Capital Budgeting

CAPITAL BUDGETING
ANDCOST ANALYSIS
Submitted by:
Amit Jaiswal
Fall Winter 2011-13
IIPM, Noida

Introduction
Capital budgeting methods deal with how to
select projects (or programs) that increase rather
than decrease the “capital” (value) of a
business.
These methods assist managers in analyzing
projects that span multiple years.

Learning Objectives
1. Adopt the project-by-project orientation of
capital budgeting when evaluating projects
spanning multiple years
2. Follow the six stages of capital budgeting for a
project
3. Use and evaluate the two main discounted
cash-flow (DCF) methods – the net present
value (NPV) method and the internal rate-of-
return (IRR) method

Learning Objectives
4 Identify relevant cash inflows and outflows for
capital-budgeting decisions that use DCF
methods
5 Use and evaluate the payback method
6 Use and evaluate the accrual accounting rate-
of-return (AARR) method
7 Identify and reduce conflicts from using DCF for
capital budgeting and accrual accounting for
performance evaluation
8 Incorporate depreciation deductions into the
computation of after-tax cash flows in capital
budgeting

Learning Objective
Adopt the project-by-project
orientation of capital
budgeting when evaluating
projects spanning multiple
years

Cost Analysis
 There are two different dimensions of cost
analysis:
1 A project dimension
2 An accounting period dimension
 The accounting system that corresponds to
the project dimension is termed life-cycle
costing.

Cost Analysis
 Life-cycle costing accumulates revenues
and costs on a project-by-project basis.
 This accumulation extends the accrual
accounting system that measures income
on a period-by-period basis to a system that
computes cash flow or income over the entire
project covering many accounting periods.

Cost Analysis
2000 2001 2002 2003 2004
Project A
Project B
Project C
Project D

Cost Analysis
 The life of the project is usually longer than
one year, so capital budgeting decisions
consider revenues and costs over relatively
long periods.

Capital Budgeting
Capital budgeting is the making of long-run
planning decisions for investments in projects and
programs.
It is a decision-making and control tool that
focuses primarily on projects or programs that
span multiple years.

Capital Budgeting
Capital budgeting is a six-stage process:
Identification stage. To distinguish which types of
capital expenditure projects are necessary to
accomplish organization objectives.
Search stage. To explore alternative capital
investments that will achieve organization
objectives.

Capital Budgeting
 Information-acquisition stage. To consider the
expected costs and the expected benefits of
alternative capital investments.
 Selection stage. To choose projects for
implementation.
 Financing stage. To obtain project funding.
 Implementation and control stage. To get
projects underway and monitor their
performance.

Capital Budgeting
 Healthy Living is a non-profit organization.
 One of its goals is to improve the diagnostic
capabilities of its Miami facility.
 Management ide ntifie s a need to consider the
purchase of new, state-of-the-art equipment.
 The se arch stage yields several alternative
models, but management focuses on one
machine as being particularly suitable.

Capital Budgeting
 The administration next begins to acq uire
info rm atio n to do more detailed evaluation.
 The required net initial investment consists of
the cost of the new machine ($245,000) plus an
additional cash investment in working capital
(supplies and spare parts) of $5,000.
 Management expects the new machine to have
a three-year useful life and a $0 terminal
disposal price at the end of the three years.

Capital Budgeting
 This proposed investment will yield net cash
savings of $125,000, $130,000, and $110,000
over its life.
 The working capital investment of $5,000 is
expected to be recovered at the end of year 3.
 Operating cash flows are assumed to occur at
the end of the year.

Capital Budgeting
 Management also identifies the following
nonfinancial quantitative and qualitative
benefits of investing in the new diagnostic
machine.
– Improved diagnoses and patient care
– Reduced inconvenience of transporting
patients to other facilities for diagnoses

Capital Budgeting
 Nonfinancial benefits are not incorporated into
the analysis.
 In the se le ctio n stag e , management must
decide whether Healthy Living should
purchase the new machine.
 Assume that the required rate of return for
Healthy Living is 10%.

Learning Objective
Use and evaluate the two main
discounted cash-flow (DCF)
methods – the net present value
(NPV) method and the internal
rate-of-return (IRR) method

Discounted Cash Flow
 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 discounted cash-flow methods
incorporate the time value of money.

 The time value of money means that a
dollar received today is worth more than
a dollar received at any future time.
 Why?
 Because it can earn income and become
greater in the future.

 There are two main DCF methods:
1 Net present value (NPV) method
2 Internal rate-of-return (IRR) method

Net Present Value
 The NPV method computes the expected net
monetary gain or loss from a project by
discounting all expected cash flows to the
present point in time, using the required rate of
return.
 Management’s minimum desired rate of return
is also called the discount rate, hurdle rate,
required rate of return, or cost of capital.

Net Present Value
 Only projects with a zero or positive net
present value are acceptable.
 What is the the net present value of the
diagnostic machine?

Net Present Value
Sketch of Relevant Cash Flows
Net initial
investment ($250,000)
Annual cash inflow $125,000$125,000 $130,000$130,000 $115,000$115,000
0 1 2 3

Net Present Value
Net Cash NPV of Net
Year 10% Col. Inflows Cash Inflows
1 0.909 $125,000 $113,625
2 0.826 130,000 107,380
3 0.751 115,000 86,365
Total PV of net cash
inflows $307,370 Investment
250,000 Net present value of
project $ 57,370

Net Present Value
 This project is acceptable because its net
present value is $57,370.
 Assume that Healthy Living is considering
another investment that will generate $80,000
per year for three years, and have a residual
value of $4,000 at the end of the third year.

Net Present Value
 The cost of this investment is $250,000
including working capital.
 The working capital investment of $5,000 is
expected to be recovered at the end of year
3.
 Healthy Living expects a return of 10%.
 Should the investment be made?

Net Present Value
 No, the net present value is negative.
 Net Cash NPV of Net
Years 10% Col. Inflows Cash Inflows
1-3 2.487 $80,000
$198,960 3 0.751 9,000
6,759 Total PV of net cash inflows
$205,719 Investment
250,000 Net present value of project
($44,281)

Internal Rate of Return...
– is another model using discounted cash flows.
 The internal rate-of-return (IRR) method
calculates the discount rate at which the
present value of expected cash inflows from
a project equals the present value of expected
cash outflows.

Internal Rate of Return
 Investment = Expected annual net cash inflow
× PV annuity factor
 Investment ÷ Expected annual net cash inflow
= PV annuity factor

investing $303,280 in a scanning machine that
will yield net cash savings of $80,000 per year
over its five-year life.
 What is the IRR of this project?
 $303,280 ÷ $80,000 = 3.791 (PV annuity factor)

 The annuity table shows that 3.791 is in
the 10% column for a 5 period row in this
example.
 Therefore, 10% is the internal rate of return of
this project.
 If the m inim um de sire d rate o f re turn is 10% or
less, Healthy Living should undertake this
project.

Comparison of NPV and IRR
 The NPV method has the important advantage
that the end result of the computations is
expressed in dollars and not in a percentage.
 Individual projects can be added to see the
effect of accepting a combination of projects.
 It can be used in situations where the required
rate of return varies over the life of the project.

Comparison of NPV and IRR
 The IRR of individual projects cannot be
added or averaged to derive the IRR of a
combination of projects.

Learning Objective
Identify relevant cash inflows
and outflows forcapital-
budgeting decisions that use
DCF methods

Relevant Cash Flows
 Relevant cash flows are expected future cash
flows that differ among the alternatives.
 Capital investment projects typically have three
major categories of cash flows:
1 Net initial investment
2 Cash flow from operations
3 Cash flow from terminal disposal of assets and
recovery of working capital

Relevant Cash Flows
 Typically, net initial investment components
are:
1 Initial asset investment
2 Initial working capital investment
3 Current disposal value of old asset

Net Initial Investment
 The original Healthy Living example included
the following:
 Initial machine investment $245,000
Initial working capital investment $ 5,000
Current disposal value of old machine
0

Cash Flow From Operations
 Cash inflows may result from producing and
selling additional goods or services, or, as in the
Healthy Living example, from savings in cash
operating costs.
 Depreciation is irrelevant in DCF analysis
because it is a noncash allocation of costs.
 DCF is based on inflows and outflows of cash.

Terminal Disposal Price
 At the end of the machine’s useful life the
terminal disposal price may be zero or an
amount considerably less than the initial
machine investment.
 The original Healthy Living example assumed
zero disposal value of the new diagnostic
machine.

Working Capital Recovery
 The initial investment in working capital is
usually fully recouped when the project is
terminated.
 The relevant working capital cash inflow is the
$5,000 that Healthy Living will recover in year
3.

Learning Objective
Use and evaluate the
paybackmethod

Payback Method
 Payback measures the time it will take to
recoup, in the form of expected future cash
flows, the initial investment in a project.

Payback Method
buying some equipment (Machine 1) for
$210,000, with an estimated useful life of 11
years, and zero predicted residual value.
 Managers expect use of the equipment to
generate $35,000 of net cash inflows from
operations per year.

Payback Method
 How long would it take to recover the
investment?
 $210,000 ÷ $35,000 = 7 years
 7 years is the payback period.

Payback Method
 Suppose that an alternative to the $210,000
piece of equipment, there is another one
(Machine 2) that also costs $210,000 but will
save $42,000 per year during its five -ye ar life .
 What is the payback period?
 $210,000 ÷ $42,000 = 5 years
 Which piece of equipment is preferable?

Payback Method
 Machine 1 is preferable because it will
continue to generate net cash inflows for
four years after its payback period.
 This will give the company an additional net
cash inflow of $140,000.

Payback Method
 When cash flows are uneven, calculations must
take a cumulative form.
 Assume that Healthy Living’s diagnostic
machine investment is going to yield net cash
savings of $160,000, $180,000, and $110,000
over its life.
 The initial investment is $250,000.
 What is the payback period?

Payback Method
 Year 1 brings in $160,000.
 Recovery of the amount invested occurs in
Year 2.

Payback Method
 Payback
= 1 year
+ $90,000 needed to complete recovery
$180,000 net cash inflow in Year 2
 1 year + 0.5 year = 1.5 years or,
 1 year and 6 months

Learning Objective
Use and evaluate the accrual
accounting rate-of-return
(AARR) method

Accrual Accounting
Rate-of-Return Method
 The accrual accounting rate-of-return (AARR)
method divides an accounting measure of
income by an accounting measure of
investment.
 This method is also called the accounting
rate of return.

Accrual Accounting
 Recall the scanning machine with a cost
$303,280, no residual value, expected annual
net cash savings of $80,000, and a useful life
of 5 years.
 The IRR of this machine is 10%.
 What is the average operating income?

Accrual Accounting
 Straight-line depreciation is $60,656 per year.
 Average operating income is $19,344.
 $80,000 – $60,656 = $19,344
 What is the AARR?
 AARR = $80,000 – $60,656 = 6.38%
$303,280

Accrual Accounting
 An AARR of 6.38% indicates the rate at which
a dollar of investment generates operating
income.
 Projects whose AARR exceeds an accrual
accounting required rate of return for the
project are considered desirable.

Accrual Accounting
 The AARR method is similar to the IRR
method in that both methods calculate a
rate-of-return percentage.
 While the AARR calculates return using
operating income numbers after considering
accruals, the IRR method calculates return
on the basis of cash flows and the time value
of money.

Learning Objective
Identify and reduce conflicts
from using DCF forcapital
budgeting and accrual
accounting for
performance evaluation

Performance Evaluation
 A manager who uses DCF methods to make
capital budgeting decisions can face goal
congruence problems if AARR is used for
performance evaluation.
 Suppose top management uses the AARR to
judge performance if the minimum desired rate
of return is 10%.
 A machine with an AARR of 6.38% will be
rejected.

 The AARR is low because the investment
increases the denominator and, as a result of
depreciation, also reduces the numerator
(operating income) in the AARR computation.
 Frequently, the optimal decision made using a
DCF method will not report good “operating
income” results in the project’s early years on
the basis of the AARR.

 The conflict between using AARR and DCF
methods to evaluate performance can be
reduced by evaluating managers on a project-
by-project basis.

Income-Tax Considerations
Although depreciation is a noncash expense, it
is a deductible cost for calculating tax outflow.
Taxes saved as a result of depreciation
deductions increase cash flows in discounted
cash-flow (DCF) computations.

Assume Miami Transit is considering the
replacement of an old piece of equipment with
new, more modern equipment.
The income tax rate is 40%.
The company uses straight-line depreciation.
The tax effects of cash inflows and outflows
occur at the same time that the inflows and
outflows occur.

Old equipment:
Current book value $50,000
Current disposal price $ 3,000
Terminal disposal price
(5 years) 0
Annual depreciation $10,000
Working capital $ 5,000

 Current disposal price of
old equipment $ 3,000
Deduct current book value
of old equipment
50,000 Loss on disposal of equipment
$47,000
 How much is the tax savings?
 $47,000 × 0.40 = $18,800

 What is the after-tax cash flow from current
disposal of old equipment?
 Current disposal price $ 3,000
Tax savings on loss
18,800 Total
$21,800

New equipment
Current book value $225,000
Current disposal price is
irrelevant Terminal disposal price (5
years) 0 Annual depreciation
$ 45,000 Working capital
$ 15,000

 How much is the net investment for the new
equipment?
 Current cost $225,000
Add increase in working capital
10,000 Deduct after-tax cash flow from
current disposal of old equipment – 21,800
Net investment $213,200

 Assume $90,000 pretax annual cash flow from
operations (excluding depreciation effect).
 What is the after-tax flow from operations?
 Cash flow from operations $90,000
Deduct income tax (40%) 36,000
Annual after-tax flow from
operations $54,000

 What is the difference in depreciation
deduction?
 Annual depreciation of new
equipment $45,000
Deduct annual depreciation
of old equipment 10,000
Difference $35,000

 What is the annual increase in income tax
savings from depreciation?
 Increase in depreciation $35,000
Multiply by tax rate
× .40 Income tax
cash savings from
additional depreciation $14,000

 What is the cash flow from operations, net of
income taxes?
 Annual after-tax flow from
operations $54,000
Income tax cash savings from
additional depreciation 14,000
Cash flow from operations, net
of income taxes $68,000

 Miami Transit requires 14% rate of return on
its investments.
 What is the net present value of the new
equipment incorporating income taxes?

Net Cash NPV of Net
Years 14% Col. Inflows Cash Inflows
1-5 3.433 $68,000 $233,444
5 0.519 10,000 5,190
Total PV of net cash inflows $238,636
Investment 213,200
Net present value of new equipment $ 25,436

Intangible Assets
Intangible assets are critical to most organizations.
 These assets have the potential to yield net cash
inflows many years into the future.
 Top management can use a capital budgeting
tool, such as NPV, to summarize the difference
in the future net cash inflows from an intangible
asset at two different points in time.

Capital Budgeting

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