Capital Budgeting and Cost Analysis Chapter 21 Capital Budgeting and Cost Analysis

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 as if they occurred at a single 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) DCF methods use the Required Rate of Return (RRR), which is the minimum acceptable annual rate of return on an investment. RRR 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 future cash flows Based on financial factors alone, only projects with a zero or positive NPV are acceptable

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 Flow 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 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. It works very well if a project’s cash flows are identical every year. If the annual cash flows are not identical, a trial and error process must be used to find the internal rate of return. 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.

IRR Method – X-Ray Machine

Payback Method Payback 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 period are preferable Organizations choose a project payback period. The greater the risk, the shorter the payback period Easy to understand

Payback Method Continued 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) AARR Method divides an accrual accounting measure of average annual income of a project by an accrual accounting measure of its investment Also called the Accounting Rate of Return

AARR Method Formula