Capital%20Budgeting:%20Long-Term%20Assets

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Capital Budgeting Long-Term Assets

• Chapter 11

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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

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Need to Control Capital Assets

• Long-term commitment creates the potential for
• Excess capacity that creates excess costs
• Scarce capacity that creates lost opportunities
• Large amount of money committed to the
  acquisition of capital assets
• 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

• Cost-benefit analysis
• 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
• capital budgeting focuses on whether the expected
  increased cash flows (return) will justify the
  investment in the long-term asset

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Time Value of Money

• 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
• In making investment decisions, the problem is
  that investment cash is paid out now, but the
  cash return is received in the future

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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

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Some Standard Notation
Abbr. Meaning
n FV PV a r Number of periods considered in the investment analysis common period lengths are a month, a quarter, or a year Future value, or ending value, of the investment n periods from now Present value, or the value at the current moment in time, of an amount to be received n periods from now Annuity, or equal amount, received or paid at the end of each period for n periods Rate of return required, or expected, from an investment opportunity the rate of interest earned on an investment
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Future Value

• Because money has time value, it is better to
  have money now than in the future
• 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)

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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

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
1.0000 1.0500 1.1025 1.1576 1.2155 1.2763

• This calculation assumes the following
• Interest earned stays invested until the end of
  year
• Compound effect of interest

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Computing Future Values For Multiple Periods (1
of 2)

• The formula for a future value is FVPV x (1r)n
• Calculator methods (using 5 years at 5)
• 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

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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
• 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

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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
• The conventional choice is the point when the
  investment is undertaken
• Analysts call this time zero, or period zero
• Capital budgeting analysis converts all future
  cash flows to their equivalent value at time zero

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Present Value

• Analysts call a future cash flows value at time
  zero its present value
• The process of computing present value is called
  discounting
• The FV formula can be rearranged to compute the
  present value
• FV PV x (1 r)n
• PV FV/(1 r)n or PV FV x (1 r)-n

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Decay of a Present Value

• Invested amounts grow at a compound rate over
  time
• 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
• Arbitrarily high interest rates will result in
  projects (especially long-term ones) being
  inappropriately turned down

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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

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PV of an Annuity

• 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

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Computing the Required Annuity

• Computing 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

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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

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Capital Budgeting

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

• Payback
• Accounting rate of return
• Net present value

• Internal rate of return
• Profitability index
• EVA criterion

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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 with a cost of capital is 10
• The new cooker would be sold for 10,000 at the
  end of five years

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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 (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
• Compare a projects payback period with a target
  that reflects the organizations acceptable level
  of risk

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Problems with Payback

• The payback criterion has two problems
• Ignores the time value of money
• Ignores the cash outflows that occur after the
  initial investment and the cash inflows that
  occur after the payback period so focus is on
  short-run performance instead of overall
  profitability
• Despite these limitations, some surveys show that
  the payback calculation is the most used approach
  by organizations for capital budgeting

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Accounting Rate of Return

• Accounting rate of return - average accounting
  income divided by the average level of investment
• Used 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

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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
• Drawback does not consider the timing of cash
  flows
• An improvement over the payback method in that it
  considers cash flows in all periods

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Net Present Value

• The net present value (NPV) is the sum of the
  present values of a projects cash flows
• 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

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Net Present Value

• 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

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Net Present Value

• To determine the NPV of Shirleys investment
• Step 1 The period length is one year
• Step 2 Shirleys cost of capital is 10 per year
• 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

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Net Present Value

• 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 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

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Internal Rate of Return

• 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

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Internal Rate of Return

• IRR has some disadvantages
• It assumes that a projects intermediate cash
  flows can be reinvested at the projects IRR
• 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
• Because a projects NPV summarizes all its
  financial elements, using the IRR criterion is
  unnecessary when preparing capital budget

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Survey Results Rating the Capital Budgeting
Tool as Extremely Important
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Profitability Index

• 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

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Profitability Index

• Shirleys Doughnut Hole example the present
  value of the cash inflows was 82,025 and the
  present value of the cash outflows was 70,000
• The profitability index for that project is 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

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Economic Value Added

• Economic value added (EVA) criterion - new way to
  evaluate organization performance
• EVA adjusted accounting income (cost of
  capital investment level)
• Accounting income is adjusted for what the EVA
  proponents consider to be GAAPs conservative
  bias
• Common adjustments 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

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Economic Value Added

• 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

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Effect of Taxes

• In practice, capital budgeting must consider the
  tax effects of potential investments
• 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

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Effect of Taxes

• Assume Shirleys income taxed rate is 40
• 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
• Convert 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

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Effect of Taxes

• 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

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Effect of Inflation

• Inflation is a general increase in the price
  level
• Adjust future cash flow to compare dollars of
  similar purchasing power
• Discount future cash flows to the present using
  an appropriate discount rate to account for the
  time value of money
• 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

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Uncertainty in Cash Flows

• Capital budgeting analysis relies on estimates of
  future cash flows
• 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

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Uncertainty in Cash Flows

• Most cash flow estimation is incremental
• 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

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High Low Method

• Estimate the most likely effect of a decision,
  such as a cost decrease or a revenue increase,
  and then estimate the highest and lowest possible
  values
• 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 probabilistic statements about the results
  can be developed

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Expected Value Method

• Identify 4-5 possible outcomes and assign each a
  probability of occurring, such that the total
  probabilities assigned equals one
• Compute the expected value of the estimate by
  weighting each estimate by its probability
• This estimate is used in the capital budgeting
  model to project the revenue and cost effects of
  the investment project

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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
• 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 European call
  option)
• The value of the option is determined by the
  volatility of the future value of the asset

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What-If Sensitivity Analysis

• 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?
• The planner can set up a computer spreadsheet to
  make changes to the estimates of the decisions
  key parameters

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What-If Sensitivity Analysis

• 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 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 How low can sales fall before this
  investment becomes unattractive?

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Strategic Considerations

• 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 because they
  can be difficult to estimate

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Strategic Considerations

• Long-term assets usually provide the following
  strategic benefits
• They allow an organization to make goods or
  deliver a service that competitors cannot
• They support improving product quality by
  reducing the potential to make mistakes
• They help shorten the production cycle time

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Strategic Considerations

• Shirleys may consider investing in a cooker that
  senses when a doughnut is cooked and ejects it
  automatically
• 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

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Post-Implementation Audits

• 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

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Post-Implementation Audits

• Many organizations fail to compare the estimates
  made in the capital budgeting process with the
  actual results
• This is a mistake for three reasons

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Post-Implementation Audits

• By comparing estimates with results, the
  organizations planners can identify where
  estimates are wrong and 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

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Budgeting OtherSpending Proposals

• Organizations develop spending proposals for
  discretionary items other than capital
  expenditures
• Such items can provide benefits that will be
  realized for many periods into the future
• Their magnitude suggests that they should be
  evaluated like capital spending projects when
  possible

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Budgeting OtherSpending Proposals

• 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