1. Capital Budgeting and Cost Analysis
Chapter 21
Capital Budgeting and Cost Analysis

2. Project and Time Dimensions of Capital Budgeting

3. 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.

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

5. 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

6. 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.

7. 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

8. 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.

9. 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

10. 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.

11. 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.

12. 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.

13. 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

14. Effect on Year One Cash Flow from Operations – Net of Income Taxes

15. 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

16. 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

17. 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)

18. 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

19. Relevant Cash Inflows and Outflows for X-Ray Machine

20. NPV Method – X-Ray Machine

21. 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.

22. IRR Method – X-Ray Machine

23. 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

24. 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

25. 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 Year Year Year Year Net cash inflows $1, $2, $4, $6, $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

26. 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

27. AARR Method Formula