Capital Budgeting

1. Capital Budgeting

2. Typical Capital Budgeting Decisions Capital budgeting tends to fall into two broad categories . . . • Screening decisions. Does a proposed project meet some present standard of acceptance? • Preference decisions. Selecting from among several competing courses of action.

3. Four Capital Budgeting Methods • Net Present Value (NPV) • Internal Rate of Return (IRR) • Payback Period • Accrual Accounting Rate of Return (AARR)

4. Discounted Cash Flows • Discounted Cash Flow (DCF) Methods measure all expected future cash inflows and outflows of a project as if they occurred at a single point in time • The key feature of DCF methods is the time value of money (interest), meaning that a dollar received today is worth more than a dollar received in the future

5. Discounted Cash Flows (continued) • DCF methods use the Required Rate of Return (RRR), which is the minimum acceptable annual rate of return on an investment. • RRR is usually the Weighted Average Cost of Capital for a firm. • RRR is also called the discount rate, hurdle rate, cost of capital or opportunity cost of capital.

6. Repairs and maintenance Working capital Initial investment Incremental operating costs Typical Cash Outflows

7. Salvage value Release of working capital Reduction of costs Incremental revenues Typical Cash Inflows

8. Net Present Value (NPV) Method • The NPV method calculates the expected monetary gain or loss from a project by discounting all expected future cash inflows and outflows to the present point in time, using the Required Rate of Return • NPV is the arithmetic sum of the future cash flows • Based on financial factors alone, only projects with a zero or positive NPV are acceptable

9. Lifetime Care Hospital • Lifetime Care Hospital is a for-profit taxable company. • One of Lifetime Care’s goals is to improve the productivity of its X-ray machine. • As a first step to achieve this goal, the manager of Lifetime Care identifies a new state-of-the-art X-ray machine, XCAM8, as a possible replacement for the existing X-ray machine. • The manager next acquires information to do more-detailed evaluation of XCAM8. • Quantitative information for the formal analysis follows.

10. Lifetime Care Hospital (Cont) • Revenues will be unchanged regardless of whether the new X-ray machine is acquired. The only relevant financial benefit in purchasing the new X-ray machine is the cash savings in operating costs. • Lifetime Care is a profitable company. The income tax rate is 40% of operating income each year. • The operating cash savings from the new X-ray machine are $120,000 in years 1-4 and $105,000 in year 5.

11. Lifetime Care Hospital (Cont) • Lifetime uses straight-line depreciation method, which means an equal amount of depreciation is taken each year. • Gains or losses on the sale of depreciable assets are taxed at the same rate as ordinary income. • The tax effects of cash inflows and outflows occur at the same time that the cash inflows and outflows occur. • Lifetime Care uses an 8% required rate of return for discounting after-tax cash flows.

12. Summary Data for the X-Ray Machine

13. Effect on Year One Cash Flow from Operations – Net of Income Taxes

14. The 40% tax rate reduces the benefit of the $120,000 operating cash flow savings for years 1-4 with the new X-ray machine. After tax cash flow (excluding depreciation effects) is: Annual After-Tax Cash Flow from Operations

15. For year 5, the after-tax cash flow (excluding depreciation effects is: Annual After-Tax Cash Flow from Operations(Cont)

16. Tax Consequences of Disposing of the Old Machine

17. Tax Consequences of Disposing of the Old Machine (cont)

18. Relevant Cash Inflows and Outflows for X-Ray Machine

19. NPV Method – X-Ray Machine

20. Preference Decisions - Net Present Value The net present value of one project cannot be directly compared to the net present value of another project unless the investments are equal.

21. Sum of PV of cash inflowsInitial Investment Present Value Index = Ranking Capital Investment Opportunities Using NPV

22. Internal Rate of Return Method • The internal rate of return is the rate of returnpromised by an investment project over its useful life. It is computed by finding the discount rate that will cause the net present value of a project to be zero. • It works very well if a project’s cash flows are identical every year. If the annual cash flows are not identical, a trial and error process must be used to find the internal rate of return. • A project is accepted only if the IRR equals or exceeds the RRR

23. IRR Method – X-Ray Machine

24. Preference Decisions - IRR When using the internal rate of return method to rank competing investment projects, the preference rule is: The higher the internal rate of return, the more desirable the project.

25. Payback Method • Payback measures the time it will take to recoup, in the form of expected future cash flows, the net initial investment in a project • Shorter payback period are preferable • Organizations choose a project payback period. The greater the risk, the shorter the payback period • Easy to understand

26. With uniform cash flows: With non-uniform cash flows: add cash flows period-by-period until the initial investment is recovered; count the number of periods included for payback period Payback Method Continued

27. Pop Quiz (Ignore income taxes in this problem.) Dumora Corporation is considering an investment project that will require an initial investment of $9,400 and will generate the following net cash inflows in each of the five years of its useful life: Year 1 Year 2 Year 3 Year 4 Year 5 Net cash inflows $1,000 $2,000 $4,000 $6,000 $5,000 Dumora’s discount rate is 16%. Dumora's payback period for this investment project is closest to: A) 1.91 years B) 2.61 years C) 2.89 years D)3.40 years

28. Accrual Accounting Rate of Return Method (AARR) • AARR Method divides an accrual accounting measure of average annual income of a project by an accrual accounting measure of its investment • Also called the Accounting Rate of Return

29. AARR Method Formula