Capital Budgeting

1
Capital Budgeting

• Chapter 11

2
Long-Term (Capital) Assets

• Chapters 3 and 4 discussed the cost of capacity
  resources that organizations purchase and use for
  years to make goods and provide services
• Capital assets create these capacity-related
  costs
• Cost commitments associated with long-term assets
  create risk for an organization
• Remain even if the asset does not generate the
  anticipated benefits
• Reduce an organizations flexibility
• Therefore, organizations approach investments in
  long-term assets with considerable care

3
Need to Control Capital Assets

• Organizations have developed specific tools to
  control the acquisition and use of long-term
  assets because
• Organizations are usually committed to long-term
  assets for an extended time, creating the
  potential for
• Excess capacity that creates excess costs
• Scarce capacity that creates lost opportunities
• The amount of money committed to the acquisition
  of capital assets is usually quite large
• The long-term nature of capital assets creates
  technological risk
• Capital budgeting is a systematic approach to
  evaluating an investment in a capital asset

4
Investment and Return

• The fundamental evaluation issue in dealing with
  a long-term asset is whether its future benefits
  justify its initial cost
• Investment is the monetary value of the assets
  the organization gives up to acquire a long-term
  asset
• Return is the increased future cash inflows
  attributable to the long-term asset
• Investment and return form the foundation of
  capital budgeting analysis, which focuses on
  whether the expected increased cash flows
  (return) will justify the investment in the
  long-term asset

5
Time Value of Money (1 of 2)

• Time value of money (TVM) is a central concept in
  capital budgeting
• Because money can earn a return
• Its value depends on when it is received
• Using money has a cost
• The lost opportunity to invest the money in
  another investment alternative
• In making investment decisions, the problem is
  that investment cash is paid out now, but the
  cash return is received in the future
• We need an equivalent basis to compare the cash
  flows that occur at different points in time

6
Time Value of Money (2 of 2)

• Because money has a time-dated value, the
  critical idea underlying capital budgeting is
• Amounts of money spent or received at different
  periods of time must be converted into their
  value on a common date in order to be compared

7
Some Standard Notation

• For simplicity, the following notation is used

8
Future Value

• Because money has time value, it is better to
  have money now than in the future
• Having 1.00 today is more valuable than
  receiving 1.00 in the future because the 1.00
  on hand today can be invested to grow to more
  than 1.00
• The future value (FV) is the amount that todays
  investment will be after earning a stated
  periodic rate of return for a stated number of
  periods
• For one period FVPV x (1r)
• Because investment opportunities usually extend
  over multiple periods, we need to compute future
  value over several periods

9
FV with Multiple Periods

• An initial amount of 1.00 accumulates to 1.2763
  over five years if the annual rate of return is
  5

• This calculation assumes the following
• Interest earned stays invested until the end of
  year 5
• Therefore, interest is earned each year on both
  the initial investment and the interest earned in
  previous periods
• Financial analysts call that process the compound
  effect of interest
• The rate of return is constant

10
Computing Future Values For Multiple Periods (1
of 2)

• The formula for a future value is FVPV x (1r)n
• One may compute this value in different ways
• Calculator methods (using 5 years at 5 for
  examples)
• Multiply 1.00 by 1.05 five times
• If your calculator computes exponents directly,
  you may compute 1.00x(1.05)5
• Financial calculators have TVM functions that
  allow you to compute FV
• Follow your calculators instructions

11
Computing Future Values For Multiple Periods (2
of 2)

• Table Method
• Tables that provide the factors needed to compute
  a future value for different numbers of periods
  and rates of return are available
• For example, Exhibit 11-2 in the textbook
• Find where the column (r) intersects with the row
  (n). Multiply this factor by the amount of the
  initial investment to find the future value
• Spreadsheet Method
• Every computer spreadsheet program can compute
  future values and all other financial
  calculations described in this chapter

12
Choosing a Common Date

• An investments cash flows must be converted to
  their equivalent value at some common date in
  order to make meaningful comparisons between the
  projects cash inflows and outflows
• Although any point in time can be chosen as the
  common date, the conventional choice is the point
  when the investment is undertaken
• Analysts call this time zero, or period zero
• Therefore, conventional capital budgeting
  analysis converts all future cash flows to their
  equivalent value at time zero

13
Present Value

• Analysts call a future cash flows value at time
  zero its present value
• The process of computing present value is called
  discounting
• We can rearrange the FV formula to compute the
  present value
• FV PV x (1 r)n
• PV FV/(1 r)n or PV FV x (1 r)-n
• Methods similar to those described earlier may be
  used to compute this value
• Calculator, tables, or spreadsheet software

14
Decay of a Present Value

• Invested amounts grow at a compound rate through
  time
• Similarly, a fixed amount of cash to be received
  at some future time becomes less valuable as
• Interest rates increase
• The time period before receipt of the cash
  increases
• One consequence of this decay is that large
  benefits expected far in the future will have
  relatively little current value, especially when
  interest rates exceed 10
• Arbitrarily high interest rates will result in
  projects (especially long-term ones) being
  inappropriately turned down

15
Annuities

• Not all investments have cash outlays at time
  zero and provide a single benefit at some future
  point
• Most investments provide a series, or stream, of
  benefits over a specified future period
• An investment that promises a constant amount
  each period over n periods is called an n-period
  annuity
• Many lotteries are examples of an n-period
  annuity because they pay prizes in the form of an
  annuity that lasts for 20 years or longer

16
PV of an Annuity

• To illustrate the idea of an annuity and its
  present value, suppose you have won a 20 million
  lottery prize that pays 1 million a year for 20
  years
• You are interested in selling this annuity to
  raise cash to purchase a business
• What is the value of this annuity today, if the
  current rate of interest is 7?
• Using a table we can compute the present value of
  the lottery annuity as follows
• PV a x annuity present value factor7, 20
  periods
• 1,000,000 x 10.594
• 10,594,000

17
Computing the Required Annuity

• We may need to compute the annuity value that a
  current investment will generate
• For example, if you agreed to repay a loan with
  equal periodic payments, then you are selling the
  lender an annuity in exchange for the face value
  of the loan
• The factor required to compute the amount of the
  annuity to repay a present value is simply the
  inverse of the present value factor for an
  annuity
• Annuity factor 1 / PV factor

18
Cost of Capital

• The cost of capital is the interest rate used for
  discounting future cash flows
• Also known as the risk-adjusted discount rate
• The cost of capital is the return the
  organization must earn on its investment to meet
  its investors return requirements
• The organizations cost of capital reflects
• The amount and cost of debt and equity in its
  financial structure
• The financial markets perception of the
  financial risk of the organizations activities

19
Capital Budgeting

• Capital budgeting is the collection of tools that
  planners use to evaluate the desirability of
  acquiring long-term assets
• Organizations have developed many approaches to
  capital budgeting
• Six approaches are discussed here

• Payback
• Accounting rate of return
• Net present value

• Internal rate of return
• Profitability index
• EVA criterion

20
Shirleys Doughnut Hole

• To show how each of these methods works and
  alternative perspectives, we apply each to
  Shirleys Doughnut Hole as it considers the
  purchase of a new automatic doughnut cooker
• Cost 70,000
• Life five years
• Benefit expanded capacity and reduced operating
  costs would increase Shirleys profits by 20,000
  per year
• Shirleys cost of capital is 10
• The new cooker would be sold for 10,000 at the
  end of five years

21
Payback Criterion

• The payback period is the number of periods
  needed to recover a projects initial investment
• Shirleys initial investment of 70,000 is
  recovered midway between years 3 and 4
• The payback period for this project is 3.5 years
• Many people consider the payback period to be a
  measure of the projects risk
• The organization has unrecovered investment
  during the payback period
• The longer the payback period, the higher the
  risk
• Organizations compare a projects payback period
  with a target that reflects the organizations
  acceptable level of risk

22
Problems with Payback

• The payback criterion has two problems
• It ignores the time value of money
• Some organizations use the discounted payback
  method, which computes the payback period but
  uses discounted cash flows
• It ignores the cash outflows that occur after the
  initial investment and the cash inflows that
  occur after the payback period
• Despite these limitations, some surveys show that
  the payback calculation is the most used approach
  by organizations for capital budgeting
• This popularity may reflect other considerations,
  such as bonuses that reward managers based on
  current profits, that create a preoccupation with
  short-run performance

23
Accounting Rate of Return (1 of 2)

• Analysts compute the accounting rate of return by
  dividing the average accounting income by the
  average level of investment
• Analysts use the accounting rate of return to
  approximate the return on investment
• The increased annual income that Shirleys will
  report related to the new cooker will be 8000
• 20,000 - 12,000 of depreciation
• The average income will equal the annual income
  since the annual income is equal each year
• The average investment is 40,000
• (70,000 10,000) / 2

24
Accounting Rate of Return (2 of 2)

• The accounting rate of return for the cooker
  investment is computed as
• 8,000 / 40,000 20
• If the accounting rate of return exceeds the
  target rate of return, then the project is
  acceptable
• Like the payback method the accounting rate of
  return method has a drawback
• By averaging, it does not consider the timing of
  cash flows
• This method is an improvement over the payback
  method in that it considers cash flows in all
  periods

25
Net Present Value (1 of 4)

• The net present value (NPV) is the sum of the
  present values of a projects cash flows
• This is the first method considered that
  incorporates the time value of money
• The steps used to compute an investments net
  present value are as follows
• Step 1 Choose the appropriate period length to
  evaluate the investment proposal
• The period length depends on the periodicity of
  the investments cash flows
• The most common period used in practice is one
  year
• Analysts also use quarterly and semiannual periods

26
Net Present Value (2 of 4)

• Step 2 Identify the organizations cost of
  capital, and convert it to an appropriate rate of
  return for the period length chosen in step 1
• Step 3 Identify the incremental cash flow in
  each period of the projects life
• Step 4 Compute the present value of each
  periods cash flow using the organizations cost
  of capital for the discount rate
• Step 5 Sum the present values of all the
  periodic cash inflows and outflows to determine
  the investment projects net present value
• Step 6 If the projects net present value is
  positive, the project is acceptable from an
  economic perspective

27
Net Present Value (3 of 4)

• To determine the NPV of Shirleys investment
• Step 1 The period length is one year
• All cash flows are stated annually
• Step 2 Shirleys cost of capital is 10 per year
• Because the period chosen in step 1 is annual, no
  adjustment is necessary to the rate of return
• Step 3 The incremental cash flows are
• 70,000 outflow immediately
• 20,000 inflow at the end of each year for five
  years
• 10,000 inflow from salvage at the end of five
  years
• It is useful to organize the cash flows
  associated with a project on a time line to help
  identify and consider all the projects cash
  flows systematically

28
Net Present Value (4 of 4)

• Step 4 The present value of the cash flows when
  the organizations cost of capital is 10 are
• For a five-year annuity of 20,000, PV 75,816
• For the 10,000 salvage in five years, PV
  6,209
• Step 5 To sum the present values of all the
  periodic cash flows and determine NPV
• The PV of the cash inflows (from step 4) is
  82,025
• Because the investment of 70,000 takes place at
  time zero, the PV of the total outflows is
  (70,000)
• The NPV of this investment project is 12,025
• Step 6 Because the NPV is positive, Shirleys
  should purchase the cooker
• It is economically desirable

29
Internal Rate of Return (1 of 2)

• The internal rate of return (IRR) is the actual
  rate of return expected from an investment
• The IRR is the discount rate that makes the
  investments net present value equal to zero
• If an investments NPV is positive, then its IRR
  exceeds its cost of capital
• If an investments NPV is negative, then its IRR
  is less than its cost of capital
• By trial and error, or the use of a financial
  calculator or spreadsheet software, we find that
  the IRR in Shirleys is 16.14
• Because a 16.14 IRR gt 10 cost of capital, the
  project is desirable

30
Internal Rate of Return (2 of 2)

• IRR has some disadvantages
• It assumes that a projects intermediate cash
  flows can be reinvested at the projects IRR
• Frequently an invalid assumption
• It can create ambiguous results, particularly
• When evaluating competing projects in situations
  where capital shortages prevent the organization
  from investing in all positive NPV projects
• When projects require significant outflows at
  different times during their lives
• Moreover, because a projects NPV summarizes all
  its financial elements, using the IRR criterion
  is unnecessary when preparing capital budgets
• Still, it is a widely used capital budgeting tool

31
Survey Results Rating the Capital Budgeting
Tool as Extremely Important
32
Profitability Index (1 of 2)

• The profitability index is a variation of the net
  present value method
• It is used to make comparisons of mutually
  exclusive projects with different sizes and is
  computed by dividing the present value of the
  cash inflows by the present value of the cash
  outflows
• A profitability index of 1 or greater is required
  for the project to be acceptable

33
Profitability Index (2 of 2)

• Recall that with Shirleys Doughnut Hole, the
  present value of the cash inflows was 82,025 and
  the present value of the cash outflows was
  70,000
• Therefore, the profitability index for that
  project was 1.17
• 82,025/70,000
• It is possible for project A to have a higher
  profitability index while project B has a higher
  NPV
• An organization must determine how to choose when
  the criteria give conflicting results

34
Economic Value Added (1 of 2)

• Recently, some analysts and consultants have
  proposed using the economic value added (EVA)
  criterion as a way to evaluate organization
  performance
• Although the criterion is not directly suitable
  for evaluating new investments, its insights are
  useful
• Computing EVA begins by using accounting income
  calculated according to GAAP
• Then the analyst adjusts accounting income for
  what the EVA proponents consider to be GAAPs
  conservative bias
• Common adjustments include capitalizing and
  amortizing research and development and
  significant product launch costs, adjusting for
  the LIFO effect on inventory valuation, and
  eliminating the effect of deferred income taxes

35
Economic Value Added (2 of 2)

• Next, the analyst computes the amount of
  investment in the organization and derives
  economic value added as follows
• EVA Adj. accounting income - (Cost of capital x
  Investment)
• The formula for economic value added is directly
  related to the net present value criterion
• The major difference between the two is that EVA
  begins with accounting income, which includes
  various accruals and allocations rather than net
  cash flow as does NPV
• This is why EVA is more suited to evaluating an
  ongoing investment than a new investment
  opportunity

36
Effect of Taxes (1 of 3)

• In practice, capital budgeting must consider the
  tax effects of potential investments
• The exact effect of taxes on the capital
  budgeting decisions depends on tax legislation,
  which is specific to a tax jurisdiction
• In general, the effect of taxes is twofold
• Organizations must pay taxes on any net benefits
  provided by an investment
• Organizations can use the depreciation associated
  with a capital investment to reduce income and
  offset some of their taxes
• The rate of taxation and the way that legislation
  allows organizations to depreciate the
  acquisition cost of their long-term assets as a
  taxable expense varies over time and by
  jurisdiction

37
Effect of Taxes (2 of 3)

• Assume Shirleys income taxed rate is 40
• For simplicity, assume that the relevant tax law
  requires Shirleys to claim straight-line
  depreciation as a tax-deductible expense
• (Historical cost less salvage value) / useful
  life
• This analysis requires converting all pretax cash
  flows to after-tax cash flows
• Using straight-line depreciation, Shirleys
  Doughnut Hole will claim 12,000 depreciation
  each year
• Taxable income of 8,000 will result in Shirleys
  paying 3,200 in income taxes each year
• The annual after-tax cash flow will be 16,800

38
Effect of Taxes (3 of 3)

• The investment provides two after-tax benefits
• Five-year annuity of 16,800
• Lump-sum payment of 10,000 at the end of five
  years
• Because book value after five years is 10,000,
  there is no gain in selling it for 10,000 and,
  therefore, no tax
• The present value of the five-year annuity of
  16,800 discounted at 10 is 63,685
• The present value of the lump-sum payment of
  10,000 is 6,209
• The net present value of this investment project
  is (106)
• (63,685 6,209 - 70,000)
• Because the projects net present value is
  negative, it is not economically desirable

39
Effect of Inflation

• Inflation is a general increase in the price
  level
• To account for inflation we must adjust future
  cash flows so that we can compare dollars of
  similar purchasing power
• Similarly, we discounted future cash flows to the
  present using an appropriate discount rate to
  account for the time value of money
• We discount each cash flow by the appropriate
  discount rate and the expected inflation rate
• If Shirleys expected inflation of 2.5, the
  combined discount rate would be 1.1275
• 1.10 x 1.025

40
Uncertainty in Cash Flows (1 of 2)

• Capital budgeting analysis relies on estimates of
  future cash flows
• Because estimates are not always realized, many
  decision makers like to know how their estimates
  affect the decision they are making
• Estimating future cash flows is an important and
  difficult task
• Important because many decisions will be affected
  by those estimates
• Difficult because these estimates will reflect
  circumstances that the organization may not have
  previously experienced

41
Uncertainty in Cash Flows (2 of 2)

• Most cash flow estimation is incremental
• Meaning that it is based on previous experience
• E.g., based on manufacturer claims, a new machine
  might be expected to decrease costs by 10
• Many organizations assume that learning will
  systematically reduce the costs of a new system
  or process
• Cash flows related to sales of a new product are
  often estimated based on past experiences with
  similar products
• The forecast usually starts with previous
  experience and makes adjustments

42
High Low Method

• One approach to estimating cash flows begins by
  asking the planner to estimate the most likely
  effect of a decision, such as a cost decrease or
  a revenue increase, and then to estimate the
  highest and lowest possible values
• The planner next constructs a normal distribution
  with a mean equal to the most likely value
  estimated and a standard deviation calculated by
  subtracting the mean from the highest estimated
  value and dividing the difference by 3
• Only the mean or expected value of the estimate
  is needed for the net present value model, but by
  developing a distribution of expected outcomes,
  the planner can develop probabilistic statements
  about the results
• E.g., I believe the probability is about 98
  (.9772) that the net cash flow benefit will be at
  least 80,000

43
Expected Value Method

• Another approach for the planner is to identify
  four or five possible outcomes and to assign each
  a probability of occurring, such that the total
  probabilities assigned equals one
• Then the expected value of the estimate is
  computed by weighting each estimate by its
  probability
• This estimate would be used in the capital
  budgeting model to project the revenue and cost
  effects of the investment project

44
Wait and See

• In some circumstances, an organization may be
  able to delay a final decision and undertake a
  smaller version of the project to gain more
  information
• E.g., introducing a prototype of a new product to
  a consumer panel, or purchasing a few machines
  instead of many machines
• Analysts have developed an interest in applying
  options theory to investment decisions
• A process called real options analysis
• In real options analysis, the organization
  purchases an option that allows the option holder
  to purchase an asset at a specified future point
  in time at a specified price
• A form of option called a European call option
• The value of the option is determined by the
  volatility of the future value of the asset

45
What-If Sensitivity Analysis (1 of 2)

• Two other approaches to handling uncertainty are
  what-if and sensitivity analysis
• In the Shirleys Doughnut Hole example, Shirley
  might ask, What must the cash flows be to make
  this project unattractive?
• Fortunately, computer spreadsheets make questions
  like this easy to answer
• Most planners today use personal computers and
  electronic spreadsheets for capital budgeting
• The planner can set up a computer spreadsheet to
  make changes to the estimates of the decisions
  key parameters

46
What-If Sensitivity Analysis (2 of 2)

• If the analysis explores the effect of a change
  in a parameter on an outcome, we call this
  investigation a what-if analysis
• For example, the planner may ask, What will my
  profits be if sales are only 90 of the plan?
• A planners investigation of the effect of a
  change in a parameter on a decision, rather than
  on an outcome, is called a sensitivity analysis
• For example, the planner may ask, How low can
  sales fall before this investment becomes
  unattractive?

47
Strategic Considerations (1 of 3)

• The common benefits associated with acquiring
  long-term assets (e.g., increased profits) ignore
  the assets strategic benefits, which are of
  increasing importance
• Including strategic benefits in a capital
  budgeting example is controversial
• They are difficult to estimate, so they are risky
  to include
• However, strategic benefits are likely to be no
  more difficult to estimate than the profits from
  expected sales or expected cost savings

48
Strategic Considerations (2 of 3)

• Long-term assets usually provide the following
  strategic benefits
• They allow an organization to make goods or
  deliver a service that competitors cannot
• E.g., by developing a patented process to make a
  product that competitors cannot replicate
• They support improving product quality by
  reducing the potential to make mistakes
• E.g., by improving machining tolerances or
  reducing reliance on operator settings
• They help shorten the production cycle time
• E.g., by implementing one-hour photo developing

49
Strategic Considerations (3 of 3)

• Shirleys may consider investing in a cooker that
  senses when a doughnut is cooked and ejects it
  automatically
• It may allow the hiring of less-skilled, and
  lower-paid employees
• The cooker may improve the consistency of cooking
  and the quality of the doughnuts
• Customers are likely to find Shirleys doughnuts
  more desirable
• In this situation, the benefits from the
  automatic cooker can include increased sales and
  lower operating expenses if the competitors do
  not have this cooker
• The automatic cooker can prevent an erosion of
  sales if Shirleys competitors also purchase it
• In either situation, acquiring the automatic
  cooker provides benefits that should be
  incorporated in the capital budgeting analysis

50
Post-Implementation Audits (1 of 3)

• After-the-fact audits can provide an important
  discipline to capital budgeting
• Revisiting the decision to purchase a long-lived
  asset is called a post-implementation audit of
  the capital budgeting decision and provides many
  valuable insights for decision makers
• When estimates are used to support proposals,
  recognizing the behavioral implications that lie
  behind them is important
• For example, a production supervisor who is
  anxious to have the latest production equipment
  may be optimistic to the point of being reckless
  in forecasting the benefits of acquiring the
  equipment

51
Post-Implementation Audits (2 of 3)

• This behavior is mitigated if people understand
  that, once equipment is acquired, the company
  will compare results with the claims made in
  support of the equipments acquisition
• And that higher costs, including depreciation,
  will be assigned to products or customers
  produced with or served by this asset
• Many organizations fail to compare the estimates
  made in the capital budgeting process with the
  actual results
• This is a mistake for three reasons

52
Post-Implementation Audits (3 of 3)

• By comparing estimates with results, the
  organizations planners can identify where their
  estimates are wrong and try to avoid making
  similar mistakes in the future
• By assessing the skill of planners, organizations
  can identify and reward those who are good at
  making capital budgeting decisions
• By auditing the results of acquiring long-term
  assets, companies create an environment in which
  planners are less tempted to inflate estimates of
  the cash benefits associated with their projects
  in order to get them approved

53
Budgeting OtherSpending Proposals (1 of 2)

• Organizations develop spending proposals for
  discretionary items other than capital
  expenditures
• E.g., RD, advertising, and training
• Such items can provide benefits that will be
  realized for many periods into the future
• Even if GAAP requires that they be currently
  expensed
• Their magnitude suggests that they should be
  evaluated like capital spending projects when
  possible

54
Budgeting OtherSpending Proposals (2 of 2)

• The approach to analyzing a discretionary
  expenditure is identical to that used to decide
  whether to make a capital investment
• Estimate the discounted cash inflows (benefits)
  and discounted cash outflows (costs) associated
  with any discretionary spending project
• Accept the project if the NPV is positive

55
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concerning this PowerPoint presentation, please
contactTerry M. Lease(terry.lease_at_sonoma.edu)S
onoma State University