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26-1 C APITAL B UDGETING LONG-RANGE PLANNING CHAPTER 26

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26-2 Capital Budgeting l It is the process of considering alternative capital projects and selecting those alternatives that provide the most profitable return on available funds. l Examples of capital projects include land, buildings, equipment and other major fixed asset items.

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26-3 I will choose the project with the most profitable return on available funds. ? ? ? Limited Investment Funds Plant Expansion New Equipment Office Renovation Alternatives: Capital Budgeting

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26-4 Capital Budgeting Implementation of a capital project involves... u a large commitment of money in the decision period. u a large increase in fixed costs for a number of years. u potential returns in future years. u an opportunity cost because of the rejection of other projects.

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26-5 Project Selection: A General View l Analysis of cash inflows and cash outflows u Net cash inflow is the net cash benefit expected from a capital project in a period. l Time value of money u Cash received today is worth more than the same amount received in the future..

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26-6 Capital Budgeting Cash Flow Analysis Initial Investment Increased Working Capital Repairs and Maintenance Incremental Operating Costs Typical Cash Outflows

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26-7 Capital Budgeting Cash Flow Analysis Typical Cash Inflows Reduced Operating Costs Released Working Capital Incremental Revenues Salvage Value.

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26-8 Capital Budgeting Terminology Interest rate indicating the cost of debt and equity investment funds Cost of capital Out-of-pocket costs Avoided by not selecting a project Future cash outflows Sunk costs Not avoided by current decision Past cash outflows

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26-9 Depreciation and Taxes Depreciation itself is not a cash flow. However, depreciation results in a reduction of cash outflows by reducing federal income taxes.

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26-10 Depreciation and Taxes Example Apex Company is considering the purchase of new equipment. Given the following information, and a tax rate of 40 percent, compute the: Ê Tax savings due to depreciation. Ë After-tax net cash inflow.

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26-11 Tax savings Tax savings = $2,400 (.40 × $6,000 depreciation = $2,400) Depreciation and Taxes Example

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26-12. After-tax net cash inflow 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 ×× Alternatively, reducing this analysis to a formula yields: Depreciation and Taxes Example

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26-13 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)

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26-14 Project Selection Method 1: Payback Period Time required for the sum of the annual net cash inflows to equal the initial cash outlay.

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26-15 Payback Period When the annual net cash inflows are equal, use the following formula: Initial cash outlay Annual net cash inflow Payback period =

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26-16 Payback Period Example l Gators wants to install a separate seafood bar in its pub. l The seafood bar will... u cost $150,000 and has a 10-year life with zero salvage value. u generate net annual cash inflows of $30,000. l Gators requires a payback period of 6 years or less on all investments. Should Gators invest in the seafood bar?

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26-17 Initial cash outlay Annual net cash inflow Payback period = $150,000 $30,000 per year = 5.0 years Gators should invest in the seafood bar because the payback period is less than 6 years. Payback Period Example

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26-18 Payback Period Limitations Ignores the time value of money. Ignores cash flows after the payback period.

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26-19 Payback Period Limitations Example Consider two projects, each with a five-year life and each costing $6,000. Which project has the better payback period?

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26-20 l Project one returns the $6,000 investment faster -- shorter payback period of three years ($6,000 ÷ $2,000 per year = 3 years). l Project two is clearly superior because of the large cash inflow in the last year. l Can you see the limitations of the payback period? Payback Period Limitations Example

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26-21 Project Selection Method 2: Unadjusted Rate of Return The unadjusted rate of return focuses on annual income instead of cash flows. Unadjusted Average annual income rate of return Average amount of investment = Beginning balance + Ending balance 2

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26-22 Unadjusted Rate of Return Example What is the the unadjusted rate of return on the seafood bar? l The seafood bar will... u cost $150,000 and has a 10-year life with zero salvage value. u generate net annual cash inflows of $30,000. l Gators requires a payback period of 6 years or less on all investments and pays tax at 40%. Reconsider the Gators example:

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26-23. Unadjusted (30,000 - 15,000) x (1 -.40) rate of return (150,000 + 0) ÷ 2 == 12.0% Unadjusted Rate of Return Example Annual net cash inflows30,000$ Depreciation ($150,000 ÷ 10 years)15,000 Annual income before tax15,000$ Unadjusted Average annual income after tax rate of return Average amount of investment = Unadjusted Average annual before- Average annual Tax Rate of tax net cash inflow depreciation rate return Average amount of investment = ( - ) × ( 1 - )

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26-24 l Depreciation may be calculated several ways thereby giving different results. l Time value of money is ignored. Unadjusted Rate of Return Limitations

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26-25 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

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26-26 ÊChose a minimum rate of return (cost of capital). ËCalculate the present value of cash inflows. ÌCalculate the present value of cash outflows. NPV = – Net Present Value Procedure

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26-27 l If NPV is positive, the investment yields a higher return than the cost of capital. l Decision rule: Invest if NPV is positive. Net Present Value Interpretation

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26-28 Net Present Value Question 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 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

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26-29 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 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 Net Present Value Question

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26-30 Calculate the NPV if Savak Company’s required return is 14 percent instead of 12 percent. Net Present Value Question

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26-31 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 Net Present Value Question Note that the NPV is smaller using the larger interest rate.

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26-32 Net Present Value Now that you have mastered the basic concept of net present value, it’s time for a more sophisticated checkup!

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26-33 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. l The new equipment will... u cost $160,000, have a five-year useful life, and a $5,000 salvage value. u need an overhaul at the end of three years costing $30,000. l Initial working capital requirement is $100,000.

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26-34 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. Net Present Value Example

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26-35 Harper Company Net Present Value Analysis Net Present Value Example

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26-36 Harper Company Net Present Value Analysis Net Present Value Example

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26-37 Harper Company Net Present Value Analysis Net Present Value Example Present value of an annuity of $1 factor for 5 years at 10%.

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26-38 Harper Company Net Present Value Analysis Net Present Value Example $80,000 × 3.79079 = $303,263

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26-39 Harper Company Net Present Value Analysis Net Present Value Example Present value of $1 factor for 3 years at 10%.

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26-40 Harper Company Net Present Value Analysis Net Present Value Example Present value of $1 factor for 5 years at 10%.

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26-41 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. Net Present Value Example

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26-42 Project Selection Method 4: Profitability Index l Provides a means of ranking projects that have different initial investments. l Decision rule: consider only those projects with a profitability index of 1.00 or more. Present value of net cash inflows Present value of cash outflows Profitability index =.

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26-43 The interest rate that makes... Project Selection Method 5: Time Adjusted Rate of Return Present value of cash inflows Present value of cash outflows = Also known as the internal rate of return. Ë The net present value equal zero.

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26-44 For projects with equal annual cash flows (i.e., annuities) ÊDetermine the payback period. ËUse the present value of annuity table to determine the IRR. Internal Rate of Return (IRR) Procedure

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26-45 Internal Rate of Return (IRR) Procedure Project life = 4 years Initial cost = $42,523 Annual 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)

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26-46 Locate the row whose number equals the life of the project. 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...

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26-47 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 the interest factor closest in amount to the payback period.

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26-48 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 the interest rate of the column in which the interest factor is found.

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26-49 Internal Rate of Return Example 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?

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26-50 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. Internal Rate of Return Example $104,322 $20,000 per year Payback period = = 5.21610 Initial cash outlay Annual net cash inflow Payback period =

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26-51 Here’s the proof... Internal Rate of Return Example

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26-52 Internal Rate of Return Complication #1 If the exact interest rate is not found in the present value table, an estimate of the interest rate is required. For a project with a five-year life and a payback period of 3.65000, the IRR would be approximately 11.5 percent.

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26-53 Internal Rate of Return Complication #2 If cash inflows involve both annuities and one-time amounts, a trial and error solution will result if present value tables are used. Sophisticated business calculators and electronic spreadsheets can be used to easily solve these problems.

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26-54 Internal Rate of Return u Compare the cost of capital to the internal rate of return on a project. u To be acceptable, a project’s rate of return cannot be less than the cost of capital. Net Present Value u The cost of capital is used as the actual discount rate. u Any project with a negative net present value is rejected. Net Present Value vs. Internal Rate of Return

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26-55 THE END I’m telling you, that’s the end. There isn’t any more of this virtual lecture.

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