1. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 Chapter Three Opportunity Cost of Capital and of Capital and Capital Budgeting

2. 3-2 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 Outline of Chapter 3 Opportunity Cost of Capital and Capital Budgeting Opportunity Cost of Capital (pp. 93-95) Interest Rate Fundamentals (pp. 95-102) Capital Budgeting: The Basics (pp. 102-106) Capital Budgeting: Some Complexities (pp. 106-111) Alternative Investment Criteria (pp. 111-118)

3. 3-3 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 Opportunity Cost of Capital (pp. 92-93) Opportunity cost of capital: benefits of investing capital in a bank account that is foregone when that capital is invested in some other alternative. Importance for decision making: when expected cash flows occur in different time periods. Capital budgeting: analysis of investment alternatives involving cash flows received or paid over time. Capital budgeting is used for decisions about replacing equipment, lease or buy, and plant acquisitions.

4. 3-4 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 Time Value of Money (pp. 92-93) A dollar today is worth more than a dollar tomorrow, because you could invest the dollar today and have your dollar plus interest tomorrow. Value at end Alternativeof one year A. Invest $1,000 in bank account earning 5 percent per year$1,050 B. Invest $1,000 in project returning $1,000 in one year$1,000 Alternative B foregoes the $50 of interest that could have been earned from the bank account. The opportunity cost of selecting alternative B is $1,050.

5. 3-5 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 Present Value Concept (p. 94) Since investment decisions are being made now at beginning of the investment period, all future cash flows must be converted to their equivalent dollars now. Beginning-of-year dollars  (1  Interest rate) = End-of-year dollars Beginning-of-year dollars = End-of-year dollars  (1  Interest rate)

6. 3-6 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 Interest Rate Fundamentals (pp. 95-98) FV = Future Value PV = Present Value r= Interest rate per period (usually per year) n= Periods from now (usually years) Future Value of a single flow: FV = PV (1 + r) n Present Value of a single flow: PV = FV  (1 + r) n Discount factor = 1  (1 + r) n

7. 3-7 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 Interest Rate Fundamentals (pp. 99-100) Present value of a perpetuity (a stream of equal periodic payments for infinite periods) PV = FV  r Present value of an annuity (a stream of equal periodic payments for a fixed number of years) PV = {FV  r }  { 1 - (1  (1 + r) n )} Multiple cash flows per year - see pp. 100-102.

8. 3-8 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 NPV Basics (pp. 102-106) 1.Identify after-tax cash flows for each period 2.Determine discount rate 3.Multiply by appropriate present-value factor (single or annuity) for each cash flow. PV factor is 1.0 for cash invested now 4.Sum of the present values of all cash flows = net present value (NPV) 5. If NPV  0, then accept project 6. If NPV < 0, then reject project NPV is also known as discounted cash flow (DCF). See examples at pp. 103, 105, 109, 120-124.

9. 3-9 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 Capital Budgeting - Warnings (pp. 105-106) 1.Discount after-tax cash flows, not accounting earnings Cash can be invested and earn interest. Accounting earnings include accruals that estimate future cash flows. 2.Include working capital requirements Consider cash needed for additional inventory and accounts receivable. 3.Include opportunity costs but not sunk costs Sunk costs are not relevant to decisions about future alternatives. 4.Exclude financing costs The firm’s opportunity cost of capital is included in the discount rate.

10. 3-10 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 Adjustment for Risk (pp. 106-107) Discount risky projects at a higher discount rate than safe projects =Risk-free rate of interest on government bonds +Risk premium associated with project i = Risk-adjusted discount rate for project i (Determining the appropriate discount rate is covered in a corporate finance course. In most problems in the managerial accounting course, the discount rate is given.) Use expected cash flows rather than highest or lowest cash flow that could occur Example: If cash flow could be $100 or $200 with equal probability, then expected cash flow is $150.

11. 3-11 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 Adjustment for Inflation (pp. 107-109) If inflation exists in the economy, then the discount rate should be adjusted for inflation. r nominal = nominal interest rate with inflation i= inflation rate r real = real interest rate if no inflation = riskless rate + risk premium (1 + r nominal ) = (1 + r real ) (1 + i) Solving: r nominal = r real + i + (r real  i ) 1.Restate future cash flows into nominal dollars (after inflation) 2.Discount cash flows with nominal interest rate

12. 3-12 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 After-Tax Cash Flow(ATCF) - Concept (pp. 109-110) Determine cash flows after taxes On the firm’s income tax return, they cannot fully deduct the cost of a capital investment in the year purchased. Instead firms depreciate the investment over several years at the rate allowed by the tax law. TimeCash flow Beginning of projectCash to acquire assets Future yearsDepreciation deduction on tax return reduces future tax payments (depreciation tax shield)

13. 3-13 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 ATCF - Definitions (p. 110) t= Tax rate (tax refund rate if negative income) R= Revenue in one year (assume all cash) E= All cash expenses in one year (excludes depreciation) D= Depreciation allowed in one year on income tax return Tax expense for one year TAX= (R - E - D)  t After-tax cash flow for year ATCF = R - E - Tax = R - E - (R - E - D)  t = (R - E)(1 - t) + Dt

14. 3-14 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 ATCF - Equivalent Methods (adapted from p. 110) 1. Separate tax computation ATCF = (Cash flow before tax) - TAX = ( R - E ) - (R - E - D)  t 2. Depreciation tax shield ATCF = (After-tax cash flow without depreciation) + Depreciation tax shield = ( R - E ) (1 - t) + D  t 3. Financial accounting income after tax and add back non-cash expenses ATCF= (Accounting income after tax) + (Non-cash expenses) = (R - E - D) (1 - t) + D

15. 3-15 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 Alternative Capital Budgeting Methods Methods that consider time value of money: 1. Discounted cash flow (DCF), also known as net present value (NPV) method {pp. 93-111} 2. Internal rate of return (IRR) {pp. 114-117} Methods that do not consider time value of money: 3.Payback method {p. 112} 4.Accounting rate of return on investment (ROI) {pp. 112-114}

16. 3-16 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 Alternative: Payback Method (p. 112) Payback = the time required until cash inflows from a project equal the initial cash investment. Rank projects by payback and accept those with shortest payback period Advantages of payback method: Simple to explain and compute Disadvantages of payback method: Ignores time value of money (when is cash received within payback period) Ignores cash flows beyond end of payback period

17. 3-17 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 Alternative: Accounting Return (ROI) (pp. 112-114) Average annual accounting income from project  Average annual investment in the project =Return on investment (ROI) Average annual investment =(Initial investment + Salvage value at end)  2 Advantages of ROI method: Simple to explain and compute using financial statements Disadvantages of payback method: Ignores time value of money (when is cash received within payback period) Accounting income is often not equal to cash flow

18. 3-18 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 Alternative: Internal Return (IRR) (pp. 114-117) Internal rate of return (IRR) is the interest rate that equates the present value of future cash flows to the cash outflows. By definition: PV = FV  (1 + irr) Solution for a single cash flow: irr = (FV  PV) - 1 Comparison of IRR and DCF/NPV methods Both consider time value of cash flows IRR indicates relative return on investment DCF/NPV indicates magnitude of investment’s return IRR can yield multiple rates of return IRR assumes all cash flows reinvested at project’s constant IRR DCF/NPV discounts all cash flows with specified discount rate

19. 3-19 Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 Capital Budgeting in Practice (pp. 117-118) See Table 3-11 at page 118. DCF/NPV has become the most commonly used capital budgeting method for evaluating new and replacement projects in large US corporations. “Urgency,” such as governmental mandates, is still a significant cause for approving replacement projects.