Chapter 21

Capital Budgeting and Cost Analysis

Project and Time Dimensions of Capital Budgeting

Typical Capital Budgeting Decisions

Capital budgeting tends to fall into two broad Capital budgeting tends to fall into two broad categories . . .categories . . .

Screening decisionsScreening decisions.. Does a proposed project Does a proposed project meet some present standard of acceptance?meet some present standard of acceptance?

Preference decisionsPreference decisions.. Selecting from among Selecting from among several competing courses of action. several competing courses of action.

Capital budgeting tends to fall into two broad Capital budgeting tends to fall into two broad categories . . .categories . . .

Screening decisionsScreening decisions.. Does a proposed project Does a proposed project meet some present standard of acceptance?meet some present standard of acceptance?

Preference decisionsPreference decisions.. Selecting from among Selecting from among several competing courses of action. several competing courses of action.

Four Capital Budgeting Methods

1. Net Present Value (NPV)

2. Internal Rate of Return (IRR)

3. Payback Period

4. 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 andRepairs andmaintenancemaintenance

IncrementalIncrementaloperatingoperating

costscosts

InitialInitialinvestmentinvestment

WorkingWorkingcapitalcapital

Typical Cash Inflows

ReductionReductionof costsof costs

SalvageSalvagevaluevalue

IncrementalIncrementalrevenuesrevenues

Release ofRelease ofworkingworkingcapitalcapital

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 more-detailed 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 X-ray 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

New X-Ray Machine

Purchase Price --- $390,000

Current book value $40,000 ---

Current disposal value 6,500 Not applicable

Terminal disposal value

5 years from now 0 0

Annual depreciation 8,000a 78,000b

Working capital required 6,000 15,000

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 $120,000

Deduct income tax payments (0.40 X $120,000) 48,000

Annual after-tax cash flow from operations $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 $105,000

Deduct income tax payments

(0.40 X $105,000)42,000

Annual after-tax cash flow from operations $63,000

Tax Consequences of Disposing of the Old Machine

•Loss on disposal:

Current disposal value of old machine

$6,500

Deduct current book value of old machine

40,000

Loss on disposal of machine

$(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

Internal Rate of Return Method

• The The internal rate of returninternal rate of return is the rate of return is the rate of return promised by an investment project over its useful promised by an investment project over its useful life. It is computed by finding the discount rate life. It is computed by finding the discount rate that will cause the that will cause the net present valuenet present value of a project of a project to be to be zerozero..

• It works very well if a project’s cash flows are It works very well if a project’s cash flows are identical every year. If the annual cash flows are identical every year. If the annual cash flows are not identical, a trial and error process must be not identical, a trial and error process must be used to find the internal rate of return.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

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

Payback Net Initial InvestmentPeriod Uniform Increase in Annual Future Cash Flows=

• With uniform 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) 1.91 years

B) 2.61 years

C) 2.89 years

D) 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

Increase in Expected AverageAccrual Accounting Annual After-Tax Operating Income

Rate of Return Net Initial Investment=