Capital Asset Selection and Capital Budgeting

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Chapter 8

• Capital Asset Selection and Capital Budgeting

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Learning Objectives

• 1. How do managers choose which capital projects
  to fund?
• 2. Why do most capital budgeting methods rely on
  analysis of cash flows?
• 3. What are the differences among payback period,
  the net present value method, profitability
  index, and internal rate of return?

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Continuing . . . Learning Objectives

• 4. How do the underlying assumptions and
  limitations of each capital project evaluation
  method affect its use?
• 5. How do taxes and depreciation methods affect
  cash flows?

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Continuing . . . Learning Objectives

• 6. Why are quality management, training, and
  research and development controlled largely by
  capital budget analyses?
• 7. Why do managers occasionally need to quantify
  qualitative information in making capital
  budgeting decisions?

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Continuing . . . Learning Objectives

• 8. Why are environmental issues becoming an
  increasingly important influence on the capital
  budget?
• 9. How and why should management conduct a
  post-investment audit of a capital project?

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Continuing . . . Learning Objectives

• 10. What calculations are necessary to control
  for the time value of money? (Appendix 1)
• 11. How is the accounting rate of return for a
  project determined? (Appendix 2)

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Capital Assets
Lease
Nuclear Power Plant
Copy Machine
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Capital Budgeting Is
Capital budgeting is the process of evaluating
long-range investment proposals for the purpose
of allocating limited resources effectively and
efficiently.
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Capital Budgeting Questions

• Is the activity worth the investment?
• Which assets can be used for the activity?
• Of the suitable assets, which are the best
  investments?
• Screening decision
• Preference decision
• Which of the best investments should the company
  choose?
• Mutually exclusive projects
• Independent projects
• Mutually inclusive projects

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Cash Flows

• Cash receipts and disbursements that arise from
  the purchase, operation, and disposition of
  capital assets
• Cash receipts
• Project revenues that have been earned and
  collected
• Savings generated by reduced project operating
  costs
• Inflows from assets sale and release of working
  capital at end of assets useful life
• Cash disbursements
• Expenditures to acquire asset
• Additional working capital investments
• Amounts paid for related operating costs

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Interest
Interest is a cash flow created by the method of
financing a project.
It should not be considered in project evaluation.
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Return of Capital vs. Return on Capital
Recovery of original investment
Return of Capital
Income for each investment period Interest
included in receipt or payment
Return on Capital
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Use a Timelineto Determine Cash Flows
t0
Time Point
t1
t2
t3
t4
Cash In
Cash Out
Net Cash Flow 500
500 500 500
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Payback Period
A measure of the time it will take a projects
cash inflows to equal the original investment

• The longer it takes to recover the initial
  investment, the greater is the projects risk
• Management sets a maximum acceptable payback
  period
• Often used as a screening technique

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Assumptions of Payback Period

• Speed of investment recovery is the key
  consideration
• Timing and size of cash flows are accurately
  predicted
• Risk (uncertainty) is lower for a shorter payback
  project

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Purchase of Machine Example

• Machine costs 60,000
• Will be used to produce and sell 3,000 units per
  year at 14 for the next 5 years
• Variable costs are 5 per unit
• Annual fixed costs are 5,000
• Cutoff rate of 12 percent
• All revenues and costs are in cash amounts

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Annual Incremental Cash Inflows
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Payback Period

• Payback Period Investment required ? Annual
  cash returns
• 60,000? 22,000 2.7 years

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Limitations of Payback Period

• Ignores cash flows after payback
• Basic method treats cash flows and project life
  deterministically without explicit consideration
  of probabilities
• Ignores time value of money
• Cash flow pattern preferences are not explicitly
  recognized

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Discounted Cash Flow Methods

• Net present value (NPV)
• Profitability index (PI)
• Internal rate of return (IRR)

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Net Present Value Method
Determines whether the rate of return (ROR) on a
project is equal to, higher than, or lower than
the desired ROR

• Accept if
• If NPV 0, actual ROR desired ROR
• If NPV gt 0, actual ROR gt desired ROR
• Reject if
• If NPV lt 0, actual ROR lt desired ROR
• Does not determine expected ROR

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Remember!

• Changing discount rate affects NPV
• Changing timing and size of cash flows affects
  NPV
• NPV can be used to select the best project when
  choosing among investments that can perform the
  same task or achieve the same objective
• NPV should not be used to compare independent
  investment projects that do not have
  approximately the same original asset cost or
  asset life

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Net Present Value Example
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Assumptions of Net Present Value

• Discount rate used is valid
• Timing and size of cash flows are accurately
  predicted
• Life of project is accurately predicted
• If the shorter-lived of two projects is selected,
  the proceeds of that project will continue to
  earn the discount rate of return through the
  theoretical completion of the longer-lived project

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Limitations of Net Present Value

• Basic method treats cash flows and project life
  deterministically without explicit consideration
  of probabilities
• NPV does not measure expected rates of return on
  projects being compared
• Cash flow pattern preferences are not explicitly
  recognized
• IRR of project is not reflected

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Profitability Index
Ratio that compares present value of net cash
inflows with present value of net investment

• Compares projects with different costs
• PI should be at least equal to 1.0
• Gauges the firms efficiency at using its capital
• Does not indicate expected ROR

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Continuing . . . Profitability Index

• PV of Cash Flows
• Profitability Index (PI) ---------------------
  -----
• Investment required
• 79,310
• ---------- 1.3
• 60,000

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Assumptions of Profitability Index

• Same as NPV
• Size of PV of net inflows relative to size of PV
  of investment measures efficient use of capital

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Limitations of Profitability Index

• Same as NPV
• Gives a relative answer but does not reflect
  dollars of NPV

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Internal Rate of Return

• Is the projects expected rate of return
• The discount rate where PV of net cash flows
  cost of project
• Discount rate where NPV 0
• IRR compared with hurdle rate(which is the lowest
  acceptable return on investment)
• Acceptable if IRR gt hurdle rate

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Internal Rate of Return
Discount factor PV of future flows/Annual cash
flows Discount factor 60,000/22,000
2.7 The factor of 2.7 corresponds to an interest
rate between 24 and 25 percent when the number
of periods is five. The IRR is between 24 and 25
percent.
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Assumptions of IRR

• Hurdle rate is valid
• Timing and size of cash flows are accurately
  predicted
• Life of project is accurately predicted
• If the shorter-lived of two projects is selected,
  the proceeds of that project will continue to
  earn the IRR through the theoretical completion
  of the longer-lived project

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Limitations of IRR

• Projects are ranked for funding based on IRR
  rather than dollar size
• Does not reflect dollars of NPV
• Basic method treats cash flows and project life
  deterministically without explicit consideration
  of probabilities
• Cash flow pattern preferences are not explicitly
  recognized
• It is possible to calculate multiple rates of
  return on the same project

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The Effect of Taxation On Cash Flows

• Managers should use after-tax cash flows to
  determine projects acceptability
• Depreciation expense is a tax shield for revenues
• Tax benefit equal to depreciation amount
  multiplied by tax rate
• Type of depreciation method affects amount of
  annual taxable income
• Tax laws can change every year use most current
  regulations
• Tax rates and tax related asset lives may also
  change use most current information

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Annual Incremental After-Tax Cash Inflows
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Payback Period

• Payback Period Investment required ? Annual
  cash returns
• 60,000 ? 18,000 3.3 years

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Net Present Value of After-Tax Example
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Profitability Index

• PV of Cash Flows
• Profitability Index (PI) ---------------------
  -----
• Investment required
• 64,890
• ---------- 1.1
• 60,000

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Internal Rate of Return

• Discount
• factor PV of future flows/Annual cash
  flows
• Discount factor 60,000/18,000 3.333
• The factor of 3.333 corresponds to an interest
  rate between 14 and 16 percent when the number of
  periods is five.
• The IRR is between 14 and 16 percent.

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Uneven Cash Flows

• Now, assume that the salvage value in the
  example is 5,000 at the end of the fifth year.

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Summary of Present Value of Investment
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Net Present Value of Salvage Value Example
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High-Tech Investments
The decision is more a question of how much and
when than whether
Generally requires massive monetary investment
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Possible Reasons for Not Investing

• Worker displacement
• Morale problems
• Implementation problems
• Computers not considered competitive assets
• Difficult to justify investment using traditional
  analyses

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Considerations in High-Tech Investment Analysis

• Discount or hurdle rate may need to be set lower
• Both quantitative and qualitative benefits need
  to be considered
• Quality improvements
• Shortened delivery time
• Improved competitive position
• High-tech investments are not free-standing
• Opportunity cost of not acquiring automated
  equipment is often critical

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Post-Investment Audit
Compare actual project results with expected
results

• Complete after project has stabilized
• Use same analysis techniques as used for original
  decision to accept project
• Used to pinpoint areas of operation not in line
  with expectations
• Helps evaluate accuracy of original cost/benefit
  predictions

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Accounting Rate of Return (ARR)
Measures the expected rate of earnings obtained
on the average capital investment over a
projects life

• Not based on cash flows
• Compared with hurdle rate which may be higher
  than the discount rate
• Compared with ARR of other projects

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Continuing . . . Accounting Rate of Return (ARR)

• Average Annual Income from Project
• ARR -------------------------------------------
  -----
• Average Investment in Project
• 22,000 - (60,000/5)
• Before Taxes ------------------------ 33.3
  
• (60,000 - 0)/2
• 18,000 - (60,000/5)
• After Taxes ------------------------ 20.0
• (60,000 - 0)/2

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Assumptions of ARR

• Effect on company accounting earnings relative to
  average investment in a project is a key
  consideration
• Size and timing of investment cost, project life,
  salvage value, and increases in earnings can be
  accurately predicted

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Limitations of ARR

• Ignores cash flows
• Ignores time value of money
• Treats earnings, investment, and project life
  deterministically without explicit consideration
  of probabilities