NIKE company to profile from the standpoint of an investor

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Capital Budgeting Decisions

Module 25

Peter D.

EASTON

Robert F.

HALSEY

Mary Lea

McANALLY

Al L.

HARTGRAVES

Wayne J.

MORSE

FINANCIAL & MANAGERIAL ACCOUNTING for MBAs 5e

Explain the role of capital budgeting in long-range planning.

Learning Objective

Capital Expenditures

Investments of financial resources in projects

To develop or introduce new products or services

To expand current production or service capacity, or

To change current production or service facilities

Made with the expectation that the new product, process, or service will generate future financial inflows that exceed initial costs

Capital Budgeting

A process that involves

The identification of potentially desirable projects for capital expenditures

The subsequent evaluation of capital expenditure proposals, and

The selection of proposals that meet certain criteria

Effective Capital Budgeting

Long-range planning is necessary since models involve cash flows over several years

Well-defined business strategy guides a company’s capital expenditure decisions

Capital Budgeting Procedures

Management of Capital Budgeting

Management should develop procedures for review, evaluation, approval, and post-audit of capital expenditure proposals

Capital budgeting committee

Provides management guidance in formulation of capital expenditure proposals

May preauthorize certain types and amounts of proposals with guidelines

Post-Audit of Capital Budgeting

Involves the development of project performance reports comparing planned and actual results

Reports should be provided to those involved with the proposal

To help keep the project on target

To help identify the need to reevaluate the project if the initial analysis is in error or significant changes occur

To improve investment proposal quality

To help the capital budgeting committee better evaluate proposals

Analyze capital budgeting decisions, using models that consider the time value of money, such as net present and internal rate of return.

Learning Objective

Capital Budgeting Models

Time Value of Money methods

Net present value

Internal rate of return

Payback period

Accounting rate of return

Three Phases of a Project’s Cash Flows

Occurs at the end of the project’s life when assets are disposed of for their salvage value and any initial investment of working capital is recovered

Includes all cash operating receipts and expenditures during operations

Includes all cash expenditures necessary to begin operations

Initial Investment

Operation

Disinvestment

Predicted Cash Flow Analysis Example

Bates’ Limo is considering the purchase of a new limo with these predicted cash flows:

Initial investment (time 0):
	Limo purchase	$84,000
	Working capital	2,500
	Total	$86,500

Operations (per year for 4 years):
	Sales		$105,000
	Cash operating costs:
	Fuel and maintenance	$21,600
	Insurance	2,300
	Driver's salary	53,000	76,900
	Net annual cash flows		$28,100

Disinvestment (end of 4 years):
	Sale of limo	$12,000
	Recovery of working capital	1,000
Total disinvestment		$13,000

Calculating Net Present Value

Present value of the project’s net cash inflows from operations

+ Present value of the disinvestment cash flows

– Amount of the initial investment

NET PRESENT VALUE

Cash flows are adjusted for time value of money, using a discount rate (the minimum rate of return required for the project to be acceptable).

Initial investment occurs at time 0

All other cash flows occur at end of each year

Net Present Value Assumptions

Disinvestment

Treated as a lump-sum amount

Operations

Treated as an annuity (if equal in amount each year)

Initial Investment

Treated as a lump-sum amount

Net Present Value Approaches

Table Approach

Select factors from Tables 25A.1 and 25A.2 in Appendix 25A

Spreadsheet Approach

Use built in NPV function

Input required for the discount rate and cash flow amounts for each period

Net Present Value Table Approach Example

Assume Bates Limo uses an 8% discount rate.

	Predicted Cash Inflows (Outflows)	Years(s) of Cash Flows	8% Present Value Factor	Present Value of Cash Flows
Initial investment	$(86,500)	0	1.00000	$(86,500)
Operations	28,100	1-4	3.31213	93,071.
Disinvestment	13,000	4	0.73503	9,555.
Net present value of all cash flows				$ 16,126.

Table 12A.2

Table 12A.1

Net Present Value Spreadsheet Approach Example

Assume Bates Limo uses an 8% discount rate.

$28,100 + $13,000

NPV function: =NPV(0.08, B2:B5)

Because the NPV is positive, this is an acceptable project.

Caution in Using the Spreadsheet Approach

NPV spreadsheet formula assumes that the first cash flow occurs at time “1” rather than at time “0,” i.e., omit time 0 cash flow in the formula.

Arrange operating cash flows from top to bottom in a column, or left to right in a row.

Internal Rate of Return (IRR)

Also called the time-adjusted rate of return

The discount rate that equates the present value of the cash inflows with the present value of the cash outflows

The minimum rate that could be paid for the money invested in a project without losing money

The discount rate that results in a project’s net present value equaling zero

Spreadsheet Approach to Internal Rate of Return (IRR)

IRR function: =IRR(B2:B6, 0.08)

The investment will generate an internal rate of return of 15.6%. The IRR should be compared to the required rate of return.

Sometimes requires an initial guess of the project’s rate of return

Cost of Capital

The average cost an organization pays to obtain resources necessary to make investments

Considers items such as

Effective interest rate on debt

Effective dividend rate on preferred stock

Discount rate that equates the present value of all dividends expected on common stock over the life of the organization to the current market value of the company’s common stock

Computing the Cost of Equity Capital

The cost of capital for a company that has no debt or preferred stock:

Current annual dividend per common share

Current market price per common share

Expected dividend growth rate

Cost of equity capital =

Investing in a project that has an IRR greater than the cost of capital should increase the market value of a firm’s securities.

Analyze capital budgeting decisions using methods that do not consider the time value of money, such as payback period and accounting rate of return.

Learning Objective

Payback Period

Indicates the time required to recover the initial investment in a project from operations

Acceptable projects must have less than some maximum payback period designated by management

Does not consider the time value of money.

Calculating Payback Period

For projects with equal annual operating cash flows

Initial investment

Annual operating cash inflows

Payback period =

Bates Limo will recover all of its initial cash investment in 3.08 years.

Payback period for Bates Limo =

$86,500

$28,100

= 3.08 years

Calculating Payback Period

For projects with unequal annual operating cash flows

Assume Bates Limo’s net operating cash inflow is $26,000, $27,000, $28,000, and $29,000 in Years 1 through 4, respectively.

Three full years plus a portion of year 4:

$5,500 / $29,000 = 0.19

Recovery period = 3.19 years

Payback period for Bates Limo:

Year	Net Cash Inflow	Unrecovered Investment
0	$ 0	$86,500
1	26,000	60,500
2	27,000	33,500
3	28,000	5,500
4	29,000

Accounting Rate of Return

Average annual increase in net income that results from acceptance of a capital expenditure proposal divided by the initial investment or the average investment in the project

Focuses on net income, not cash flows

Determining Net Income:

Annual net cash inflow from operations

– Average annual depreciation

Average annual increase in net income

Accounting Rate of Return Example

Bates Limo is considering the purchase of a new limo for $84,000 with an estimated disposal value of $12,000 at the end of its useful life of 4 years. The annual operating cash flows total $28,100.

Average annual increase in net income =

Annual net cash inflow from operations	$ 28,100
Less average annual depreciation:
($84,000 - $12,000) / 4 years	(18,000)
Average annual increase in net income	$ 10,100

Accounting Rate of Return Example

Bates Limo is considering the purchase of a new limo for $84,000 with an estimated disposal value of $12,000 at the end of its useful life of 4 years. The average annual increase in net income is $10,100.

Accounting rate of return on initial investment:

$10,100

$84,000

= 0.1202

Average annual increase in net income

Initial investment

Management will reject investments that do not exceed the minimum required return.

Accounting rate of return on average investment:

$10,100

($84,000 + $12,000) / 2

= 0.2104

Avg. annual increase in net income

Avg. investment

Evaluate the strengths and weaknesses of alternative capital budgeting models.

Learning Objective

Evaluating Payback Period

Disadvantages when used solely to evaluate investments

Ignores time value of money

Ignores profit

Ignores cash flows after the payback period

Evaluating Accounting Rate of Return

Superior to payback period method for total life evaluations as it considers the proposals’ profitability

Fails to consider the timing of cash flows

Treats all cash flows equally

Early period cash flows are worth more than later cash flows

Evaluating Accounting Rate of Return

Predicted net cash inflow from operations	Project 1	Project 2
Year 1	$ 30,000.	$ 5,000.
Year 2	30,000.	5,000.
Year 3	5,000.	30,000.
Year 4	5,000.	30,000.
Total	70,000.	70,000.
Total depreciation	(48,000)	(48,000)
Net income	22,000.	22,000.
Project life	÷ 4 years.	÷ 4 years.
Average annual increase in income	$ 5,500.	$ 5,500.
Increase in investment	÷ 48,000.	÷ 48,000.
Accounting rate of return on initial investment	0.1146.	0.1146.

While both investments have the same accounting rate of return, receiving cash flows earlier (as in Project 1) is preferable to the timing of the cash flows in Project 2, due to the time value of money.

Preferable cash flows

Evaluating Net Present Value

Predicted net cash inflow from operations	Project 1	Project 2
Years 1 and 2	$ 30,000.	$ 5,000.
Years 3 and 4	5,000.	30,000.
Initial investment	48,000.	48,000.

Project 1	Predicted Cash Inflows (Outflows)	Years(s) of Cash Flows	8% Present Value Factor	Present Value of Cash Flows
Initial investment	$ (48,000)	0	1.00000	$(48,000)
Operations	30,000	1-2	1.78326	53,498.
Operations	5,000	3-4	3.31213 – 1.78326	7,644.
Net present value of all cash flows				$ 13,142.

Project 2	Predicted Cash Inflows (Outflows)	Years(s) of Cash Flows	8% Present Value Factor	Present Value of Cash Flows
Initial investment	$ (48,000)	0	1.000	$(48,000)
Operations	5,000	1-2	1.78326	8,916.
Operations	30,000	3-4	3.31213 – 1.78326	45,866.
Net present value of all cash flows				$ 6,782.

Project 1 generates the higher net present value.

Comparing NPV and the Internal Rate of Return Methods

Net Present Value

Gives explicit consideration to investment size

Assumes all net cash inflows are reinvested at the discount rate

Internal Rate of Return

Gives no consideration to investment size

Assumes all net cash inflows are reinvested at the project’s internal rate of return

Examine the impact of judgment, attitudes toward risk, and relevant cash flow information on capital budgeting decisions.

Learning Objective

Using Multiple Investment Criteria

Investment models aid managers in making investment decisions

Management considerations

Reduce risk

Ensure an adequate return to investors

Availability of resources

Nonquantitative factors

Market position

Operational performance improvement

Strategy implementation

Top management’s attitudes and confidence in decision makers

Evaluating Capital Expenditure Risk

Risks are often related to…

Cost of the initial investment

Time required to complete the initial investment and begin operations

Whether the new facilities will operate as planned

Life of the facilities

Customers’ demand for the product or service

Final selling price

Operating costs

Disposal values

Risk Analysis Techniques

Suggested approaches to assist in capital budgeting risk…

Adjust the discount rate for individual projects based on management’s perception of a project’s risks

Compare several internal rates of return and/or net present values for a project

Subject a capital expenditure proposal to sensitivity analysis

Differential Analysis of Cash Flows

Some capital expenditure proposals create no cash inflows, such as

Not-for-profit and government units providing services

For-profit firms maintaining product quality or improving safety standards

Cannot calculate payback period, accounting rate of return and internal rate of return

Solution

Compute the present value of all life cycle costs

Select the investment with the least negative net present value

Differential Analysis Example

Yater College wants to replace its 3 year old fitness equipment in its student fitness center. The equipment has a remaining useful life of 1 year, a current book value of $43,600, and a current market value of $35,000.

The new equipment will cost $88,000 and will have an estimated useful life of 4 years and a $5,000 salvage value. The new equipment will reduce annual utility costs from $75,000 to $72,800 due to improved energy efficiency.

Differential Analysis Example

	Keep Old Equipment		Replace with New Equipment	Difference
Initial investment
Cost of new equipment			$88,000.	$88,000.
Disposal value of old machine			(35,000)	(35,000)
Net initial investment				$53,000.

Annual operating cash savings
Utility costs on old equipment		$75,000
Utility costs on new equipment			$72,800.
Net annual cost savings				$ 2,200.

Disinvestment at end of life
Old equipment		$ 0
New equipment			$ 5,000.

Differential Analysis Example

The proposal provides no net incremental cash flows, though it still may be accepted since it is a replacement of older equipment.

	Predicted Cash Inflows (Outflows)	Year(s) of Cash Flows	8% Present Value Factor	Present Value of Cash Flows
Initial investment, net	$(53,000)	0	1.000	$(53,000)
Operations	2,200	1-4	3.312	7,286
Disinvestment of new equipment	5,000	1	0.735	3,675
Net present value of all cash flows				$(42,039)

High-Tech Investments

Includes such innovations such as flexible manufacturing systems and computer integrated manufacturing

Care must be taken when evaluating

Potential errors in evaluating

Investing in unnecessary or overly complex equipment

Overestimating cost savings

Underestimating incremental sales

Investing in Unnecessary or Overly Complex Equipment

Common error

Comparing the cost associated with the current inefficient way of doing things with the predicted cost of performing the identical operations with modern equipment

Potential outcome

Generation of costly non-value-added activities

Careful evaluation of situations will help mitigate problems of this type of error.

Other Problems with High-Tech Investments

Overestimating cost savings

Common error

Basing estimates on a single activity cost driver

Underestimating incremental sales or cost savings

Common errors

Assuming that the baseline for comparison is the current sales level

Forgetting that investments in manufacturing technologies increase rapid, low-cost switching to new products

Determine the net present value of investment proposals with consideration of taxes.

Learning Objective

Taxes in Capital Budgeting Decisions

Cost of asset is depreciated over the operating life of an asset

Depreciation reduces income taxes but does not cause cash outflows

Two assumptions in dealing with taxes in capital budgeting decisions

Revenues and operating cash receipts are the same each year

Depreciation is the only noncash expense of an organization

Depreciation Tax Shield

Depreciation provides a “tax shield”

Reduces cash payments for income taxes

Depreciation tax shield = Depreciation x Tax rate

EXAMPLE

Depreciation tax shield for Bates Limo, assuming a 30% tax rate:

$84,000 – $12,000

4 years

x 30% = $5,400

Effect of Depreciation Example

If Bates Limo purchases the new limo for $84,000, incremental sales and cash operating expenses will be $132,100 and $104,000, respectively.

How much are net annual cash inflows assuming a 30% income tax rate?

Depreciation expense =

$84,000 – $12,000

4 years

= $18,000 per year

Effect of Depreciation Example

Annual Taxes and Income without Depreciation:

Annual Taxes and Income with Depreciation:

Tax difference = Depreciation Tax Shield = $5,400

Sales	$132,100.
Operating expenses (except depreciation)	(104,000)
Depreciation	0.
Income before taxes without depreciation	28,100.
Income taxes	(8,430)
Net income	$ 19,670.

Sales	$132,100.
Operating expenses (except depreciation)	(104,000)
Depreciation	18,000.
Income before taxes with depreciation	10,100.
Income taxes	(3,030)
Net income	$ 7,070.

Sales	$132,100.
Operating expenses (except depreciation)	(104,000)
Income taxes	(3,030)
Net annual cash inflow	$ 25,070.

Sales	$132,100.
Operating expenses (except depreciation)	(104,000)
Income taxes	(8,430)
Net annual cash inflow	$ 19,670.

Tax difference = $5,400

Effect of Depreciation Example

Annual Taxes and Cash Flow without Depreciation:

Annual Taxes and Cash Flow with Depreciation:

Cash flow difference = $5,400

Investment Tax Credit

A government tax incentive for the purpose of stimulating investment and economic growth

A reduction of taxes in the year a new asset is placed in service

Reduces cash payments for taxes

Treated as a cash inflow for capital budgeting purposes

Net Present Value with Taxes

*No gain recognized:

Sale price at end of life, $12,000

Less book value at end of life, $12,000

Equals $0 gain.

		Predicted Cash Inflows (Outflows)	Year(s) of Cash Flows	8% Present Value Factor	Present Value of Cash Flows
Initial investment
	Limo purchase	$(84,000)	—	1.00000	$(84,000)
	Working capital	(2,500)	—	1.00000	(2,500)
Operations					—
	Annual taxable income without depreciation	28,100.	1-4	3.31213	93,071.
	Taxes on income ($28,100 × 30%)	(8,430)	1-4	3.31213	(27,921)
	Depreciation tax shield ($18,000 × 30%)	5,400.	1-4	3.31213	17,886.
Disinvestment					—
	Sale of limo*	12,000.	4	0.73503	8,820.
	Recovery of working capital	1,000.	4	0.73503	735.
Net present value of all cash flows					$ 6,091.

Appendix 25A

Compute basic present value cash flow amounts.

Learning Objective

Time Value of Money

Money is worth more if received today rather than received in the future

Two reasons

The time value of money

Risk

If invested, money will earn interest and grow in value over time

Future Value

The amount that a current sum of money earning a stated rate of interest will accumulate to at the end of a future period

Calculating future value

fv = pv(1 + i)n

How much will a deposit of $800 in the bank that pays 8% annual interest accumulate in 1 year?

fv of $800 = $800(1 + 0.08)1 = $864

Present Value

The current worth of a sum of money to be received at some future date at a stated rate of interest

Calculating present value

How much is the current value of $864 to be received one year in the future at an 8% annual interest rate?

pv =

(1 + i)n

pv of $864 =

$864

(1 + 0.08)1

= $800

Annuities

A series of equal cash flows received or paid over equal intervals of time

Example: Suppose that $300 will be received at the end of each of the next 3 years. The discount rate is 8%.

How much is the present value the cash flows?

Year 1	$300 × $1 ÷ (1 + 0.08)1	$278
Year 2	$300 × $1 ÷ (1 + 0.08)2	257
Year 3	$300 × $1 ÷ (1 + 0.08)3	238
Present value		$773

OR: pva =

(1 + 0.08)3

= $773

x 1 –

300

0.08

Unequal Cash Flows

A series of unequal cash flows received or paid over equal intervals of time

Example: Suppose that $300 will be received at the end of Year 1, with $200 received at the end of Year 2, and $100 received at the end of 3 years. The discount rate is 8%.

How much is the present value the cash flows?

Year	Annual Cash Flow	Present Value at 8%	Present Value Amount
1	$300	0.92593	$277.78
2	200	0.85734	171.47
3	100	0.79383	79.38
			$528.63

Appendix 25B

Determine internal rate of return using present value tables.

Learning Objective

Internal Rate of Return

Equal cash flows

A single investment is followed by a series of equal annual net cash flows

Present value factor for an annuity of $1

Initial investment

Annual net cash inflows

$84,000

$28,100

= 2.98932

Bates Limo Example =

Locate this factor in the row for 4 periods in the Present Value of an Annuity of $1 table.

The factor is found between 12% and 14%, at approximately 12.8%.

Internal Rate of Return

Unequal cash flows

A single investment is followed by a series of unequal annual net cash flows

Trial and error must be used

First, select a discount rate estimated to be close to the proposal’s IRR

Calculate the net present value

If net present value is positive, select a higher rate

If net present value is negative, select a lower rate

Recalculate the net present value until an approximate IRR is found

The End