CAPITAL BUDGETING ANDLEASING Chapter 4
Investment • The addition of durable assets to a business • Disinvestment is the withdrawal of durable assets from the business
Investment Opportunities • Maintenance and replacement of depreciable capital items • Adoption of cost-reducing investments • Adoption of income-increasing investments • A combination of the above
Investment Analysis • STEPS IN INVESTMENT ANALYSIS: • 1. IDENTIFY POTENTIALLY PROFITABLE INVESTMENT ALTERNATIVES • 2. COLLECT RELEVANT DATA ON: • CAPITAL OUTLAYS • COSTS • RETURNS • 3. USE AN APPROPRIATE METHOD TO ANALYZE THE DATA. • 4. DECIDE WHETHER TO ACCEPT OR REJECT THE INVESTMENT OR SELECT THE TOP RANKING AMONG MUTUALLY EXCLUSIVE PROJECTS.
Capital Budgeting • The process of planning expenditures on assets whose returns will extend beyond one year.
Weighted Average Cost of Capital There are two types of capital invested in a business: • Debt Capital • Equity Capital • What is the cost of debt? • What is the cost of equity?
Weighted Average Cost of Capital • Kc = wd Kd + we Ke • Where: • Kc is the weighted average cost of capital • wd is the proportion of assets financed with debt • Kd is the cost of debt capital • we is the proportion of assets financed with equity • Ke is the cost of equity capital
Payback Method • The payback method gives the number of years necessary to recover the initial investment. • Does not account for the timing of cash flows.
Payback Method P = I / E WHERE: P = PAYBACK PERIOD IN YEARS I= INITIAL INVESTMENT OUTLAY E = ANNUAL NET CASH RETURN
Simple Rate of Return • Expresses the average annual net income as a percentage of the amount invested. • This may be in terms of the initial capital outlay or the average amount invested over the useful life of the investment.
Simple Rate of Return SRR= Y/I Where: SRR = SIMPLE RATE OF RETURN Y = AVERAGE ANNUAL NET CASH RECEIPTS (DEPRECIATION TAKEN INTO ACCOUNT) I = INITIAL INVESTMENT OUTLAY
Calculation of Annual Cash Receipts Y=(E – D) WHERE: Y = AVERAGE ANNUAL NET INCOME E = TOTAL EXPECTED ANNUAL CASH RECEIPTS D= TOTAL ANNUAL DEPRECIATION
Net Present Value (NPV) • With the NPV, the cash flows of the investment are discounted by a minimum acceptable compound annual rate of return. • The investment is judged to be acceptable if the present value of the cash inflows exceeds the investment’s present value of the cash outflows.
Net Present Value (NPV) NPV = ΣPVCashInflows– ΣPVCash Outflows
Benefit Cost Ratio • A ratio that utilizes the same two elements of the Net Present Value. B/C = ΣPV cash inflows / ΣPV cash outflows
Internal Rate of Return (IRR) • The IRR is the compound interest rate that equates the present value of the future net cash inflows with the cash outflows. • Or in other words the discount rate that gives a NPV = Zero. • Both the NPV and IRR take into account the time value of money. • The purpose of these investment analysis techniques is to evaluate the acceptability of investments relative to an acceptable rate of return.
What goes into the Discount Rate? • The discount rate should reflect the cost of capital or the cost of funds used to finance the business. • An investment is not acceptable unless it generates a return sufficient to cover the cost of funds.
What goes into the Discount Rate? The discount rate contains three components: • Real Risk-Free Rate • Risk Premium • Inflation Expectations
Other Considerations Regarding Capital Budgeting • Profitability Index • Used to allocate limited capital among several independent projects. • Present value of the cash inflows divided by the cash outflows.
Other Considerations Regarding Capital Budgeting • Annuity Equivalent • Used to compare NPVs with unequal lives.
Other Considerations Regarding Capital Budgeting • Financial Feasibility • Once you have evaluated an investment, the financing of the project should be determined. • After-tax cash flows may not be sufficient to meet debt repayment requirements.
Payback Method • A 20000/6000 = 3.33 YEARS • B 20000/5800 = 3.45 YEARS • C 20000/5600 = 3.57 YEARS
Simple Rate of Return • A (30000-20000)/5 = 2000 • 2000/20000 = 0.10 10% • B (29000-20000)/5 = 1800 • 1800/20000 = 0.09 9% • C (28000-20000)/5 = 1600 • 1600/20000 = 0.08 8%
Net Present Value • A NPV = -20000 + 2000/(1.08) + 4000/(1.08)2 + 6000/(1.08)3 + 8000/(1.08)4 + 10000/(1.08)5 + 0/(1.08)5 • NPV = -20000 + 1852 + 3429 + 4763 + 5880 + 6806 + 0 • NPV = 2730
Net Present Value and Internal Rate of Return • A NPV = 2730 IRR = 12.01 • B NPV = 3158 IRR = 13.82 • C NPV = 3766 IRR = 17.57
Leasing Versus Owning • A lease represents an agreement that gives control over an asset owned by the lessor to the lessee for a specific period of time upon the payment of an agreed upon amount, known as rent.
Types of Leases • IN NON-REAL ESTATE LEASING THERE ARE SEVERAL TYPES OF LEASES: • OPERATING LEASE • CAPITAL (OR FINANCIAL) LEASE • CUSTOM HIRE
Operating Lease • USUALLY A SHORT-TERM RENTAL ARRANGEMENT IN WHICH THE RENTALCHARGE IS CALCULATED ON A TIME BASIS. • SUCH AS THE HOUR OR THE DAY, ETC. • THE LESSEE PAYS THE DIRECT COST SUCH AS FUEL AND LABOR.
Capital or Financial Lease • A LONG - TERM CONTRACTUAL ARRANGEMENT IN WHICH THE LESSEE ACQUIRES CONTROL OF AN ASSET IN RETURN FOR RENTAL PAYMENTS. • USUALLY RUNS FOR SEVEAL YEARS AND CANNOT BE CANCELLED WITHOUT PENALTY. • IS FULLY AMORTIZED, MEANING THAT THE PRESENT VALUE OF THE LEASE PAYMENTS EQUALS THE FULL PRICE OF THE LEASED EQUIPMENT. • MAY HAVE A PRUCHASE OPTION AT THE END OF THE LEASE.
Capital Vs. Operating Lease • Capital lease transfers some of the risks of ownership to the lessee.
Issues in Capital Leasing • Advantages: • CONSERVATION OF WORKING CAPITAL • NEARLY 100% FINANCING • THE USE OF MODERN EQUIPMENT • POSSIBLE TAX BENEFITS
Evaluation of a lease vs. Purchase • May be evaluated by looking at the present value of cash flows for each option.
Sample Problem • $ 30,000 TRUCK • 35% TAX BRACKET • 12% COST OF CAPITAL • PURCHASE • 30% DOWN PAYMENT • LEVEL PAYMENTS • 10% INTEREST • 5 YEARS • LEASE • 5 YEAR LEASE • ANNUAL PAYMENTS OF $7,000