Capital Budgeting 2 2

Capital Budgeting Process A capital investment is an investment that requires commitment of a large sum of funds and has expected expenditures and benefits stretch well into the future. Project Identification and Definition Evaluation and Selection Monitoring and Review

Types of Capital Investment Assets to meet regulatory, safety, health, and environmental requirements. Assets to enhance operating efficiency and/or increase revenue. Assets to enhance competitive effectiveness.

Characteristics of Capital Budgeting Data

Cash Flows

Depreciation Tax Shield Depreciation charges are not cash costs and do not directly affect the net present values of capital investments. Tax regulations permit depreciation write-offs that reduce the required tax payment. This reduction in the tax payment is called the . . . Tax Shield. 18 26

Application of Cash Flows Smith Company manufactures high-pressure pipe for deep-sea oil drilling. The firm is considering the purchase of a milling machine.

Effect of Asset Acquisition on Cash Flow

Effect of Asset Acquisition on Cash Flow The milling machine would require $200,000 in additional working capital for operations. This amount would be tied up in inventories and accounts receivable and will not be available for use during operations.

Effects of Disposal of the Asset Replaced on Cash Flow Direct Effect: Inflow: Proceeds from disposal Outflow: Expenditures for equipment removal and site restoration Tax Effect: Inflow: Tax effect on loss on disposal Outflow: Tax effect of gain on disposal

Cash Flows from Disposal of Equipment

Effects of Periodic Operations Transaction Effect on Cash Flow Cash receipts Amount received × (1 - tax rate) Cash expenditures Amount paid × (1 - tax rate) Depreciated initial cost Tax shield: Depreciation expense × tax rate Allocated cost No effect The company expects its investment to bring in $1,000,000 in cash revenue from increases in production volume in each of the next four years. Cash operating expenses are expected to be $750,000 per year

Effects on Cash Flows Cash from operations increases by $194,000 each year ($150,000 + $44,000).

Total Effect of Cash Flows Release of working capital. One time training charges of $50,000, net of tax.

Effect of Final Disinvestment on Cash Flow The company plans to sell the machine at the end of its useful life for $100,000 and incur removal and cleanup costs of $20,000.

Effect of Final Disinvestment on Cash Flow At the end of the project, the company will incur $150,000 in relocation costs for displaced workers. This amount is deductible on the company’s tax return. The remaining working capital will be released for use in other projects.

Effect of Investing in the Milling Machine

Capital Budgeting Techniques Payback Period The length of time required for the cumulative total net cash inflows from an investment to equal the total initial cash outlays of the investment.

Capital Budgeting Techniques Project Information A four-year project requires an initial investment of $555,000 in Year 0. The project is expected to produce $900,000 in cash revenues and require $660,000 in cash expenses each year. No additional working capital is required and the investment will have a salvage value of $60,000. At the end of the fourth year management expects to sell the investment for $200,000. Expected relocation costs are $240,000 and the company is subject to a 40% tax rate.

Capital Budgeting Techniques

The Payback Period Payback Period = Payback Period = Total Original Investment Annual Net After-Tax Cash Flow Return $555,000 $193,500 Payback Period = Payback Period = 2.87 years

The Payback Period Easy to calculate and comprehend ADVANTAGES DISADVANTAGES Easy to calculate and comprehend Provides a measure of the risk Indicates effect on liquidity Ignores timing and time value of money Ignores cash flows beyond pack back period

Average Net Income Investment (Book value) The Book Rate of Return Book Rate of Return = Average Net Income Investment (Book value)

Average Net Income Investment (Book value) The Book Rate of Return Book Rate of Return = Average Net Income Investment (Book value) Book Rate of Return = $69,750 $307,500 = 22.68%

Evaluation of the Book Rate of Return ADVANTAGES LIMITATIONS Readily available data Consistency between data for capital budgeting and data for performance evaluation Easily identifiable impact on financial resources No adjustment for time value of money Arbitrary measurements Periodic net income not equal to cash flow

Discounted Cash Flow Evaluate a capital investment by considering equivalent present values of all future net cash inflows from the initial investment. Factors to consider: The total initial investment. The expected future cash receipts and disbursements. The investor’s desired rate of return. Minimum rate of return. Cost of capital.

Cost of Capital Assume a firm issued a 10%, $5,000 bond and sold the bond for $4,365 (issued at a discount). With a 30% tax rate, the after-tax cost of the bond is 8% as show below:

Dividend Per Share Market Price Per Share Cost of Capital Assume a firm issues 100 shares of preferred stock that pays and annual dividend of $2.40. The shares for sold of $25 each. The income tax rate is 30%, but is not relevant because dividends are not deductible for tax purposes. Cost of Preferred Stock = Dividend Per Share Market Price Per Share $2.40 $25.00 = 9.6%

Return Demanded by Investors Market Price Per Share Cost of Capital Assume a firm issues 100 shares of its $10 par value common stock. Each share is selling in the market for $200, and the stockholders demand a return of $25 return. The cost of common stock is 12.5% as shown below: Cost of Common Stock Return Demanded by Investors Market Price Per Share = $25 $200 = 12.5%

Let’s calculate the weighted cost of capital. A firm has a $100,000 bank loan with 12% interest; $500,000, 10%, 20-year mortgage bonds selling at 90% of face’ $200,000, 15%, $20 noncumulative, noncallable preferred stock with a total market value of $300,000; and 10,000 shares of $1 par common stock that the firm sold for $5 per share. The common stock is currently selling in the market for $75 per share. Common stock investors demand a $15 per share return. The firm is subject to a 40% tax rate. Let’s calculate the weighted cost of capital.

Cost of Capital $100,000 ÷ $1,600,000 = 6.250% 7.20% × 6.250% = 0.4500%

Determining the NPV of an Investment Opportunity Determine net cash flow return in each year Select the desire rate of return Find the discount factor for each of the years based on the desired rate of return selected in 2 Multiply Steps 1 and 3 to determine the present values of the cash flow returns Sum the amount in Step 4 for all the years Subtract the initial investment from the amount obtained in Step 5

NPV with Uneven Cash Inflows Net present value of cash inflows discounted at 10%. (1 + 10%)-1 **Excel and Lotus use continuous discounting and yield a slightly different net present value [NPV(Rate, Range of inflows and outflows)].

NPV with Uneven Cash Inflows Net present value of cash inflows discounted at 10%. Because this project has a positive net present value, the actual rate of return is greater than 10%. If the net present value was zero, the return would be exactly 10%.

NPV Payback Period An investment opportunity has an initial cost of $550,000, and will product after-tax cash inflows of $193,500 for the next four years. Present Value Payback Period = 3 years + ($73,794 ÷ $132,163) = 3.56 years

Present Values with Interest Rates of 14% and 16% An investment opportunity has an initial cost of $625,000 and provides the cash inflows shown below: 14% + 2% × $25,255 $29,439 = 15.72% Internal rate of return $650,255 - $625,000 16% - 14% $650,255 - $620,816

Comparison of NPV and IRR Methods Results from net present value and internal rate of return may differ if projects differ in . . . Required initial investment Cash flow pattern Length of useful life Varying cost of capital Multiple investments

Pattern of Cash Flows

Investment with Multiple Rates of Return PV PV Discount with 10% Discount with 16% Cash Factor Discount Factor Discount Period Flow at 10% Rate at 16% Rate 0 -$1,323 1.000 -$1,323 1.000 -$1,323 1 3,000 .909 2.727 .862 2,586 2 -1,700 .826 -1,424 .743 -1,263 NPV 0 0

Effect of Length of Useful Life

NPV of Project with Different Desired Rates of Return (1 + 15%)-4

Comparison of NPV and IRR Methods

Factors Affecting Results

Strategic Missions and Capital Budgeting

Cost Driver Analysis Workforce involvement (participation management) Workforce commitment to continuous improvement Adherence to total quality management concepts Utilization of effective capacity Efficiency of production flow layout Effectiveness of product design or formulation Exploiting linkages with suppliers and customers all along the value chain

End of Chapter 11 78