Capital Budgeting
Typical Capital Budgeting
Decisions
Capital budgeting tends to fall into two broad
categories . . .
Screening decisions. Does a proposed project
meet some present standard of acceptance?
Preference decisions. Selecting from among
several competing courses of action.
Four Capital Budgeting Methods
1.
2.
3.
4.
Net Present Value (NPV)
Internal Rate of Return (IRR)
Payback Period
Accrual Accounting Rate of Return
(AARR)
Discounted Cash Flows
• Discounted Cash Flow (DCF) Methods
measure all expected future cash inflows
and outflows of a project as if they occurred
at a single point in time
• The key feature of DCF methods is the time
value of money (interest), meaning that a
dollar received today is worth more than a
dollar received in the future
Discounted Cash Flows (continued)
• DCF methods use the Required Rate of Return
(RRR), which is the minimum acceptable annual
rate of return on an investment.
• RRR is usually the Weighted Average Cost of
Capital for a firm.
• RRR is also called the discount rate, hurdle rate,
cost of capital or opportunity cost of capital.
Typical Cash Outflows
Repairs and
maintenance
Working
capital
Initial
investment
Incremental
operating
costs
Typical Cash Inflows
Salvage
value
Release of
working
capital
Reduction
of costs
Incremental
revenues
Net Present Value (NPV) Method
• The NPV method calculates the expected
monetary gain or loss from a project by
discounting all expected future cash inflows and
outflows to the present point in time, using the
Required Rate of Return
• NPV is the arithmetic sum of the future cash flows
• Based on financial factors alone, only projects
with a zero or positive NPV are acceptable
Lifetime Care Hospital
• Lifetime Care Hospital is a for-profit taxable
company.
• One of Lifetime Care’s goals is to improve the
productivity of its X-ray machine.
• As a first step to achieve this goal, the manager of
Lifetime Care identifies a new state-of-the-art X-ray
machine, XCAM8, as a possible replacement for the
existing X-ray machine.
• The manager next acquires information to do moredetailed evaluation of XCAM8.
• Quantitative information for the formal analysis
follows.
Lifetime Care Hospital (Cont)
1. Revenues will be unchanged regardless of whether
the new X-ray machine is acquired. The only
relevant financial benefit in purchasing the new Xray machine is the cash savings in operating costs.
2. Lifetime Care is a profitable company. The income
tax rate is 40% of operating income each year.
3. The operating cash savings from the new X-ray
machine are $120,000 in years 1-4 and $105,000
in year 5.
Lifetime Care Hospital (Cont)
4. Lifetime uses straight-line depreciation method,
which means an equal amount of depreciation is
taken each year.
5. Gains or losses on the sale of depreciable assets are
taxed at the same rate as ordinary income.
6. The tax effects of cash inflows and outflows occur
at the same time that the cash inflows and outflows
occur.
7. Lifetime Care uses an 8% required rate of return for
discounting after-tax cash flows.
Summary Data for the X-Ray Machine
Old X-Ray
Machine
Purchase Price
Current book value
New X-Ray
Machine
---
$390,000
$40,000
Current disposal value
---
6,500
Not applicable
0
0
8,000a
78,000b
6,000
15,000
Terminal disposal value
5 years from now
Annual depreciation
Working capital required
a
$40,000 / 5 years = $8,000 annual depreciation
b
$390,000 / 5 years = $78,000 annual depreciation
Effect on Year One Cash Flow from Operations – Net of Income Taxes
Annual After-Tax Cash Flow from Operations
• The 40% tax rate reduces the benefit of the $120,000
operating cash flow savings for years 1-4 with the
new X-ray machine.
• After tax cash flow (excluding depreciation effects) is:
Annual cash flow from operations with new
machine
Deduct income tax payments (0.40 X
$120,000)
Annual after-tax cash flow from operations
$120,000
48,000
$72,000
Annual After-Tax Cash Flow from
Operations(Cont)
• For year 5, the after-tax cash flow
(excluding depreciation effects is:
Annual cash flow from operations with
new machine
Deduct income tax payments
(0.40 X $105,000)
Annual after-tax cash flow from
operations
$105,000
42,000
$63,000
Tax Consequences of Disposing of the
Old Machine
•Loss on disposal:
Current disposal value
of old machine
Deduct current book
value of old machine
Loss on disposal of
machine
$6,500
40,000
$(33,500)
Tax Consequences of Disposing of the
Old Machine (cont)
•Any loss on sale of assets lowers taxable income and
results in tax savings. The after-tax cash flow from
disposal of the old machine equals:
Current disposal value of old
machine
$6,500
Tax savings on loss
(0.40 X $33,500)
13,400
After-tax cash inflow from current
disposal of old machine
$19,900
Relevant Cash Inflows and Outflows for X-Ray Machine
NPV Method – X-Ray Machine
Preference Decisions - Net Present Value
The net present value of one project cannot
be directly compared to the net present
value of another project unless the
investments are equal.
Ranking Capital Investment Opportunities
Using NPV
Present Value Index =
Sum of PV of cash inflows
Initial Investment
Internal Rate of Return Method
• The internal rate of return is the rate of return
promised by an investment project over its useful
life. It is computed by finding the discount rate
that will cause the net present value of a project
to be zero.
• It works very well if a project’s cash flows are
identical every year. If the annual cash flows are
not identical, a trial and error process must be
used to find the internal rate of return.
• A project is accepted only if the IRR equals or
exceeds the RRR
IRR Method – X-Ray Machine
Preference Decisions - IRR
When using the internal rate of return
method to rank competing investment
projects, the preference rule is:
The higher the internal
rate of return, the
more desirable the
project.
Payback Method
• Payback measures the time it will take to
recoup, in the form of expected future cash
flows, the net initial investment in a project
• Shorter payback period are preferable
• Organizations choose a project payback
period. The greater the risk, the shorter the
payback period
• Easy to understand
Payback Method Continued
• With uniform cash flows:
Payback
Period
=
Net Initial Investment
Uniform Increase in Annual Future Cash Flows
• With non-uniform cash flows: add cash flows
period-by-period until the initial investment is
recovered; count the number of periods
included for payback period
Pop Quiz
(Ignore income taxes in this problem.) Dumora Corporation is considering an
investment project that will require an initial investment of $9,400 and will
generate the following net cash inflows in each of the five years of its
useful life:
Year 1 Year 2 Year 3 Year 4 Year 5
Net cash inflows
$1,000 $2,000 $4,000 $6,000
$5,000
Dumora’s discount rate is 16%.
Dumora's payback period for this investment project is closest to:
A)
B)
C)
D)
1.91 years
2.61 years
2.89 years
3.40 years
Accrual Accounting Rate of Return
Method (AARR)
• AARR Method divides an accrual
accounting measure of average annual
income of a project by an accrual
accounting measure of its investment
• Also called the Accounting Rate of Return
AARR Method Formula
Accrual Accounting
Rate of Return
=
Increase in Expected Average
Annual After-Tax Operating Income
Net Initial Investment