Chapter 15 Capital Budgeting ⎯ Qualitative

Capital Budgeting • Employee morale, safety, and responsibility

• Corporate image
• Social responsibility
Capital Assets • Market share
• Growth
 Capital assets are long-term assets used to • Strategic planning
 Generate future revenues or cost • Insure wood supply
savings
 Provide distribution, service, or
production capabilities
 Tangible fixed assets Capital Budgeting Financial Analysis
 Land, building, machinery, etc.
 Intangible assets • Payback period
 Capital lease, patent, etc. • Net present value Cash Flow
• Profitability index Focus
• Internal rate of return
• Accounting rate of return
Capital Budgeting
 Capital budgeting is the process for
evaluating and ranking alternative long- Cash Flow
range projects for the purpose of allocating
limited resources. • Cash Receipts
 Plan and prepare the capital budget. ➔ Revenues earned and collected
 Review past investments to assess ➔ Savings generated by reducing
success of past decisions and enhance operating costs
the decision process in the future. ➔ Proceeds from sale of assets
 Compare and evaluate alternative projects • Cash Disbursements
 financial and nonfinancial criteria ➔ Expenditures for asset acquisition
 short and long-term benefits ➔ Working capital investments
 usually multiple criteria ➔ Costs for direct material, direct labor,
 consider all significant stakeholders and overhead

Capital Budgeting Part of the Financial Budget Investment vs. Financing

Investment Decision Financing Decision
Which assets to How to raise capital
acquire (debt/equity) to fund
an investment

Made by divisional Made by Treasurer and

managers and top top management
management
Interest is a financing
decision

First justify the acquisition

Capital Budgeting ⎯ Quantitative
Then justify how to finance it
• Accounting rate of return
• Payback period
• Discounted payback period
• Internal rate of return
• Profitability index

1 | STCM211 F E R R E R , I . A .
Interest Cost  Cost of Capital – weighted average cost for
the debt and equity that comprise a firm’s
 Cash flow associated with debt financing financial structure.
 Not part of the project selection process
Returns

Payback Period
 Time required for project’s cash inflows to
equal the original investment
 longer it takes to recover the original
investment, the greater the risk.
 the faster capital is returned, the more
rapidly it can be invested in other
projects.
 management sets a maximum
payback period.
 Ignores
 cash inflows that occur after payback
has been reached
 desired rate of return
 time value of money
• Return OF Capital
➔ Recovery of the initial investment
• Return ON Capital
➔ Represents income
➔ Original investment multiplied by the
discount rate
$100,000 × 12% = $12,000 return on capital
Discounted Cash Flow Methods
• Net Present Value
• Profitability Index
• Internal Rate of Return

Net Present Value

Original Investment

Annual Cash Inflows = Payback Period

(assuming equal cash flows)
Example:
Original Investment
Annual Cash Inflows
➔ Evaluates if project rate of return is greater
than, equal to, or less than the desired rate
of return.
➔ Present value equals the cash flows
discounted using the desired rate of return.
➔ Net present value equals present value of
cash inflows minus present value of cash
outflows.
$25,000
➔ Does not calculate the rate of return.
$10,000

Payback Period 2.5 years

Minus Investment made currently

Plus PV of future cash inflows or

Discounting Future Cash Flows cost savings

 Reduce the future value of cash flows by Minus PV of future cash outflows
the portion that represents interest. Equals Net present value
 Variables are
 length of time until the cash flow is
received or paid
 required rate of return on capital - • Net present value = 0 actual rate of return
discount rate equals desired rate of return.
 Present value is stated in a common base • Net present value > 0 actual rate of return
of current dollars. is greater than desired rate of return.
• Net present value < 0 actual rate of return
is less than desired rate of return.
Discount Rate
 Discount rate should equal or exceed the
cost of capital.

2 | STCM211 F E R R E R , I . A .
 ➔ Function of two factors
 Discount rate
 Amount and timing of cash flows
➔ Useful to select best project among
investments that can perform the same
task or achieve the same objective.
➔ When comparing independent projects
requiring different initial investments, use
the Profitability Index.
Profitability Index
➔ Compares present value of net cash flows
to net investment
➔ Measures efficiency of the use of capital
➔ Should be greater than or equal to 1
➔ Does not calculate the rate of return
Profitability PV of Net Cash Flows Index
Index = Net Investment
• Annuity tables (assuming equal cash
flows)
• Trial and error
Income Taxes
➔ An integral part of the business planning
and decision-making process.
➔ Operating income is taxed which reduces
the cash inflows from projects.
➔ Depreciation reduces operating income
which reduces the taxes paid.
After-Tax Cash Flows
 Depreciation is not a cash flow item.
 Depreciation on capital assets affects cash
flows by reducing the tax obligation.
 Depreciation is a tax shield that provides a
tax benefit.
Depreciation = Depreciation × Tax rate

Project 1 2
Tax Depreciation
PV of net cash flows $900,000 $580,000

Net investment 720,000 425,000

 Deprecation tax shield is affected by
 Changes in tax laws
Net present value $180,000 $155,000  Different depreciation methods
 Changes in tax rates
Profitability Index

$900,000/$720,000 1.25
Capital Budgeting
$580,000/$425,000 1.36
➔ Understand similarities and differences of
capital budgeting methods.
Internal Rate of Return ➔ Use several techniques.
 Limitations of all methods
 Discount rate where  Management preferences regarding
PV of cash inflows = PV of cash outflows timing of cash flows are not included.
NPV = 0  Single, deterministic measures of cash
 Hurdle rate is the lowest acceptable return flow are used rather than probabilities.
on investment (at least equal to the cost of
capital)
 If Internal Rate of Return = Hurdle
Rate; Accept
 If Internal Rate of Return > Hurdle
Rate; Accept
 If Internal Rate of Return < Hurdle
Rate; Reject
 Computed using
• Financial calculators
• Computers

3 | STCM211 F E R R E R , I . A .
Payback
Assumptions
Speedy recovery of
investment is key
Cash flows can be
accurately predicted
Risk is lower for the
shorter payback project
Net Present Value
Assumptions
Discount rate is valid
Timing and size of cash
flows can be predicted
Life of project can be
predicted
If shorter-lived project
selected, proceeds of
shorter project will earn
the discount rate through
theoretical completion of
longer project
Profitability Index
Assumptions
Measures efficient use of
capital
Discount rate is valid
Timing and size of cash flows
can be predicted
Life of project can be
predicted
If shorter project selected,
proceeds of shorter project
will earn the discount rate
through theoretical
completion of longer project
Internal Rate of Return (IRR)
Assumptions
Hurdle rate is valid
Timing and size of cash
flows can be predicted
Project life can be
predicted
If shorter project selected,
proceeds of shorter
project will continue to
earn the IRR through
theoretical completion of
longer project
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Limitations
Ignores cash flows after
payback
Ignores time value of
money
Limitations
Alternative project rates
of return are not known
Internal rate of return on
project is not reflected
Limitations
A relative answer is given but
dollars of NPV are not
reflected
Alternative project rates of
return are not known
Internal rate of return on
project is not reflected
Limitations
Projects are ranked by
IRR and not dollar size
Net present value dollars
are not reflected
Multiple rates of return
can be calculated on the
same project
Comparing Techniques
Payback NPV PI IRR
Uses time
value money N Y Y Y
Provides
specific rate N N N Y
of return
Uses cash
flows Y Y Y Y
Considers
returns
during life of N Y Y Y
project
Uses
discount rate N Y Y N*
*often uses as a hurdle rate
The Investment Decision
 Is the activity worthy of an investment?
 Which assets can be used for the activity?
 Of the available assets for each activity,
which is the best investment?
 Of the “best investments” for all worthwhile
activities, in which ones should the
company invest?
Consider Quantitative and Qualitative Factors
Capital Budgeting Terms
• Screening decision
• Preference decision
• Mutually exclusive projects
• Independent projects
• Mutually inclusive projects
Ranking Capital Projects
 For the projects under consideration
 Net present value is nonnegative
 Profitability index of 1 or more
 Internal rate of return equals or
exceeds hurdle rate
 Selection ranking of multiple projects
 Results can vary depending on
evaluation techniques and whether
dollars or percentages are used
 Reinvestment Assumptions
F E R R E R , I . A .
  Net present value and profitability
index assume that released cash flows
are reinvested at the discount rate
➢ at least the cost of capital
 Internal rate of return assumes that
released cash flows are reinvested at
the expected internal rate of return
➢ could be substantially different
than the cost of capital
 Net present value compared to internal
rate of return
 more realistic reinvestment
assumption
 results measured in dollars not rates
Compensating for Risk
 Judgmental method
 Use logic and reasoning to decide if
acceptable rate of return will be
achieved
 Risk-adjusted discount rate method
 Higher discount/hurdle rate for riskier
projects and/or cash flows
 Shorter payback period for riskier
projects
 Higher IRR for riskier projects
 Sensitivity Analysis – the amount of change
that must occur in a variable before a
different decision would be made
 Discount rate – What increases could
occur in the cost of capital and related
discount rate before a project
becomes unacceptable?
 Cash flows – How small can the net
cash inflows be before a project
becomes undesirable?
 Asset life – What is the minimum time
the cash flows must be received for the
project to remain acceptable?
Post investment Audit
➔ Complete after project has stabilized
➔ Compare actual results to expected results
➔ Use same analysis techniques
➔ Identify areas where results differ from
expectation
➔ Evaluate capital budgeting process,
particularly original projections, problems
with implementation, sponsor credibility
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Time Value of Money (Appendix 1)
 Future value (FV) and present value (PV)
depend on
 amount of cash flow
 rate of interest
 timing of cash flow
 Simple vs. compound interest
 Single cash flow
 Annuity
 Ordinary annuity or annuity due
Accounting Rate of Return (Appendix 2)
 Measures rate of return on earnings for
average capital investment over project’s
life
 Consistent with accounting model
 Uses profits shown on accrual-based
financial statements
 Not based on cash flows
Accounting Average Annual Profits
Rate of Return = Average Investment
Potential Ethical Issues
• Ignoring detrimental environmental impact
of project decisions
• Changing assumptions or estimates to
meet criteria for approval
• Using a discount rate that is inappropriately
low
• Not conducting a post-investment audit to
hold decision makers accountable
• Choosing projects based on accounting
earnings only rather than including
discounted cash flow methods
F E R R E R , I . A .