Chapter 21
Capital Budgeting and Cost Analysis
WHAT IS A CAPITAL BUDGETING
PROCESS?
A capital budgeting process is the decision
making process that involves long-term planning
for investments and related financing matters
WHY IS IT IMPORTANT?
⚫
Enormous cost commitment
⚫
Long-run nature
⚫
Strategic role it may play
OVERVIEW OF THE STAGES OF THE
CAPITAL BUDGETING PROCESS
⚫
Project Identification and Search
⚫
Determine which types of capital investments are necessary to
accomplish company objectives and strategies
⚫
⚫
⚫
Cost leadership – focus on projects that improve efficiency
and productivity
Product differentiation – focus on projects that develop new
products, new customers, or new markets
Need cross-functional efforts
OVERVIEW OF THE STAGES OF THE
CAPITAL BUDGETING PROCESS
⚫
Project Evaluation and Selection
⚫ Conduct cost and benefit analysis
⚫ Consider both quantitative and qualitative
factors
⚫ Develop selection and ranking criterion
⚫ Choose projects for implementation
OVERVIEW OF THE STAGES OF THE
CAPITAL BUDGETING PROCESS
⚫
Financing the Projects
–
⚫
Obtain project funding
Implementation and Control
–
–
Get project under way and monitor their performance
Conduct a post-investment review by comparing
expected performance against actual results
QUESTIONS FOR EVALUATING AND
SELECTING PROJECTS
1.
2.
3.
How to measure the economic value of a
project?
How to determine whether a project is
economically attractive?
How to rank projects and to decide on the
most economically attractive project?
METHODS FOR EVALUATING AND
SELECTING PROJECTS
⚫
Discounted Cash Flows Models
– Net Present Value (NPV)
– Internal Rate of Return (IRR)
– Discounted Payback Model
⚫
Non-Discounted Cash Flow Model
– Traditional Payback Model
⚫
Non-Cash Flow Model
– Accrual Accounting Rate of Return (AARR)
Net Present Value (NPV) Method
⚫
How to measure the costs and benefits of a
project?
– Cost: present value of relevant future cash
outflows
– Benefit: present value of relevant future cash
inflows
– Net benefit (NPV): PV of relevant future cash
inflows – PV of relevant future cash outflows
Net Present Value (NPV) Method
⚫
How to compute present values?
– Use “cost of capital” as the discount rate
– Cost of capital is also referred to as “hurdle
rate” or “minimum rate of return”.
– Use Table 2 (present value of $1.00) or Table 4
(present value of an annuity of $1.00). An
annuity is series of equal cash flows at equal
time intervals
Net Present Value (NPV) Method
⚫
What is the selection rule?
– NPV > 0
Accept
– NPV < 0 Reject
– NPV = 0 Need more information (e.g.,
consider alternative methods or some
qualitative factors)
⚫
How to rank the projects?
– The higher the NPV, the better the project
Net Present Value (NPV) Method
⚫
Example: Consider the purchase of a new
machine.
– Initial cash outflow -- $37,910
– This new machine will provide cash operating
cost savings of $10,000 each year for next 5
years
– Cost of capital is assumed to be 8%
– What is the NPV of this new machine?
Net Present Value (NPV) Method
⚫
Example:
⚫ PV of cash inflows
$10,000 * 3.993 (PV factor from Table 4)
= $39, 930
⚫
PV of cash outflows = $37,910
⚫ NPV = $39,930 - $37,910 = $2,020
Internal Rate of Return (IRR) Method
⚫
How to measure the costs and benefits of a
project?
– Similar to the NPV method, we consider both
future cash inflows and outflows
– IRR is the discount rate at which the PV of
future cash inflows from a project equals the
PV of its future cash outflows
Internal Rate of Return (IRR) Method
⚫
⚫
⚫
⚫
⚫
Continue our earlier example, what is the IRR of
the new machine?
PV of inflows = PV of outflows
$10,000 * PV factor = $37,910
PV factor = 3.791 What is the discount rate
associated with this PV factor (based on 5-year
period)?
Answer = 10%. In other words, the IRR of this
new machine is 10%
Internal Rate of Return (IRR) Method
⚫
What is the selection rule?
– IRR > Cost of capital
Accept
– IRR < Cost of capital Reject
– IRR = Cost of capital Need more information
(e.g., consider alternative method or some
qualitative factors)
⚫
How to rank the projects?
– The higher the IRR, the better the project
Accrual Accounting Rate of Return
(AARR) Method
⚫
How to measure the costs and benefits of a
project?
– AARR = Average Increase in Annual
Operating Income ÷ Net Initial Investment
Accrual Accounting Rate of Return
(AARR) Method
⚫
Continue our earlier example, what is the
AARR of the new machine?
⚫ Average increase in annual operating
income = $10,000 - $7,582 (annual
depreciation expense = $37,910 ÷ 5,
assuming SL and no salvage value)
⚫ AARR = $2,418 ÷ $37,910 = 6.38%
Accrual Accounting Rate of Return
(AARR) Method
⚫
What is the selection rule?
– AARR > Cost of capital
Accept
– AARR < Cost of capital Reject
– AARR = Cost of capital Need more
information (e.g., consider alternative method
or some qualitative factors)
⚫
How to rank the projects?
– The higher the AARR, the better the project
Payback Method
⚫
⚫
How to measure the costs and benefits of a
project?
Payback period measures the amount of time it
will take to recoup, in the form of future cash
flows, the net initial investment in a project
⚫ Payback period may be computed using
discounted or non-discounted cash flows
Payback Method
⚫
Continue our earlier example, what is the
payback period for the new machine?
⚫
Non-discounted payback period = $37,910
÷ $10,000 = approximately 3.8 years
Payback Method
⚫
Continue our earlier example, what is the payback period
for the new machine?
⚫ Discounted payback period ?
⚫
PV of inflow
Cumulative amount
⚫ Year 1 $10,000*0.926=9,260
$ 9,260
⚫ Year 2
10,000*0.857=8,570
17,830
⚫ Year 3
10,000*0.794=7,940
25,770
⚫ Year 4
10,000*0.735=7,350
33,120
⚫ Year 5
10,000*0.681=6,810
39,930
⚫ Discounted payback period
⚫ = 4 years + ($37,910 - $33,120) ÷ $6,810 = 4.7 years
Payback Method
⚫
What is the selection rule?
– Payback period < Cutoff period
– Payback period > Cutoff period
– Payback period = Cutoff period
Accept
Reject
Need more
information (e.g., consider alternative method
or some qualitative factors)
⚫
How to rank the projects?
– The shorter the payback period, the better the
project
Payback Method
Payback method highlights “liquidity”
⚫ Managers are most likely to emphasize
payback analysis if
⚫
– The future is very uncertain and they do not
want to tie up cash for a long period of time,
and
– Interest rates are high (making it expensive to
tie up cash for a long period of time)
Payback Method
⚫
It neglects project profitability
⚫
It discourages selection of long-lived projects
(e.g., R&D or automation projects may have a
long payback period but they may be critical to a
company’s long-term survival
⚫
Too much focus on payback analysis may
contribute to short-term “myopia”
REMARKS ON HANDOUT #6
Remark 1
CASH OUTFLOWS ASSOCIATED WITH TAXDEDUCTIBLE OPERATING COSTS
AFTER-TAX CASH OUTFLOWS
= (1-TAX RATE) * BEFORE-TAX CASH OUTFLOWS
Remark 2
CASH INFLOWS ASSOCIATED WITH TAXABLE
OPERATING REVENUE
AFTER-TAX CASH INFLOWS
= (1-TAX RATE) * BEFORE-TAX CASH INFLOWS
Remark 3
CASH INFLOWS ARISING FROM
DEPRECIATION TAX SHIELD
= DEPRECIATION DEDUCTIONS * TAX RATE
Remark 4
CASH INFLOWS ASSOCIATED WITH
DISPOSAL VALUES OF CAPITAL
INVESTMENTS WHEN GAIN IS REALIZED
= CASH DISPOSAL VALUE – TAX ON GAIN
Remark 5
CASH INFLOWS ASSOCIATED WITH
DISPOSAL VALUES OF CAPITAL
INVESTMENTS WHEN LOSS IS REALIZED
= CASH DISPOSAL VALUES + TAX
SAVINGS ON LOSS
INCOME TAX FACTORS AND CAPITAL
BUDGETING
⚫H6
⚫For “Keep” option:
– 1. PV of inflow from cash operating income
$60,000*(1-0.4)*3.433 = $123,588
– 2. PV of outflow from overhaul 2 years later
$10,000*(1-0.4)*0.769 = ($4,614)
– 3. PV of inflow from depreciation tax savings
$7,000*0.4*3.433 = $9,612.40
INCOME TAX FACTORS AND CAPITAL
BUDGETING
⚫H6
⚫For “Keep”
option:
– 4. PV of inflow from selling old machine 5 years later
$8,000 (cash price of the old machine 5 years later) - $0** (book value of
the old machine 5 years later) = $8,000 (capital gain)
**$0(book value) = $56,000 (initial cost of the old machine) - $56,000
($7,000*8 years; accumulated depreciation of the old machine 5 years later)
Additional taxes on gain = $8,000 * 0.4 = $3,200
Net inflow = $8,000 - $3,200 = $4,800
PV of net inflow = $4,800 * 0.519 (from table 2) = $2,491.20
INCOME TAX FACTORS AND CAPITAL
BUDGETING
⚫H6
⚫For
“Keep” option:
5. PV of “Keep”:
(1)+(2)+(3)+(4) = $131,077.60
INCOME TAX FACTORS AND CAPITAL
BUDGETING
⚫H6
⚫For “Replace” option:
– 1. PV of inflow from cash operating income
$70,000*(1-0.4)*3.433 = $144,186
– 2. PV of inflow from depreciation tax savings
Year 1 $51,000*5/15*0.4*0.877 = $5,963.60
Year 2 $51,000*4/15*0.4*0.769 = $4,183.36
Year 3 $51,000*3/15*0.4*0.675 = $2,754
Year 4 $51,000*2/15*0.4*0.592 = $1,610.24
Year 5 $51,000*1/15*0.4*0.519 = $705.84
__________
Total
$15,217.04
INCOME TAX FACTORS AND CAPITAL
BUDGETING
⚫H6
⚫For “Replace” option:
– 3. PV of inflow from selling old machine today
$20,000 (cash price of the old machine today) - $35,000** (book value of
the old machine today) = $15,000 (capital loss)
**$35,000 (book value) = $56,000 (initial cost of the old machine) $21,000 ($7,000*3 years; accumulated depreciation of the old machine
today)
Tax savings on loss = $15,000 * 0.4 = $6,000
Net inflow = $20,000 + $6,000 = $26,000
PV of net inflow = $26,000 * 1.00 (because it occurs today) = $26,000
INCOME TAX FACTORS AND CAPITAL
BUDGETING
⚫H6
⚫For “Replace” option:
– 4. PV of inflow from selling new machine 5 years later
$3,000 (cash price of the new machine 5 years later) - $0** (book value
of the new machine 5 years later) = $3,000 (capital gain)
**$0(book value) = $51,000 (initial cost of the old machine) - $51,000
(accumulated depreciation of the new machine 5 years later)
Additional taxes on gain = $3,000 * 0.4 = $1,200
Net inflow = $3,000 - $1,200 = $1,800
PV of net inflow = $1,800 * 0.519 (from table 2) = $934.20
INCOME TAX FACTORS AND CAPITAL
BUDGETING
⚫H6
⚫For
“Replace” option:
– 5. PV of outflow from initial purchase cost:
($51,000)
– 6. PV of “Replace” : (1)+(2)+(3)+(4)+(5)=
$135,337.24
INCOME TAX FACTORS AND CAPITAL
BUDGETING
⚫H6
⚫Difference
in PV between “Keep” and
“Replace”: $4,259.64 (in favor of “Replace”)
FOUR MAJOR CATEGORIES OF CASH
FLOWS FOR A REPLACEMENT DECISION:
1. Investment cash flows
Cost of new equipment
Proceeds of existing assets sold, net of taxes
Tax effects arising from a loss or gain
Working capital commitments
2. Periodic operating cash flows
These cash flows may result from revenuegenerating activities or cost-saving programs
3. Depreciation tax shield
4. Disinvestment flows
Cash freed from working capital commitments
Cash disposal values of assets, net of taxes
Inflation and Capital Budgeting Analysis
⚫
Inflation is a decline in the general purchasing power of
the monetary unit, such as dollars.
⚫ An inflation rate of 10% per year means that an item
bought for $100 at the beginning of the year will cost $110
at the end of the year
⚫ Inflation rate: 4%
– $2.50 * 1.04 = $2.60
– $2.50 * (1.04)2 = $2.704
–
$2.50 * (1.04)5 = $3.163
$2.50 * (1.04)10 = $3.849
Inflation and Capital Budgeting Analysis
⚫
How do we account for inflation in the NPV analysis?
⚫
Nominal approach:
1.
2.
Predict future cash inflows and outflows in nominal dollars
Use nominal discount rate to calculate PV
Inflation and Capital Budgeting Analysis
⚫
Real rate of return is the rate of return demanded to
cover investment risk if there is no inflation.
–
–
⚫
Risk free element: the pure rate of return on risk-free long-term
government bonds assuming no inflation.
Business risk element: the risk premium demanded for bearing
risk
Nominal rate of return is the rate of return demanded
to cover investment risk and the decline in the
purchasing power as a result of expected inflation
–
–
–
Risk free element
Business risk element
Inflation element
Inflation and Capital Budgeting Analysis
⚫
⚫
⚫
What is the relation between real and nominal rates of
return?
Nominal rate
= (1+Real rate)*(1+Inflation rate) – 1
Real rate = 20%; Inflation rate = 10%
Nominal rate = (1+20%)*(1+10%) -1
= 32%
Inflation and Capital Budgeting Analysis
Example – H7
Abbie Young is manager of the customer-service division of an electrical
appliance store. Abbie is considering buying a machine at a cost of
$10,000 on December 31, 2008. The machine will last five years.
Abbie estimates that the incremental before-tax cash savings from
using the machine will be $3,000 annually. The $3,000 is measured
at current prices and will be received at the end of each year. For tax
purposes, she will depreciate the machine using the straight-line
method, assuming no terminal disposal value. Abbie requires a 10%
after-tax real rate of return (that is, the rate of return is 10% when all
cash flows are denominated in December 31, 2008 dollars)
Assume the annual inflation rate is 20%, and the income tax rate is 40%.
Calculate the NPV of the machine.
Inflation and Capital Budgeting Analysis
⚫
Example – H7
⚫
PV of inflows from cost savings
–
Step 1: Adjust inflows to nominal dollars
Yr1: $3,000*(1.2) = $3,600
Yr2: $3,000*(1.2)2 = $4,320
Yr3: $3,000*(1.2)3 = $5,184
Yr4: $3,000*(1.2)4 = $6,222
Yr5: $3,000*(1.2)5 = $7,464
Inflation and Capital Budgeting Analysis
Example – H7
PV of inflows from cost savings
⚫
⚫
–
Step 2: Compute PV of after-tax inflows using nominal dollars
and nominal discount rate (i.e., 32%)
Yr1: $3,600*(1-0.4)*0.758 = $1,637.28
Yr2: $4,320*(1-0.4)*0.574 = $1,487.81
Yr3: $5,184*(1-0.4)*0.435 = $1,353.02
Yr4: $6,222*(1-0.4)*0.329 = $1,228.22
Yr5: $7,464*(1-0.4)*0.250 = $1,119.60
Total PV of inflows from cost savings = $6,825.93
Inflation and Capital Budgeting Analysis
⚫
⚫
Example – H7
PV of inflows from depreciation tax savings
Depreciation deduction each year: ($10,000 - $0)/5 = $2,000
(assumed in nominal dollars under current tax law)
Total PV of inflows from DTS = $2,000*0.4*2.345
=$1,876
Inflation and Capital Budgeting Analysis
Example – H7
Summary:
⚫
⚫
–
–
–
–
PV of inflows from cost savings
PV of inflows from DTS
PV of initial outflows
NPV
$6,825.93
1,876.00
(10,000.00)
(1,298.07)