Capital

Budgeting

23-1
 Objectives
Objectives

1. Describe theAfter
difference
After between
studying
studying this independent
this
and mutually exclusive
chapter,
chapter, youcapital
you shouldinvestment
should
decisions. be
be able
able to:
to:
2. Explain the roles of the payback period and
accounting rate of return in capital
investment decisions.
3. Calculate the net present value (NPV) for
independent projects.
Continued
Continued
23-2
 Objectives
Objectives

4. Compute the internal rate of return (IRR) for

independent projects.
5. Tell why NPV is better than IRR for choosing
among mutually exclusive projects.
6. Convert gross cash flows to after-tax cash flows.
7. Describe the capital investment for advanced
technology and environmental impact settings.

23-3
Capital investment decisions are
concerned with the process of
planning, setting goals and
priorities, arranging financing,
and using certain criteria to
select long-term assets.

23-4
 Capital
Capital Budgeting
Budgeting
Capital budgeting is the process of making capital
investment decisions.
Two types of capital budgeting projects:
Projects that, if accepted or
rejected, will not affect the cash
Independent flows of another project.
Projects
Projects that, if accepted, preclude the
acceptance of competing projects.
Mutually
Exclusive
Projects
23-5
 Payback
Payback Period
Period
Payback period = Original investment/Annual cash flow

Unrecovered Investment
Year Beginning of year Annual Cash Flow
1 $200,000 $60,000
2 140,000 80,000
3 60,000 100,000
4 ---- 120,000
5 ---- 140,000
$60,000
$60,000was
wasneeded
needed
in
inYear
Year33totorecover
recover
the
theinvestment.
investment.
23-6
 Payback
Payback Period
Period
The payback period provides information to
managers that can be used as follows:
 To help control the risks associated with the
uncertainty of future cash flows.
 To help minimize the impact of an investment
on a firm’s liquidity problems.
 To help control the risk of obsolescence.

 To help control the effect of the investment on

performance measures.

23-7
 Payback
Payback Period
Period
Deficiency
 Ignores the time value of money

 Ignores the performance of the

investment beyond the payback
period

23-8
Accounting
Accounting Rate
Rate Of
Of Return
Return (ARR)
(ARR)
ARR = Average income ÷ Original investment or
Average investment

Average
Average annual
annual net
net
cash
cash flows,
flows, less
less Average
Average investment
investment
average
average == ((II ++ SS)/2
)/2
depreciation
depreciation
II==the
theoriginal
originalinvestment
investment
SS==salvage
salvagevalue
value
Assume
Assumethatthatthe
theinvestment
investment
isisuniformly
uniformlyconsumed
consumed

23-9
 Accounting
Accounting Rate
Rate Of
Of Return
Return (ARR)
(ARR)
The major deficiency of the accounting rate of
return is that it ignores the time value of money.

23-10
 The
The Net
Net Present
Present Value
Value Method
Method
NPV = P – I
where:
P = the present value of the project’s future cash
inflows
I = the present value of the project’s cost (usually
the initial outlay)
Net present value is the difference between the present value
of the cash inflows and outflows associated with a project.

23-11
The
The Net
Net Present
Present Value
Value Method
Method
Polson Company has
developed a new cell phone
that is expected to generate
an annual revenue of
$750,000. Necessary
production equipment
would cost $800,000 and
can be sold in five years for
$100,000.

23-12
The
The Net
Net Present
Present Value
Value Method
Method
In addition, working capital
is expected to increase by
$100,000 and is expected to
be recovered at the end of
five years. Annual operating
expenses are expected to be
$450,000. The required rate
of return is 12 percent.

23-13
 Step 1. Cash Flow Identification
Year Item Cash Flow
0 Equipment $-800,000
Working capital -100,000
Total $-900,000

1-4 Revenues $ 750,000

Operating expenses -450,000
Total $ 300,000

5 Revenues $ 750,000
Operating expenses -450,000
Salvage 100,000
Recovery of working capital 100,000
Total $ 500,000

23-14
 Step 2A. NPV Analysis
Year Cash Flow Discount Factor Present Value
0 $-900,000 1.000 $-900,000
Present
1 300,000 0.893 267,900
Value of $1
2 300,000 0.797 239,100
3 300,000 0.712 213,600
4 300,000 0.636 190,800
5 500,000 0.567 283,500
Net present value $ 294,900
Step 2B. NPV Analysis
Year Cash Flow Discount Factor Present Value
0 Present Value
$-900,000 1.000 $-900,000
1-4 of an Annuity
300,000 3.307 911,100
Present Value
5 of $1
500,000 0.567 283,500
of $1
Net present value $ 294,600
23-15
 The
The Net
Net Present
Present Value
Value Method
Method
Decision Criteria for NPV

If NPV > 0, this indicates:

1. The initial investment has been
recovered
2. The required rate of return has been
recovered

Thus, Polson should manufacture the cell

phones

23-16
 The
The Net
Net Present
Present Value
Value Method
Method
Reinvestment
Reinvestment Assumption
Assumption
The NVP model assumes that all cash flows generated by
a project are immediately reinvested to earn the required
rate of return throughout the life of the project.

23-17
 Internal
Internal Rate
Rate of
of Return
Return
The internal rate of return (IRR) is the interest rate that
sets the project’s NPV at zero. Thus, P = I for the IRR.
Example: A project requires a $10,000
investment and will return $12,000
after one year. What is the IRR?

$12,000/(1 + i) = $10,000
1 + i = 1.2
i = 0.20

23-18
 Internal
Internal Rate
Rate of
of Return
Return

Decision Criteria:
If the IRR > Cost of Capital, the project
should be accepted.
If the IRR = Cost of Capital, acceptance or
rejection is equal.
If the IRR < Cost of Capital, the project
should be rejected.

23-19
 NPV
NPV Compared
Compared With
With IRR
IRR
There are two major differences between net present
value and the internal rate of return:
 NPV assumes cash inflows are reinvested at the
required rate of return, whereas the IRR method
assumes that the inflows are reinvested at the
internal rate of return.
 NPV measures the profitability of a project in
absolute dollars, whereas the IRR method
measures it as a percentage.

23-20
 NPV
NPV Compared
Compared With
With IRR
IRR

Year Project A Project B

0 $-1,000,000 $-1,000,000
1 --- 686,342
2 1,440,000 686,342
IRR 20 % 24 %
NPV $234,080 $223,748

23-21
 Example:
Example: Mutually
Mutually
Exclusive
Exclusive Projects
Projects
Milagro
Milagro Travel
Travel Agency
Agency Example
Example
Standard Custom
T2 Travel
Annual revenues $240,000 $300,000
Annual operating costs 120,000 160,000
System investment 360,000 420,000
Project life 5 years 5 years
The cost of capital is 12 percent

23-22
NPV and IRR Analysis: Standard T2 versus Custom Travel
Cash Flow Pattern
Year Standard T2 Custom Travel
0 $-360,000 $-420,000
1 120,000 140,000
2 120,000 140,000
3 120,000 140,000
4 120,000 140,000
5 120,000 140,000
Standard T2: NPV Analysis
Year Cash Flow Discount Factor Present Value
0 $-360,000 1.000 $-360,000
1-5 140,000 3.605 432,600
Net present value $ 72,600
23-23
NPV and IRR Analysis: Standard T2 versus Custom Travel
IRR ANALYSIS

Initial investment
Discount factor =
Annual cash flow
$360,000
= = 3.0
120,000
Custom Travel Systems: NPV Analysis
Year Cash Flow Discount Factor Present Value
0 $-420,000 1.000 $-420,000
1-5 140,000 3.605 504,700
Net present value $ 84,700

23-24
NPV and IRR Analysis: Standard T2 versus Custom Travel
IRR ANALYSIS

Initial investment
Discount factor =
Annual cash flow
$420,000
= = 3.0
140,000
From Exhibit 23B-2, df = 3.0
= implies
3,000 that IRR = 20%

23-25
 After-Tax
After-Tax Cash
Cash Flows
Flows
Lewis Company uses two types of manufacturing
equipment (M1 and M2) to produce one of its
products. It is now possible to replace these two
machines with a flexible manufacturing system.
Management wants to know the net investment
needed to acquire the flexible equipment. If the
system is acquired, the old equipment will be sold.

23-26
 After-Tax
After-Tax Cash
Cash Flows
Flows
Disposition of Old Machine
Book Value Sale Price
M1 $ 600,000 $ 780,000
M2 1,500,000 1,200,000
Acquisition of Flexible System
Purchase cost $7,500,000
Freight 60,000
Installation 600,000
Additional working capital 540,000
Total $8,700,000
23-27
 After-Tax
After-Tax Cash
Cash Flows
Flows
The two machines are sold:
Sales price, M1 $ 780,000
Sales price, M2 1,200,000
Tax savings 48,000
Net proceeds $2,028,000
The net investment is:
Total cost of flexible system $8,700,000
Less: Net proceeds 2,028,000
Net investment (cash outflow) $6,672,000

23-28
 After-Tax
After-Tax Cash
Cash Flows
Flows

Asset Gain (Loss)

M1 $ 180,000
M2 -300,000
Net gain (loss) $ 120,000
Tax rate x 0.40
Tax savings $ 48,000

23-29
 After-Tax
After-Tax Operating
Operating Cash
Cash Flows:
Flows:
Life
Life of
of the
the Project
Project
After-tax cash flow = After-tax net income +
Noncash expenses
CF = NI + NC
A company plans to make a new product that
requires new equipment costing $1,600,000. The
new product is expected to increase the firm’s
annual revenue by $1,200,000. Materials, labor,
etc. will be $500,000 per year.

23-30
After-Tax
After-Tax Operating
Operating Cash
Cash Flows:
Flows:
Life
Life of
of the
the Project
Project
Revenues $1,200,000
Less: Cash operating expenses -500,000
Depreciation (straight-line) -400,000
Income before income taxes $ 300,000
Less: Income taxes (@ 40%) 120,000
Net income $ 180,000

23-31
 After-Tax
After-Tax Operating
Operating Cash
Cash Flows:
Flows:
Life
Life of
of the
the Project
Project

Cash flow = [(1– Tax rate) x Revenues] – [(1– Tax

rate) x Cash expenses] + (Tax rate x
Noncash expenses)

After-tax revenues $720,000

After-tax cash expenses -300,000
Depreciation tax shield 160,000
Operating cash flow $580,000

23-32
 MACRS
MACRS Depreciation
Depreciation Rates
Rates
The tax laws classify most assets into the following three classes
(class = allowable years):
Class Types of Assets
3 Most small tools
5 Cars, light trucks, computer equipment
7 Machinery, office equipment
Assets in any of the three classes can be depreciated using either
straight-line or MACRS (Modified Accelerated Cost Recovery
System) with a half-year convention.

23-33
 MACRS
MACRS Depreciation
Depreciation Rates
Rates
 Half the depreciation for the first year can be
claimed regardless of when the asset is actually
placed in service.
 The other half year of depreciation is claimed in
the year following the end of the asset’s class
life.
 If the asset is disposed of before the end of its
class life, only half of the depreciation for that
year can be claimed.

23-34
 Example
An automobile is purchased on March 1, 2003 at a
cost of $30,000. The firm elects the straight-line
method for tax purposes. Automobiles are five-year
assets. The annual depreciation is $6,000 ($30,000 ÷
5). However, due to the half-year convention, only
$3,000 can be deducted in 2003.

23-35
 Example
Year S/L Depreciation Deduction
2003 $3,000 (half-year amount)
2004 6,000
2005 6,000
2006 6,000
2007 6,000
2008 3,000 (half-year amount)
Assume that the asset is disposed of in April
2005. Only $3,000 of depreciation can be
claimed for 2005 (early disposal rule).

23-36
 Example
MACRS Depreciation Rates for
Five-Year Assets
Year Percentage of Cost Allowed
1 20.00%
2 32.00
3 19.20
4 11.52
5 11.52
6 5.76

23-37
 Example
Year Depreciation Deduction
2003 20.00% x $30,000 $6,000
2004 32.00% x $30,000 9,600
2005 19.20% x $30,000 5,760
2006 11.52% x $30,000 3,456
2007 11.52% x $30,000 3,456
2008 5.76% x $30,000 1,728

23-38
 Example

A firm is considering the

purchase of computer
equipment for $60,000.
The tax guidelines require
that the cost of the
equipment be depreciated
over five years.

23-39
 Example—S/L Method
Tax Tax Discount Present
Year Depreciation Rate Savings Factor Value
1 $ 6,000 0.40 $2,400.00 0.909 $ 2,181.60
2 12,000 0.40 4,800.00 0.826 3,964.80
3 12,000 0.40 4,800.00 0.751 3,604.80
4 12,000 0.40 4,800.00 0.683 3,278.40
5 12,000 0.40 4,800.00 0.621 2,980.80
6 6,000 0.40 2,400.00 0.564 1,353.60
Net present value $17,364.00

23-40
 Example—MACRS Method
Tax Tax Discount Present
Year Depreciation Rate Savings Factor Value
1 $12,000 0.40 $4,800.00 0.909 $ 4,362.20
2 19,200 0.40 7,680.00 0.826 6,343.68
3 11,520 0.40 4,608.00 0.751 3,460.61
4 6,912 0.40 2,764.80 0.683 1,888.36
5 6,912 0.40 2,764.80 0.621 1,716.94
6 3,456 0.40 1,382.40 0.564 779.67
Net present value $18,551.46

23-41
 How
How Estimates
Estimates of
of Operating
Operating
Cash
Cash Flows
Flows Differ
Differ
A company is evaluating a potential investment in a
flexible manufacturing system (FMS). The choice is to
continue producing with its traditional equipment,
expected to last 10 years, or to switch to the new system,
which is also expected to have a useful life of 10 years.
The company’s discount rate is 12 percent.
Present value ($4,000,000 x 5.65) $22,600,000
Investment 18,000,000
Net present value $ 4,600,000

23-42
 How
How Estimates
Estimates of
of Operating
Operating
Cash
Cash Flows
Flows Differ
Differ
FMS STATUS QUO
Investment (current outlay):
Direct costs $10,000,000 ---
Software, engineering 8,000,000 ---
Total current outlay $18,000,000
Net after-tax cash flow $ 5,000,000 $1,000,000
Less: After-tax cash flow
for status quo 1,000,000 n/a
Incremental benefit $ 4,000,000 n/a

23-43
 FMS STATUS QUO
Incremental Benefits Explained
Direct benefits:
Direct labor $1,500,000
Scrap reduction 500,000
Setups 200,000 $2,200,000
Intangible benefits (Quality
savings):
Rework $ 200,000
Warranties 400,000
Maintenance of competitive
position 1,000,000 1,600,000
Indirect benefits:
Production scheduling $ 110,000
Payroll 90,000 200,000
Total $4,000,000
23-44
 Future
Future Value:
Value: Time
Time Value
Value
of
of Money
Money
Let:
F = future value
i = the interest rate
P = the present value or original outlay
n = the number or periods
Future value can be expressed by the following formula:
F = P(1 + i)n

23-45
 Future
Future Value:
Value: Time
Time Value
Value
of
of Money
Money

Assume the investment is

$1,000. The interest rate is
8%. What is the future value
if the money is invested for
one year? Two? Three?

23-46
 Future
Future Value:
Value: Time
Time Value
Value
of
of Money
Money

F = $1,000(1.08) = $1,080.00 (after one year)

F = $1,000(1.08)2 = $1,166.40 (after two years)
F = $1,000(1.08)3 = $1,259.71 (after three years)

23-47
 Present
Present Value
Value
P = F/(1 + i)n
The discount factor, 1/(1 + i), is computed for various combinations of I
and n.
Example: Compute the present value of $300 to be received
three years from now. The interest rate is 12%.
Answer: From Exhibit 23B-1, the discount factor is 0.712. Thus,
the present value (P) is:
P = F(df)
= $300 x 0.712
= $213.60

23-48
 Present
Present Value
Value
Example: Calculate the present value of a $100 per year annuity, to be received for the next three years. The
interest rate is 12%.

Answer:
Discount Present Year CashFactor Value
1 $1000.893 $ 89.30
2 1000.797 79.70
3 1000.712 71.20
2.402 *$240.20

* Notice that it is possible to multiply the sum of the individual discount factors (.40) by
$100 to obtain the same answer. See Exhibit 23B-2 for these sums which can be used as
discount factors for uniform series.

23-49
 End of

Chapter

23-50