Capital Budgeting

1
Capital Budgeting
Chapter Twenty
2
Learning Objectives

• Explain the strategic role of capital budgeting
• Describe how accountants can add value to the
  capital budgeting process
• Provide a general model for determining relevant
  cash flows for capital expenditure analysis
• Apply discounted cash flow (DCF) decision models
  for capital budgeting purposes

3
Learning Objectives (continued)

• Conduct sensitivity analysis as part of the
  capital budgeting process
• Discuss and apply other capital budgeting
  decision models
• Identify behavioral factors associated with the
  capital budgeting process
• (Appendix) Discuss some complexities associated
  with using DCF decision models

4
Strategic Nature of Capital Budgeting Decisions

• Capital investment decisions
• Involve large amounts of capital outlays
• Provide anticipated returns (cash flows) over an
  extended period of time
• Linkage of capital investment decisions to the
  organizations chosen strategy
• Build strategy
• Hold strategy
• Harvest strategy

5
Introductory Definitions

• Capital budgeting
• The process of identifying, evaluating,
  selecting, and controlling capital investments
• Capital investments
• Long-term investment opportunities involving
  substantial initial cash outlays followed by a
  series of future cash returns
• Capital budget
• Part of the organizations master budget (Chap.
  8) that deals with the current periods planned
  capital investment outlays

6
Introductory Definitions (continued)

• Discounted cash-flow (DCF) decision models
• Decision models (e. g., NPV and IRR) that
  explicitly incorporate the time-value-of-money
• Weighted-average cost of capital (WACC)
• Under normal circumstances, the discount factor
  used in DCF capital budgeting decision models
• A weighted average of the cost of obtaining
  capital from various sources (e.g., equity and
  debt)
• Non-discounted cash flow decision models
• Capital budgeting decision models that do not
  incorporate the time-value-of-money into the
  analysis of capital investment projects

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How Accounting Can Add Value to the Capital
Budgeting Process

• Linking capital budgeting to the master budgeting
  process (planning)
• Linking capital budgeting decisions to the
  organizations Balanced Scorecard (control)
• Generation of relevant data for investment
  analysis purposes (decision making)
• Conducting post-audits (control)

8
Identifying Relevant Cash Flows for Capital
Expenditure Analysis

• Project initiation
• Required investment outlays, including
  installation costs
• Includes incremental net working capital
  commitments
• Project operation
• Cash operating expenses, net of tax
• Additional net working capital requirements
• Operating cash inflows, net of tax
• Project disposal
• Net of tax investment disposal
• Recapture of investment in net working capital

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Decision Example
Smith Company manufactures high-pressure pipe for
deep-sea oil drilling. The firm is considering
the purchase of a milling machine.
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Project Initiation Net After-tax Cash Inflow,
Disposal of Old Asset

• Net proceeds Selling price Disposal costs
• For gain situation
• Net cash inflow Net proceeds (Gain on
  disposal x t)
• For loss situation
• Net cash inflow Net proceeds (Loss on
  disposal x t)

11
Smith Company Data After-tax Cash Inflow,
Disposal of Old Asset
12
Project Initiation Acquisition of New Machine
13
Project Operation After-tax Cash Operating
Receipts/Savings
Transaction Effect on Cash Flow Cash
receipts Amount received (1 - t) Cash
expenditures Amount paid (1 - t) Depreciated
initial cost Tax shield Depreciation expense
t Allocated costs No effect
The company expects its investment to bring in
1,000,000 in cash revenue from increases in
production volume in each of the next four years.
Cash operating expenses are expected to be
750,000/year.
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Smith Company After-tax Cash Operating
Receipts/Savings
Thus, after-tax cash from operations increases by
194,000/year (150,000 44,000)
15
Determining the Annual Depreciation Tax Shield
For simplicity, the preceding example calculated
depreciation expense using the SL method. In most
instances, however, companies use the Modified
Accelerated Cost Recovery (MACRS) method to
determine depreciation expense for tax purposes.
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Smith Company Project Disposal

• The company plans to sell the machine at the end
  of its useful life for 100,000 and incur removal
  and cleanup costs of 20,000
• Return of net working (200,000) originally
  invested in year 0
• At the end of the projects life, the company
  will incur an estimated cost of 150,000 in
  relocation costs for displaced workers. This
  amount is fully deductible for tax purposes.

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Smith Company Project Disposal (continued)
18
Smith Company Project Disposal (continued)
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Smith Company Projected Cash Flows--Summary
Note--Not discussed previously 50,000 (pre-tax)
training costs estimated for Year 1
20
Additional Measurement Issues

• Inflation?
• Opportunity costs?
• Sunk costs?
• Allocated overhead costs?

21
Calculating the Discount Rate (WACC)

• The weighted average cost of capital (WACC) is
  used in capital budgeting to discount future
  anticipated cash flows back to present-dollar
  equivalents
• Weights can be determined based on the target
  capital structure for the firm or based on the
  current market values of the various sources of
  funds

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Calculating the Discount Rate (WACC) (continued)

• The after-tax cost of debt
• Effective interest rate on debt x (1 t)
• Cost of common equity is equal to the
  expected/required market rate of return on the
  companys stock (for listed companies, can be
  estimated using the CAPM)

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Example Calculating the Discount Rate (WACC)
A firm has a 100,000 bank loan with an effective
interest rate of 12 500,000, 10, 20-year
mortgage bonds selling at 90 of face 200,000,
15, 20 noncumulative, noncallable preferred
stock with a total market value of 300,000 and
10,000 shares of 1 par common stock. The
estimated required rate of return on the common
stock, based on application of the CAPM, is 20.
The firm is subject to a 40 tax rate. Lets
calculate the weighted average cost of capital...
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Example Calculating the Discount Rate (WACC)
(continued)
Note the cost of preferred stock is equal to the
current dividend yield on the stock, that is,
current dividend per share of preferred stock ?
current market price per share.
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NPV Decision Model

• Discount all future net-of-tax cash inflows to
  present value using the WACC as the discount
  rate
• Discount all future net-of-tax cash outflows to
  present value using the WACC as the discount
  rate
• If NPV gt 0, accept the project (that is, the
  project adds to the value of the company)
• If NPV lt 0, reject the project (that is, the
  project does not add value to the company)

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NPV Smith Company (_at_ 10.0)
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Internal Rate of Return (IRR) Model

• IRR represents an estimate of the true (i.e.,
  economic) rate of return on a proposed
  investment project
• IRR is calculated as the rate of return that
  produces a NPV of zero
• If IRR gt WACC, then the proposed project should
  be accepted (i.e., its anticipated rate of
  return gt the cost of invested capital for the
  firm)
• If IRR lt WACC, the proposed project should be
  rejected (i.e., its NPV will be lt 0)

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Estimating the IRR of a Project

• General Solution
• Use built-in function in Excel
• When Future Cash Inflows are Uniform
• Use annuity table to identify, in the row
  corresponding to the life of the
  project, an amount initial investment
  outlay ? annual net-of-tax cash inflow
• When Future Cash Inflows are Uneven
• Use a trial-and-error approach (with
  interpolation)

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Sensitivity Analysis

• NPV and IRR models provide an investment
  recommendationaccept or reject a given project
• Sensitivity analysis refers to the sensitivity of
  the recommendation to estimated values for the
  variables in the decision model
• What-if analysis
• Scenario analysis
• Monte Carlo simulation analysis

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What-if Analysis

• Involves changing one variable (e.g., the
  discount rate) at a time as part of this form of
  sensitivity analysis we might consider the
• Most optimistic case
• Most pessimistic case
• Break-even after-tax cash flow amount (use Goal
  Seek option in Excel)

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Other Capital Budgeting Decision Models Payback
Period

• Payback period length of time (in years)
  needed to recover original net investment
  outlay
• When after-tax cash inflows are expected to
  be equal, the payback period is determined as
• Total initial investment/Annual after-tax
  cash inflows

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Investment Decision Example
A four-year project requires an initial
investment of 555,000 in Year 0. The project is
expected to produce 900,000 in cash revenues and
require 660,000 in cash expenses each year. No
additional working capital is required and the
investment will have a salvage value of 60,000.
At the end of the fourth year management expects
to sell the investment for 200,000. Expected
relocation costs are 240,000 and the company is
subject to a 40 tax rate.
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Decision Example (continued)
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Investment Decision Example Payback Calculation
555,000
193,500
Payback Period Payback Period 2.87 years
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Strengths of the Payback Decision Model

• Easy to compute
• Businesspeople have an intuitive understanding
  of payback periods
• Payback period can serve as a rough measure of
  riskthe longer the payback period, the higher
  the perceived risk

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Weaknesses of the Payback Decision Model

• The model fails to consider returns over the
  entire life of the investment
• In its unadjusted state, the model ignores the
  time value of money
• The decision rule for accepting/rejecting
  projects is ill-defined (ambiguous)
• Use of this model may encourage excessive
  investment in short-lived projects

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Present Value Payback Model
Present value payback the amount of time, in
years, for the time-adjusted (i.e., discounted)
future cash inflows to cover the original
investment outlay Note if the discounted
payback period is less that the life of the
project, then the project must have a positive
NPV
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Present Value Payback Model (continued)

• Strength
• Takes into consideration the time value of money
• Weaknesses
• Can motivate excessive short-term investments
• Returns beyond the payback period are ignored
• Decision rule for project acceptance is
  ambiguous/subjective

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Example Calculating the Present Value Payback
Period
Present Value Payback Period 3 years (73,794
132,163)
3.56 years
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Accounting Rate of Return (ARR)
ARR Average annual accounting income ?
Average investment
41
Example Calculating ARR
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Evaluation of ARR Decision Model

• Advantages
• Readily available data
• Consistency between data for capital budgeting
  purposes and data for subsequent performance
  evaluation
• Disadvantages
• No adjustment for the time value of money
  (undiscounted data are used)
• Decision rule for project acceptance is not
  well defined
• The ARR measure relies on accounting numbers,
  not cash flows (which is what the market values)

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Behavioral Issues

• Cost escalation (escalating commitment)--decisi
  on makers may consider past costs or losses as
  relevant
• Incrementalism (the practice of choosing
  multiple, small investments)
• Uncertainty Intolerance (risk-averse managers
  may require excessively short payback periods)
• Goal congruence (i.e., the need to align DCF
  decision models with models used to subsequent
  financial performance)

44
Appendix DCF ModelsSome Advanced Considerations

• In go/no-go situations for independent
  projects, the NPV and IRR methods generally lead
  to the same decision however, there are some
  pitfalls in using the IRR method
• The potential for multiple IRRs
• Mutually exclusive projects
• Capital rationing

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Appendix DCF ModelsSome Advanced Considerations
(continued)

• Except for the capital rationing issue, the
  general rule is to base capital budget
  decision-making on project NPVs, not IRRs.
• Under capital rationing, the indicated approach
  is to make capital budgeting decisions on the
  basis of the profitability index (PI)
  associated with each proposed project
• PI NPV/Initial capital investment

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Chapter Summary

• We explained the nature of capital budgeting
  decisions and the strategic role of capital
  budgeting for organizational success
• We described out accountants can add value to the
  capital budgeting process
• Linking capital budgets to the master budget for
  the organization
• Linking capital budgeting decisions to overall
  strategy, e.g., to the organizations Balanced
  Scorecard (BSC)
• Providing decision-makers with relevant data for
  capital budgeting decision models

47
Chapter Summary (continued)

• We developed a general model for determining
  relevant cash flows for each stage of a projects
  life
• Project initiation
• Project operation
• Project disposal
• We defined and learned how to apply the following
  two DCF capital budgeting decision models
• NPV
• IRR

48
Chapter Summary (continued)

• We discussed, applied, and learned the
  advantages and disadvantages of the following
  other capital budgeting decision models
• Non-DCF Models
• Payback period
• Accounting (Book) rate of return (ARR)
• Additional DCF model
• Present value payback period

49
Chapter Summary (continued)

• We discussed the need for, and methods that can
  be used to perform, sensitivity analysis in
  terms of capital budgeting decisions
• What-if analysis
• Scenario analysis
• Monte Carlo simulation analysis
• We identified several important behavioral
  factors associated with the capital budgeting
  process

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Chapter Summary (continued)

• Finally, in the Appendix we dealt with the
  following complexities associated with the use of
  DCF capital budgeting decision models
• The case of multiple IRRs
• The case of mutually exclusive projects
• The case of capital rationing
• Except for the capital rationing situation, the
  indicated solution is to base capital budgeting
  decisions on project NPVs