PowerPoint Slides - Chapter 20

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

Capital Budgeting

Chapter Twenty

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• 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

Learning Objectives

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• 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

Learning Objectives (continued)

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• 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 organization’s chosen strategy:

– Build strategy– Hold strategy– Harvest strategy

Strategic Nature of Capital Budgeting Decisions

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• 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 organization’s master budget (Chap. 8)

that deals with the current period’s planned capital investment outlays

Introductory Definitions

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• 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

Introductory Definitions (continued)

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• Linking capital budgeting to the master budgeting process (planning)

• Linking capital budgeting decisions to the

organization’s Balanced Scorecard (control)

• Generation of relevant data for investment analysis purposes (decision making)

• Conducting post-audits (control)

How Accounting Can Add Value to the Capital Budgeting Process

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• 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

Identifying Relevant Cash Flows for Capital Expenditure Analysis

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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.

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)

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Smith Company Data: After-tax Cash Inflow, Disposal of Old Asset

Immediate Cash EffectSelling price on old equipment 80,000$ Expenses related to disposal Brokers' commission (8,000) Equipment removal costs (2,000) Net proceeds from sale 70,000$ Total

Tax Savings from the DisposalCost of old equipment 320,000$ Accumulated depreciation (200,000) Book value 120,000 Net proceeds from disposal 70,000 Loss on disposal 50,000 Income tax rate 40%Income tax savings from disposal 20,000 Total cash inflow from disposal 90,000$

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Project Initiation: Acquisition of New Machine

Cost of equipment 500,000$ Installation cost 5,000 Testing and adjusting 10,000 Total cash outflows in Year 0 515,000$

Year 0

Years 1 through Year 4Basis for depreciation 515,000$ Salvage value 75,000 Amount to deprecate 440,000 Useful life in years 4 Straight-line depreciation 110,000 Total income tax rate 40%Cash inflow from deprecation 44,000$

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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 × tAllocated costs No effect

Transaction Effect on Cash Flow

Cash receipts Amount received × (1 - t)

Cash expenditures Amount paid × (1 - t)Depreciated initial cost Tax shield:

Depreciation expense × tAllocated 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.

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

Cash Revenues and ExpensesRevenue 1,000,000$ Operating expenses (750,000) Cash increase before tax 250,000 Income taxes (at 40%) (100,000) Increase in cash from operations $150,000

Noncash ExpenseDeprecation expense 110,000$ Income tax rate 40%Decrease in cash outlfows 44,000$

Thus, after-tax cash from operations increases by $194,000/year ($150,000 + $44,000)

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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.

Year 3-year 5-year 7-year1 33.33 20.00 14.292 44.45 32.00 24.493 14.81 19.20 17.494 7.41 11.52 12.495 11.52 8.936 5.76 8.927 8.928 4.47

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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 project’s 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.

• 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 project’s 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)

At the End of Year 4Proceeds from sale of machine 100,000$ Removal and cleanup (20,000) 80,000$

Cost of milling machine 515,000 Accumulated depreciation (440,000) 75,000 Gain on sale of machine 5,000 Income tax rate 40%Taxes to be paid 2,000$

Net cash inflow from sale 80,000$ Taxes to be paid (2,000) Net cash inflow from disposal 78,000$

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Smith Company: Project Disposal (continued)

At the End of Year 4: Summary

Net cash inflows from disposal 78,000$ Release of working capital 200,000 Relocation cost of displaced employees ($150,000 before tax) (90,000) Total effect of final disposal 188,000$

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Smith Company: Projected Cash Flows--Summary

Year 0 Year 1 Year 2 Year 3 Year 4Cost of equipment ($500,000)Installation cost ($5,000)Testing and adjusting ($10,000)Working capital ($200,000) $200,000Disposal of old machine $90,000Cash inflows from oper. $194,000 $194,000 $194,000 $194,000Training costs (net of tax) ($30,000)Disposal of new machine $78,000Employee relocation ($90,000)Inflows (Outflows) ($625,000) $164,000 $194,000 $194,000 $382,000

Note--Not discussed previously: $50,000 (pre-tax) training costs estimated for Year 1

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Additional Measurement Issues

• Inflation?

• Opportunity costs?

• Sunk costs?

• Allocated overhead costs?

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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 company’s 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.

Let’s calculate the weighted average cost of capital...

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.

Let’s calculate the weighted average cost of capital...

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Example: Calculating the Discount Rate (WACC) (continued)

Book Value

Rate

After-Tax Rate

Market Value Weight WACC

Bank loan 100,000$ 12% 7.20% $100,000 6.250% 0.4500%Bond 500,000 10% 6.00% $450,000 28.125% 1.6875%Preferred stock* 200,000 15% 10.00% $300,000 18.750% 1.8750%Common stock** 50,000 20.00% $750,000 46.875% 9.3750%

850,000$ $1,600,000 100% 13.3875%

*$3 divdend per share ÷ $30 selling price per share = 10%**Required (market) rate of return estimated via CAPM.

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 > 0, accept the project (that is, the project adds to the value of the company)

• If NPV < 0, reject the project (that is, the project does not add value to the company)

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NPV: Smith Company (@ 10.0%)

Cash Inflow PV Factor

Present Value

0 (625,000)$ 1.000000 (625,000)$ 1 164,000 0.909091 149,091 2 194,000 0.826446 160,331 3 194,000 0.751315 145,755 4 382,000 0.683013 260,911

NPV 91,088$

(1 + 10%)-1(1 + 10%)-1

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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 > WACC, then the proposed project should be accepted (i.e., its anticipated rate of return > the cost of invested capital for the firm)

• If IRR < WACC, the proposed project should be rejected (i.e., its NPV will be < 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 recommendation—accept 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.

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)

Annual Cash InflowsCash revenues 900,000$ Cash operating expenses (660,000) Pre-tax net cash flow 240,000 Less: Taxes (46,500) Net after-tax cash inflow 193,500$

Depreciation CalculationAsset cost 555,000$ Salvage value (60,000) Basis for deprecation 495,000 Useful life 4 Annual deprecation 123,750$

Calculation of Income TaxesCash infl. before deprec. 240,000$ Annual deprecation (123,750) Taxable amount 116,250 Tax rate 40%Cash taxes 46,500$

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Investment Decision Example: Payback Calculation

Payback Period = Total Original Investment

Annual Net After-Tax Cash Inflow

Payback Period =

Payback Period = 2.87 years

$555,000

$193,500

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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 risk—the 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

0 (555,000)$ 1.000000 (555,000)$ (555,000)$ 1 193,500 0.909091 175,909 (379,091) 2 193,500 0.826446 159,917 (219,174) 3 193,500 0.751315 145,379 (73,794) 4 193,500 0.683013 132,163 *Assumed WACC = 10%.

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

Revenues 900,000$ Expenses other than depreciation (660,000) Depreciation expense (123,750) Income before taxes 116,250 Income taxes (46,500) Net income 69,750$

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Example: Calculating ARR

NBV Beginning End AverageYear 1 555,000$ 431,250$ 493,125$ Year 2 431,250 307,500 369,375 Year 3 307,500 183,750 245,625 Year 4 183,750 60,000 121,875

1,230,000$

Average = $1,230,000/4 = $307,500

Accounting Rate of Return

=$69,750

$307,500= 22.68%

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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)--decision 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)

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Appendix: DCF Models—Some 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 Models—Some 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 organization’s Balanced Scorecard (BSC)

– Providing decision-makers with relevant data for capital budgeting decision models

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Chapter Summary (continued)

• We developed a general model for determining relevant cash flows for each stage of a project’s life:

– Project initiation– Project operation– Project disposal

• We defined and learned how to apply the following two DCF capital budgeting decision models:

– NPV– IRR

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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

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• 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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• 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

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capital budgeting chapter

cash flow cash receipts

net cash inflow

capital expenditure

cash inflows

cash revenue

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net aftertax cash inflow