CAPITAL BUDGETING

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CAPITAL BUDGETING

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CAPITAL BUDGETING

• PROCESS OF SELECTING THAT SET OF INVESTMENTS THAT
  WILL MAXIMIZE SHAREHOLDER WEALTH

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TYPES OF PROJECTS
INDEPENDENT - TWO PROJECTS ARE INDEPENDENT IF
THE DECISION TO ACCEPT ONE PROJECT HAS NO EFFECT
ON THE CASH FLOWS OF THE OTHER PROJECT EXAMPLE-
MCDONALDS IS CONSIDERING THE ADDITION OF TWO NEW
RESTAURANTS ONE ON THE NORTH POLE AND ONE ON THE
SOUTH POLE. MUTUALLY EXCLUSIVE PROJECTS - TWO
PROJECTS ARE MUTUALLY EXCLUSIVE IF THE DECISION
TO ACCEPT ONE PROJECT PRECLUDES ACCEPTANCE OF THE
OTHER PROJECT
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ESTIMATING PROJECT CASH FLOWS
RELEVANT CASH FLOWS ARE THOSE THAT ARE
INCREMENTAL DUE TO THE PROJECT CASH FLOWS ARE
ESTIMATED AT THREE POINTS IN TIME 1. AT THE
START OF THE PROJECT (TIME ZERO) 2. DURING THE
PROJECT (OPERATING CASH FLOWS) 3. AT THE
CONCLUSION OF THE PROJECT (TERMINAL CASH
FLOWS)
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A PROBLEM FOR PRACTICE
TECHTONIC PLATING IS CONSIDERING A NEW FOUR YEAR
REPLACEMENT PROJECT. THE OLD ASSET HAS A BOOK
VALUE OF 0 AND CAN BE SOLD FOR 100,000. THE
NEW MACHINE COSTS 1 MILLION AND WILL COST
500,000 TO INSTALL. THE NEW MACHINE IS IN THE
THREE-YEAR PROPERTY CLASS. THE PROJECT IS
ESTIMATED TO GENERATE 1,750,000 IN ANNUAL SALES
WITH FIXED AND VARIABLE COSTS TOTALING 650,000.
THE PROJECT WILL REQUIRE NET WORKING CAPITAL TO
INCREASE BY 200,000. IT IS ESTIMATED THE
NEW MACHINE CAN BE SOLD FOR 150,000 AT THE
CONCLUSION OF THE PROJECT. IF THE TAX RATE IS
40, ESTIMATE THE TOTAL INCREMENTAL CASH FLOWS
ARISING FROM THE PROJECT.
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TIME ZERO CASH FLOWS
TIME ZERO CASH FLOWS OCCUR DUE TO 1. SALE OF
OLD EQUIPMENT 2. PURCHASE AND INSTALLATION OF NEW
EQUIPMENT 3. AN INCREASE IN NET WORKING CAPITAL
DUE TO THE PROJECT
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SALE OF OLD EQUIPMENT
SELLING AN ASSET GENERATES CASH AND CAN HAVE TAX
CONSEQUENCES. THE FOLLOWING EQUATION ILLUSTRATES
THE CASH AND TAX EFFECTS OF SELLING AN
ASSET AFTER-TAX CF FROM ASSET SP - (SP -
BV)T WHERE SP SALE PRICE OF THE ASSET
BV BOOK VALUE OF THE ASSET
T TAX RATE
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EXAMPLE
SP 100,000 BV 0 T
40 AFTER-TAX CASH FLOW FROM ASSET 100,000 -
(100,000 - 0).4 60,000
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LETS WORK SOME PROBLEMS!!
PROBLEMS 8-6 AND 8-7 ON PAGE 331
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PURCHASE AND INSTALLATION OF NEW EQUIPMENT
AS TITLE SUGGESTS, CASH OUTFLOWS DUE TO PURCHASE
AND INSTALLATION OF NEW EQUIPMENT ARE TO BE
CONSIDERED FOR CAPITAL BUDGETING PURPOSES. COST
INSTALLATION 1,500,000
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INCREASE IN NET WORKING CAPITAL
RECALL THAT NWC CA - CL 200,000 A CAPITAL
BUDGETING PROJECT CAN CAUSE THE NEED FOR NWC TO
INCREASE. THIS IS REPRESENTED AS A CASH OUTFLOW
AT TIME ZERO AND A CASH INFLOW AT THE END OF THE
TERMINATION OF THE PROJECT
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LETS WORK A PROBLEM!!
PROBLEM 8-10 ON PAGE 332
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CASH FLOWS OCCURING DURING THEPROJECT
THESE ARE INCREMENTAL OPERATING CASH FLOWS
CAUSED BY THE PROJECT. THEY CAN BE ESTIMATED BY
THE FOLLOWING EQUATION DOCF (DS - DC)(1 - T)
DD(T) WHERE OCF OPERATING CASH
FLOW S SALES C
COSTS (FIXED AND VARIABLE) D
DEPRECIATION T TAX RATE
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EXAMPLE
DOCF (DS - DC)(1 - T) DD(T) DOCF
(1,750,000 - 650,000)(1 - .4) 495,000(.4)
858,000
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SOLUTION
STEP 1 FIND DEPRECIATION FOR EACH OF THE
FOUR YEARS. D1 1,500,000(.33)
495,000 D2 1,500,000(.45) 675,000 D3
1,500,000(.15) 225,000 D4 1,500,000(.07)
105,000 STEP 1 USE EQUATION DOCF (DS -
DC)(1 - T) DD(T) DOCF1 (1,750,000 -
650,000)(1 - .4) 495,000(.4) 858,000 DOCF2
(1,750,000 - 650,000)(1 - .4) 675,000(.4)
930,000 DOCF3 (1,750,000 - 650,000)(1 -
.4) 225,000(.4) 750,000 DOCF4 (1,750,000
- 650,000)(1 - .4) 105,000(.4) 702,000
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LETS WORK A PROBLEM!!
PROBLEM 8-14 ON PAGE 333.
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TERMINAL CASH FLOWS
CONSIDER AFTER-TAX CASH FLOWS FROM SALE OF THE
PROJECT AT THE END OF ITS USEFUL LIFE AFTER-TAX
CF FROM ASSET SP - (SP - BV)T
150,000 -
(150,000 - 0).4
90,000 RECAPTURE OF NET
WORKING CAPITAL
200,000
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TOTAL PROJECT CASH FLOWS
0 1
2 3 4
60,000 858,000 930,000
750,000 702,000 -200,000

90,000 -1,500,000

200,000 -1,640,000

992,000
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OTHER THINGS TO CONSIDEER
OPPORTUNITY COSTS SIDE EFFECTS
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THINGS NOT CONSIDERED
SUNK COSTS FINANCING COSTS
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LETS WORK A PROBLEM
PROBLEM 8-21 ON PAGE 336.
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CAPITAL BUDGETING TECHNIQUES

• PAYBACK
• NPV
• IRR
• MODIFIED IRR

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NUMERICAL DATA
TIME INVESTMENT A
INVESTMENT B 0
-1,640,000
-2,000,000 1
858,000
575,000 2
930,000
575,000 3
750,000
575,000 4
992,000
575,000 FIRMS COST OF CAPITAL 12
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PAYBACK COMPUTATION
TO DETERMINE A PROJECTS PAYBACK PERIOD, NET THE
CASH INFLOWS FROM THE INITIAL CASH OUTFLOW UNTIL
YOU GET TO ZERO PROJECT A
PROJECT B -1,640,000
-2,000,000/575,000 3.48
858,000 1 - 782,000
782,000/930,000 .84 SO PAYBACK A 1.84 YEARS
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PAYBACK DECISION RULE
ACCEPT ALL INDEPENDENT PROJECTS WITH PAYBACKS
LESS THAN MANAGEMENTS ALLOWABLE PAYBACK ACCEPT
MUTUALLY EXCLUSIVE PROJECT WITH THE LOWEST
PAYBACK IF IT IS LESS THAN MANAGEMENTS ALLOWABLE
PAYBACK
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PROBLEMS WITH PAYBACK
DOESNT CONSIDER CASH FLOWS AFTER THE PAYBACK
PERIOD DOESNT CONSIDER THE TIME VALUE OF MONEY
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PROFITABILITY INDEX
SIMPLY COMPUTED AS THE PRESENT VALUE OF THE
INFLOWS COMING AFTER THE INITIAL INVESTMENT
DIVIDED BY THE INITIAL INVESTMENT PI PRESENT
VALUE OF THE CASH FLOWS AFTER INITIAL INVESTMENT

INITIAL INVESTMENT
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COMPUTATION OF PI FOR PROJECT A
PV OF PROJECT A CASH INFLOWS 858,000/(1.12)
930,000/(1.12)2 750,000/(1.12)3
992,000/(1.12)4
2,671,730.85
PI 2,671,730.85 1.63
1,640,000
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COMPUTATION OF PI FOR PROJECT B
PV OF PROJECT B CASH FLOWS 575,000(PVIFA, 4,
12) 1,746,475.87 PI 1,746,475.87
.8733 2,000,000
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PI DECISION RULE
ACCEPT ALL INDEPENDENT PROJECTS WITH PI gt 1. FOR
MUTUALLY EXCLUSIVE PROJECTS, ACCEPT THE PROJECT
WITH THE HIGHEST PI AS LONG AS IT IT gt 1.
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PROBLEM WITH PI
IGNORES DIFFERENCES IN PROJECT SCALE
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NET PRESENT VALUE
A PROJECTS NPV IS SIMPLY THE PRESENT VALUE OF
ALL PROJECT CASH FLOWS NPV ?CFt/(1
i)t PROJECT A NPV -1,640,000 858,000/1.12
930,000/1.122
750,000/1.123 992,000/1.124
1,031,730.85 PROJECT B NPV -2,000,000
575,000/1.12 575,000/1.122
575,000/1.123 575,000/1.124
-253,524.13
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NPV DECISION RULE
ACCEPT ALL INDEPENDENT PROJECTS WITH NPV
gt0 ACCEPT MUTUALLY EXCLUSIVE PROJECT
WITH HIGHEST NPV IF IT IS gt 0
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INTERNAL RATE OF RETURN
A PROJECTS IRR IS THE DISCOUNT RATE CAUSING THE
PRESENT VALUE OF ITS CASH INFLOWS TO EQUAL THE
PRESENT VALUE OF ITS OUTFLOWS OR THE DISCOUNT
RATE PRODUCING AN NPV OF 0 AKA THE PROJECTS
YIELD
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IRR PROJECTS A AND B
0 ?CFt/(1 irr)t - I
IRR A 0 -1,640,000 858,000 930,000
750,000 992,000
(1 IRR) (1 IRR)2 (1 IRR)3
(1 IRR)4
IRR A 39.14 IRR B 0 - 2,000,000 575,000
575,000 575,000 575,000
(1 IRR)
(1 IRR)2 (1 IRR)3 (1 IRR)4 IRR B
5.83
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IRR DECISION RULE
ACCEPT ALL INDEPENDENT PROJECTS WITH IRRS HIGHER
THAN THE FIRMS COST OF CAPITAL ACCEPT MUTUALLY
EXCLUSIVE PROJECT WITH THE HIGHEST IRR IF IT IS
HIGHER THAN FIRMS COST OF CAPITAL
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PROBLEMS WITH IRR
1. IMPLICITLY ASSUMES REINVESTMENT OF CASH
INFLOWS AT IRR 2. MULTIPLE IRRS POSSIBLE IF CASH
FLOW SIGN CHANGES MORE THAN ONCE 3. FOR
MUTUALLY EXCLUSIVE PROJECTS, IRR CAN SELECT
WRONG PROJECT
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NPV PROFILE
NPV

X
Y

Y
X
DISCOUNT RATE
CROSS RATE
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MODIFIED IRR
RETURN EQUATING THE PRESENT VALUE OF THE
CASH OUTFLOWS WITH THE FUTURE VALUE OF THE
CASH INFLOWS. IT IS MEANT TO CORRECT THE
REINVESTMENT RATE ASSUMPTION OF THE IRR (I.E.
THAT CASH INFLOWS CAN BE REINVESTED AT THE
PROJECTS IRR)
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MODIFIED IRR
O CFTV/(1 irr)n - I WHERE CFTV CF1(1
i)n-1 CF2(1 i)n-2 . . . CFn I INITIAL
INVESTMENT PROJECT A MODIFIED IRR 0 858,000(1
.12)3 930,000(1 .12)2 750,000(1.12)1
992,000 - 1,620,000
(1
IRR)4

CALCULATOR
4,204,020.22 -1,640,000
-1,640,000 PV
(1 IRR) 4

4,204,020.22 FV

4 N IRR 26.53

CPT I/Y
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MODIFIED IRR PROJECT B
0 CFTV/(1 IRR)n - I 0 575,000(1.12)3
575,000(1.12)2 575,000(1.12)1 575,000
- 2,000,000
(1 IRR)4
CALCULATOR
0 2,748,113.60 - 2,000,000
-2,000,000 PV (1 IRR)4

2,748,113.60 FV

4 N

CPT I/Y
IRR 8.27
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MODIFIED IRR DECISION RULE
ACCEPT ALL INDEPENDENT PROJECTS WHOSE IRR
EXCEEDS THE FIRMS COST OF CAPITAL. IF PROJECTS
ARE MUTUALLY EXCLUSIVE, SELECT THE PROJECT WITH
THE HIGHEST IRR AS LONG AS IT EXCEEDS THE
FIRMS COST OF CAPITAL.