8-1 Capital Budgeting Decisions–Part II Prepared by Douglas Cloud Pepperdine University Prepared by Douglas Cloud Pepperdine University 8.

8-1

Capital Capital Budgeting Budgeting

Decisions–Part IIDecisions–Part II

Prepared by Douglas Cloud

Pepperdine University

Prepared by Douglas Cloud

Pepperdine University

88

8-2

Analyze investments in working capital. Analyze replacement decisions using two

approaches. Explain and apply sensitivity analysis. Describe and analyze mutually exclusive

investments. Describe the Modified Accelerate Cost

Recovery System and use it in evaluating investments.

ObjectivesObjectivesObjectivesObjectives

After reading this After reading this chapter, you should chapter, you should

be able to:be able to:

After reading this After reading this chapter, you should chapter, you should

be able to:be able to:

ContinuedContinuedContinuedContinued

8-3

Explain how capital budgeting applies to not-for-profit entities and to social welfare.

ObjectivesObjectivesObjectivesObjectives

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Investments in Working CapitalInvestments in Working CapitalInvestments in Working CapitalInvestments in Working Capital

Current assets

- Current liabilities

= Working capital

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Increases in Working Increases in Working Capital InvestmentCapital Investment

Increases in Working Increases in Working Capital InvestmentCapital Investment

Companies strive to reduce working capital requirements to increase returns

Companies invest to reduce working capital

ExampleExample

Annual revenues $30,000Annual cash costs $12,000Investment $50,000 in equipment

$35,000 in working capitalLife 5 years

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Annual Incremental After-TaxAnnual Incremental After-TaxCash Flows (Years 1-5)Cash Flows (Years 1-5)

Annual Incremental After-TaxAnnual Incremental After-TaxCash Flows (Years 1-5)Cash Flows (Years 1-5)

Revenues $30,000 $30,000Cash expenses (variable

and fixed) 12,000 12,000

Cash inflow before taxes $18,000 $18,000Depreciation ($50,000 ÷ 5) 10,000Increase in taxable income $8,000Income taxes (40 percent) $3,200 3,200Net increase in annual cash inflow $14,800

Tax Computation

Cash Flow

8-7

Summary of Net PresentSummary of Net PresentValue of InvestmentValue of Investment

Summary of Net PresentSummary of Net PresentValue of InvestmentValue of Investment

Operating cash inflows ($14,800 x

3.605) $ 53,354

Recovery of working capital ($35,000 x 0.567) 19,845

Total present value $ 73,199

Investment required ($50,000 + $35,000) 85,000

Net present value $(11,801 )

*Cost of Capital Used = 12%

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Inventory is the most common target of investments that focus on reducing working capital.

A company embarking on an inventory- reduction project will draw down existing inventory the first year of the project.

Delaying production or purchases in this first year frees up cash for other purposes.

Decreases in Working Decreases in Working Capital InvestmentCapital Investment

Decreases in Working Decreases in Working Capital InvestmentCapital Investment

8-9

Replacement DecisionsReplacement Decisions

Businesses frequently face the problem of whether to

replace an asset currently in use. Such a question is

called a replacement decision. Replacement

decisions are made when economic or technological factors make it possible to

perform tasks at lower cost.

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Two Approaches to Two Approaches to Replacement DecisionsReplacement Decisions

Two Approaches to Two Approaches to Replacement DecisionsReplacement Decisions

The incremental approach focuses on the differences between the cash flows, given the alternatives of keeping the existing assets or replacing them.

The total-project approach compares the present values of operating each way.

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Replacement Decision ExampleReplacement Decision ExampleReplacement Decision ExampleReplacement Decision Example

Cost $100,000 five years ago

Remaining useful life 5 years

Current book value $50,000

Annual depreciation $10,000

Expected sales value—now $20,000

—in 5 years $0

Annual cash operating costs $30,000

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Information on new machine:

Cost is $60,000

Useful life is 5 years

Annual cash operating costs is $15,000

Tax rate is 40 percent

Straight-line depreciation

Cut off rate is 16%


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Purchase price of new asset $60,000Book value of old machine $50,000Sales price, which is cash inflow 20,000 (20,000 )Loss for taxes, which can be

offset against regular income $30,000Taxes saved (40% x $30,000) $12,000 (12,000 )Net outlay for new asset $28,000


Tax Computation

Cash Flow

8-14

Annual Incremental After-TaxAnnual Incremental After-TaxCash Inflows (Years 1-5)Cash Inflows (Years 1-5)


Pretax cash savings:Cash cost of using old machine $30,000Cash cost of using new machine 15,000Difference favoring replacement $15,000 $15,000

Additional depreciation:Depreciation on new machine $12,000Depreciation on old machine 10,000Additional tax deduction for depreciation with replacement 2,000

Increase in taxable income $13,000

Tax Computation

Cash Flow

ContinuedContinuedContinuedContinued

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Increase in taxable income $13,000Additional tax ($13,000 x 40%) outflow 5,200

$ (5,200)

Additional net cash inflow favoringreplacement

$ 9,800Present value factor, 5 years, 16%

3.274Present value of savings

$32,085Investment

28,000Net present value

$ 4,085

Tax Computation

Cash Flow

The NPV is positive, so The NPV is positive, so replacement is desirablereplacement is desirableThe NPV is positive, so The NPV is positive, so replacement is desirablereplacement is desirable

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Total-Project ApproachTotal-Project ApproachTotal-Project ApproachTotal-Project Approach

Annual operating costs $30,000 $30,000

Depreciation 10,000

Total tax-deductible expenses $40,000

Tax savings expected $16,000 16,000

Net cash outflow expected per year $14,000

Present value factor, 5 years at 16% x 3.274

Present value of future operating outflows $45,836

Decision: Operate Existing Machine

Tax Cash Computation Flow

8-17

Annual operating costs $15,000 $15,000Depreciation 12,000Total tax-deductible expenses $27,000Tax savings expected $10,800 10,800Net cash outflow expected per year $ 4,200Present value factor, 5 years at 16% x 3.274Present value of future operating outflows $13,751Net outlay required for the new machine 28,000Present value to buy new machine $41,751

Total-Project ApproachTotal-Project ApproachTotal-Project ApproachTotal-Project ApproachDecision: Sell Existing Machine, Buy New Machine


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Comparing the Two AlternativesComparing the Two AlternativesComparing the Two AlternativesComparing the Two Alternatives

Present value of using existing machine $45,836

Present value of buying new machine 41,751

Difference in favor of replacing old machine $ 4,085

8-19

Insight: Know When to Fold Em

Set limits up front

Be skeptical of optimistic analyses

Consider alternatives

Question assumptions and projections

8-20

Sensitivity AnalysisSensitivity Analysis

Sensitivity analysis involves finding out how much the value of a variable can rise or fall before a different decision is indicated.

Sensitivity analysis applies to all types of decisions, but is especially beneficial when applied to capital budgeting decisions.

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A company with a cost of capital of 14 percent and a 40 percent tax rate can bring out a product priced at

$22. Managers estimate variable costs at $4 per unit, fixed costs of $100,000 annually, and 10,000 units annual sales volume. The product requires an investment of $200,000 for depreciable assets with a

five-year life and no salvage value.

Example

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Expected contribution margin (10,000 x $18) $180,000 $180,000

Fixed costs:Cash 100,000 (100,000 )Depreciation ($200,000/5) 40,000

$140,000Increase in taxable income 40,000Tax at 40% $ 16,000 (16,000 )Net cash inflow per year $ 64,000Present value factor, 5-years at 14% x 3.433Present value of annual cash inflows $219,712Investment required 200,000Net present value $ 19,712


Accept the Project!Accept the Project!

8-23

Mutually Exclusive AlternativesMutually Exclusive AlternativesMutually Exclusive AlternativesMutually Exclusive Alternatives

Mutually exclusive alternatives happen when a company has two or more ways of accomplishing the same goal, so that selecting one alternative precludes selecting the others.

The replacement decision discussed earlier fits the definition.

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Unequal LivesUnequal LivesUnequal LivesUnequal Lives

To illustrate this method, assume the following facts about two mutually exclusive investment opportunities involving a machine, versions Model G-40 and Model G-70, that is essential to the company’s operations

Model G-40 Model G-70Purchase price $40,000 $70,000Annual cash operating costs $8,000 $6,000Expected useful life 4 years 8 years

Neither machine has any expected salvage value at the end of its useful life.

The cutoff rate is 14 percent.

8-25

Present Value for Model G-70Present Value for Model G-70

Annual operating costs $ 6,000

Present value factor, 8 years, 14% x 4.639

Present value of operating costs $27,834

Investment required 70,000

Net present value $97,834


8-26

Annual operating costs, years 1-8 $ 8,000Present value factor, 8 years, 14% x 4.639Present value of operating costs, yrs 1-8 $ 37,112Present value of purchase of replacement

Model G-40 at the end of Year 4 26,048Present value of future cash outlays $ 63,160Investment required 40,000Net present value $103,160

Present Value for Model G-40Present Value for Model G-40


8-27

Ranking Investment OpportunitiesRanking Investment OpportunitiesRanking Investment OpportunitiesRanking Investment Opportunities

Profitability index (PI) is the ratio of the present value of the future cash flows to the investment.

PI = PV of future cash flows/Investment

8-28

Investment required $50,000 $10,000Life of investment 1 year 1 yearCash flows, end of year 1 $55,991 $11,403

Net present value of project $896 $365Internal rate of return 12% 14%Profitability index 1.018 1.037

Ranking Investment OpportunitiesRanking Investment OpportunitiesRanking Investment OpportunitiesRanking Investment Opportunities

X Y

Below are data for two mutually exclusive investment opportunities confronting a company with a 10 percent cost of capital.

8-29

5-Year Class5-Year Class

automobiles

trucks

typewriters

copiers

Personal computers

8-30


office furniture and equipment

most types of machinery

Any property not designated by law as being in some

other class

8-31


Lives of at least 16 years and less than 20 years, including certain

types of transportation equipment

8-32

31.5-Year Class31.5-Year Class

Nonresidential real property such as factory buildings

8-33

Percentages of Cost Depreciated Under MACRS

Percentages of Cost Depreciated Under MACRS

Year 5-Year Class 7-Year Class 10-Year Class1 20% 14% 10%2 32% 25% 18%3 19% 18% 14%4 12% 12% 12%5 12% 9% 9%6 5% 9% 7%7 9% 7%8 4% 7%9 7%

10 6%11 3%

8-34

Discount Rate 5-Year Class 7-Year Class8% 0.811 0.766

10% 0.774 0.722 12% 0.738 0.681 14% 0.706 0.645 16% 0.675 0.611 18% 0.647 0.580 20% 0.621 0.552 22% 0.597 0.526 24% 0.574 0.502

Present Value of MACRS Tax Shields

Present Value of MACRS Tax Shields

8-35

ExampleExample

A company expects pretax cash flows of $3,000 per year from an asset costing

$10,000. The asset is in the 5-year class and, to reduce calculations, has a useful

life of six years. The tax rate is 40 percent and cost of capital is 12 percent

8-36

Pretax inflow $3,000 $3,000 $3,000 $3,000 $3,000 $3,000

MACRS deduction 2,000 3,200 1,900 1,200 1,200 500

Taxable income $1,000 $(200 ) $1,100 $1,800 $1,800 $2,500

Tax at 40% 400 (80 ) 440 720 720 1,000

Net cash inflow $2,600 $3,080 $2,560 $2,280 $2,280 $2,000

PV factor .893 .797 .712 .636 .567 .507

Present values $2,322 $2,455 $1,823 $1,450 $1,293 $1,014

Total present value $10,357

ExampleExample

1 2 3 4 5 6

8-37

Present value of operating flows

$3,000 x (1 – 0.40) x 4.11 (from Table B) $ 7,400

Present value of MACRS shield

$10,000 x 0.40 x .738 (from Slide 8-34) 2,952

Total present value $10,352

ExampleExample

8-38

Criticisms of DCF MethodsCriticisms of DCF MethodsCriticisms of DCF MethodsCriticisms of DCF Methods

Companies downplay quantitative analysis because of overriding quantitative, or hard-to-quantify, concerns about particular investment.

High-tech investments often fail discounted cash flow tests yet such investments are clearly important.

8-39

Social Consequences of Social Consequences of Decision MakingDecision Making

Social Consequences of Social Consequences of Decision MakingDecision Making

Social costs are not borne directly by the entity making a decision and taking an action.

Social benefits (also called externalities) are benefits not accruing directly to the entity making a decision.

8-40

The EndThe End

Chapter 8Chapter 8

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8-1 Capital Budgeting Decisions–Part II Prepared by Douglas Cloud Pepperdine University Prepared by Douglas Cloud Pepperdine University 8.

Documents

cost of capital

recovery of working

annual cash costs

annual cash inflow

working capital requirements

working capitalincreases

pretax cash savings

cash expenses variable