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Capital Budgeting

Capital Budgeting. Chapter 8. Introduction. In early August of 1999, Dow Chemical Company announced that it was acquiring Union Carbide Corporation for $9.3 billion. Their merger reflected a global trend among companies that made primary or intermediate chemical products. Introduction.

cameron-mckay
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Capital Budgeting

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  1. Capital Budgeting Chapter 8

  2. Introduction • In early August of 1999, Dow Chemical Company announced that it was acquiring Union Carbide Corporation for $9.3 billion. • Their merger reflected a global trend among companies that made primary or intermediate chemical products.

  3. Introduction • Dow Chemical believed that the acquisition would increase its earnings and that rationalization and reengineering would create, within two years, at least $500 million of annual cost savings relative to the existing cost structures of the two organizations. • After reading this chapter you should be able to...

  4. Learning Objectives • Describe the nature and importance of long-term assets. • Use the basic tools and concepts of financial analysis: investment, return, future value, present value, annuities, and required rate of return.

  5. Learning Objectives • Demonstrate how capital budgeting is used to evaluate investment proposals and how the concepts of payback, accounting rate of return, net present value, internal rate of return, and economic value added relate to capital budgeting.

  6. Learning Objectives • Evaluate the effect of income taxes on investment decisions and show how to incorporate tax considerations in capital budgeting. • Define and use what-if and sensitivity analysis in capital budgeting including strategic considerations in capital budgeting. • Use postimplementation audits in capital budgeting.

  7. Learning Objective 1 Describe the nature and importance of long-term assets.

  8. Long-Term (Capital) Assets • What are long-term capital assets? • Long-term capital assets are equipment or facilities that provide productive services to the organization for more than one accounting period.

  9. Long-Term (Capital) Assets • Organizations have developed specific tools to control the acquisition and use of long-term assets for three reasons: • Organizations commit to long-term assets for extended periods of time. • The amount of capital committed is usually very large. • The long-term nature of capital assets creates technological risk for organizations.

  10. Long-Term (Capital) Assets • What is capital budgeting? • It is a systematic approach to evaluating an investment in long-term assets.

  11. Learning Objective 2 Use the basic tools and concepts of financial analysis: investment, return, future value, present value, annuities, and required rate of return.

  12. Investment and Return • Investment is the monetary value of the assets that the organization gives up to acquire a long-term asset. • Return is the increased cash inflows in the future that are attributable to the long-term asset. • Investment andreturn are the foundations of capital budgeting analysis.

  13. Time Value of Money • A central concept in capital budgeting is the time value of money. • Because money can earn a return, its value depends on the time period in which it is received. • Amounts of money received at different periods of time must be converted to their value on a common date to be compared.

  14. Time Value of Money • The future value of money is the value that an amount invested today will be after a stated number of periods at a given rate of return. • How much would an initial amount of $100 accumulate over five years when the rate of return is 5% per year?

  15. Time Value of Money Today Year 5 5% 5% 5% 5% 5% $100.00 $127.63 FV = PV × (1 + r)n

  16. Time Value of Money Compound Growth of Investment, 5 periods at 5% Year 5: $1.2763 Year 4: $1.2155 Year 3: $1.1576 Year 2: $1.1025 Year 1: $1.05 Year 0: $1.00

  17. Present Value • What is the present value of money? • It is the current monetary worth of an amount to be paid in the future under stated conditions of interest and compounding. • Analysts call a future cash flow’s value at time zero its present value. • The process of computing present value is called discounting.

  18. Present Value • What is the present value of $127.63 to be received 5 years from now when the rate of return is 5% per year? • $100.00 PV = FV ÷ (1 + r)n

  19. Time Value of Money Today Year 5 5% 5% 5% 5% 5% $100.00 $127.63 Present value of $127.63 in 5 years at a 5% annual rate of return

  20. Present Value and Future Value of Annuities • What is an annuity? • It is a contract involving a series of constant payments or receipts to be paid or received for a stated number of periods at a specified rate.

  21. Present Value and Future Value of Annuities • What is the future value of an annuity? • It is the sum of payments plus accumulated interest. • What is the present value of an annuity? • It is the value today of a series of future payments or receipts.

  22. Present Value and Future Value of Annuities Future value of an annuity of $1, 5 periods at 5% PeriodsFuture Value 1 $1.000 2 $2.050 3 $3.153 4 $4.310 5 $5.526

  23. Present Value and Future Value of Annuities Present value of an annuity of $1, 5 periods at 5% PeriodsPresent Value 1 $0.952 2 $1.859 3 $2.723 4 $3.546 5 $4.329

  24. Cost of Capital • What is the cost of capital? • It is the interest rate organizations use in computing the time value of money. • It equals the return that the organization must earn on its investments to meet its investor’s return requirements. • The cost of capital is the benchmark the organization uses to evaluate investment proposals.

  25. Learning Objective 3 Demonstrate how capital budgeting is used to evaluate investment proposals and how the concepts of payback, accounting rate of return, net present value, internal rate of return, and economic value added relate to capital budgeting.

  26. Approaches to Capital Budgeting • Payback • Accounting rate of return • Net present value • Internal rate of return • Profitability index • Economic value added

  27. Approaches to Capital Budgeting • Shirley’s Doughnut Hole is considering the purchase of a new machine that will cost $70,000 and last five years. • Its salvage value is $10,000. • The machine will increase profits by $20,000 per year. • The cost of capital is 10%. • Is this investment worthwhile?

  28. Payback Criterion • The payback period, or payback criterion, computes the number of periods needed to recover a project’s initial investment. Payback time = 70,000 ÷ 20,000 = 3.5 years

  29. Accounting Rate of Return Criterion • The accounting rate of return approximates the return of investment. Accounting Rate of Return = Average Income ÷ Average Investment

  30. Accounting Rate of Return Criterion • What is the straight-line method annual depreciation? • ($70,000 – $10,000) ÷ 5 = $12,000 • What is the increased annual income? • $20,000 – $12,000 = $8,000 • What is the average investment? • ($70,000 + $10,000) ÷ 2 = $40,000

  31. Accounting Rate of Return Criterion • What is the accounting rate of return? • ARR = $8,000 ÷ $40,000 = 20% • If the accounting rate of return exceeds the criterion, or target rate of return, the project is acceptable. • The accounting rate of return does not consider the explicit timing of cash flows.

  32. Net Present Value Criterion • The net present value is the sum of the present values of all cash inflows and outflows associated with a project. • This model is the most widely recommended approach to capital budgeting. • It specifically considers the time value of money.

  33. Net Present Value Criterion • What are the steps in computing NPV? • Choose the period length. • Identify the firm’s cost of capital. • Identify the incremental cash flows. • Compute the PV of the cash flows. • Sum the project’s cash flows and determine the NPV. • Accept or reject the project.

  34. Net Present Value Criterion PeriodsAmountPV FactorPresent Value 0 ($70,000) 1.0000 ($70,000.00) 1 20,000 0.9091 18,181.82 2 20,000 0.8264 16,528.93 3 20,000 0.7513 15,026.30 4 20,000 0.6830 13,660.27 5 30,000 0.6209 18,627.64 Total $12,024.96

  35. Internal Rate of Return Criterion • The internal rate of return (IRR) is the actual rate of return expected from an investment. • The IRR is the discount rate that makes the investment’s net present value equal zero.

  36. Internal Rate of Return Criterion Internal Rate of Return: 16.14% PeriodsAmountPV FactorPresent Value 0 ($70,000) 1.0000 ($70,000.00) 1 20,000 0.8610 17,220.60 2 20,000 0.7414 14,827.45 3 20,000 0.6383 12,766.87 4 20,000 0.5496 10,992.66 5 30,000 0.4733 14,197.51 Total $ 5.09

  37. Profitability Index • The profitability index is a variation on the net present value method. • It is computed by dividing the present value of the cash inflows by the present value of the cash outflows. • A profitability index of 1 or greater is required for the project to be acceptable.

  38. Profitability Index • What is Shirley’s profitability index? • $82,025 ÷ $70,000 = 1.17

  39. Economic Value Added Criterion • Economic value added is used as a tool to evaluate organizational performance. Economic Value Added = Adjusted Accounting Income – (Cost of Capital × Investment)

  40. Learning Objective 4 Evaluate the effect of income taxes on investment decisions and show how to incorporate tax considerations in capital budgeting.

  41. Effect of Taxes • Organizations must pay taxes on net benefits (taxable income). • The allocation of the cost of a capital investment through depreciation can offset some taxes. • Taxable income, the tax rate, and tax depreciation methods are determined by legislation.

  42. Effect of Taxes Net Present Value Calculations with Taxes Tax @ 40% $3,200 3,200 3,200 3,200 3,200 0 Net Cash Flow ($70,000) 16,800 16,800 16,800 16,800 16,800 10,000 Tax Income $8,000 8,000 8,000 8,000 8,000 0 PV Factor 1.0000 0.9346 0.8734 0.8163 0.7629 0.7130 0.7130 Time 0 1 2 3 4 5 5 Total Cash Flow ($70,000) 20,000 20,000 20,000 20,000 20,000 10,000 Depreciation $12,000 12,000 12,000 12,000 12,000 0 PV ($70,000) 15,701 14,674 13,714 12,817 11,978 7,130 $6,013

  43. Learning Objective 5 Define and use what-if and sensitivity analysis in capital budgeting including strategic considerations in capital budgeting.

  44. What-if and Sensitivity Analysis • What-if analysis is the process of varying the assumptions underlying a forecasting model to determine the effects of those assumptions on the forecasted amounts. • Sensitivity analysis is the process of varying the assumptions underlying a decision to determine the decision’s sensitivity to those assumptions.

  45. What-if and Sensitivity Analysis • Why are what-if and sensitivity analyses important tools? • They allow decision makers to estimate the opportunity cost of the imperfect information upon which decisions are based.

  46. Strategic Considerations • Strategic benefits reflect the enhanced revenue and profit potential that derive from some attribute or long-term asset. • What are some strategic benefits provided by long-term assets?

  47. Strategic Considerations • They allow an organization to make goods or deliver a service that competitors cannot. • They support improving product quality by reducing the potential to make mistakes. • They help shorten the cycle time needed to make the product.

  48. Learning Objective 6 Use postimplementation audits in capital budgeting.

  49. Postimplementation Audits and Capital Budgeting • A postimplementation audit of the capital budgeting decision is revisiting the decision to purchase a long-lived asset. • It is an opportunity to re-evaluate a past decision by comparing expected and actual inflows and outflows.

  50. Postimplementation Audits and Capital Budgeting • What are some benefits of postimplementation audits? • Planners can avoid future mistakes. • By comparing estimates with results, planners can determine why their estimates were incorrect.

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