rate of Return (IRR)Procedure For projects with equal annual cash flows (i.e., annuities) • Determine the payback period. • Use the present value of annuity table to determine the IRR.

  45. Internal Rate of Return (IRR)Procedure Say that: Project life = 4 yearsInitial cost = $42,523Annual net cash inflows = $14,000 Determine the IRR for this project. 1. Determine the payback period. ($42,523 ÷ $14,000 per year = 3.03736 years)

  46. Internal Rate of Return (IRR)Procedure 1. Determine the payback period. ($42,523 ÷ $14,000 per year = 3.03736 years) 2. Using present value of annuity table . . . Locate the rowwhose numberequals the lifeof the project.

  47. Internal Rate of Return (IRR)Procedure 1. Determine the payback period. ($42,523 ÷ $14,000 per year = 3.03736 years) 2. Using present value of annuity table . . . In that row,locate theinterest factorclosest inamount to thepayback period.

  48. Internal Rate of Return (IRR)Procedure 1. Determine the payback period. ($42,523 ÷ $14,000 per year = 3.03736 years) 2. Using present value of annuity table . . . IRR is theinterest rateof the columnin which theinterest factoris found.

  49. Internal Rate of ReturnExample Decker Company can purchase a new machine at a cost of $104,322 that will save $20,000 per year in cash operating costs. The machine will have a 10-year life. What is the internal rate of return on this investment project?

  50. Initial cash outlay Annual net cash inflow Payback period = $104,322 $20,000 per year Payback period = = 5.21610 Internal Rate of ReturnExample In Table A-4 in the appendix of your textbook, look across the 10-period row until you find an interest factor of 5.21610 in the 14 percent column. The internal rate of return is 14 percent. If 14 percent is greater than Decker’s required rate of return, Decker should purchase the new machine.

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