AMIS 3300 Capital Budgeting

Project and Time Dimensions of Capital Budgeting

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. There are two main types of capital budgeting decisions: Screening decisions relate to whether a proposed project passes a preset hurdle. For example, a company may have a policy of accepting projects only if they promise a return of 20% on the investment. Preference decisions relate to selecting among several competing courses of action. For example, a company may be considering several different machines to replace an existing machine on the assembly line.   In this chapter, we initially discuss ways of making screening decisions. Preference decisions are discussed toward the end of the chapter.

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

Discounted Cash Flows Discounted Cash Flow (DCF) Methods measure all expected future cash inflows and outflows of a project, discounted back to the present 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

Discounted Cash Flows (continued) The reason is that $1 received today could be invested at, say, 10% per year so that it grows to $1.10 at the end of one year DCF methods use the Required Rate of Return (RRR), which is the minimum acceptable annual rate of return on an investment. RRR is internally set , usually by upper management, and 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.

Typical Cash Outflows Repairs and maintenance Working capital Initial investment Examples of typical cash outflows that are included in net present value calculations are as shown. Notice the term working capital which is defined as current assets less current liabilities. The initial investment in working capital is a cash outflow at the beginning of the project for items such as inventories. It is recaptured at the end of the project when working capital is no longer required. Thus, working capital is recognized as a cash outflow at the beginning of the project and a cash inflow at the end of the project. Incremental operating costs

Typical Cash Inflows Salvage value Release of working capital Reduction of costs Incremental revenues Examples of typical cash inflows that are included in net present value calculations are as shown.

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 present value of the future cash flows Based on financial factors alone, only projects with a zero or positive NPV are acceptable We’ll use three steps for the NPV method

Three-Step NPV Method Draw a sketch of the relevant cash inflows and outflows. Discount the Cash Flows using the Correct Compound Interest Table from Appendix A and Sum Them. Make the Project Decision on the Basis of the Calculated NPV (zero or positive should be accepted because the expected rate of return equals or exceeds the required rate of return.) Draw a sketch of the relevant cash inflows and outflows. (see right side of next slide) Discount the Cash Flows using the Correct Compound Interest Table from Appendix A and Sum Them. Make the Project Decision on the Basis of the Calculated NPV (zero or positive should be accepted because the expected rate of return equals (zero) or exceeds the required rate of return.)

Relevant Cash Flows in NPV Analysis One of the biggest challenges in capital budgeting, particularly DCF analysis, is determining which cash flows are relevant in making an investment selection. Relevant cash flows are the differences in expected future cash flows as a result of making the investment. A capital investment project typically has four categories of cash flows: Net initial investment. After-tax cash flow from operations. After-tax cash flow from terminal disposal of an investment. Recovery of working capital. One of the biggest challenges in capital budgeting, particularly DCF analysis, is determining which cash flows are relevant in making an investment selection. Relevant cash flows are the differences in expected future cash flows as a result of making the investment. A capital investment project typically has three categories of cash flows: Net initial investment After-tax cash flow from operations After-tax cash flow from terminal disposal of an asset and recovery of working capital

Net Initial Investment The three components of net-initial investment cash flows are as follows: Initial machine investment. Initial working capital investment. After-tax cash flow from current disposal of old machine. Three components of net-initial investment cash flows: Initial machine investment Initial working capital investment After-tax cash flow from current disposal of old machine

Cash Flow from Operations Two components of cash flow from operations are relevant: Annual after-tax cash flow from operations (excluding the depreciation effect). Income tax cash savings from annual depreciation deductions. Two components of cash flow from operations: Annual after-tax cash flow from operations (excluding the depreciation effect) Income tax cash savings from annual depreciation deductions For economic-policy reasons, tax laws specify which depreciation methods and which depreciable lives are permitted. When there is a legal choice, take the depreciation sooner rather than later because this will increase a project’s NPV.

Cash Flow from Terminal Disposal of Investment After-tax cash flow from terminal disposal of the investment (asset). The disposal of an investment generally increases cash inflow of a project at its termination. Two components of Terminal Disposal of Investment: After-tax cash flow from terminal disposal of asset (investment) After-tax cash flow from recovery of working capital (liquidating receivables and inventory that was needed to support the project)

Recovery of Working Capital Cash flow from recovery of working capital (liquidating receivables and inventory that was needed to support the project). The disposal of an investment generally increases cash inflow of a project at its termination. Two components of Terminal Disposal of Investment: After-tax cash flow from terminal disposal of asset (investment) After-tax cash flow from recovery of working capital (liquidating receivables and inventory that was needed to support the project)

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.

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.

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.

Summary Data for the X-Ray Machine Old X-Ray Machine New X-Ray Machine Purchase Price --- $390,000 Current book value $40,000 Current disposal value 6,500 Not applicable Terminal disposal value 5 years from now Annual depreciation 8,000a 78,000b Working capital required 6,000 15,000 a $40,000 / 5 years = $8,000 annual depreciation b $390,000 / 5 years = $78,000 annual depreciation

Effect on Year One Cash Flows from Operations – Net of Income Taxes

Annual After-Tax Cash Flow from Operations 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 cash flow from operations with new machine $120,000 Deduct income tax payments (0.40 X $120,000) 48,000 Annual after-tax cash flow from operations $72,000

Annual After-Tax Cash Flow from Operations (Cont) For year 5, the after-tax cash flow (excluding depreciation effects) is: Annual cash flow from operations with new machine $105,000 Deduct income tax payments (0.40 X $105,000) 42,000 Annual after-tax cash flow from operations $63,000

Tax Consequences of Disposing of the Old Machine Loss on disposal: Current disposal value of old machine $6,500 Deduct current book value of old machine 40,000 Loss on disposal of machine $(33,500)

Tax Consequences of Disposing of the Old Machine (cont) Any loss on sale of assets lowers taxable income and results in tax savings. The after-tax cash flow from disposal of the old machine equals: Current disposal value of old machine $6,500 Tax savings on loss (0.40 X $33,500) 13,400 After-tax cash inflow from current disposal of old machine $19,900

Relevant Cash Inflows and Outflows for X-Ray Machine

NPV Method – X-Ray Machine

Internal Rate of Return Method The internal rate of return is the true rate of return promised 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. A project is accepted only if the IRR equals or exceeds the RRR The internal rate of return is the rate of return promised by an investment project over its useful life. It is sometimes referred to as the yield on a project.   The internal rate of return is the discount rate that will result in a net present value of zero. The internal rate of return works very well if a project’s cash flows are identical every year. If the cash flows are not identical every year a trial-and-error process can be used to find the internal rate of return.

Internal Rate of Return Method (cont) Managers or analysts solving capital budgeting problems typically use a calculator or computer program to determine the internal rate of return, but a more manual trial and error approach can also provide the answer. Trial and error approach: Use a discount rate and calculate the project’s NPV. Goal: find the discount rate for which NPV = 0 If the calculated NPV is greater than zero, use a higher discount rate. If the calculated NPV is less than zero, use a lower discount rate. Continue until NPV = 0. Managers or analysts solving capital budgeting problems typically use a calculator or computer program to provide the internal rate of return, but a more manual trial and error approach can also provide the answer. Trial and error approach: Use a discount rate and calculate the project’s NPV. Goal: find the discount rate for which NPV = 0 If the calculated NPV is greater than zero, use a higher discount rate. If the calculated NPV is less than zero, use a lower discount rate. Continue until NPV = 0. Computing the IRR is easier when the cash inflows are constant.

IRR Method – X-Ray Machine

Payback Method The Payback method 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 periods are preferable Organizations choose an acceptable project payback period for them The payback method is easy to understand The two weaknesses of the payback method are: Fails to recognize the time value of money. Doesn’t consider the cash flow beyond the payback point

Payback Method Calculation 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

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

Accrual Accounting Rate of Return Method (AARR) The AARR method divides the average annual [accrual accounting] income of a project by a measure of the investment in it. That “measure of the investment” in the project can vary company by company. Also called the accounting rate of return. The AARR method divides the average annual [accrual accounting] income of a project by a measure of the investment in it. That “measure of the investment” in the project can vary company by company. Also called the accounting rate of return. The AARR method is similar to the IRR method in that both calculate a rate-of-return percentage; however, the IRR method is generally regarded as better than the AARR.

AARR Method Formula

AARR Method, Advantages and Disadvantages Firms vary in how they calculate AARR. Easy to understand, and uses numbers reported in financial statements. Does not track cash flows. Ignores time value of money. Some advantages and disadvantages of the AARR method are: Firms vary in how they calculate AARR Easy to understand, and uses numbers reported in financial statements Does not track cash flows Ignores time value of money When different methods lead to different rankings of projects, more weight should be given to the NPV method because the assumptions made by the NPV method are most consistent with making decisions that maximize a company’s value.