1. Capital Budgeting 2 2

2. Capital Budgeting Process
A capital investment is an investment that requires commitment of a large sum of funds and has expected expenditures and benefits stretch well into the future.
Project Identification and Definition
Evaluation and Selection
Monitoring and Review

3. Types of Capital Investment
Assets to meet regulatory, safety, health, and environmental requirements.
Assets to enhance operating efficiency and/or increase revenue.
Assets to enhance competitive effectiveness.

4. Characteristics of Capital Budgeting Data

5. Cash Flows

6. Depreciation Tax Shield
Depreciation charges are not cash costs and do not directly affect the net present values of capital investments.
Tax regulations permit depreciation write-offs that reduce the required tax payment. This reduction in the tax payment is called the . . .
Tax
Shield. 18 26

7. Application of Cash Flows
Smith Company manufactures high-pressure pipe for deep-sea oil drilling. The firm is considering the purchase of a milling machine.

8. Effect of Asset Acquisition on Cash Flow

9. Effect of Asset Acquisition on Cash Flow
The milling machine would require $200,000 in additional working capital for operations. This amount would be tied up in inventories and accounts receivable and will not be available for use during operations.

10. Effects of Disposal of the Asset Replaced on Cash Flow
Direct Effect:
Inflow: Proceeds from disposal
Outflow: Expenditures for equipment removal and site restoration
Tax Effect:
Inflow: Tax effect on loss on disposal
Outflow: Tax effect of gain on disposal

11. Cash Flows from Disposal of Equipment

12. Effects of Periodic Operations
Transaction Effect on Cash Flow
Cash receipts Amount received × (1 - tax rate)
Cash expenditures Amount paid × (1 - tax rate)
Depreciated initial cost Tax shield: Depreciation expense × tax rate
Allocated cost No effect
The company expects its investment to bring in $1,000,000 in cash revenue from increases in production volume in each of the next four years. Cash operating expenses are expected to be $750,000 per year

13. Effects on Cash Flows
Cash from operations increases by $194,000 each year ($150,000 + $44,000).

14. Total Effect of Cash Flows
Release of working capital.
One time training charges of $50,000, net of tax.

15. Effect of Final Disinvestment on Cash Flow
The company plans to sell the machine at the end of its useful life for $100,000 and incur removal and cleanup costs of $20,000.

16. Effect of Final Disinvestment on Cash Flow
At the end of the project, the company will incur $150,000 in relocation costs for displaced workers. This amount is deductible on the company’s tax return. The remaining working capital will be released for use in other projects.

17. Effect of Investing in the Milling Machine

18. Capital Budgeting Techniques
Payback Period
The length of time required for the cumulative total net cash inflows from an investment to equal the total initial cash outlays of the investment.

19. Capital Budgeting Techniques
Project Information
A four-year project requires an initial investment of $555,000 in Year 0. The project is expected to produce $900,000 in cash revenues and require $660,000 in cash expenses each year. No additional working capital is required and the investment will have a salvage value of $60,000. At the end of the fourth year management expects to sell the investment for $200,000. Expected relocation costs are $240,000 and the company is subject to a 40% tax rate.

20. Capital Budgeting Techniques

21. The Payback Period Payback Period = Payback Period =
Total Original Investment
Annual Net After-Tax Cash Flow Return
$555,000
$193,500
Payback Period =
Payback Period = years

22. The Payback Period Easy to calculate and comprehend
ADVANTAGES
DISADVANTAGES
Easy to calculate and comprehend
Provides a measure of the risk
Indicates effect on liquidity
Ignores timing and time value of money
Ignores cash flows beyond pack back period

23. Average Net Income Investment (Book value)
The Book Rate of Return
Book Rate of Return =
Average Net Income Investment (Book value)

24. Average Net Income Investment (Book value)
The Book Rate of Return
Book Rate of Return =
Average Net Income Investment (Book value)
Book Rate of Return =
$69,750 $307,500
= 22.68%

25. Evaluation of the Book Rate of Return
ADVANTAGES
LIMITATIONS
Readily available data
Consistency between data for capital budgeting and data for performance evaluation
Easily identifiable impact on financial resources
No adjustment for time value of money
Arbitrary measurements
Periodic net income not equal to cash flow

26. Discounted Cash Flow
Evaluate a capital investment by considering equivalent present values of all future net cash inflows from the initial investment.
Factors to consider:
The total initial investment.
The expected future cash receipts and disbursements.
The investor’s desired rate of return.
Minimum rate of return.
Cost of capital.

27. Cost of Capital
Assume a firm issued a 10%, $5,000 bond and sold the bond for $4,365 (issued at a discount). With a 30% tax rate, the after-tax cost of the bond is 8% as show below:

28. Dividend Per Share Market Price Per Share
Cost of Capital
Assume a firm issues 100 shares of preferred stock that pays and annual dividend of $2.40. The shares for sold of $25 each. The income tax rate is 30%, but is not relevant because dividends are not deductible for tax purposes.
Cost of Preferred Stock =
Dividend Per Share Market Price Per Share
$2.40 $25.00
= 9.6%

29. Return Demanded by Investors Market Price Per Share
Cost of Capital
Assume a firm issues 100 shares of its $10 par value common stock. Each share is selling in the market for $200, and the stockholders demand a return of $25 return. The cost of common stock is 12.5% as shown below:
Cost of Common Stock
Return Demanded by Investors Market Price Per Share =
$25 $200
= 12.5%

30. Let’s calculate the weighted cost of capital.
A firm has a $100,000 bank loan with 12% interest; $500,000, 10%, 20-year mortgage bonds selling at 90% of face’ $200,000, 15%, $20 noncumulative, noncallable preferred stock with a total market value of $300,000; and 10,000 shares of $1 par common stock that the firm sold for $5 per share. The common stock is currently selling in the market for $75 per share. Common stock investors demand a $15 per share return. The firm is subject to a 40% tax rate.
Let’s calculate the weighted cost of capital.

31. Cost of Capital
$100,000 ÷ $1,600,000 = 6.250%
7.20% × 6.250% = %

32. Determining the NPV of an Investment Opportunity
Determine net cash flow return in each year
Select the desire rate of return
Find the discount factor for each of the years based on the desired rate of return selected in 2
Multiply Steps 1 and 3 to determine the present values of the cash flow returns
Sum the amount in Step 4 for all the years
Subtract the initial investment from the amount obtained in Step 5

33. NPV with Uneven Cash Inflows
Net present value of cash inflows discounted at 10%.
(1 + 10%)-1
**Excel and Lotus use continuous discounting and yield a slightly different net present value [NPV(Rate, Range of inflows and outflows)].

34. NPV with Uneven Cash Inflows
Net present value of cash inflows discounted at 10%.
Because this project has a positive net present value, the actual rate of return is greater than 10%. If the net present value was zero, the return would be exactly 10%.

35. NPV Payback Period
An investment opportunity has an initial cost of $550,000, and will product after-tax cash inflows of $193,500 for the next four years.
Present Value Payback Period = 3 years + ($73,794 ÷ $132,163)
= 3.56 years

36. Present Values with Interest Rates of 14% and 16%
An investment opportunity has an initial cost of $625,000 and provides the cash inflows shown below:
14% + 2% ×
$25,255 $29,439
= 15.72% Internal rate of return
$650, $625,000
16% - 14%
$650, $620,816

37. Comparison of NPV and IRR Methods
Results from net present value and internal rate of return may differ if projects differ in . . .
Required initial investment
Cash flow pattern
Length of useful life
Varying cost of capital
Multiple investments

38. Pattern of Cash Flows

39. Investment with Multiple Rates of Return
PV PV
Discount with 10% Discount with 16%
Cash Factor Discount Factor Discount
Period Flow at 10% Rate at 16% Rate
0 -$1, $1, $1,323
1 3, ,586
2 -1, , ,263
NPV

40. Effect of Length of Useful Life

41. NPV of Project with Different Desired Rates of Return
(1 + 15%)-4

42. Comparison of NPV and IRR Methods

43. Factors Affecting Results

44. Strategic Missions and Capital Budgeting

45. Cost Driver Analysis Workforce involvement (participation management)
Workforce commitment to continuous improvement
Adherence to total quality management concepts
Utilization of effective capacity
Efficiency of production flow layout
Effectiveness of product design or formulation
Exploiting linkages with suppliers and customers all along the value chain

46. End of Chapter 11 78