Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. The Capital Budgeting Decision 12

12-2 Chapter Outline Capital budgeting decision. Cash flows and capital budgeting. Methods for ranking investments –Payback methods –Internal rate of return –Net present value. Discount or cutoff rate. After-tax operating benefits and tax shield benefits of depreciation.

12-3 Capital Budgeting Decision Involves planning of expenditures for a project with a minimum period of a year or longer. Capital expenditure decisions requires: –Extensive planning and coordination of different departments. Uncertainties are common in areas such as: –Annual costs and inflows, product life, economic conditions, and technological changes.

12-4 Administrative Considerations Steps in the decision-making process: –Search for and discovery for investment opportunities. –Collection of data-Accctg./Fin./Engineering –Evaluation and decision making. –Reevaluation and adjustment.

12-5 Capital Budgeting Procedures

12-6 Accounting Flows vs Cash Flows Capital budgeting decisions - emphasis remains on cash flow. –Depreciation (non cash expenditure) is added back to profit to determine the amount of cash flow generated. An example shown in the next slide. The emphasis is on the use of proper evaluation techniques for to make best economic choices and assure long term wealth.

12-7 Cash Flow for Alston Corporation

12-8 Revised Cash Flow for Alston Corporation

12-9 Methods of Ranking Investment Proposals 3 methods used: –Payback method – although not sound conceptually, is often used. –Internal rate of return - more acceptable and commonly used. –Net present value - more acceptable and commonly used.

12-10 Payback Method Time required to recoup the initial investment. –Table 12-3, using Investment A: There is no consideration of inflows after the cutoff period. The method fails to consider the concept of the time value of money. Year Early Returns Late Returns 1……….. $9,000 $1,000 2……….. $1,000 $9,000 3……….. $1,000 $1,000

12-11 Investment Alternatives

12-12 Payback Method (cont’d) Advantages: –Easy to understand and emphasizes liquidity. –Must recoup the initial investment quickly or it will not qualify. –Rapid payback preferred in industries characterized by dynamic technological environment. Shortcomings: –Fails to discern the optimum or most economic solution to a capital budgeting problem.

12-13 Internal Rate of Return Requires the determination of the yield on an investment with subsequent cash inflows. –Assuming that a $1,000 investment returns an annuity of $244 per annum for five years, provides an internal rate of return of 7%: Dividing the investment (present value) by the annuity: (Investment) = $1,000 = 4.1 (PV IFA ) (Annuity) $244 The present value of an annuity (given in Appendix D) shows that the factor of 4.1 for five years indicates a yield of 7%.

12-14 Determining Internal Rate of Return Cash Inflows (of $10,000 investment) Year Investment A Investment B 1……………… $5,000 $1,500 2……………… $5,000 $2,000 3……………… $2,000 $2,500 4……………… $5,000 5……………… $5,000 To find a beginning value to start the first trial, the inflows are averaged out as though annuity was really being received. $5,000 $2,000 $12,000 ÷ 3 = $4,000

12-15 Determining Internal Rate of Return (cont’d) Dividing the investment by the ‘assumed’ annuity value in the previous step, we have; (Investment) = $10,000 = 2.5 (PV IFA ) (Annuity) $4,000 The first approximation (derived from Appendix D) of the internal rate of return using; the factor falls between 9 and 10 percent; PV IFA factor = 2.5 n (period) = 3 Averaging understates the actual IRR and the same method would overstate the IRR for Investment B. Cash flows in the early years are worth more and increase the return, it is possible to gauge whether the first approximation is over- or under- stated.

12-16 Determining Internal Rate of Return (cont’d) Using the trial and error approach, we use both 10% and 12% to arrive at the answer: Year 10% 1…….$5,000 X = $4,545 2…….$5,000 X = $4,130 3…….$2,000 X = $1,502 $10,177 (At 10%, the present value of the inflows exceeds $10,000 – we therefore use a higher discount rate). Year 12% 1…….$5,000 X = $4,465 2…….$5,000 X = $3,985 3…….$2,000 X = $1,424 $9,874 (At 12%, the present value of the inflows is less than $10,000 – thus the discount rate is too high).

12-17 Interpolation of the Results The internal rate of return is determined when the present value of the inflows (PV I ) equals the present value of the outflows (PV O ). The total difference in present values between 10% and 12% is $303. $10,177…… PV 10% $10,177…….PV 10% - $9,874…....PV 12% - $10,000……(cost) $303 $177 The solution is ($177/$303) percent of the way between 10 and 12 percent. Due to a 2% difference, the fraction is multiplied by 2% and the answer is added to 10% of the final answer of: 10% + ($177/$303) (2%) = 11.17% IRR. The exact opposite of this conclusion is yielded for Investment B (14.33%).

12-18 Interpolation of the Results (cont’d) The use of the internal rate of return requires the calculated selection of Investment B in preference to Investment A, the conclusion being exactly the opposite under the payback method. The final selection of any project will also depend on the yield exceeding some minimum cost standard, such as the cost of capital to the firm. Investment A Investment B Selection Payback method……..2 years 3.8 years Quicker payback: Investment A Internal Rate of Return………11.17% 14.33% Higher yield: Investment B

12-19 Net Present Value Discounting back the inflows over the life of the investment to determine whether they equal or exceed the required investment. –Basic discount rate is usually the cost of the capital to the firm. –Inflows must provide a return that at least equals the cost of financing those returns.

12-20 Net Present Value (cont’d) $10,000 Investment, 10% Discount Rate Year Investment A Year Investment B 1……… $5,000 X = $4,545 1………. $1,500 X = $1,364 2……… $5,000 X = $4,130 2………. $2,000 X = $1,652 3……… $2,000 X = $1,502 3………. $2,500 X = $1,878 $10,177 4………. $5,000 X 0,683 = $3,415 5………. $5,000 X = $3,105 $11,414 Present value of inflows…..$10,177 Present value of inflows…..$11,414 Present value of outflows -$10,000 Net present value……………..$177 Net present value…………...$1,414

12-21 Capital Budgeting Results

Capital Budgeting End of the Lecture 12-22

Sample Project Investment & Salvage Value Purchase Price $ 60,000 Shipping & Installation $ 6,000 Total Investment Salvage Value $ 5,000 Units Shipped 500 Annual Growth Rate 10% Unit Selling Price $ 100 Sales Revenue Cost of Goods Sold $ 20 $ 50 Maintenance $ 1,200

12-24 The Rules of Depreciation Assets are classified according to nine categories. –Determine the allowable rate of depreciation write-off. –Modified accelerated cost recovery system ( MACRS ) represent the categories. –Asset depreciation range (ADR) is the expected physical life of the asset or class of assets.

12-25 Categories for Depreciation Write-Off

12-26 Depreciation % (Expressed in Decimals)

12-27 Depreciation Schedule

12-28 The Tax Rate Corporate tax rates are subject to changes. –Maximum quoted federal corporate tax rate is now in the mid 30 percent range. –Smaller corporations and others may pay taxes only between 15 – 20%. –Larger corporations with foreign tax obligations and special state levies may pay effective taxes of 40% or more.

12-29 Example - Investment Decision Assumption: –$50,000 depreciation analysis allows the purchase of a machinery with a 6 year productive life. –Produces an income of $18,500 for the first three years before deductions for depreciation and taxes. –In the last three years, the income before depreciation and taxes will be $12,000. –Corporate tax rate taken at 35% and cost of capital 10%. –For each year: The depreciation is subtracted from earnings before depreciation and taxes to arrive at earnings before taxes. The taxes are then subtracted to determine the earnings after taxes. Depreciation is then added to earnings to arrive at the cash flow.

12-30 Cash Flow Related to the Purchase of Machinery

12-31 Net Present Value Analysis

12-32 The Replacement Decision Investment decision for new technology. Includes several additions to the basic investment situation. –The sale of the old machine. –Tax consequences. Decision can be analyzed by using a total or an incremental analysis.

12-33 Book Value of Old Computer

12-34 Net Cost of New Computer

12-35 Analysis of Incremental Depreciation Benefits

12-36 Analysis of Incremental Cost Savings Benefits

12-37 Present Value of the Total Incremental Benefits

12-38 Elective Expensing Businesses can write off tangible property, in the purchased year for up to $100,000. –Includes: equipment, furniture, tools, and computers etc. Beneficial to small businesses: –Allowance is phased out dollar for dollar when total property purchased exceed $200,000 in a year.