26-1 CAPITAL BUDGETING LONG-RANGE PLANNING CHAPTER 26
Dec 14, 2015
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Capital Budgeting Capital Budgeting
It is the process of considering alternative capital projects and selecting those alternatives that provide the most profitable return on available funds.
Examples of capital projects include land, buildings, equipment and other major fixed asset items.
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I will choose theproject with the mostprofitable return on
available funds.
?
?
?Limited
InvestmentFunds
PlantExpansion
NewEquipment
OfficeRenovation
Alternatives:
Capital Budgeting Capital Budgeting
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Capital Budgeting Capital Budgeting
Implementation of a capital project involves . . . a large commitment of money in
the decision period. a large increase in fixed costs
for a number of years. potential returns in future years. an opportunity cost because of
the rejection of other projects.
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Project Selection:Project Selection:A General ViewA General View
Analysis of cash inflows and cash outflows Net cash inflow is the net cash benefit
expected from a capital project in a period. Time value of money
Cash received today isworth more than thesame amount receivedin the future.
.
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Capital BudgetingCapital BudgetingCash Flow AnalysisCash Flow Analysis
InitialInvestment
IncreasedWorking Capital
Repairsand
Maintenance
IncrementalOperating
Costs
TypicalCash Outflows
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Capital BudgetingCapital BudgetingCash Flow AnalysisCash Flow Analysis
TypicalCash Inflows
ReducedOperating
Costs
ReleasedWorkingCapital
IncrementalRevenues
SalvageValue .
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Capital BudgetingCapital BudgetingTerminologyTerminology
Interest rateindicating thecost of debtand equityinvestment
funds
Cost of capital
Out-of-pocketcosts
Avoided by not selecting
a project
Future cashoutflows
Sunkcosts
Not avoidedby currentdecision
Past cashoutflows
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Depreciation and TaxesDepreciation and Taxes
Depreciation itself is not a cash flow.
However, depreciation results in a reduction of cash outflows by reducing federal
income taxes.
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Depreciation and TaxesDepreciation and TaxesExampleExample
Apex Company is considering the purchase ofnew equipment. Given the following information,
and a tax rate of 40 percent, compute the:
Tax savings due to depreciation. After-tax net cash inflow.
Asset cost 72,000$ Asset life 10 yearsAsset salvage value 12,000$ Straight-line depreciation 6,000 Annual cash inflows 90,000 Annual cash outflows 70,000
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With WithoutDepreciation Depreciation
Net cash inflow from project 20,000$ 20,000$
Depreciation 6,000 -
Amount subject to tax 14,000$ 20,000$
Tax at 40% 5,600$ 8,000$
Tax savings
Tax savings = $2,400 (.40 × $6,000 depreciation = $2,400)
Depreciation and TaxesDepreciation and TaxesExampleExample
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.
Income Cash Flow
Net cash inflow from project 20,000$ 20,000$
Depreciation 6,000 -
Income subject to tax 14,000$ 20,000$
Tax at 40% 5,600 5,600
After-tax amount 8,400$ 14,400$
After-tax net cash inflow
After-tax net Before-tax net Tax Depreciation Tax cash inflow cash inflow rate expense rate+1 - = [ ]
] [ ×( ) ×
[$20,000 (1 - .4)] + [$6,000 .4] = $14,400 × ×
Alternatively, reducing this analysis to a formula yields:
Depreciation and TaxesDepreciation and TaxesExampleExample
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Project Selection MethodsProject Selection Methods
Payback Period Unadjusted Rate of Return Net Present Value (NPV) Profitability Index Time Adjusted Rate of Return
i.e., Internal Rate of Return (IRR)
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Project Selection Method 1:Project Selection Method 1:Payback PeriodPayback Period
Time required for the sumof the annual net cash
inflows to equal theinitial cash outlay.
Time required for the sumof the annual net cash
inflows to equal theinitial cash outlay.
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Payback PeriodPayback Period
When the annual net cash inflows are equal, use the following formula:
Initial cash outlay
Annual net cash inflowPayback period =
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Payback PeriodPayback PeriodExampleExample
Gators wants to install a separate seafood bar in its pub.
The seafood bar will . . . cost $150,000 and has a 10-year life with zero
salvage value.
generate net annual cash inflows of $30,000.
Gators requires a payback period of 6 years or less on all investments.
Should Gators invest in the seafood bar?
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Initial cash outlay Annual net cash inflowPayback period =
Payback period = $150,000$30,000 per year
= 5.0 years
Gators should invest in the seafood bar because the payback period is less than 6 years.
Payback PeriodPayback PeriodExampleExample
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Payback Period LimitationsPayback Period Limitations
Ignores the time valueof money.
Ignores cashflows after the payback
period.
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Payback Period LimitationsPayback Period LimitationsExampleExample
Consider two projects, each with a five-year life and each costing $6,000.
Project One Project TwoNet Cash Net Cash
Year Inflows Inflows
1 2,000$ 1,000$ 2 2,000 1,000 3 2,000 1,000 4 2,000 1,000 5 2,000 1,000,000
Which project has the better payback period?
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Project one returns the $6,000 investment faster -- shorter payback period of three years ($6,000 ÷ $2,000 per year = 3 years).
Project two is clearly superior because of the large cash inflow in the last year.
Can you see the limitations of the payback period?
Payback Period LimitationsPayback Period LimitationsExampleExample
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Project Selection Method 2:Project Selection Method 2:Unadjusted Rate of ReturnUnadjusted Rate of Return
The unadjusted rate of return focuses on annual income instead of cash flows.
Unadjusted Average annual incomerate of return Average amount of investment
=
Beginning balance + Ending balance2
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Unadjusted Rate of ReturnUnadjusted Rate of ReturnExampleExample
What is the the unadjustedrate of return on the seafood bar?
The seafood bar will . . . cost $150,000 and has a 10-year life with zero salvage
value. generate net annual cash inflows of $30,000.
Gators requires a payback period of 6 years or less on all investments and pays tax at 40%.
Reconsider the Gators example:
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.
Unadjusted (30,000 - 15,000) x (1 - .40)rate of return (150,000 + 0) ÷ 2
= = 12.0%
Unadjusted Rate of ReturnUnadjusted Rate of ReturnExampleExample
Annual net cash inflows 30,000$ Depreciation ($150,000 ÷ 10 years) 15,000
Annual income before tax 15,000$
Unadjusted Average annual income after taxrate of return Average amount of investment
=
Unadjusted Average annual before- Average annual TaxRate of tax net cash inflow depreciation rate return Average amount of investment
=( - ) × (1 - )
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Depreciation may be calculated several ways thereby giving different results.
Time value ofmoney is ignored.
Unadjusted Rate of ReturnUnadjusted Rate of ReturnLimitationsLimitations
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Project Selection Method 3:Project Selection Method 3:Net Present Value (NPV) Method Net Present Value (NPV) Method
A comparison of the present value of cash inflows with the present value of
cash outflows
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Chose a minimum rate of return (cost of capital).
Calculate the present value of cash inflows.
Calculate the present value of cash outflows.
NPV = –
Net Present ValueNet Present ValueProcedureProcedure
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If NPV is positive, the investment yields a higher return than the cost of capital.
Decision rule: Invest if NPV is positive.
Net Present ValueNet Present ValueInterpretationInterpretation
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Net Present ValueNet Present ValueQuestionQuestion
Savak Company can buy a new machine for $96,000 which will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is
12 percent, what is the NPV (rounded)?
a. $ 4,306
b. $12,721
c. $11,553
d. $17,004
Savak Company can buy a new machine for $96,000 which will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is
12 percent, what is the NPV (rounded)?
a. $ 4,306
b. $12,721
c. $11,553
d. $17,004
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Savak Company can buy a new machine for $96,000 which will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is
12 percent, what is the NPV (rounded)?
a. $ 4,306
b. $12,721
c. $11,553
d. $17,004
Savak Company can buy a new machine for $96,000 which will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is
12 percent, what is the NPV (rounded)?
a. $ 4,306
b. $12,721
c. $11,553
d. $17,004
Use present value of annuity table (A.4)
PV of inflows = $20,000 × 5.65022 = $113,004
NPV = $113,004 - $96,000 = $17,004
Net Present ValueNet Present ValueQuestionQuestion
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Calculate the NPV if Savak Company’s required return is 14 percent instead of 12 percent.
Calculate the NPV if Savak Company’s required return is 14 percent instead of 12 percent.
Net Present ValueNet Present ValueQuestionQuestion
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Calculate the NPV if Savak Company’s required return is 14 percent instead of 12 percent.
Calculate the NPV if Savak Company’s required return is 14 percent instead of 12 percent.
Use present value of annuity table (A.4)
PV of inflows = $20,000 × 5.21612 = $104,322
NPV = $104,322 - $96,000 = $8,322
Net Present ValueNet Present ValueQuestionQuestion
Note that the NPV is smallerusing the larger interest rate.
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Net Present ValueNet Present Value
Now that you have mastered the basic concept of net present value, it’s time
for a more sophisticated checkup!
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Net Present ValueNet Present Value Example Example
Harper Co. has been offered a five-year contract to provide parts for a large manufacturer,
requiring an investment in new equipment.
The new equipment will . . . cost $160,000, have a five-year useful life, and
a $5,000 salvage value. need an overhaul at the end of three years
costing $30,000. Initial working capital requirement is $100,000.
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The contract is expected to produce the following annual cash flows:
Revenues 750,000$Less: Cost of goods sold 400,000 Gross margin 350,000$Less: Other cash expenses 270,000 Annual net cash inflow 80,000$
Harper uses a 10 percent discount rate. Ignoring income taxes, compute the net
present value of the contract.
Net Present ValueNet Present Value Example Example
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Harper Company Net Present Value Analysis
Net Present ValueNet Present Value Example Example
Year(s) Cash Flow PV factor PV(rounded)Equipment Now (160,000)$ 1.00000 (160,000)$
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Harper Company Net Present Value Analysis
Net Present ValueNet Present Value Example Example
Year(s) Cash Flow PV factor PV(rounded)Equipment Now (160,000)$ 1.00000 (160,000)$ Working capital Now (100,000) 1.00000 (100,000)
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Year(s) Cash Flow PV factor PV(rounded)Equipment Now (160,000)$ 1.00000 (160,000)$ Working capital Now (100,000) 1.00000 (100,000) Annual inflow 1-5 80,000 3.79079 303,263
Harper Company Net Present Value Analysis
Net Present ValueNet Present Value Example Example
Present value of an annuity of $1 factor for 5 years at 10%.
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Year(s) Cash Flow PV factor PV(rounded)Equipment Now (160,000)$ 1.00000 (160,000)$ Working capital Now (100,000) 1.00000 (100,000) Annual inflow 1-5 80,000 3.79079 303,263
Harper Company Net Present Value Analysis
Net Present ValueNet Present Value Example Example
$80,000 × 3.79079 = $303,263
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Year(s) Cash Flow PV factor PV(rounded)Equipment Now (160,000)$ 1.00000 (160,000)$ Working capital Now (100,000) 1.00000 (100,000) Annual inflow 1-5 80,000 3.79079 303,263 Overhaul 3 (30,000) 0.75131 (22,539)
Harper Company Net Present Value Analysis
Net Present ValueNet Present Value Example Example
Present value of $1 factor for 3 years at 10%.
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Year(s) Cash Flow PV factor PV(rounded)Equipment Now (160,000)$ 1.00000 (160,000)$ Working capital Now (100,000) 1.00000 (100,000) Annual inflow 1-5 80,000 3.79079 303,263 Overhaul 3 (30,000) 0.75131 (22,539) Working capital 5 100,000 0.62092 62,092 Salvage value 5 5,000 0.62092 3,105 NPV 85,921$
Harper Company Net Present Value Analysis
Net Present ValueNet Present Value Example Example
Present value of $1 factor for 5 years at 10%.
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Harper Company Net Present Value Analysis
Since the contract has positive NPV, we know the rate of return is greater than the 10 percent discount rate.
Net Present ValueNet Present Value Example Example
Year(s) Cash Flow PV factor PV(rounded)Equipment Now (160,000)$ 1.00000 (160,000)$ Working capital Now (100,000) 1.00000 (100,000) Annual inflow 1-5 80,000 3.79079 303,263 Overhaul 3 (30,000) 0.75131 (22,539) Working capital 5 100,000 0.62092 62,092 Salvage value 5 5,000 0.62092 3,105 NPV 85,921$
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Project Selection Method 4: Project Selection Method 4: Profitability IndexProfitability Index
Provides a means of ranking projects that have different initial investments.
Decision rule: consider only those projects with a profitability index of 1.00 or more.
Present value of net cash inflows Present value of cash outflowsProfitability index =
.
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The interest rate that makes . . .
Project Selection Method 5:Project Selection Method 5:Time Adjusted Rate of ReturnTime Adjusted Rate of Return
Presentvalue of
cash inflows
Presentvalue of
cash outflows
=
Also known as the internal rate of return.
The net present value equal zero.
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For projects with equal annual cash flows (i.e., annuities)
Determine the payback period. Use the present value of annuity table
to determine the IRR.
Internal Rate of Return (IRR)Internal Rate of Return (IRR)ProcedureProcedure
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Internal Rate of Return (IRR)Internal Rate of Return (IRR)ProcedureProcedure
Project life = 4 yearsInitial cost = $42,523
Annual net cash inflows = $14,000
Determine the IRR for this project.
1. Determine the payback period.
($42,523 ÷ $14,000 per year = 3.03736 years)
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Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308
Locate the rowwhose numberequals the lifeof the project.
Internal Rate of Return (IRR)Internal Rate of Return (IRR)ProcedureProcedure
1. Determine the payback period. ($42,523 ÷ $14,000 per year = 3.03736 years)
2. Using present value of annuity table . . .
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Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308
Internal Rate of Return (IRR)Internal Rate of Return (IRR)ProcedureProcedure
1. Determine the payback period. ($42,523 ÷ $14,000 per year = 3.03736 years)
2. Using present value of annuity table . . .
In that row,locate the
interest factorclosest in
amount to thepayback period.
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Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308
Internal Rate of Return (IRR)Internal Rate of Return (IRR)ProcedureProcedure
1. Determine the payback period. ($42,523 ÷ $14,000 per year = 3.03736 years)
2. Using present value of annuity table . . .
IRR is theinterest rate
of the columnin which the
interest factoris found.
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Internal Rate of ReturnInternal Rate of ReturnExampleExample
Decker Company can purchase a new machine at a cost of $104,322 that will
save $20,000 per year in cash operating costs. The machine will have a 10-year
life.
What is the internal rate of return on this investment project?
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In Table A-4 in the appendix of your textbook, look across the 10-period row until you find an interest factor of 5.21610 in the 14 percent column. The internal rate of
return is 14 percent.
If 14 percent is greater than Decker’s required rate of return, Decker should purchase the new machine.
Internal Rate of ReturnInternal Rate of ReturnExampleExample
$104,322 $20,000 per yearPayback period = = 5.21610
Initial cash outlay Annual net cash inflowPayback period =
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Here’s the proof . . .
Year Amount14%
FactorPresent Value
Investment required Now (104,322)$ 1.00000 (104,322)Annual cost savings 1-10 20,000 5.21610 104,322 Net present value $ 0
Internal Rate of ReturnInternal Rate of ReturnExampleExample
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Internal Rate of ReturnInternal Rate of ReturnComplication #1Complication #1
If the exact interest rate is not found in the present value table, an estimate of the interest
rate is required.
Periods 10% 11% 12%1 0.90909 0.90090 0.89286 2 1.73554 1.71252 1.69005 3 2.48685 2.44371 2.40183 4 3.16987 3.10245 3.03735 5 3.79079 3.69590 3.60478
For a project with a five-year life and a payback periodof 3.65000, the IRR would be approximately 11.5 percent.
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Internal Rate of ReturnInternal Rate of ReturnComplication #2Complication #2
If cash inflows involve both annuities and one-time amounts, a trial and error solution will result if present value tables are used.
Sophisticated business calculators and electronic spreadsheets can be used to
easily solve these problems.
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Internal Rate of Return
Compare the cost of capital to the internal rate of return on a project.
To be acceptable, a project’s rate of return cannot be less than the cost of capital.
Net Present Value
The cost of capital is used as the actual discount rate.
Any project with a negative net present value is rejected.
Net Present Value vs.Net Present Value vs.Internal Rate of ReturnInternal Rate of Return