chapter 8 capital asset selection and capital budgeting

Chapter 8

Capital Asset Selection and Capital Budgeting

1. How do managers choose which capital projects to fund?

2. Why do most capital budgeting methods rely on analysis of cash

flows?

3. What are the differences among payback period, the net present

value method, profitability index, and internal rate of return?

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Learning Objectives

4. How do the underlying assumptions and limitations of

each capital project evaluation method affect its use?

5. How do taxes and depreciation methods affect cash

flows?

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Continuing . . . Learning Objectives

6. Why are quality management, training, and research and

development controlled largely by capital budget analyses?

7. Why do managers occasionally need to quantify qualitative

information in making capital budgeting decisions?

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8. Why are environmental issues becoming an

increasingly important influence on the capital

budget?

9. How and why should management conduct a post-

investment audit of a capital project?

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10. What calculations are necessary to control

for the time value of money? (Appendix 1)

11. How is the accounting rate of return for a

project determined? (Appendix 2)

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Capital Assets

Lease

Nuclear Power Plant

Copy

Machine

Capital Budgeting Is

Capital budgeting is the process of evaluating long-range investment proposals for the purpose of allocating limited resources effectively and efficiently.

Capital Budgeting Questions

• Is the activity worth the investment?

• Which assets can be used for the activity?

• Of the suitable assets, which are the best investments?

– Screening decision

– Preference decision

• Which of the best investments should the company choose?

– Mutually exclusive projects

– Independent projects

– Mutually inclusive projects

Cash Flows

• Cash receipts and disbursements that arise from the purchase, operation, and disposition of capital assets

• Cash receipts– Project revenues that have been earned and collected

– Savings generated by reduced project operating costs

– Inflows from asset’s sale and release of working capital at end of asset’s useful life

• Cash disbursements– Expenditures to acquire asset

– Additional working capital investments

– Amounts paid for related operating costs

Interest

It should not be considered in project evaluation.

Interest is a cash flow created by the method of financing a project.

Return of Capital

vs. Return on Capital

Return of CapitalRecovery of

original investment

Return on Capital

Incomefor each investment period

= Interest includedin receipt or payment

Use a Timeline

to Determine Cash Flows

t0

Cash In

Cash Out

Time Point t1 t2 t3 t4

Net Cash Flow $500 $500 $500 $500

Payback Period

• The longer it takes to recover the initial investment, the greater is the project’s risk

• Management sets a maximum acceptable payback period

• Often used as a screening technique

A measure of the time it will take a project’s cash inflows to equal the original investment

Assumptions of Payback Period

• Speed of investment recovery is the key consideration

• Timing and size of cash flows are accurately predicted

• Risk (uncertainty) is lower for a shorter payback project

Purchase of Machine Example

• Machine costs $60,000

• Will be used to produce and sell 3,000 units per year at $14 for the next 5 years

• Variable costs are $5 per unit

• Annual fixed costs are $5,000

• Cutoff rate of 12 percent

• All revenues and costs are in cash amounts

Annual Incremental Cash Inflows

Annual

Cash Flows

Revenues ($14 x 3,000) 42,000$

Variable costs ($5 x 3,000) 15,000

Contribution margin ($9 x 3,000) 27,000$

Fixed costs 5,000

Expected increase in net cash inflows 22,000$

Payback Period

Payback Period = Investment required Annual cash returns

= $60,000 $22,000 = 2.7 years

Limitations of Payback Period

• Ignores cash flows after payback

• Basic method treats cash flows and project life deterministically without explicit consideration of probabilities

• Ignores time value of money

• Cash flow pattern preferences are not explicitly recognized

Discounted Cash Flow Methods

• Net present value (NPV)• Profitability index (PI)• Internal rate of return (IRR)

Net Present Value Method

• Accept if:– If NPV = 0, actual ROR = desired ROR

– If NPV > 0, actual ROR > desired ROR

• Reject if:– If NPV < 0, actual ROR < desired ROR

• Does not determine expected ROR

Determines whether the rate of return (ROR) on a project is equal to, higher than, or lower than the desired ROR

Remember!

• Changing discount rate affects NPV• Changing timing and size of cash flows affects NPV• NPV can be used to select the best project when

choosing among investments that can perform the same task or achieve the same objective

• NPV should not be used to compare independent investment projects that do not have approximately the same original asset cost or asset life

Net Present Value Example


Present value factor 3.605

Present value of future cash flows 79,310$

Investment required 60,000

Net present value 19,310$

Assumptions of Net Present Value

• Discount rate used is valid• Timing and size of cash flows are accurately

predicted• Life of project is accurately predicted• If the shorter-lived of two projects is selected,

the proceeds of that project will continue to earn the discount rate of return through the theoretical completion of the longer-lived project

Limitations of Net Present Value


• NPV does not measure expected rates of return on projects being compared


• IRR of project is not reflected

Profitability Index

• Compares projects with different costs

• PI should be at least equal to 1.0

• Gauges the firm’s efficiency at using its capital

• Does not indicate expected ROR

Ratio that compares present value of net cash inflows with present value of net investment

Continuing . . . Profitability Index

PV of Cash Flows

Profitability Index (PI) = --------------------------

Investment required

$79,310

= ---------- = 1.3

$60,000

Assumptions of Profitability Index

• Same as NPV• Size of PV of net inflows relative to size of PV of

investment measures efficient use of capital

Limitations of Profitability Index

• Same as NPV• Gives a relative answer but does not reflect

dollars of NPV

Internal Rate of Return

• Is the project’s expected rate of return• The discount rate where PV of net cash

flows = cost of project– Discount rate where NPV = 0

• IRR compared with hurdle rate(which is the lowest acceptable return on investment)

• Acceptable if IRR > hurdle rate


Discount factor = PV of future flows/Annual cash flows

Discount factor = $60,000/$22,000 = 2.7

The factor of 2.7 corresponds to an interest rate between 24 and 25 percent when the number of periods is five.

The IRR is between 24 and 25 percent.

Assumptions of IRR

• Hurdle rate is valid• Timing and size of cash flows are accurately

predicted• Life of project is accurately predicted• If the shorter-lived of two projects is selected,

the proceeds of that project will continue to earn the IRR through the theoretical completion of the longer-lived project

Limitations of IRR

• Projects are ranked for funding based on IRR rather than dollar size

• Does not reflect dollars of NPV



• It is possible to calculate multiple rates of return on the same project

The Effect of Taxation

On Cash Flows

• Managers should use after-tax cash flows to determine project’s acceptability

• Depreciation expense is a tax shield for revenues– Tax benefit equal to depreciation amount multiplied by tax rate

• Type of depreciation method affects amount of annual taxable income

• Tax laws can change every year; use most current regulations

• Tax rates and tax related asset lives may also change; use most current information

Annual Incremental After-Tax

Cash Inflows

Tax Annual

Computation Cash Flows

Revenues 42,000$ 42,000$

Cash expenses (variable and fixed) 20,000 20,000

Cash inflow before taxes 22,000$ 22,000$

Depreciation 12,000

Increase in taxable income 10,000$

Income taxes (40 percent) 4,000 4,000

Net increase in annual cash inflow 18,000$

Payback Period

Payback Period = Investment required Annual cash returns

= $60,000 $18,000 = 3.3 years

Net Present Value of

After-Tax Example


Present value factor 3.605




Profitability Index

PV of Cash Flows

Profitability Index (PI) = --------------------------

Investment required

$64,890

= ---------- = 1.1

$60,000


Discount

factor = PV of future flows/Annual cash flows

Discount factor = $60,000/$18,000 = 3.333

The factor of 3.333 corresponds to an interest rate between 14 and 16 percent when the number of periods is five.

The IRR is between 14 and 16 percent.

Uneven Cash Flows

Now, assume

that the salvage

value in the

example is

$5,000 at the end

of the fifth year.

Summary of Present Value

of Investment

PV of future cash flows 64,890$

Salvage value:

Total salvage value 5,000$

Tax on salvage value 2,000

After-tax cash inflow on salvage value 3,000$

PV factor 0.567

Present value of salvage value 1,701

Total present value 66,591$

Net Present Value of

Salvage Value Example




High-Tech Investments

The decision is more a question of“how much” and “when”

than “whether”

Generally requiresmassive monetary

investment

Possible Reasons for Not Investing

– Worker displacement

– Morale problems

– Implementation problems

– Computers not considered competitive assets

– Difficult to justify investment using traditional analyses

Considerations in High-Tech

Investment Analysis

• Discount or hurdle rate may need to be set lower• Both quantitative and qualitative benefits need to

be considered– Quality improvements

– Shortened delivery time

– Improved competitive position

• High-tech investments are not “free-standing”• Opportunity cost of not acquiring automated

equipment is often critical

Post-Investment Audit

• Complete after project has stabilized

• Use same analysis techniques as used for original decision to accept project

• Used to pinpoint areas of operation not in line with expectations

• Helps evaluate accuracy of original cost/benefit predictions

Compare actual project results with expected results

Accounting Rate of Return (ARR)

• Not based on cash flows

• Compared with hurdle rate which may be higher than the discount rate

• Compared with ARR of other projects

Measures the expected rate of earnings obtained on the

average capital investment over a project’s life

Continuing . . . Accounting Rate

of Return (ARR)

Average Annual Income from Project

ARR = ------------------------------------------------

Average Investment in Project

$22,000 - ($60,000/5)

Before Taxes = ------------------------ = 33.3%

($60,000 - $0)/2

$18,000 - ($60,000/5)

After Taxes = ------------------------ = 20.0%

($60,000 - $0)/2

Assumptions of ARR

• Effect on company accounting earnings relative to average investment in a project is a key consideration

• Size and timing of investment cost, project life, salvage value, and increases in earnings can be accurately predicted

Limitations of ARR

• Ignores cash flows• Ignores time value of money• Treats earnings, investment, and project life

deterministically without explicit consideration of probabilities

chapter 8 capital asset selection and capital budgeting

Documents

capital budgeting slide

capital projects

capital income

capital budgeting methods

capital budgeting decisions

capital budgeting questions

original investment

payment slide