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Capital Budgeting
Objectives 1. Explain the nature and importance of capital investment analysis. 2. Evaluate capital investment proposals, using the following methods: a. net present value, and internal rate of return, profitability index b. average rate of return, payback period
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Background
One that raises the current market value of the firms equity, thereby creating value for the firms owners Comparing the amount of cash spent on an investment today with the cash inflows expected from it in the future
Discounting is the mechanism used to account for the time value of money
Converts future cash flows into todays equivalent value called present value or discounted value
Apart the timing issue, there is also the issue of the risk associated with future cash flows
Since there is always some probability that the cash flows realized in the future may not be the expected ones
Capital Budgeting
Capital budgeting is the making of long-run planning decisions for investments in projects and programs.
It is a decision-making and control tool that focuses primarily on projects or programs that span multiple years.
It seeks to identify investments that will enhance a firms competitive advantage and increase shareholder wealth. Poor capital budgeting decisions can ultimately result in company bankruptcy
Examples
Replacing worn out or obsolete assets improving business efficiency acquiring assets for expansion into new products or markets acquiring another business complying with legal requirements
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Payback period Accounting Rate of Return Discounted payback Net present value Profitability index Internal rate of return
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Does it adjust for the timing of the cash flows? Does it take risk into consideration? Does it maximize the firms equity value?
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Considers cash flows and the time value of money Cash flows assumed to be reinvested at the hurdle rate Considers all cash flows
Disadvantages/Weaknesses
Assumes that cash received can be reinvested at the rate of return May not include managerial options embedded in the project
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So, we have to use the present value of P1 for each of the five years.
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<200,000>
70,000
60,000
50,000
40,000
40,000
70,000 x 0.90909 (n = 1; i = 10%) 60,000 x 0.82645 (n = 2; i = 10%) 50,000 x 0.75131 (n = 3; i = 10%) 40,000 x 0.68301 (n = 4; i = 10%) 40,000 x 0.620921(n = 5; i = 10%)
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<200,000>
70,000
60,000
50,000
40,000
40,000
The equipment should be purchased because the net present value is positive.
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NPV Solution
Basket Wonders has determined that the appropriate discount rate (k) for this project is 14%. NPV = 10,000 + 12,000 15,000 + (1.14)1 (1.14)2 (1.14)3 10,000 7,000 4 + (1.14)5 - 40,000 (1.14)
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NPV Solution
NPV = 10,000(PVIF14%,1) + 12,000(PVIF14%,2) + 15,000(PVIF14%,3) + 10,000(PVIF14%,4) + 7,000(PVIF14%,5) - 40,000 NPV = 10,000(.877) + 12,000(.769) + 15,000(.675) + 10,000(.592) + 7,000(.519) - 40,000 NPV = 8,770 + 9,228 + 10,125 + 5,920 + 3,633 = 37,676 - 40,000 = - 2,324
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Should this project be accepted? NPV = - 2,324 No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject as NPV < 0 ]
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97,360 20,000
= 4.868
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10%
4
5 6
3.465
4.212 4.917
3.170
3.791 4.355 4.868 4.868
3.037
3.605 4.111
2.855
3.353 3.785
5.582
4.564
4.160
Move vertically to the top of the table to determine the interest47 rate
Determine the table value using the present value for an annuity of P1 table. Amount to be invested Equal annual cash flow 97,360 20,000 = 4.868
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2. An accounting-period dimension
The accounting system that corresponds to the project dimension is termed life-cycle costing.
Learning Objective 2 Understand the six stages of capital budgeting for a project.
The search stage yields several alternative models, but management focuses on one particular machine.
Net cash savings is $125,000, $130,000, and $110,000 over its life.
Operating cash flows are assumed to occur at the end of the year.
In the selection stage, management must decide whether to purchase the new machine.
Learning Objective 3
Use and evaluate the two main discounted cash-flow (DCF) methods: the net present value (NPV) method and the internal rate-of-return (IRR) method.
5 periods at 6%
Only projects with a zero or positive net present value are acceptable.
1 $125,000 $130,000
$(250,000)
$115,000
What is the IRR of this project? $303,280 $80,000 = 3.791 (PV annuity factor)
It can be used in situations where the required rate of return varies over the life of the project.
Payback Method
Payback measures the time it will take to recoup, in the form of expected future cash flows, the initial investment in a project.
What is the payback period? $210,000 $42,000 = 5 years Which piece of equipment is preferable?
+ = =
$ 90,000 needed to complete recovery 180,000 net cash inflow in Year 2 1 year + 0.5 year 1.5 years or 1 year and 6 months
Learning Objective 5 Use and evaluate the accrual accounting rate-of-return (AARR) method.
AARR
Learning Objective 6
Identify and reduce conflicts from using DCF for capital budgeting decisions and accrual accounting for performance evaluation.
Performance Evaluation
A manager who uses DCF methods to make capital budgeting decisions can face goal congruence problems if AARR is used for performance evaluation.
Suppose top management uses the AARR to judge performance if the minimum desired rate of return is 10%.
Performance Evaluation
The conflict between using AARR and DCF methods to evaluate performance can be reduced by evaluating managers on a project-by-project basis.
Learning Objective 7 Identify relevant cash inflows and outflows for capital budgeting decisions.
Current cost Add increase in working capital 10,000 Deduct after-tax cash flow from current disposal of old equipment 21,800 Net investment
$225,000
$213,200
What is the after-tax flow from operations? Cash flow from operations Deduct income tax (40%) Annual after-tax flow from operations $90,000 36,000 $54,000
Increase in depreciation Multiply by tax rate Income tax cash savings from additional depreciation
Annual after-tax flow from operations Income tax cash savings from additional depreciation Cash flow from operations, net of income taxes
What is the net present value of the new equipment incorporating income taxes?
Postinvestment Audit
A postinvestment audit compares the actual results for a project to the costs and benefits expected at the time the project was selected.
Strategic Considerations
Capital investment decisions that are strategic in nature require managers to consider a broad range of factors that may be difficult to estimate.
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Firm cannot simply select the project(s) with the highest NPV
Must first find out the combination of investments with the highest present value of future cash flows per dollar of initial cash outlay Can be done using the projects profitability index
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Firm should first rank the projects in decreasing order of their profitability indexes
Then select projects with the highest profitability index Until it has allocated the total amount of funds at its disposal
choosing among mutually exclusive investments When capital rationing extends beyond the first year of the project
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EXHIBIT 5: Cash Flows, Present Values, and Net Present Values for Three Investments of Unequal Size with k= 0.10.
INVESTMENT E (1) Initial cash outlay (CF0) Year-one cash flow (CF1) Year-two cash flow (CF2) (2) Present value of CF1 and CF2 at 10% Net present value = (2) (1) $1,000,000 800,000 500,000 INVESTMENT F $500,000 200,000 510,000 INVESTMENT G $500,000 100,000 700,000
$1,140,496
$603,306
$669,421
$140,496
$103,306
$169,421
INVESTMENT E
(1) Initial cash outlay (2) Present value of future cash-flow stream
(2) (1)
INVESTMENT F
$500,000
INVESTMENT G
$500,000
$1,000,000
= 1.14
= 1.21
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Comparison should be made between sequences of projects such that all sequences have the same duration
In many instances, the calculations may be tedious Possible to convert each projects stream of cash flows into an equivalent stream of equal annual cash flows with the same present value as the total cash flow stream Called the constant annual-equivalent cash flow or annuity-equivalent cash flow Then, simply compare the size of the annuities
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EXHIBIT 7a: Cash Outflows and Present Values of Cost for Two Investments with Unequal Life Spans.
SEQUENCE OF TWO MACHINE AS END OF YEAR Now 1 2 3 4 CASH OUTFLOWS MACHINE 1 MACHINE 2 $80,000 4,000 4,000 $80,000 4,000 4,000 PRESENT VALUE COST OF CAPITAL = 10% $80,000 3,636 69,422 3,005 2,732 $158,795
TOTAL
$80,000 4,000 $84,000 4,000 4,000
Exhibit 7 illustrates the case of choosing between two machines, one having an economic life half that of the other.
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EXHIBIT 7b: Cash Outflows and Present Values of Cost for Two Investments with Unequal Life Spans.
ONE MACHINE B END OF YEAR Now CASH OUTFLOWS $120,000 PRESENT VALUE COST OF CAPITAL = 10% $120,000
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2 3 4
3,000
3,000 3,000 3,000 Present Value of Costs
2,727
2,479 2,254 2,049 $129,509
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EXHIBIT 8: Original and Annuity-Equivalent Cash Flows for Two Investments with Unequal Life Spans.
Figures from Exhibit 6.14 and Appendix 6.1
Machine A Original Cash Flow -$80,000 -4,000 -4,000 -50,096 -50,096 AnnuityEquivalent Cash Flow
Machine B Original Cash Flow -$120,000 -3,000 -3,000 -3,000 -3,000 -40,855 -40,855 -40,855 -40,855 -$129,509 AnnuityEquivalent Cash Flow
-$86,942
-$86,942
-$129,509
Exhibit 8 shows how to apply the annuityequivalent cash flow approach to the choice between the two machines.
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using the designer desk lamp project of Sunlight Manufacturing Company (SMC) as an illustration
affect its net present value Demonstrated using an extended version of the designer-desk lamp project
Although the project was planned to last for five years, we assume now that SMCs management will always have the option to abandon the project at an earlier date
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Above options are not the only managerial options embedded in investment projects
Thus, NPV of a project will always underestimate the value of an investment project The larger the number of options embedded in a project and the higher the probability that the value of the project is sensitive to changing circumstances
The greater the value of those options and the higher the value of the investment project itself
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should at least conduct a sensitivity analysis to identify the most salient options embedded in a project, try at valuing them and then exercise sound judgment
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Capital Budgeting
ALTERNATIVES TO THE NPV RULE
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A projects payback period is the number of periods required for the sum of the projects cash flows to equal its initial cash outlay
Usually
measured in years
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According to this rule, a project is acceptable if its payback period is shorter than or equal to the cutoff period
For
mutually exclusive projects, the one with the shortest payback period should be accepted
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Does the payback period rule meet the conditions of a good investment decision?
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Often in addition to other approaches Simple and easy to apply for small, repetitive investments Favors projects that pay back quickly
Makes sense to apply the payback period rule to two investments that have the same NPV Because it favors short-term investments, the rule is often employed when future events are difficult to quantify
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of periods required for the sum of the present values of the projects expected cash flows to equal its initial cash outlay
Discounted payback periods are longer May result in a different project ranking
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Among several projects, the one with the shortest period should be accepted
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Does the discounted payback period rule meet the conditions of a good investment decision?
Projects NPV when estimated with cash flows up to the cutoff period is always positive
The rule is biased against long-term projects The discounted payback period rule cannot discriminate between the two investments
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The Discounted Payback Period Rule Vs. The Ordinary Payback Period Rule
The discounted payback period rule is superior to the ordinary payback period rule
Considers the time value of money Considers the risk of the investments expected cash flows
Requires the same inputs as the NPV rule Used less than the ordinary payback period rule
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A project should be accepted if its IRR is higher than its cost of capital and rejected if it is lower
If
a projects IRR is lower than its cost of capital, the project does not earn its cost of capital and should be rejected
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Does the IRR rule meet the conditions of a good investment decision?
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mutually exclusive projects are considered A projects cash flow stream changes sign more than once
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Firm
should ignore the IRR rule and use the NPV rule instead
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Why Do Managers Usually Prefer The IRR Rule To The NPV Rule?
IRR calculation requires only a single input (the cash flow stream)
However, applying the IRR rule still requires a second input the cost of capital
When a projects cost of capital is uncertain, the IRR method may be the answer
Managers usually have a good understanding of what an investment should "return If they agree, use the IRR If they disagree, trust the NPV rule
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ratio equal to the ratio of the present value of a projects expected cash flows to its initial cash outlay
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A project's internal rate of return (IRR) is the discount rate that makes the net present value (NPV) of the project equal to zero An investments IRR summarizes its expected cash flow stream with a single rate of return that is called internal
Because it only considers the expected cash flows related to the investment
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to the PI rule a project should be accepted if its profitability index is greater than one and rejected if it is less than one
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The PI rule considers risk because it uses the cost of capital as the discount rate
Maximization of the firms equity value? When a projects PI > 1 the projects NPV > 0 and viceversa
Thus, it may appear that PI is a substitute for the NPV rule Unfortunately, the PI rule may lead to a faulty decision when applied to mutually exclusive investments with different initial cash outlays
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is an absolute measure
Thus, the PI rule can be a useful substitute for the NPV rule when presenting a projects benefits per dollar of investment
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