CAPITAL INVESTMENT Capital Investment (Capital Budgeting) involves the allocation of large amounts of resources in long-term investments

. Examples: => Replacement of Equipment => Expansion of Existing Product Lines => Development of New Product Lines => Intangibles: => Research & Development => Patents => Advertising campaigns Success: Texas Instruments - semiconductor in 1950s and 1960s; microchip in 1970s Microsoft - Bought Quick and Dirty Operating System for $20,000 Failure: Ford Edsel (Loss of $250 million in 1957-59, or approximately $1.6 billion today) Once the Investment is made, it is almost impossible to back out. Unlike a surplus of inventory which can be quickly corrected, an unutilized refinery just sits vacant. The firm's existence is a series of capital investment decisions that are necessary for the company to grow, remain competitive, etc. Basic Concept: Accept all projects that yield a return that exceeds the cost of financing the project. Thus, if we are maximizing stockholder wealth, we would accept Projects A – D and reject the remainder:

% A B C D E F G Cost of Capital

$

PV of Cash Outflows .000 Proj. but not the second.. B --------(3. The primary concern in the investment decision regards cash flows: => => => => => => Incremental Revenues Incremental Costs Taxes Depreciation considerations Investment in Working Capital Cost Savings Any cash inflow or outflow.000) 2.Numerous investment alternatives exist.000 3. Problems: 1) 2) Ignores the Time Value of Money Ignores cash flows beyond the payback period Project B returns $1. overcomes the first problem.000 1.000 a year earlier than Project A and also returns an additional $1.000 in the last year. a means of evaluating and ranking proposals.000 4. B) Net Present Value (NPV) We need a methodology that takes into account all of the cash flows as well as the time value of money.000) 1. Present Value Payback. Net Present Value is one such technique: NPV = PV of Cash Inflows .e. A --------(3. i.000 2. Payback Period Proj. EVALUATION TECHNIQUES A.000 Payback = 2 years Year 0 Year 1 Year 2 Year 3 Payback = 2 years Both projects have a payback of two years. which utilizes the present value of each year's cash flow. We need a means of ranking the projects from best to worst in order to select those that are most valuable to the firm. so the payback method indicates that the two projects are equally desirable.

000 2 2.Year 1 Less: Interest Return of Investment Cash Flow .740 (2.000 (400) (10%*$4. Proof: Year 0 Investment Return of Investment Year 1 Investment Return of Investment Year 2 Investment Return of Investment Surplus Return PVIF10%.9091 909 0. Proj.000) -------600 2.7513 --------816 Cash Flow .086) 0.254 NPV @ 10% = 816 1 1.000) 0. or what is referred to as size disparity.826) -------(1.740) -------2. choose one or the other.8264 1.000 (174) (10%*$1.660 3. the NPV criterion says to choose Project A.. A Proj.Year 2 Less: Interest Return of Investment Cash Flow .3 Present Value 4.050 125 Cost (1.7513 2.000 (600) -------3.826 The problem with NPV is that there is no consideration of cost. While Project A increases the value of the firm by twice the .e. it represents the amount by which the value of the project exceeds its cost.Year 3 Less: Interest Return of Investment 1.653 0.000 (340) (10%*$3.000 3 3. In other words.400) -------1.400 (1.Required Rate of Return = 10% 0 (4.000) (100) -------------Net Present Value 50 25 If these are mutually exclusive projects (i. but not both).000 NPV represents the increase in the value of the firm that occurs by accepting the project.660) -------1. B -------------Present Value of Inflows 1.

5787) .6944) + 3.000*(. C) Profitability Index (PI) (or Benefit-Cost Ratio) . it costs ten times as much.000 = (42) Interpolating provides an estimate: 10% Z 10% IRR 20% 816 0 (42) 858 816 Z 816 = 10% 858 . in this case money.a measure of efficiency of investment Profitabil ity Index = PV of Inflows PV of Outflows PIB = 1. From the previous example. The NPV does not indicate how efficiently money has been invested. When someone asks what rate of return an investment is earning. Try 20% NPV @ 20% = 1.8333) + 2.amount of Project B. since the NPV is $816. the more general situation of uneven cash flows requires that the IRR be found by trial and error.4. Capital Rationing .4.958 .000*(. The IRR can be defined as PV of Inflows @ IRR = PV of Outflows @ IRR or NPV @ IRR = 0 This is the actual rate of interest that is being earned on the investment. D) Internal Rate of Return (IRR) Another measure of the efficiency of investment is the Internal Rate of Return. they mean the Internal Rate of Return.25 PIA = 1. it is clear that more than 10% is being earned. While the present value and annuity tables can be used in certain cases. This indicates how efficiently you have invested money.05 The interpretation of PI is that of the amount of money in today's dollar terms that you get per dollar of investment.000 = 3.000*(.the allocation of a scarce resource.

000) 220 2. The conflict is in the ranking of the investment proposals. Note also that the Profitability Index. III) THE REINVESTMENT ASSUMPTION Consider the following two projects.000 NPV @ 10% 1.518) 2. a measure of efficiency of investment.262 3.3 Present Value 4.000 30.Year 3 Less: Interest Return of Investment 1.355 4.19 1. their NPVs.000 0 Year 2 5. and IRRs.600 0 Year 3 0 17. Note that the "true" IRR is 19. does not always agree with IRR in terms of which is the most efficient use of funds.000 (780) (19.000 Year 2 10. PIs.000 (220) 3.780 (1.000) (48.Year 2 Less: Interest Return of Investment Cash Flow -.Z= IRR = 9.51% +10.262) 2.9% 19.000 (738) (19.000 30.5% * $3.000) Year 1 10.780) 1.901 2.08 IRR 21. Year 0 Project A Project B (15.509 Hence.518 2.00 19.509 9 0. Note that all three measures agree as to whether a project is acceptable or not.3% Which project is better? The major difference is the timing of the cash flows.5% * $2.000) (10.066 PI @ 10% 1.16 1.44%.000 Year 3 0 0 NPV @ 10% 2. Year 0 Project C Project D (10. This is the economic interpretation of the mathematical solution.7513 (7) Cash Flow -. . The error occurs because interpolation assumes linearity of a non-linear function.51% Year 0 Investment Return of Investment Year 1 Investment Return of Investment Year 2 Investment Return of Investment Surplus Return PVIF10%.000 (491) (19.28 IRR 24.5% 16.000) Year 1 8.3% Which project is better? The major difference is the costs of the projects. it is the rate of interest earned on the funds that remain invested within the project.772 PI @ 10% 1.5% * $4.Year 1 Less: Interest Return of Investment Cash Flow -.

100 (886) Year 1 900 Year 2 150 Year 3 55 (886) Year 1 100 Year 2 100 Year 3 1. investments are made to maximize future wealth.089 1. Project X Year 0 Cash Flows (886) Year 1 100 1. The reinvestment assumption is invoked in order to make the future value (terminal value) rankings consistent with the present value rankings.10 110 Terminal Value = 1. Present value (discounted cash flow techniques) are used since we know the value of a dollar today.11 IRR = 20. Net Present Value and Profitability Index assume reinvestment at the discount rate.10 Year 2 150 Year 3 55 . Hence. Internal Rate of Return can be thought of as a special case of NPV (when it equals zero). it assumes reinvestment at the IRR.Project X Year 0 Cash Flows NPV @ 10% = 114 PI @ 10% = 1.0% Most academicians claim that the conflict is a consequence of the reinvestment assumption.21 121 1.21 1.13 IRR = 15.331 Year 2 100 Year 3 1.100 Project Y Year 0 Cash Flows (886) Year 1 900 1. Realistically. let's reinvest the cash flows of Projects X and Y at the discount rate of 10%. To see this.0% Project Y Year 0 Cash Flows NPV @ 10% = 97 PI @ 10% = 1.

while the $1.3223 132 1. Similarly. and is . the following is obtained: Project X Year 0 Cash Flows (886) Year 1 100 1. it is clear that Project Y is better since it maximizes future wealth. IV.331 terminal value of Project X represents a 14. RELEVANT CASH FLOWS Incremental Cash Flows The relevant cash flows for investment analysis is the change in the cash flows that would occur by accepting a proposal.347 Year 2 100 Year 3 1.531 terminal value of Project Y is a 20% return on the investment in Project Y.97 = 17). Moreover. the terminal value rankings are consistent with the NPV and PI rankings that indicate Project X is superior to Project Y.309 Since the costs are the same.531 Year 2 150 Year 3 55 1. if the cash flows of each project are reinvested at their respective IRRs.165 Terminal Value = 1. or what is referred to by the term incremental cash flows.2000 180 Terminal Value = 1. A.1499 115 Terminal Value = Project Y Year 0 Cash Flows (886) Year 1 900 1. An opportunity cost is a cash flow given up as a consequence of a decision. The difference in the terminal values of $22 has a present value of $17 which is the same as the difference in NPVs of the two projects (114 .100 Since the costs are identical.53% rate of return on an investment of $886 over three years while the $1.4400 1. the terminal values are both relative to the same size of investment.309 terminal value of Project Y is a 13. Thus. The $1.296 1. and agrees with the rankings of the IRRs.89% return on the initial investment.347 of Project X represents a 15% return on the cost of the project. the terminal value of $1.

Also. Note that the relevant cash flows include those found on the income statement as well as those that are not on the income statement (such as working capital). some cash flows are only reflected on the income statement in part (such as the gain or loss on the sale of an asset).generally defined as the next-best-alternative. it is relevant to the investment decision. Sunk costs are not relevant since they occurred in the past and the decision of whether or not to undertake a project does not change the past. . Since an opportunity cost is a change in cash flow. A general (simplified) format for analyzing a capital expenditure that considers all incremental cash flows is on the following page. A sunk cost refers to past expenditures.

I. Less: Incremental Costs from new asset G. Cash proceeds from sale of old asset C. the gain above the original purchase price is subject to the capital gains tax rate while the accumulated depreciation is taxed as ordinary income. Tax effect of gain or loss on disposal of old asset1 M. Incremental Revenues from new asset F. D. This loss reduces taxable income and thereby creates a tax savings equal to the difference between the market value of the asset and its book value multiplied by the tax rate: Loss * t If the asset is sold for more than the book value. t = applicable tax rate Last Year I. the company must report the difference as a profit to be taxed as ordinary income to the extent that the profit is less than the accumulated depreciation for the asset: Gain * t In the event that the asset is sold for more than the original purchase price. E. the relevant occurrences are A through M 1 If the asset is sold for less than the book value. (t) ------------------------------------------Change in Net Income Plus: Incremental Depreciation ------------------------------------------Incremental Operating Cash Flow H. the company incurs a loss which is tax-deductible. Tax effect of gain or loss on disposal of old asset1 D. Inc. J. Less: Incremental Depreciation ------------------------------------------Change in Taxable Income Less: Taxes on Tax. and M In a Replacement Decision. Salvage of new asset J. <Additional working capital> In a Purchase Decision. < > indicates that the cash flow is an outflow. F. <Salvage value lost on old asset> L.CASH FLOW ANALYSIS PURCHASE/REPLACEMENT DECISION Today A. <Cash outlay for new asset> B. <Additional working capital needed to support new asset> Intervening Years E. the relevant occurrences are A. Tax effect of gain or loss on disposal of new asset1 K. Recovery of working capital . H.

The Replacement Decision The classic capital investment decision is that of whether or not to replace a large piece of equipment.52%.000 3.700 72. $6.000 two years ago and is also being depreciated using the same MACRS rates for 5-year assets.000 in administrative expenses would be allocated to the project each year.500) (2.12 = 67. all of which will be recovered in the third year. Example Kinky's Copying Service is considering expanding operations to include color copying service.264 (2.06 = 50. even though you expect that after three years of 24-hour per day operation.000 51. a new color copier will have to be purchased at a cost of $28.933 . The new machine will be depreciated using the MACRS rates for 5-year assets (20%.000 in the first year. To accommodate the service. The existing copy machine was purchased for $9.933 3. only $3.B. 32%. increasing by 12% per year as word of the color copies spreads.880 x 1.000 per year.000 x 1. The new service is expected to result in additional sales of $60. 5. Labor and material costs are predicted to rise by $48.880 56.52%.000 of the amount represents an actual increase in expenses not otherwise incurred by the firm. one of the small existing copy machines can be sold to a local university for $4.06 = 53.76%). 19.2%.000 rather than keeping it for the remaining three years of its useful life and scrapping it for $800. with additional increments of 8% per year due to both inflation and increasing sales.764 48. 11.200 x 1.000 3. Calculate the net cash flows for each year of the project's life.500 64. it will have a resale value of only $10. Kinky's is in the 40% tax bracket.000 will initially be required.500) 57. Solution Year 1 Incremental Revenues Increased sales Lost lease payments Total Incremental Revenues Incremental Costs Labor & materials Administrative expense Total Incremental Costs Year 2 Year 3 60. Since the color copier can also copy black and white.000. The existing floor space could be leased annually for $2. An investment in working capital of $15.000 in the first year.500 if the project is not accepted. increasing at a 6% annual rate due primarily to inflation. 11.000 x 1.000 and will have to be replaced.12 = 75. however.000 53. The expanded service would use existing floor space which would result in an allocation of depreciation totalling $5. Also.500) (2.

76%) 10.000 19.Yr.037 4.000 32.376 9.00% 5.296 1.Year 1 Incremental Depreciation New Machine MACRS rate New Depreciation Old Machine MACRS rate New Depreciation Incremental Depreciation Sale of Equipment Old machine .000*48%) 800 518 282 40% 113 (9.8%) Required 15.600 9.200 17.960 9.037 7.52% 1.Yr.339 4. 3 Market Value Book Value Gain (loss) Tax rate Tax due (refund) Working Capital 28.20% 5. 3 Market Value Book Value Gain (loss) Tax rate Tax due (refund) New machine . 0 Market Value Book Value Gain (loss) Tax rate Tax due (refund) Old machine .000 4.00% 8.000 8.000 11.872 Year 2 28.20% 1.496 18.923 Year 3 28.064 1.000 11.000 20.000 19.896 Change 15.936 40% 774 Year 0 1 2 3 (28.000 16.320 (320) 40% (128) (9.000*5.400 .52% 1.000 1.200 1.Yr.728 3.000*28.

000 128 (800) 113 37.577 3.Yr.933) (4.200) Year 2 64.872) 4.764 (56.Yr.923 9.234 (1.Putting it all together Year 0 Operating Cash Flows Revenues Less: Costs Less: Depreciation Change in Taxable Income Less: Taxes (40%) Change in Net Income Add-back depreciation Change in Operating Cash Flow Working Capital Requirements Additional Working Capital Working Capital Recovery New Machine Purchase Sale .923) 2. 3 Tax on Sale TOTAL INCREMENTAL CASH FLOW (38.897 (1.296) Year 3 72.872 5.249 8.700 (53.500 (51.000 (774) 4.400) 18.738 7.269 .365 (15.492 (4.628 (1.051) 1. 0 Tax on Sale Lost Sale .896 (28.895 4.661 (1.000) Year 1 57.339) 11.872) 2.000) (3.449 (1. 3 Tax on Sale Old Machine Sale .339 11.880) (7.597) 6.159) 1.Yr.000) 10.

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