Other Long-Run Decisions CHAPTER 9 Capital Budgeting and Other Long-Run Decisions

Long Run Decisions Capital expenditure decisions Decisions related to investments in property, plant and equipment Proper analysis requires taking into account the time value of money Capital expenditure decisions affect cash flows across multiple years

Capital Budgeting Decisions Investment decisions are important because they have a long run impact Capital expenditure decisions Decisions involving the acquisition of long-lived assets Capital budgeting - Process of evaluating investment opportunities - The final list of approved projects is referred to as the capital budget Learning objective 1: Define capital expenditure decisions and capital budgets

Capital Budgeting Decision Examples Learning objective 1: Define capital expenditure decisions and capital budgets

Review 1 Which of the following is not a capital expenditure decision? Building a new factory Purchasing a new piece of equipment Purchasing inventory Purchasing another company Answer: c Learning objective 1: Define capital expenditure decisions and capital budgets

Equipment Investment Learning objective 1: Define capital expenditure decisions and capital budgets

Evaluating Opportunities: Time Value of Money Approaches In evaluating an investment opportunity, a company must know - how much cash it pays or receives - when cash is received or paid It is better to receive a dollar today than any time in the future - A dollar received today can be invested and grow to more than a dollar Learning objective 1: Define capital expenditure decisions and capital budgets

Evaluating Opportunities: Time Value of Money Approaches Companies invest money today hoping to receive more money in the future By how much must the future cash flows exceed the cost of the investment? - Need to convert future dollars into their equivalent current , or present value Learning objective 1: Define capital expenditure decisions and capital budgets

Basic Time Value of Money Calculations Formula to convert future value to present value P = ___F___ (1 + r)n Where: P = Present value F = Future amount r = Required rate of return n = Number of years Learning objective 1: Define capital expenditure decisions and capital budgets

Basic Time Value of Money Calculations - Example What is the present value of $1,000 received five years from now if your required rate of return is 12%? P = __$1,000__ (1 + .12)5 = __$1,000__ 1.7623417 = $567.43 Learning objective 1: Define capital expenditure decisions and capital budgets

The Net Present Value Method Steps in the NPV method 1. Identify the amount and time period of each cash flow associated with a potential investment 2. Identify required rate of return and calculate the present values of the cash flows 3. Evaluate the net present value Learning objective 2: Evaluate investment opportunities using the net present value approach

The Net Present Value Method Amount and time period of each cash flow - Cash outflows are negative - Cash inflows are positive Only incremental cash flows are relevant to the decision - Cash flows already incurred (sunk costs) are not relevant Learning objective 2: Evaluate investment opportunities using the net present value approach

The Net Present Value Method Required rate of return (i.e. hurdle rate) Evaluate the investment opportunity - If NPV = 0, the investment earns the hurdle rate - If NPV > 0, the investment earns more than the hurdle rate - If NPV < 0, the investment earns less than the hurdle rate Learning objective 2: Evaluate investment opportunities using the net present value approach

Review 2 If the net present value of a project is zero, the project is earning a return equal to: Zero The rate of inflation The accounting rate of return The required rate of return Answer: d Learning objective 2: Evaluate investment opportunities using the net present value approach

Net Present Value Approach Learning objective 2: Evaluate investment opportunities using the net present value approach

Net Present Value Example An auto repair shop is considering the purchase of an automated paint spraying machine. The machine will last five years. Following information is available: Each year $2,000 will be saved on paint It will reduce labor costs by $20,000 each year It will require maintenance costs of $1,000 each year The machine costs $70,000 The expected residual value is $5,000 The required rate of return is 12% Learning objective 2: Evaluate investment opportunities using the net present value approach

Net Present Value Example Since the NPV > 0, the company should buy the equipment. Learning objective 2: Evaluate investment opportunities using the net present value approach

Exercise 1 Four year investment opportunity - Cost $50,000 - Annual incremental cash flow $22,000 - Residual value $8,000 - Required rate of return 14% Calculate the net present value Learning objective 2: Evaluate investment opportunities using the net present value approach

Comparing Alternatives with NPV Calculate the NPV of each alternative and choose the alternative with the highest NPV Another method to evaluate alternatives: - Calculate incremental cash flows - Calculate NPV of incremental cash flows Slide 9-20 Learning objective 2: Evaluate investment opportunities using the net present value approach 20

Comparing Alternatives with NPV Slide 9-21 Learning objective 2: Evaluate investment opportunities using the net present value approach 21

The Internal Rate of Return (IRR) Method An alternative to the NPV method Rate of return that equates PV of future cash flows to investment outlay, i.e. NPV = 0 If IRR of potential investment is equal to or greater than IRR, the investment should be undertaken Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

The Internal Rate of Return Method Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

Review 3 An investment should be made if: The IRR is equal to or greater than the required rate of return The IRR is equal to or greater than zero The IRR is greater than the accounting rate of return The IRR is greater than the present value factor Answer: a Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

The Internal Rate of Return with Equal Cash Flows Equal cash flows are called an annuity For an annuity, PV = PV factor x Annuity Therefore: Use table to find closest PV factor for the same number of years Slide 9-25 Learning objective 3: Evaluate investment opportunities using the internal rate of return approach 25

Internal Rate of Return Example Investment = $100 Cash flow $60 per year for two years PV factor = 100 / 60 = 1.667 Check PV annuity table, row 2 Closest factor is in 13% column Slide 9-26 Learning objective 3: Evaluate investment opportunities using the internal rate of return approach 26

Exercise 2 Investment costs = $79,100 Returns $14,000 a year for 10 years Required return is 18% Calculate IRR and evaluate PV Factor = 79,100 / 14,000 = 5.65 Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

Internal Rate of Return Slide 9-28 Learning objective 3: Evaluate investment opportunities using the internal rate of return approach 28

Internal Rate of Return With Unequal Cash Flows Utilized when annual cash flows are not equal amounts - Must estimate IRR - Use estimated IRR to calculate the NPV of the project If NPV > 0, increase estimated IRR If NPV < 0, decrease estimated IRR - Recalculate until NPV is equal to or close to zero Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

Internal Rate of Return With Unequal Cash Flows The IRR is approximately 16% Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

Use of NPV and IRR Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

Considering “Soft” Benefits in Investment Decisions NPV and IRR allow for a quantitative analysis of a situation “Soft” benefits are difficult to quantify “Soft” benefits include a project’s impact on: - Future sales - Firm’s reputation - New production techniques Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

“Soft” Benefits Slide 9-33 33 Learning objective 3: Evaluate investment opportunities using the internal rate of return approach 33

Calculating the Value of “Soft” Benefits Example A high-tech wheelchair project -NPV of negative $80,000 -Required rate of return 15%, 10-year life Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

Estimating the Required Rate of Return In previous examples the required rate of return was simply stated In practice, management must estimate the required rate of return - In some cases, the required rate of return should equal cost of capital - Cost of capital is the weighted average of debt and equity financing used Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

Review 4 The cost of capital is: The cost of debt financing The cost of equity financing The weighted average of the costs of debt and equity financing The internal rate of return Answer: c Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

Cost of Capital Examples Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

Additional Cash Flow Considerations Both NPV and IRR consider cash inflows and outflows Only cash inflows and outflows are discounted back to present value: - Timing of collection of revenues - Depreciation does not require cash outflow Two special topics related to cash flows - Depreciation and its effect on taxes - Effect of inflation on cash flows Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

Cash Flows, Taxes, and the Depreciation Tax Shield Depreciation does not directly affect cash flows Depreciation affects cash flows indirectly - Depreciation reduces the amount of tax a company must pay - Referred to as the depreciation tax shield Learning objective 4: Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes

Example of the Depreciation Tax Shield Slide 9-40 Learning objective 4: Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes 40

Cash Flows, Taxes, and the Depreciation Tax Shield Slide 9-41 Learning objective 4: Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes 41

Adjusting Cash Flow for Inflation It is important to consider the rate of inflation for investment decisions: - Typically, inflation is factored into the cost of capital - Inflation can be taken into account by multiplying the cash flow by the expected rate of inflation Learning objective 4: Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes

Adjusting Cash Flow for Inflation If inflation is not factored into expected cash flows, suitable projects may appear to have a negative NPV Current rates of return already include estimates of inflation - Cash inflows will be relatively low - Required rate of return will be relatively high Slide 9-43 Learning objective 4: Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes 43

Other Long-Run Decisions Evaluation of decision to sponsor a golf tournament Learning objective 5: Evaluate long-run decisions, other than investment decisions, using time value of money techniques

Other Long-Run Decisions Slide 9-45 Learning objective 5: Evaluate long-run decisions, other than investment decisions, using time value of money techniques 45

Simplified Approaches to Capital Budgeting Many companies use simpler approaches - Payback period method - Accounting rate of return Both methods have significant limitations as compared to NPV and IRR Learning objective 6: Use the payback period and the accounting rate of return methods to evaluate investment opportunities

Payback Period Method Length of time it takes to recover the initial cost of an investment An investment which costs $1,000 andyields cash flows of $500 per year has payback $1,000 / $500 = 2 years - Does not consider total stream of cash - Does not consider time value of money Slide 9-47 Learning objective 6: Use the payback period and the accounting rate of return methods to evaluate investment opportunities 47

Review 5 Which of the following methods ignores the time value of money (present and future values) in its calculation? Net present value Internal rate of return Payback period External rate of return Answer: c Learning objective 6: Use the payback period and the accounting rate of return methods to evaluate investment opportunities

Exercise 3 New construction costs $55,000 Cash flows are $10,000 per year for 10 years Calculate the payback period Payback period = $55,000 / $10,000 = 5.5 years Learning objective 6: Use the payback period and the accounting rate of return methods to evaluate investment opportunities

Accounting Rate of Return (ARR) Accounting Rate of Return Formula: ARR = Average Net Income Average Investment Average investment is the initial investment divided by 2 Learning objective 6: Use the payback period and the accounting rate of return methods to evaluate investment opportunities

Conflict Between Performance Evaluation and Capital Budgeting Managers may not use PV techniques for evaluating investments depending on how their performance is evaluated: - Manager’s performance may be evaluated based on short-term outcomes - Managers must be confident that their performance will be evaluated based on long-run profitability of the firm Learning objective 7: Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values

Short-Run Accounting Profit Learning objective 7: Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values

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