8-1

Capital
Budgeting
DecisionsPart II
Prepared
Preparedby
by

Douglas
DouglasCloud
Cloud

Pepperdine
PepperdineUniversity
University

8-2

Objectives
Objectives
Analyze investments in working capital.
After
this
After reading
reading
thisusing two
Analyze replacement
decisions
chapter,you
you should
should
approaches. chapter,
able
be
able to:
to:analysis.
Explain and applybe
sensitivity
Describe and analyze mutually exclusive
investments.
Describe the Modified Accelerate Cost Recovery
System and use it in evaluating investments.
Continued
Continued

8-3

Objectives
Objectives
Explain how capital budgeting applies to
non-for-profit entities and to social welfare.

8-4

Investments
Investments in
in Working
Working Capital
Capital
Current assets
- Current liabilities
= Working capital

8-5

Increases
Increases in
in Working
Working
Capital
Capital Investment
Investment
Companies strive to reduce working capital
requirements to increase returns
Companies invest to reduce working capital
Example
Example
Annual revenues $30,000
Annual cash costs $12,000
Investment
$50,000 in equipment
$35,000 in working capital
Life
5 years

8-6

Annual
Annual Incremental
Incremental After-Tax
After-Tax
Cash
Cash Flows
Flows (Years
(Years 1-5)
1-5)
Tax
Cash
Computation
Flow
$30,000
$30,000

Revenues
Cash expenses (variable
and fixed)
12,000
Cash inflow before taxes
$18,000
Depreciation ($50,000 5)
10,000
Increase in taxable income
$8,000
Income taxes (40 percent)
$3,200
Net increase in annual cash inflow

12,000
$18,000

3,200
$14,800

8-7

Summary
Summary of
of Net
Net Present
Present
Value
Value of
of Investment
Investment
Operating cash inflows ($14,800 x
3.605)
Recovery of working capital ($35,000 x
0.567)
Total present value
Investment required ($50,000 + $35,000)
Net present value

$ 53,354
19,845
$ 73,199
85,000
$(11,801 )

8-8

Decreases
Decreases in
in Working
Working
Capital
Capital Investment
Investment
Inventory is the most common target of investments that focus on reducing working capital.
A company embarking on an inventory- reduction project will draw down existing inventory
the first year of the project.
Delaying production of purchases frees up cash for other purposes.

8-9

Replacement
Replacement Decisions
Decisions
Businesses frequently face
the problem of whether to
replace an asset currently in
use. Such a question is
called a replacement
decision. Replacement
decisions are made when
economic or technological
factors make it possible to
perform tasks at lower cost.

8-10

Two
Two Approaches
Approaches to
to
Replacement
Replacement Decisions
Decisions
The incremental approach focuses on the
differences between the cash flows, given
the alternatives of keeping the existing
assets or replacing them.
The total-project approach compares the
present values of operating each way.

8-11

Replacement
Replacement Decision
Decision Example
Example
Cost
Remaining useful life
Current book value
Annual depreciation
Expected sales valuenow
in 5 years
Annual cash operating costs

$100,000 five
years ago
5 years
$50,000
$10,000
$20,000
$0
$30,000

8-12

Replacement
Replacement Decision
Decision Example
Example
Information on new machine:
Cost is $60,000
Useful life is 5 years
Annual cash operating costs is $15,000
Tax rate is 40 percent
Straight-line depreciation
Cut off rate is 16%

8-13

Replacement
Replacement Decision
Decision Example
Example
Tax
Computation
Purchase price of new asset
Book value of old machine
$50,000
Sales price, which is cash inflow 20,000
Loss for taxes, which can be
offset against regular income $30,000
Taxes saved (40% x $30,000)
$12,000
Net outlay for new asset

Cash
Flow
$60,000
(20,000 )

(12,000 )
$28,000

Annual
Annual Incremental
Incremental After-Tax
After-Tax
Cash
Cash Inflows
Inflows (Years
(Years 1-5)
1-5)
Pretax cash savings:
Cash cost of using old machine
Cash cost of using new machine
Difference favoring replacement
Additional depreciation:
Depreciation on new machine
Depreciation on old machine
Additional tax deduction for
depreciation with replacement
Increase in taxable income

Continued
Continued

Tax
Computation
$30,000
15,000
$15,000$15,000
$12,000
10,000
2,000
$13,000

Cash
Flow

8-14

Annual
Annual Incremental
Incremental After-Tax
After-Tax
Cash
Cash Inflows
Inflows (Years
(Years 1-5)
1-5)
Tax
Computation
Increase in taxable income
$13,000
Additional tax ($13,000 x 40%) outflow
5,200
Additional net cash inflow favoring
replacement
Present value factor, 5 years, 16%
Present value of savings
Investment
Net present value

The
The NPV
NPVisis positive,
positive, so
so
replacement
replacement isis desirable
desirable

8-15

Cash
Flow
$ (5,200 )
$ 9,800
3.274
$32,085
28,000
$ 4,085

8-16

Total-Project
Total-Project Approach
Approach
Decision: Operate Existing Machine
Tax
Flow

Annual operating costs

$30,000
Depreciation
10,000
Total tax-deductible expenses
$40,000
Tax savings expected
$16,000
Net cash outflow expected per year
Present value factor, 5 years at 16%
Present value of future operating outflows

Cash
Computation
$30,000

16,000
$14,000
x 3.274
$45,836

8-17

Total-Project
Total-Project Approach
Approach
Decision: Sell Existing Machine, Buy New Machine
Tax

Cash
Computation
Flow
Annual operating costs
$15,000
$15,000
Depreciation
12,000
Total tax-deductible expenses
$27,000
Tax savings expected
$10,800
10,800
Net cash outflow expected per year
$ 4,200
Present value factor, 5 years at 16%
x 3.274
Present value of future operating outflows
$13,751
Net outlay required for the new machine
28,000
Present value to buy new machine
$41,751

8-18

Comparing
Comparing the
the Two
Two Alternatives
Alternatives
Present value of using existing machine
Present value of buying new machine
Difference in favor of replacing
old machine

$45,836
41,751
$ 4,085

8-19

Insight: Know When to Fold Em

Set limits up front
Be skeptical of
optimistic analyses
Consider alternatives
Question assumptions
and projections

8-20

Sensitivity
Sensitivity Analysis
Analysis
Sensitivity analysis involves finding out how
much the value of a variable can rise or fall
before a different decision is indicated.
Sensitivity analysis applies to all types of
decisions, but is especially beneficial when
applied to capital budgeting decisions.

8-21

Sensitivity
Sensitivity Analysis
Analysis
Example
A company with a cost of capital of 14 percent and a
40 percent tax rate can bring out a product priced at
$22. Managers estimate variable costs at $4 per
unit, fixed costs of $100,000 annually, and 10,000
units annual sales volume. The product requires an
investment of $100,000 annually and depreciable
assets with a five-year life and no salvage value.

8-22

Sensitivity
Sensitivity Analysis
Analysis
Tax
Expected contribution margin
$10,000 x $18)
Fixed costs:
Cash
Depreciation

Flow
$180,000
100,000
40,000
$140,000
40,000
$ 16,000

Increase in taxable income

Tax at 40%
Net cash inflow per year
Present value factor, 5-years at 14%
Present value of annual cash inflows
Investment required
Accept
Net present value
Accept the
the Project!
Project!

Cash
Computation
$180,000
(100,000 )

(16,000 )
$ 64,000
x 3.433
$219,712
200,000
$ 19,712

8-23

Mutually
Mutually Exclusive
Exclusive Alternatives
Alternatives
Mutually exclusive alternatives happen when
a company has two or more ways of
accomplishing the same goal, so that selecting
one alternative precludes selecting the others.
The replacement decision discussed earlier fits
the definition.

8-24

Unequal
Unequal Lives
Lives
To illustrate this method, assume the following facts about two mutually
exclusive investment opportunities involving a machine, versions Model
G-40 and Model G-70, that is essential to the companys operations
Model G-40
Purchase price
Annual cash operating costs
Expected useful life

Model G-70
$40,000$70,000
$8,000$6,000
4 years8 years

Neither machine has any expected salvage value at the end of its useful life.
The cutoff rate is 14 percent.

8-25

Unequal
Unequal Lives
Lives
Present
PresentValue
Value for
for Model
Model G-70
G-70

Annual operating costs

Present value factor, 8 years, 14%
Present value of operating costs
Investment required
Net present value

$ 6,000
x 4.639
$27,834
70,000
$97,834

8-26

Unequal
Unequal Lives
Lives
Present
PresentValue
Value for
for Model
Model G-40
G-40
Annual operating costs, years 1-8
Present value factor, 8 years, 14%
Present value of operating costs, yrs 1-8
Present value of purchase of replacement
Model G-40 at the end of Year 4
Present value of future cash outlays
Investment required
Net present value

8,000
x 4.639
$ 37,112

26,048
$ 63,160
40,000
$103,160

8-27

Ranking
Ranking Investment
Investment Opportunities
Opportunities
Profitability index (PI) is the ratio of the
present value of the future cash flows to the
investment.
PI = PV of future cash
flows/Investment

8-28

Ranking
Ranking Investment
Investment Opportunities
Opportunities
Below are data for two mutually exclusive
investment opportunities confronting a company with
a 10 percent cost of capital.
X

Investment required
Life of investment
Cash flows, end of year 1
Net present value of project
Internal rate of return
Profitability index

$50,000
1 year
$55,991

$10,000
1 year
$11,403

$896
12%
1.018

$365
14%
1.037

8-29

5-Year
5-Year Class
Class

automobiles

typewriters

copiers
Personal
computers

trucks

8-30

7-Year
7-Year Class
Class

office
furniture and
equipment
most types of
machinery

Any property not

designated by law
as being in some
other class

8-31

10-Year
10-Year Class
Class

Lives of at least 16 years and less

than 20 years, including certain
types of transportation equipment

8-32

31.5-Year
31.5-Year Class
Class

Nonresidential real property

such as factory buildings

8-33

Percentages
Percentages of
of Cost
Cost Depreciated
Depreciated
Under
Under MACRS
MACRS
Year
1
2
3
4
5
6
7
8
9
10
11

5-Year Class
20%
32%
19%
12%
12%
5%

7-Year Class
14%
25%
18%
12%
9%
9%
9%
4%

10-Year Class
10%
18%
14%
12%
9%
7%
7%
7%
7%
6%
3%

8-34

Present
Present Value
Value of
of MACRS
MACRS
Tax
Tax Shields
Shields
Discount Rate
8%
10%
12%
14%
16%
18%
20%
22%
24%

5-Year Class
0.811
0.774
0.738
0.706
0.675
0.647
0.621
0.597
0.574

7-Year Class
0.766
0.722
0.681
0.645
0.611
0.580
0.552
0.526
0.502

8-35

Example
Example
A company expects pretax cash flows of
$3,000 per year from an asset costing
$10,000. The asset is in the 5-year class
and, to reduce calculations, has a useful
life of six years. The tax rate is 40
percent and cost of capital is 12 percent

8-36

Example
Example
Pretax inflow
MACRS deduction
Taxable income
Tax at 40%
Net cash inflow
PV factor
Present values
Total present value

1
2
3
$3,000 $3,000 $3,000
2,000 3,200 1,900
$1,000 $(200 ) $1,100
400
(80 )
440
$2,600 $3,080 $2,560
.893
.797
.712
$2,322 $2,455 $1,823
$10,357

4
$3,000
1,200
$1,800
720
$2,280
.636
$1,450

5
$3,000
1,200
$1,800
720
$2,280
.567
$1,293

6
$3,000
500
$2,500
1,000
$2,000
.507
$1,014

8-37

Example
Example
Present value of operating flows
$3,000 x (1 0.40) x 4.11 (from Table B)
Present value of MACRS shield
$10,000 x 0.40 x .738 (from Slide 8-34)
Total present value

$ 7,400
2,952
$10,352

8-38

Criticisms
Criticisms of
of DCF
DCF Methods
Methods
Companies downplay quantitative analysis
because of overriding quantitative, or
hard-to-quantify, concerns about particular
investment.
High-tech investments often fail
discounted cash flow tests yet such
investments are clearly important.

8-39

Social
Social Consequences
Consequences of
of
Decision
Decision Making
Making
Social costs are not borne directly by the
entity making a decision and taking an action.
Social benefits (also called externalities) are
benefits not accruing directly to the entity
making a decision.

8-40

Chapter 8
The
The End
End

8-41