Capital Budgeting and Cost Analysis Chapter 21

Introduction Capital budgeting methods deal with how to select projects (or programs) that increase rather than decrease the “capital” (value) of a business. These methods assist managers in analyzing projects that span multiple years.

Learning Objectives Adopt the project-by-project orientation of capital budgeting when evaluating projects spanning multiple years Follow the six stages of capital budgeting for a project Use and evaluate the two main discounted cash-flow (DCF) methods – the net present value (NPV) method and the internal rate-of-return (IRR) method

Learning Objectives Identify relevant cash inflows and outflows for capital-budgeting decisions that use DCF methods Use and evaluate the payback method Use and evaluate the accrual accounting rate-of-return (AARR) method

Learning Objectives Identify and reduce conflicts from using DCF for capital budgeting and accrual accounting for performance evaluation Incorporate depreciation deductions into the computation of after-tax cash flows in capital budgeting

Learning Objective 1 Adopt the project-by-project orientation of capital budgeting when evaluating projects spanning multiple years

Cost Analysis There are two different dimensions of cost analysis: A project dimension An accounting period dimension The accounting system that corresponds to the project dimension is termed life-cycle costing.

Cost Analysis Life-cycle costing accumulates revenues and costs on a project-by-project basis. This accumulation extends the accrual accounting system that measures income on a period-by-period basis to a system that computes cash flow or income over the entire project covering many accounting periods.

Cost Analysis Project D Project C Project B Project A 2000 2001 2002 2003 2004

Cost Analysis The life of the project is usually longer than one year, so capital budgeting decisions consider revenues and costs over relatively long periods.

Capital Budgeting Capital budgeting is the making of long-run planning decisions for investments in projects and programs. It is a decision-making and control tool that focuses primarily on projects or programs that span multiple years.

Capital Budgeting Capital budgeting is a six-stage process: Identification stage. To distinguish which types of capital expenditure projects are necessary to accomplish organization objectives. Search stage. To explore alternative capital investments that will achieve organization objectives.

Capital Budgeting Information-acquisition stage. To consider the expected costs and the expected benefits of alternative capital investments. Selection stage. To choose projects for implementation. Financing stage. To obtain project funding. Implementation and control stage. To get projects underway and monitor their performance.

Capital Budgeting Healthy Living is a non-profit organization. One of its goals is to improve the diagnostic capabilities of its Miami facility. Management identifies a need to consider the purchase of new, state-of-the-art equipment. The search stage yields several alternative models, but management focuses on one machine as being particularly suitable.

Capital Budgeting The administration next begins to acquire information to do more detailed evaluation. The required net initial investment consists of the cost of the new machine ($245,000) plus an additional cash investment in working capital (supplies and spare parts) of $5,000. Management expects the new machine to have a three-year useful life and a $0 terminal disposal price at the end of the three years.

Capital Budgeting This proposed investment will yield net cash savings of $125,000, $130,000, and $110,000 over its life. The working capital investment of $5,000 is expected to be recovered at the end of year 3. Operating cash flows are assumed to occur at the end of the year.

Capital Budgeting Management also identifies the following nonfinancial quantitative and qualitative benefits of investing in the new diagnostic machine. Improved diagnoses and patient care Reduced inconvenience of transporting patients to other facilities for diagnoses

Capital Budgeting Nonfinancial benefits are not incorporated into the analysis. In the selection stage, management must decide whether Healthy Living should purchase the new machine. Assume that the required rate of return for Healthy Living is 10%.

Learning Objective 3 Use and evaluate the two main discounted cash-flow (DCF) methods – the net present value (NPV) method and the internal rate-of-return (IRR) method

Discounted Cash Flow 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 discounted cash-flow methods incorporate the time value of money.

Discounted Cash Flow The time value of money means that a dollar received today is worth more than a dollar received at any future time. Why? Because it can earn income and become greater in the future.

Discounted Cash Flow There are two main DCF methods: Net present value (NPV) method Internal rate-of-return (IRR) method

Net Present Value The NPV method computes the expected net monetary gain or loss from a project by discounting all expected cash flows to the present point in time, using the required rate of return. Management’s minimum desired rate of return is also called the discount rate, hurdle rate, required rate of return, or cost of capital.

Net Present Value Only projects with a zero or positive net present value are acceptable. What is the the net present value of the diagnostic machine?

Net Present Value Sketch of Relevant Cash Flows 1 2 3 1 2 3 Net initial investment ($250,000) Annual cash inflow $125,000 $130,000 $115,000

Net Present Value Net Cash NPV of Net Year 10% Col. Inflows Cash Inflows 1 0.909 $125,000 $113,625 2 0.826 130,000 107,380 3 0.751 115,000 86,365 Total PV of net cash inflows $307,370 Investment 250,000 Net present value of project $ 57,370

Net Present Value This project is acceptable because its net present value is $57,370. Assume that Healthy Living is considering another investment that will generate $80,000 per year for three years, and have a residual value of $4,000 at the end of the third year.

Net Present Value The cost of this investment is $250,000 including working capital. The working capital investment of $5,000 is expected to be recovered at the end of year 3. Healthy Living expects a return of 10%. Should the investment be made?

Net Present Value No, the net present value is negative. Net Cash NPV of Net Years 10% Col. Inflows Cash Inflows 1-3 2.487 $80,000 $198,960 3 0.751 9,000 6,759 Total PV of net cash inflows $205,719 Investment 250,000 Net present value of project ($44,281)

Internal Rate of Return... is another model using discounted cash flows. The internal rate-of-return (IRR) method calculates the discount rate at which the present value of expected cash inflows from a project equals the present value of expected cash outflows.

Internal Rate of Return Investment = Expected annual net cash inflow × PV annuity factor Investment ÷ Expected annual net cash inflow = PV annuity factor

Internal Rate of Return Assume that Healthy Living is considering investing $303,280 in a scanning machine that will yield net cash savings of $80,000 per year over its five-year life. What is the IRR of this project? $303,280 ÷ $80,000 = 3.791 (PV annuity factor)

Internal Rate of Return The annuity table shows that 3.791 is in the 10% column for a 5 period row in this example. Therefore, 10% is the internal rate of return of this project. If the minimum desired rate of return is 10% or less, Healthy Living should undertake this project.

Comparison of NPV and IRR The NPV method has the important advantage that the end result of the computations is expressed in dollars and not in a percentage. Individual projects can be added to see the effect of accepting a combination of projects. It can be used in situations where the required rate of return varies over the life of the project.

Comparison of NPV and IRR The IRR of individual projects cannot be added or averaged to derive the IRR of a combination of projects.

Learning Objective 4 Identify relevant cash inflows and outflows for capital-budgeting decisions that use DCF methods

Relevant Cash Flows Relevant cash flows are expected future cash flows that differ among the alternatives. Capital investment projects typically have three major categories of cash flows: Net initial investment Cash flow from operations Cash flow from terminal disposal of assets and recovery of working capital

Relevant Cash Flows Typically, net initial investment components are: Initial asset investment Initial working capital investment Current disposal value of old asset

Net Initial Investment The original Healthy Living example included the following: Initial machine investment $245,000 Initial working capital investment $ 5,000 Current disposal value of old machine 0

Cash Flow From Operations Cash inflows may result from producing and selling additional goods or services, or, as in the Healthy Living example, from savings in cash operating costs. Depreciation is irrelevant in DCF analysis because it is a noncash allocation of costs. DCF is based on inflows and outflows of cash.

Terminal Disposal Price At the end of the machine’s useful life the terminal disposal price may be zero or an amount considerably less than the initial machine investment. The original Healthy Living example assumed zero disposal value of the new diagnostic machine.

Working Capital Recovery The initial investment in working capital is usually fully recouped when the project is terminated. The relevant working capital cash inflow is the $5,000 that Healthy Living will recover in year 3.

Use and evaluate the payback method Learning Objective 5 Use and evaluate the payback method

Payback Method Payback measures the time it will take to recoup, in the form of expected future cash flows, the initial investment in a project.

Payback Method Assume that Healthy Living is considering buying some equipment (Machine 1) for $210,000, with an estimated useful life of 11 years, and zero predicted residual value. Managers expect use of the equipment to generate $35,000 of net cash inflows from operations per year.

Payback Method How long would it take to recover the investment? $210,000 ÷ $35,000 = 7 years 7 years is the payback period.

Payback Method Suppose that an alternative to the $210,000 piece of equipment, there is another one (Machine 2) that also costs $210,000 but will save $42,000 per year during its five-year life. What is the payback period? $210,000 ÷ $42,000 = 5 years Which piece of equipment is preferable?

Payback Method Machine 1 is preferable because it will continue to generate net cash inflows for four years after its payback period. This will give the company an additional net cash inflow of $140,000.

Payback Method When cash flows are uneven, calculations must take a cumulative form. Assume that Healthy Living’s diagnostic machine investment is going to yield net cash savings of $160,000, $180,000, and $110,000 over its life. The initial investment is $250,000. What is the payback period?

Payback Method Year 1 brings in $160,000. Recovery of the amount invested occurs in Year 2.

Payback Method Payback 1 year $90,000 needed to complete recovery $180,000 net cash inflow in Year 2 1 year + 0.5 year = 1.5 years or, 1 year and 6 months

Use and evaluate the accrual accounting rate-of-return (AARR) method Learning Objective 6 Use and evaluate the accrual accounting rate-of-return (AARR) method

Accrual Accounting Rate-of-Return Method The accrual accounting rate-of-return (AARR) method divides an accounting measure of income by an accounting measure of investment. This method is also called the accounting rate of return.

Accrual Accounting Rate-of-Return Method Recall the scanning machine with a cost $303,280, no residual value, expected annual net cash savings of $80,000, and a useful life of 5 years. The IRR of this machine is 10%. What is the average operating income?

Accrual Accounting Rate-of-Return Method Straight-line depreciation is $60,656 per year. Average operating income is $19,344. $80,000 – $60,656 = $19,344 What is the AARR? AARR = $80,000 – $60,656 = 6.38% $303,280

Accrual Accounting Rate-of-Return Method An AARR of 6.38% indicates the rate at which a dollar of investment generates operating income. Projects whose AARR exceeds an accrual accounting required rate of return for the project are considered desirable.

Accrual Accounting Rate-of-Return Method The AARR method is similar to the IRR method in that both methods calculate a rate-of-return percentage. While the AARR calculates return using operating income numbers after considering accruals, the IRR method calculates return on the basis of cash flows and the time value of money.

Learning Objective 7 Identify and reduce conflicts from using DCF for capital budgeting and accrual accounting for performance evaluation

Performance Evaluation A manager who uses DCF methods to make capital budgeting decisions can face goal congruence problems if AARR is used for performance evaluation. Suppose top management uses the AARR to judge performance if the minimum desired rate of return is 10%. A machine with an AARR of 6.38% will be rejected.

Performance Evaluation The AARR is low because the investment increases the denominator and, as a result of depreciation, also reduces the numerator (operating income) in the AARR computation. Frequently, the optimal decision made using a DCF method will not report good “operating income” results in the project’s early years on the basis of the AARR.

Performance Evaluation The conflict between using AARR and DCF methods to evaluate performance can be reduced by evaluating managers on a project-by-project basis.

Income-Tax Considerations Although depreciation is a noncash expense, it is a deductible cost for calculating tax outflow. Taxes saved as a result of depreciation deductions increase cash flows in discounted cash-flow (DCF) computations.

Income-Tax Considerations Assume Miami Transit is considering the replacement of an old piece of equipment with new, more modern equipment. The income tax rate is 40%. The company uses straight-line depreciation. The tax effects of cash inflows and outflows occur at the same time that the inflows and outflows occur.

Income-Tax Considerations Old equipment: Current book value $50,000 Current disposal price $ 3,000 Terminal disposal price (5 years) 0 Annual depreciation $10,000 Working capital $ 5,000

Income-Tax Considerations Current disposal price of old equipment $ 3,000 Deduct current book value of old equipment 50,000 Loss on disposal of equipment $47,000 How much is the tax savings? $47,000 × 0.40 = $18,800

Income-Tax Considerations What is the after-tax cash flow from current disposal of old equipment? Current disposal price $ 3,000 Tax savings on loss 18,800 Total $21,800

Income-Tax Considerations New equipment Current book value $225,000 Current disposal price is irrelevant Terminal disposal price (5 years) 0 Annual depreciation $ 45,000 Working capital $ 15,000

Income-Tax Considerations How much is the net investment for the new equipment? Current cost $225,000 Add increase in working capital 10,000 Deduct after-tax cash flow from current disposal of old equipment – 21,800 Net investment $213,200

Income-Tax Considerations Assume $90,000 pretax annual cash flow from operations (excluding depreciation effect). What is the after-tax flow from operations? Cash flow from operations $90,000 Deduct income tax (40%) 36,000 Annual after-tax flow from operations $54,000

Income-Tax Considerations What is the difference in depreciation deduction? Annual depreciation of new equipment $45,000 Deduct annual depreciation of old equipment 10,000 Difference $35,000

Income-Tax Considerations What is the annual increase in income tax savings from depreciation? Increase in depreciation $35,000 Multiply by tax rate × .40 Income tax cash savings from additional depreciation $14,000

Income-Tax Considerations What is the cash flow from operations, net of income taxes? Annual after-tax flow from operations $54,000 Income tax cash savings from additional depreciation 14,000 Cash flow from operations, net of income taxes $68,000

Income-Tax Considerations Miami Transit requires 14% rate of return on its investments. What is the net present value of the new equipment incorporating income taxes?

Income-Tax Considerations Net Cash NPV of Net Years 14% Col. Inflows Cash Inflows 1-5 3.433 $68,000 $233,444 5 0.519 10,000 5,190 Total PV of net cash inflows $238,636 Investment 213,200 Net present value of new equipment $ 25,436

Intangible Assets Intangible assets are critical to most organizations. These assets have the potential to yield net cash inflows many years into the future. Top management can use a capital budgeting tool, such as NPV, to summarize the difference in the future net cash inflows from an intangible asset at two different points in time.