Capital Budgeting Decisions

1. CapitalBudgeting Decisions 10

2. Capital Budgeting • Long-term planning for making and financing acquisitions • Three phases 1. identify potential investments 2. select investments to undertake 3. follow-up monitoring (post-audit) Discounted-Cash-Flow Model • Evaluate long-term investments using the time value of money • Focuses on cash inflows and outflows rather than net income Two Approaches • Net present value (NPV) • Discount all expected future • cash flows to the present using a minimum desired rate of return • Accept project if NPV > 0 • Internal rate of return (IRR) • Determine the rate of return which will result in a NPV of zero • Accept project if IRR > minimum desired rate of return

3. Net Present Value Present Total End of Year Cash Flows Value of $1 Present @ 10% Value 0 1 2 3 4 Cash flows: annual savings .9091 $1,818 $2,000 .8264 1,653 $2,000 .7513 1,503 $2,000 .6830 1,366 $2,000 Present value of future inflows $6,340 Initial outlay 1.000 (6,075) (6,075) Net present value $ 265 Using Annuity Table Annual savings 3.1699 $6,340 $2,000 $2,000 $2,000 $2,000 Initial outlay 1.0000 (6,075) (6,075) Net present value $ 265

4. Internal Rate of Return Present Total End of Year Cash Flows Value of $1 Present @ 12% Value 0 1 2 3 4 Cash flows: annual savings .8929 $1,786 $2,000 .7972 1,594 $2,000 .7118 1,424 $2,000 .6355 1,271 $2,000 Present value of future inflows $6,075 Initial outlay 1.000 (6,075) (6,075) Net present value $ 0 Using Annuity Table Annual savings 3.0373 $6,075 $2,000 $2,000 $2,000 $2,000 Initial outlay 1.0000 (6,075) (6,075) Net present value $ 0

5. Using DCF Models • Limitations of using the discounted cash flow model • Certainty of predicted cash flows • Perfect capital markets • Never include depreciation or amortization (a non-cash expense) when determining NPV or IRR. • Cash flow related to the acquisition of equipment occurs as a lump-sum outflow at the time of purchase

6. Choosing the Minimum Desired Rate of Return • Always keep the investment and financing decisions separate investment decision - focus on whether to acquire an asset • Financing decision - focus on whether to acquire cash by issuing debt or equity or some combination of the two • Do not include financing (interest) costs in NPV or IRR model as interest costs are already included in the discount rate • Most non-profit organizations employ a minimum desired rate of return which approximates long-term debt rates

7. Other Capital Budgeting Models I Payback • Length of time required to recoup, in the form of cash flows from operations, the initial outlay Payback = initial incremental investment time equal annual incremental cash flow = $10,000 / $4,000 per year = 2.5 years • Fails to consider the "profitability" of the project

8. Other Capital Budgeting Models II Accounting Rate-of-Return • Annual rate of return including depreciation or amortization expenses • Also known as accrual accounting rate-of-return model or the unadjusted rate-of-return model Increase in expected Accounting = expected average annual operating income rate of return initial increase in required investment • Can also use average book value of fixed assets as the denominator • Major drawback is that it ignores the time value of money

9. Income Taxes and Capital Budgeting • Depreciation (or amortization) does not require an outlay of cash as cash was given up when the asset was purchased • Depreciation (or amortization) is the systematic allocation of the cost of the asset over its estimated (useful) life • Depreciation (or amortization) is a deductible expense in computing income; it reduces taxable income and the cash flow required to cover taxes payable • When performing capital budgeting analysis, always consider after-tax flows

10. After-Tax Cash Flow Formulas After-tax cash outflow from a cash outlay = cash outlay x (1 - tax rate) After-tax cash inflow from a cash receipt = cash receipt x (1 - tax rate) After-tax cash inflow from a non-cash expense = non-cash expense x tax rate After-tax cash outflow from a non-cash revenue = non-cash revenue x tax rate

11. Capital Cost Allowance • Federal Income Tax Act (ITA) does not allow a company to deduct depreciation (or amortization) in determining taxable income • It does however allow for Capital Cost Allowance (CCA) which is the income tax counterpart to depreciation • ITA assigns all assets to specific CCA classes

12. Capital Cost Allowance and The Half-Year Rule • Calculate CCA following declining-balance method • ”Half-year rule" - rate of CCA is reduced by one-half in the year of acquisition Beginning Additions Net CCA CCA Ending Year Balance Deletion Balance Rate Amount Balance 1 $0 $10,000 $10,000 10% $1,000 $9,000 2 $9,000 $0 $9,000 20% $1,800 $7,200 3 $7,200 $0 $7,200 20% $1,440 $5,760 4 $5,760 $0 $5,760 20% $1,152 $4,608 5 $4,608 $0 $4,608 20% $922 $3,686 6 $3,686 $0 $3,686 20% $737 $2,949

13. Tax Shield From Capital Cost Allowance • Tax shield is the amount of cash saved on income taxes due to the deductibility of capital cost allowance • Total savings can be discounted to the present time using the following tax shield formula Present value of tax savings where k = required rate of return Example: $10,000 desk, Class 8 (20%), 40% tax rate, 10% required rate of return Present value of tax savings = { $10,000 x .40 } x { .20 / ( .20 + .10 )} x { 2.10 / 2.20 } = $4,000 x .667 x .955 = $2,668 x .955 = $2,548

14. Trade-Ins and Disposalsof Capital Assets • Undepreciated capital cost (UCC) • Net tax book value of an asset • Capital cost allowance calculations ignore the net UCC of the asset when a capital asset is traded-in on another asset or is sold • CCA works on a pool basis so that we do not have to be concerned with the UCC of the specific asset being disposed of • Note that the half-year rule does not apply to CCA calculations when assets are sold

15. Trade-Ins and Disposals of Capital Assets (con’d) Example: Trade-in old desk with a remaining UCC of $5,760 at the end of year 3 for a new desk costing $12,000 with a trade-in allowance of $4,000 New shield on new desk = { $8,000 x .40 } x { .20 / ( .20 + .10)} x {2.10 / 2.20} = $2,038 Tax shield lost on disposal of old desk = { $4,000 x .40 } x { .20 / ( .20 + .10)} = $1,067

16. Capital Budgeting and Inflation • Inflation is the decline in the general purchasing power of the monetary unit • Include in capital budgeting model if significant over the life of the project under consideration Example An investment is expected to save $50,000 after taxes per year [$83,333 x (1 - 40%)] for 5 years; 3% inflation; 15% discount rate After-tax Inflation Adjusted PV factor Present Year Saving Adjustment Dollars @ 15% Value 1 $50,000 1.03 $51,500 .8696 $44,784 2 50,000 1.032 53,045 .7561 40,107 3 50,000 1.033 54,636 .6575 35,923 4 50,000 1.034 56,275 .5718 32,178 5 50,000 1.035 57,964 .4972 28,820 $181,812

17. Capital Investment and Risk • Risk occurs because the actual cash flows may differ from what is expected • With capital budgeting, need to first determine the riskiness of the investment • Next, the inputs t o the capital budgeting model should be adjusted to reflect the risk

18. Recognizing Risk • Three common ways: 1. Reduce individual expected cash inflows or increase or increase expected cash outflows by an amount that depends on their riskiness 2. Reduce the expected life of riskier projects 3. Increase the minimum desired rate of return for riskier projects

19. Capital Investments and Sensitivity Analysis • Shows the financial consequences that would occur if actual cash inflows and outflows differed from those expected • Two types: 1. comparing the optimistic, pessimistic, and most likely predictions 2. determining the amount of deviation from expected values before a decision is changed