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Chapter 20

Chapter 20. Capital Budgeting. Learning Objectives. Identify the major steps in capital budgeting Use appropriate data in analyzing capital investments Apply capital investment evaluation techniques to assess capital investments and identify advantages and limitations of these techniques.

malcolm-holcomb
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Chapter 20

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  1. Chapter 20 Capital Budgeting

  2. Learning Objectives • Identify the major steps in capital budgeting • Use appropriate data in analyzing capital investments • Apply capital investment evaluation techniques to assess capital investments and identify advantages and limitations of these techniques

  3. Learning Objectives • Identify the underlying assumptions of the two discounted cash flow methods • Explain the relationships between strategic cost management and capital budgeting • Identify behavioral factors in capital budgeting decisions

  4. Learning Objective One Identify the major steps in capital budgeting

  5. A capital investment is an investment that requires commitment of a large sum of funds and has expected expenditures and benefits stretch well into the future. Capital Budgeting Process • Project Identification and Definition • Evaluation and Selection • Monitoring and Review

  6. Types of Capital Investment • Assets to meet regulatory, safety, health, and environmental requirements. • Assets to enhance operating efficiency and/or increase revenue. • Assets to enhance competitive effectiveness.

  7. Learning Objective Two Use appropriate data in analyzing capital investments

  8. Characteristics of Capital Budgeting Data

  9. Cash Flows

  10. Cash Flows

  11. Cash Flows

  12. Depreciation Tax Shield Depreciation charges are not cash costs and do not directly affect the net present values of capital investments. Tax regulations permit depreciation write-offs that reduce the required tax payment. This reduction in the tax payment is called the . . . Tax Shield.

  13. Application of Cash Flows Smith Company manufactures high-pressure pipe for deep-sea oil drilling. The firm is considering the purchase of a milling machine.

  14. Effect of Asset Acquisition on Cash Flow

  15. Effect of Asset Acquisition on Cash Flow The milling machine would require $200,000 in additional working capital for operations. This amount would be tied up in inventories and accounts receivable and will not be available for use during operations.

  16. Effects of Disposal of the AssetReplaced on Cash Flow Direct Effect: • Inflow: Proceeds from disposal • Outflow: Expenditures for equipment removal and site restoration Tax Effect: • Inflow: Tax effect on loss on disposal • Outflow: Tax effect of gain on disposal

  17. Cash Flows from Disposal of Equipment

  18. Effects of Periodic Operations TransactionEffect on Cash Flow Cash receipts Amount received × (1 - tax rate) Cash expenditures Amount paid × (1 - tax rate) Depreciated initial cost Tax shield: Depreciation expense × tax rate Allocated cost No effect The company expects its investment to bring in $1,000,000 in cash revenue from increases in production volume in each of the next four years. Cash operating expenses are expected to be $750,000 per year

  19. Effects on Cash Flows Cash from operations increases by $194,000 each year ($150,000 + $44,000).

  20. One time training charges of $50,000, net of tax. Release of working capital. Total Effect of Cash Flows

  21. Effect of Final Disinvestment on Cash Flow The company plans to sell the machine at the end of its useful life for $100,000 and incur removal and cleanup costs of $20,000.

  22. Effect of Final Disinvestmenton Cash Flow At the end of the project, the company will incur $150,000 in relocation costs for displaced workers. This amount is deductible on the company’s tax return. The remaining working capital will be released for use in other projects.

  23. Effect of Investing in the Milling Machine

  24. Learning Objective Three Apply capital investment evaluation techniques to assess capital investments and identify advantages and limitations of these techniques

  25. Capital Budgeting Techniques Payback Period The length of time required for the cumulative total net cash inflows from an investment to equal the total initial cash outlays of the investment.

  26. Capital Budgeting Techniques Project Information A four-year project requires an initial investment of $555,000 in Year 0. The project is expected to produce $900,000 in cash revenues and require $660,000 in cash expenses each year. No additional working capital is required and the investment will have a salvage value of $60,000. At the end of the fourth year management expects to sell the investment for $200,000. Expected relocation costs are $240,000 and the company is subject to a 40% tax rate.

  27. Capital Budgeting Techniques

  28. Total Original Investment Annual Net After-Tax Cash Flow Return Payback Period = The Payback Period $555,000 $193,500 Payback Period = Payback Period =2.87 years

  29. Ignores timing and time value of money Ignores cash flows beyond pack back period The Payback Period DISADVANTAGES ADVANTAGES • Easy to calculate and comprehend • Provides a measure of the risk • Indicates effect on liquidity

  30. Book Rateof Return Average Net IncomeInvestment (Book value) = The Book Rate of Return

  31. Book Rateof Return Average Net IncomeInvestment (Book value) = Book Rateof Return $69,750$307,500 = = 22.68% The Book Rate of Return

  32. No adjustment for time value of money Arbitrary measurements Periodic net income not equal to cash flow Evaluation of the Book Rate of Return ADVANTAGES LIMITATIONS • Readily available data • Consistency between data for capital budgeting and data for performance evaluation • Easily identifiable impact on financial resources

  33. Discounted Cash Flow • Evaluate a capital investment by considering equivalent present values of all future net cash inflows from the initial investment. • Factors to consider: • The total initial investment. • The expected future cash receipts and disbursements. • The investor’s desired rate of return. • Minimum rate of return. • Cost of capital.

  34. Cost of Capital Assume a firm issued a 10%, $5,000 bond and sold the bond for $4,365 (issued at a discount). With a 30% tax rate, the after-tax cost of the bond is 8% as show below:

  35. Cost ofPreferred Stock Dividend Per ShareMarket Price Per Share = $2.40$25.00 = 9.6% Cost of Capital Assume a firm issues 100 shares of preferred stock that pays and annual dividend of $2.40. The shares for sold of $25 each. The income tax rate is 30%, but is not relevant because dividends are not deductible for tax purposes.

  36. $25$200 = 12.5% Cost of Capital Assume a firm issues 100 shares of its $10 par value common stock. Each share is selling in the market for $200, and the stockholders demand a return of $25 return. The cost of common stock is 12.5% as shown below: Cost ofCommon Stock Return Demanded by InvestorsMarket Price Per Share =

  37. Cost of Capital A firm has a $100,000 bank loan with 12% interest; $500,000, 10%, 20-year mortgage bonds selling at 90% of face’ $200,000, 15%, $20 noncumulative, noncallable preferred stock with a total market value of $300,000; and 10,000 shares of $1 par common stock that the firm sold for $5 per share. The common stock is currently selling in the market for $75 per share. Common stock investors demand a $15 per share return. The firm is subject to a 40% tax rate. Let’s calculate the weighted cost of capital.

  38. $100,000 ÷ $1,600,000 = 6.250% 7.20% × 6.250% = 0.4500% Cost of Capital

  39. Determine net cash flow return in each year Select the desire rate of return Find the discount factor for each of the years based on the desired rate of return selected in 2 Multiply Steps 1 and 3 to determine the present values of the cash flow returns Sum the amount in Step 4 for all the years Subtract the initial investment from the amount obtained in Step 5 Determining the NPV of anInvestment Opportunity

  40. (1 + 10%)-1 NPV with Uneven Cash Inflows Net present value of cash inflows discounted at 10%. **Excel and Lotus use continuous discounting and yield a slightly different net present value [NPV(Rate, Range of inflows and outflows)].

  41. NPV with Uneven Cash Inflows Net present value of cash inflows discounted at 10%. Because this project has a positive net present value, the actual rate of return is greater than 10%. If the net present value was zero, the return would be exactly 10%.

  42. NPV Payback Period An investment opportunity has an initial cost of $550,000, and will product after-tax cash inflows of $193,500 for the next four years. Present Value Payback Period = 3 years + ($73,794 ÷ $132,163) = 3.56 years

  43. $25,255$29,439 14% + 2% × = 15.72% Internal rate of return $650,255 - $625,000 $650,255 - $620,816 16% - 14% Present Values withInterest Rates of 14% and 16% An investment opportunity has an initial cost of $625,000 and provides the cash inflows shown below:

  44. Results from net present value and internal rate of return may differ if projects differ in . . . Required initial investment Cash flow pattern Length of useful life Varying cost of capital Multiple investments Comparison of NPV and IRR Methods

  45. Pattern of Cash Flows

  46. Investment with Multiple Rates of Return PV PV Discount with 10% Discount with 16% Cash Factor Discount Factor Discount PeriodFlowat 10% Rateat 16%Rate 0 -$1,323 1.000 -$1,323 1.000 -$1,323 1 3,000 .909 2.727 .862 2,586 2 -1,700 .826 -1,424 .743 -1,263 NPV 0 0

  47. Effect of Length of Useful Life

  48. NPV of Project with DifferentDesired Rates of Return (1 + 15%)-4

  49. Learning Objective Four Identify the underlying assumptions of the two discounted cash flow methods

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