Ch 12: Capital Budgeting Decisions

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Ch 12 Capital Budgeting Decisions
Plant expansion
Equipment selection
Equipment replacement
New technology
Lease or buy
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Capital investment decisions

• All of these decisions involve a large outlay of
  resources to acquire assets that will be used
  over multiple periods.
• The assets must generate an acceptable return on
  and return of investment to compensate for risk.

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Before we let you buy that
new machine you wanted, we want to know what
return we are going to get out
of it?
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Nondiscounted methods
Payback period
Accounting rate of return
These approaches are simple to use, but they
ignore the time value of money.
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Payback MethodThe time required for a project
to recover its original investment (i.e. pay for
itself)

• Investment
• Annual cash flows

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The Payback Method

• Meyers Company wants to install an espresso bar
  that costs 140,000 in its restaurant.
• Net annual cash inflows are estimate to be
  35,000.
• How long will it take for the espresso bar to
  pay for itself?
• If Meyers requires a payback period of 5 years or
  less on all investments, would they invest?
• What are some of the weaknesses of this approach?

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Accounting rate of return (ARR)

• Accounting income
• Investment
• Focus is on accounting earnings,
• not cash flow.
• What are some of the differences between cash
  flow and income?

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ARR Example

• The espresso bar, which costs 140,000
• Will generate revenues of 100,000, cash expenses
  of 65,000, and will be depreciated using the SL
  method over ten years.
• Meyers investors demand a minimum return on
  assets of at least 12.
• What is the annual cash inflow? Income?
• Should they invest?
• What are some of the weaknesses of this approach?

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Time Value of Money

• Capital investments extend over long periods of
  time, so we must recognize the time value of
  money.
• In general, investments that promise returns
  earlier in time are preferable to those that
  promise returns later in time.
• See Appendix for Review of PV Concepts and Tables

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Discounted methods
Net present value NPV
Internal rate of return IRR
These methods explicitly incorporate the
time value of money using present value
concepts. The emphasis is on cash flows, not
accounting earnings.
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Net Present Value (NPV)

• The difference between the present value of
  expected future cash inflows and expected future
  cash outflows (including the original investment).

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A Simple NPV example

• A one-time investment of 10,000 in training is
  expected to generate savings of 3,000 per year
  for the next four years. The prevailing interest
  rate is 7.
• What is the NPV of this investment?

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The cash flow stream looks like

• Year Amt. factor PV
• 0 (10,000) 1 (10,000)
• 1 3,000 .935 2,805
• 2 3,000 .873 2,619
• 3 3,000 .816 2,448
• 4 3,000 .763 2,289
• Total 2,000 NPV 161

Is this an acceptable investment?
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NPV Decision Rules
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Internal Rate of Return (IRR)

• The return that the investment is expected to
  yield.
• Relationship of IRR to NPV
• If IRR gt Req. rate, then NPV is positive.
• If IRR Req. rate, then NPV is zero.
• If IRR lt Req. rate, then NPV is negative.

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How to solve for IRR

• Trial and error
• Use different required rates until NPV 0.
• Previous example 10,000 investment, 3,000
  cash flows for 4 years
• 7 return NPV 161
• 8 return NPV (64).
• Thus, IRR is between 7 and 8
• Spreadsheet or calculator functions
• Make this type of sensitivity analysis easy.
• Exact IRR is 7.71

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Complicating Issues in Capital Budgeting

• Determining the discount rate.
• Estimating future cash inflows and outflows.
• Converting to after-tax cash flows.
• Depreciation issues
• Method (SL or MACRS)
• Calculating the depreciation tax shield
• Disposing of Asset at End of Project

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Choosing a Discount Rate

• Also called the required rate or hurdle rate.
• The discount rate is associated with the
  companys cost of capital.
• Capital All sources of investment funds, both
  debt and equity.

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Typical Cash Outflows
Repairs and maintenance
Initial Cost of investment Less any Proceeds from
Disposal of Old Assets
Investment in Working Capital
Incremental operating costs
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Typical Cash Inflows
Salvage value
Release of working capital
Cost Savings
Increased revenues
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Conversion to After-Tax Cash Flows

• For any cash inflow that would be taxed, or any
  cash outflow that would be tax deductible
• After-tax cash flow Cash Flow X (1 - t)
• Example
• A 20,000 investment is expected to generate
  additional revenues of 10,000 and operating
  costs of 2,000 per year. The marginal tax rate
  is 40.
• What is the annual after-tax cash flow?

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Depreciation and other non-cash adjustments

• Why is depreciation called a non-cash expense?
• But depreciation has an indirect effect on cash
  flow because it is tax deductible.
• Depreciation shield the cash inflow that
  results from tax savings.
• Cash Inflow Dep. Expense X Tax Rate

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Depreciating the Assets

• MACRS or Straight-line
• Depreciation is for taxes, not GAAP. WHY?
• Half-year convention Assume asset is purchased
  at mid-year.
• Ignore salvage value in depreciation calculation
• BUT salvage value has cash and tax consequences
  at end of project.
• Accelerated depreciation methods result in tax
  benefits! Why?

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MACRS versus SL
3- Year Assets 5-Year Assets 7-Year
Assets (Small tools) (Autos
and computers) (Equipment, furniture) Year MA
CRS SL MACRS SL MACRS
SL 1 33.33 16.67 20.00 10 14.29 7.14 2
44.45 33.33 32.00 20 24.49 14.29 3 14.
81 33.33 19.20 20 17.49 14.29 4
7.41 16.67 11.52 20 12.49 14.29 5 11.5
2 20 8.93 14.29 6 5.76 10
8.92 14.28 7 8.93 14.28 8
4.46 7.14
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Depreciation Example

• A company is considering investing in new
  computer equipment at a cost of 100,000. The
  tax rate is 40
• Compute the present value of the depreciation
  shields under straight-line and MACRS using a 10
  required rate of return.

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Difference is 1,982.59.
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Disposing of Assets

• Proceeds result in a cash inflow
• Are there any tax consequences?
• If the asset is fully depreciated, all of the
  proceeds are subject to tax. Treat like taxable
  cash inflow.
• If the asset is not fully depreciated, only the
  gain/loss is taxed.
• Gain/Loss Proceeds - Basis (Cost - A.D.)
• Losses result in tax savings (like depreciation)
• Gains result in cash outflow (extra taxes).
• Multiply by tax rate to determine cash effect.

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An Example

• A company is considering replacing an existing
  machine with a new and improved version. The tax
  rate is 40.
• The old machine, purchased five years ago for
  50,000, is being depreciated using the
  straight-line method (7 year asset). Its current
  resale value is 10,000.
• Compute the cash inflow from the old machine if
  the new machine is purchased.

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Solution for Old Machine

• Accumulated Depreciation 32,150 (64.3 of
  50,000)
• Basis 17,850 (50,000 - 32,150)
• Loss 10,000 - 17,850 lt7,850gt
• Tax Savings on Loss 7850 .40 3140
• 10,000 Proceeds
• 3,140 Tax Savings
• 13,140 Total Inflow
• How would the results change if it had been a
  gain instead of a loss?

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Example New Machine

• The old machine would be replaced with a new
  machine which would
• Cost 100,000 and be depreciated using MACRS (7
  years).
• Have a salvage value of 20,000 at the end of ten
  years.
• What is the expected cash inflow from disposing
  of the new machine at the end of its expected
  life?

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Solution for New Machine

• After ten years, the new machine would be fully
  depreciated and all proceeds would be taxed as a
  gain.
• Proceeds 20,000
• Tax on Gain 8,000
• Net Inflow 12,000 (or 20,000
  1-.40)