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Capital Budgeting Introduction

Capital Budgeting Introduction. Sound. Common Investment Cash Flows. 0 1 2 3 4 . . . . . N. cash outlays. terminal flows. cash flow from operations. Initial Cash Outlays: Capitalized Purchase Price. Other Initial Cash Outflows.

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Capital Budgeting Introduction

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  1. Capital Budgeting Introduction Sound Capital Budgeting Introduction

  2. Common Investment Cash Flows 0 1 2 3 4 . . . . . N cash outlays terminal flows cash flow from operations Capital Budgeting Introduction

  3. Initial Cash Outlays: Capitalized Purchase Price Capital Budgeting Introduction

  4. Other Initial Cash Outflows 1. Not Sunk Costs 2. Working Capital Changes (i.e., increases in inventory) 3. Selling or Salvaging Old Equipment Capital Budgeting Introduction

  5. Depreciation Q: Is depreciation a cash flow? A: No, not directly, but yes, indirectly through taxes A detour on depreciation Capital Budgeting Introduction

  6. Internal Revenue Service Publication 586A The Collection Process (Income Tax Accounts) Capital Budgeting Introduction

  7. Depreciation Tax Shield Save $8 ($20 times 40%) in taxes (cash outflow) due to depreciation. Capital Budgeting Introduction

  8. Categories of Depreciation Write-Off Class 3-year MACRS All property with ADR midpoints of four years or less. Autos and light trucks are excluded from this category. 5-year MACRS Property with ADR midpoints of more than 4, but less than 10 years. Key assets in this category include automobiles, light trucks, and technological equipment such as computers and research-related properties. 7-year MACRS Property with ADR midpoints of 10 years or more, but less than 16 years. Most types of manufacturing equipment would fall into this category, as would office furniture and fixtures. 10-year MACRS Property with ADR midpoints of 16 years or more, but less than 20 years. Petroleum refining products, railroad tank cars, and manufactured homes fall into this group. Capital Budgeting Introduction

  9. Categories of Depreciation Write-Off (cont.) Class 15-year MACRS Property with ADR midpoints of 20 years or more, but less than 25 years. Land improvement, pipeline distribution, telephone distribution, and sewage treatment plants all belong in this category. 20-year MACRS Property with ADR midpoints 25 years or more (with the exception of real estate, which is treated separately). Key investments in this category include electric and gas utility property and sewer pipes. 27.5-year MACRS Residential rental property if 80% or more of the gross rental income is from non transient dwelling units (e.g., an apartment building); low-income housing. 31.5-year MACRS Nonresidential real property that has no ADR class life or whose class life is 27.5 years or more. 39-year MACRS Nonresidential real property placed in service after May 12, 1993 Capital Budgeting Introduction

  10. Depreciation Percentages Depreciation 3-Year 5-Year 7-Year 10-Year 15-Year 20-Year Year MACRS MACRS MACRS MACRS MACRS MACRS 1 . . . .333 .200 .143 .100 .050 .038 2 . . . .445 .320 .245 .180 .095 .072 3 . . . .148 .192 .175 .144 .086 .067 4 . . . .074 .115 .125 .115 .077 .062 5 . . . .115 .089 .092 .069 .057 6 . . . .058 .089 .074 .062 .053 7 . . . .089 .066 .059 .045 8 . . . .045 .066 .059 .045 9 . . . .065 .059 .045 10 . . . .065 .059 .045 11 . . . .033 .059 .045 12 . . . .059 .045 13 . . . .059 .045 14 . . . .059 .045 15 . . . .059 .045 16 . . . .030 .045 17 . . . .045 18 . . . .045 19 . . . .045 20 . . . .045 21 . . . .017 1.000 1.000 1.000 1.000 1.000 1.000 Capital Budgeting Introduction

  11. Operating Cash Flows Find the annual operating cash flow. Capital Budgeting Introduction

  12. Operating Cash Flows: Straight Line Depreciation Capital Budgeting Introduction

  13. Operating Cash Flows: Short Cut OCF = (ΔEBDIT) (1 - t) + t(Depr.) OCF = ($30,000) (1 - .40) + .4($11,784) = $22,714 Capital Budgeting Introduction

  14. NPV @ 13% & IRR: Straight Line Depreciation 0 1 2 … 10 -117,840 22,714 22,714 22,714 NPV @ 13% = $5,411 IRR = 14.14% Capital Budgeting Introduction

  15. Modified Accelerated Cost Recovery System7 Year Property Capital Budgeting Introduction

  16. Operating Cash Flows: MACRS Depreciation Capital Budgeting Introduction

  17. NPV @ 13% and IRR: MACRS Depreciation 0 1 2 … 10 -117,840 24,736 29,544 18,000 Capital Budgeting Introduction

  18. Sale of Asset: NBV > MP Cash flow from sale = $200 + $160 (salvage value) (tax shield) = $360 Capital Budgeting Introduction

  19. Sale of Asset: NBV < MP Cash flow from sale = $800 - $80 (salvage value) (tax due) = $720 Capital Budgeting Introduction

  20. Capital Budgeting Practice Problem • Should ABC Corp. buy the following asset? • Facts • Price of the new equipment* $10,000 • Installation and transportation costs 2,000 • Straight line depreciation over 10 years to zero valve • Will be sold for scrap after 10 years at a price of $1,000 • Will generate $750 labor savings each year • Tax rate 30% • Discount or interest rate 10% • Find NPV and IRR. • *$10,000 price includes an adjustment for sales taxes and a reduction for early payment. Capital Budgeting Introduction

  21. Capital Budgeting Practice Problem 0 1 2 … 10 -12,000 885 885 1,585 Time zero: Price $ - 10,000 Inst & trans - 2,000 $ - 12,000 Time 1 to 10: OCF = ($750)(1-.3) + ($1,200)(.3) = $885 NPV @10% = -$6,292 IRR = -3.7% Capital Budgeting Introduction

  22. Replacement of Machine A with Machine B • Sell machine A • Purchase machine B • Calculate differential cash flows using machine B Capital Budgeting Introduction

  23. As the Distribution Center manager of NuSkin, you are analyzing the replacement of an automated packaging system. The old system was purchased five years ago for $200,000; it has been depreciated to a zero book value, and it has five years of remaining life and a $50,000 salvage value (if sold after five years). The current market value of the old system is $100,000. The new system has a price of $300,000, plus an additional $50,000 in installation cost. The new system falls into the MACRS five-year class, has a five-year economic life, and a $100,000 salvage value. The new automated packager will require a $40,000 increase in cardboard inventory. The primary advantage of the new system is that it will decrease operating costs (labor and maintenance) by $40,000 per year. Additionally the new equipment has higher capacity which may be needed if sales continue to grow. NuSkin has a 14 percent cost of capital and a marginal tax rate of 40 percent. Should NuSkin buy the new system? Why? (Use both NPV and IRR). Capital Budgeting Introduction

  24. NuSkin International, Inc.Buy the New, Sell the Old Time Zero * * Capital Budgeting Introduction

  25. NuSkin International, Inc.Buy the New, Sell the Old (cont.) * * Operating cash flow, detail for Year 1 Capital Budgeting Introduction

  26. NuSkin International, Inc.Buy the New, Sell the Old (cont.) Terminal Cash Flows a b Capital Budgeting Introduction

  27. NuSkin International Inc. 0 1 2 3 4 5 -330,000 52,000 68,800 50,600 40,800 39,400 + 78,400 117,800 NPV @ 14% = $-111,955 IRR = 0% Do not buy the new system! Stick with the old system. Capital Budgeting Introduction

  28. NewProject Equity Cash Flow Economic Rent Savings • Revenues • -Operating Exp. • EBDIT • -Depreciation • EBIT • -Interest • Pretax Profit • -Tax • Net Income • +Depreciation • Capital Exp • +ΔNWC • +/- ΔDebt • Free Cash Flow • Revenues • -Operating Exp. • EBDIT • -Depreciation • EBIT • -Tax • NOPAT • +Depreciation • Capital Exp • +ΔNWC • Cash Flow • -Capital Cost • EVA • Revenues • -Operating Exp. • EBDIT • -Depreciation • EBIT • -Tax • NOPAT • +Depreciation • Capital Exp • +ΔNWC • Cash Flow • EBDIT • -Depreciation • EBIT • -Tax • NOPAT • +Depreciation • Capital Exp • +ΔNWC • Cash Flow Capital Budgeting Introduction

  29. Interrelated Investment Opportunities Capital Budgeting Introduction

  30. Capital Rationing Setting an absolute limit on the size of the capital budget that is less that the level of investment called for by the NPV or IRR criteria. Capital Budgeting Introduction

  31. Capital Rationing • Rules out value maximizing • New Goal: Maximize the value of the firm subject to the capital constraint. Capital Budgeting Introduction

  32. Reasons for Rationing 1. Increase ability to take advantage of the projects in the future. 2. Small Firms: No Funds • Low cash inflows • No access to capital • Reluctance to take equity partners 3. Large Firms: Top Management • Cannot evaluate each project • Allocate dollars to control strategic direction 4. General • Reluctance to increase risk with debt • Reluctance to decrease control with equity Capital Budgeting Introduction

  33. Rationing Applied • List all positive NPV projects with capital outlay amount. • Find all possible subjects of projects which do not exceed the budget constraint. • Choose that subset with the largest total NPV summed over the projects. Capital Budgeting Introduction

  34. Capital Rationing Problem • Using a 10% discount rate, which projects should be accepted? • Using a 10% discount rate, which projects should be accepted with a budget constraint of $700,000? Capital Budgeting Introduction

  35. Capital Rationing Problem • Accept all projects except C. • $700,000 capital constraint. Capital Budgeting Introduction

  36. Capital Rationing and the Profitability Index Index Ordering: Best subset is still B, D, F, G Capital Budgeting Introduction

  37. Capital Rationing 1. Under rationing, existing projects with positive NPV’s may not be acceptable. 2. Liquidation of ongoing projects may free up funds--relaxing the budget constraint. Capital Budgeting Introduction

  38. Chemical Plant(Cost of $11 Million) Discounted at ROA of 17% PV of inflows = $10,975,672 NPV = <$24,328> Capital Budgeting Introduction

  39. NPV Common Error #1Inadequate Investment Horizon • Conservative or unfair • More years or terminal value • PV of inflows with 15 year horizon is $14 million or NPV of $3 million Capital Budgeting Introduction

  40. NPV Common Error #2Constant Dollar Cash Flows • Discount rate includes expected inflation • Cash flows are in constant dollars • Must be consistent • PV of inflows with 3% inflation of cash flows is $13 million or NPV of $2 million Capital Budgeting Introduction

  41. NPV Common Error #3Timing of the Cash Flows • Assumed all flows are at the end of year; • However, inflows occur throughout the year. • PV of inflows with semi-annual inflows is $11.5 million or NPV of $.5 million Capital Budgeting Introduction

  42. NPV Common Error #4Excessive Discount Rate • High rate low NPV • Weighted average cost of capital • Managers are more risk averse than the company • Discount rate (WACC) is between 13% and 16% • PV of inflows with 13% to 16% discount rate is $13.5 million or NPV of $2.5 to .5 million. Capital Budgeting Introduction

  43. Getting NPV To Live Up To Full Potential One trust of our presentation is that NPV analysis is a superior capital budgeting technique. It treats sunk costs, timing of cash flows, side effects, and opportunity costs properly. It uses all the CFs, only the incremental CFs, and discounts them properly. Capital Budgeting Introduction

  44. Getting NPV To Live Up To Full Potential But is there a “false sense of security,” as those in industry often say? With positive NPV, temptation is to just say “yes.” Nevertheless, the projected CF often goes unmet in practice, and the firm ends up with a money loser. How can we get NPV to live up to its potential??? Capital Budgeting Introduction

  45. Sensitivity analysis. Scenario analysis. • NPV analysis requires many assumptions and projections, all leading to one number--the NPV. What if some projections are off? • Sensitivity analysis forces us to consider how NPV is affected by our forecasts of key variables. • Examines variables one at a time. • Scenario analysis accounts for the fact that certain variables are interrelated. • In a recession, selling price may be lower than expected at the same time costs are high. Capital Budgeting Introduction

  46. Example of Sensitivity Analysis Toulouse Coupling Case Capital Budgeting Introduction

  47. Capital Budgeting Introduction

  48. Labor Savings Sensitivity Net Present Value ($) Labor Savings ($) Capital Budgeting Introduction

  49. Dealing with Bias in Capital Budgeting • Bias is the deviation of the expected value of an estimate from the actual quantity it estimates. • Biases are systematic (i.e. not due to chance). • Awareness of bias does not automatically eliminate it. • There are two kinds of bias • Cognitive • Motivational Capital Budgeting Introduction

  50. Cognitive Bias • Availability - The easier information is to recall, the greater the weight put on it. • Adjustment and anchoring - Tendency to anchor on an initial estimate and fail to adjust for the actual uncertainty. • Representativeness - If an outcome “seems to be” representative of the possibilities it is given greater weight. • Implicit conditioning - Unstated assumptions are not communicated with the estimate. Low probability events are given too much weight. Capital Budgeting Introduction

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