1
What is Capital Budgeting?
• Significant investments take place
because of many factors
 As time passes, assets wear out and must be
replaced
 Growth in demand has over-taken available
capacity
 Launching new products / market expansion
 Changing production technology
2
LO1: Understand the reasons for capital budgeting
What is Capital Budgeting?
• Such project decisions have two main
components
 Evaluate Project profitability
 Allocate scarce capital among profitable
projects
• Capital budgeting refers to the set of tools
used to evaluate such large expenditures
• Let us begin by linking to two familiar
topics
 Cost allocations and budgets
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LO1: Understand the reasons for capital budgeting
Link to Cost Allocations
• Both allocations and capital budgeting
deal with decisions concerning
capacity.
 Allocations are quick and easy to implement
 But, suffer from two main drawbacks
• Do not consider
 Time value of money
 Lumpy nature of capacity
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LO1: Understand the reasons for capital budgeting
Defects: Cost Allocations
• Time value of money
 $1 today is worth more than $1 a year from today!
 Capital assets last for many years. Thus, we need to
consider time value for effective decision making
 In capital budgeting, we discount future cash flows to their
present value so that we can consider projects with
alternate patterns of cash flow
• Lumpy nature of capacity
 Capacity resources come in discrete sizes
 Allocations assume “smooth” capacity.
 That is, they allow for capacity to be bought in small
increments. But, we cannot buy 15/16th of a machine.
 Capital budgets explicitly recognize lumpy capacity
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LO1: Understand the reasons for capital budgeting
Link To Budgets
•
•
Capital budgets link strategic and operating budgets
Strategic budgets
 Set the vision for the future
 Flesh out core competencies
•
Operating budgets (see chapter 7)
 Deal with the here and now
 Take capacity resources more or less as a given
•
Capital budgets consider both the needs as dictated
by operating budgets and visions as dictated
strategically
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LO1: Understand the reasons for capital budgeting
Steps in Capital Budgeting
• Generate a list of projects
 Proposed by management as well as others
 Dictated by strategic visions
• Evaluate each project for profitability
• Choose projects to fund
 Ability to fund projects limited by capital / managerial
talent
 Fit with strategic profile varies
 Qualitative dimensions (e.g., safety, environment)
might dominate choice
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LO1: Understand the reasons for capital budgeting
Elements of Cash Flow for Projects
•
•
•
•
Initial Outlay.
 What are the costs associated with acquiring the resource
and getting it ready for use?
Estimated Life and Salvage Value.
 How long do we expect to keep the resource?
 At the end of this period, what is the cash flow associated
with selling / disposing off the resource?
Timing and Amounts of Operating Cash Flows.
 What are the expected operating expenses every year?
 What are the expected revenues?
Cost of Capital.
 What is the opportunity cost of capital required for the
proposed investment?
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LO2: List the components of a project’s cash flows
Timeline: Project Cash Flow
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LO2: List the components of a project’s cash flows
Cash Flows for MRI Machine
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LO2: List the components of a project’s cash flows
Timeline for MRI Machine Cash Flow
How should we evaluate whether
this is a profitable investment?
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LO2: List the components of a project’s cash flows
Many Ways To Evaluate Profitability
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LO3: Apply discounted cash flow techniques
1
2
3
4
1 $62.10 = $100 x 0.621
2 $152.10 = $100 x 1.521
3 $331.20 = $100 x 3.312
4 $811.50 = $100 x 8.115
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Net Present Value (NPV)
•
•
NPV is present value of ALL cash flows
PV of cash flow in period t =
 “r” is the discount rate
 1/(1+r)t is the discount factor
•
The net present value is the sum of all of the
present values of the individual cash flows
 NPV recognizes a lump sum outflow at the start
 Periodic inflows over the life of the project
 Salvage value
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LO3: Apply discounted cash flow techniques
NPV of MRI Project
This is a profitable project.
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LO3: Apply discounted cash flow techniques
Sensitivity analysis
•
•
Can vary discount rates to reflect differing
evaluations of risk associated with the project
Can also calculate NPV for alternate scenarios
 Lower price to increase demand early on
 Benefit: Higher revenue with greater present value
 Cost: Lower revenue later on (but PV impact is also
smaller)
 Usage rates
 Life of asset
•
16
Such extensions are important because we
need to make many assumptions to estimate
the cash flow from this long-lived asset
LO3: Apply discounted cash flow techniques
High Discount Rates Lower NPV
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LO3: Apply discounted cash flow techniques
0.877
0.769
0.675
-$100,000
$52,620
$38,450
$6,750
Thus, the NPV = $6,750 + $38,450 + $52,620 – $100,000 = -$2,180.
We reject the project because it has a negative NPV.
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Assumptions in NPV Analysis
•
The initial cash outflow takes place at the beginning of
the period.
 This assumption is the reason for not discounting the initial
outlay.
•
Subsequent cash inflows and outflows occur at the end
of the relevant period.
 The net cash flow in year 1 occurs as a lump sum at the end of
year 1, which is time t =1, or a year from time t = 0
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•
NPV calculations assume that firms reinvest future cash
inflows in projects that yield a return that equals the cost
of capital
•
None of these assumptions are particularly realistic but
they are not unreasonable
LO3: Apply discounted cash flow techniques
Internal Rate of Return
• Discount rate at which the NPV is zero
• Relation to NPV analysis
 NPV analysis fixes the discount rate and calculates
the present value
 IRR fixes the NPV at zero and calculates the implied
rate
• Project evaluation criterion
 NPV > 0 => project return exceeds cost of capital
 IRR > Cost of capital => project has positive NPV
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LO3: Apply discounted cash flow techniques
Calculating IRR: Equal flows
•
•
This is like an annuity
Use annuity tables to find annuity Factor
 Periodic flow * Annuity Factor = Initial outflow
•
For the given project life, find rate that has the
relevant annuity factor
•
Example: Initial flow $50,000, $15,000 inflow for 5
years
 Annuity factor = $50,000 / $15,000 = 3.33
 Looking down column for 5 periods, the rate is between
15% and 16%
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LO3: Apply discounted cash flow techniques
Calculating IRR: Unequal Flows
•
•
This can be mathematically challenging
It is much more convenient to use a program
such as EXCEL.
 @IRR(A1..A10) function gives the IRR for a set of cash
flows in cells A1 to A10
 Remember to keep the signs consistent
•
•
The IRR for the MRI project is 20.87%
This is a highly profitable project because the
IRR exceeds the cost of capital of 12%
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LO3: Apply discounted cash flow techniques
Assumptions: IRR
•
Timing of cash flows
 Same as NPV Analysis
 Initial out flow now at start of period
 Inflows at end of period
•
Reinvestment
 Takes place at the calculated IRR
 This is not a good assumption, particularly for projects
with high IRR
•
It is possible to construct examples where the
same project has multiple IRRs
 Needs unusual cash flow patterns
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LO3: Apply discounted cash flow techniques
Test Your Knowledge!
The internal rate of return measures:
a) How quickly the initial investment can be re-couped
b) The discount rate at which the net present value of the
project is zero
c) The profitability of an investment
d) The rate at which future cash flows must be invested in
order to obtain profitability
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Comparing NPV and IRR
• Many people prefer NPV to IRR
 Unique answer for NPV
 Reinvestment assumption is more reasonable for NPV
than IRR
 We are likely to have more projects that return the cost of capital
than return a high IRR
 NPV favors larger projects with greater absolute profit
while IRR focuses on profitability without concern for
size
• Both methods have value
 Firms try to rank order projects by both methods
 Unfortunately, the above differences mean that
sometimes the rank ordering of projects may not be the
same
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LO3: Apply discounted cash flow techniques
In Excel, enter cash flows in cells A1 to A4
(starting with the –$100,000 for the initial
outlay in A1).
In cell A5, type “=IRR(A1:A4)” and Excel
will reveal that the IRR = 12.40%.
Using the same approach as in Check it!
Exercise #2, we can calculate NPV(12%) =
$550; NPV(13%) = -$820, and confirm the
validity of our estimate. Finally, we reject
the project because its IRR is lower than
the cost of capital (14%).
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The
Result
Other Ways To Evaluate Profitability
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LO4: Compare various methods for evaluating projects.
Payback Method
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•
Payback period is the length of time it takes to
recoup the initial investment
•
Initial out flow of $60,000 and periodic inflows of
$24,000
•
Payback period = 2.4 years = $60,000/$24,000.
LO4: Compare various methods for evaluating projects.
Evaluating Payback Method
• Advantages
 It is a simple easy method
 Focuses on the downside risk
• But…
 Its biggest problem is that it ignores the time value of
money
 Also ignores cash flows that occur after the payback
period
 Not enough emphasis on the upside potential
• Acceptable payback period is unclear
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LO4: Compare various methods for evaluating projects.
Payback Period for MRI Project
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LO4: Compare various methods for evaluating projects.
Cumulative cash inflows through year 5 =
$60,000 year 1
+ $60,000 year 2
+ $60,000 year 3
+ $50,000 year 4
+ $50,000 year 5
= $280,000
Payback period of 5.6 =
5 years + ($310,000 initial investment – $280,000 cumulative
cash inflows through year 5)/$50,000 cash flow in year 6.
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Modified Payback
•
Calculates the payback period using discounted
cash flows
•
•
Overcomes a major defect of the payback period
•
Overall,
But, it still does not account for cash flows after the
modified payback period
 Payback and modified payback can provide some measure of
risk in project
 But, they are not preferred because of their shortcomings
 Use as a secondary criterion rather than as the main rule
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LO4: Compare various methods for evaluating projects.
Modified Payback: MRI project
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LO4: Compare various methods for evaluating projects.
Accounting Rate of Return
AR
R
•
•
•
=
Average annual income from the project
Average annual investment
Annual income = Annual cash flow – depreciation
Investment = Average book value at start & end of period
For MRI machine
 St. Vincent’s plans to depreciate the MRI equipment using the
straight-line method and assuming zero salvage value.
 First, we decrease the book value of the MRI equipment by the
depreciation amount.
 We then calculate the average investment balance for each year as
the average of the beginning and ending book values.
 The final step is to compute ARR as the ratio of the average income
to the average investment over the life span of the investment.
34
LO4: Compare various methods for evaluating projects.
MRI Project: ARR Calculations
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LO4: Compare various methods for evaluating projects.
ARR: Evaluation
• Easy and straight forward to calculate
• Ties in well with standard “accounting”
measures of performance
• Ignores time value of money
• Ignores patterns of cash flow
 Most suited for simple projects with
somewhat equal cash flows over the life of
the project
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LO4: Compare various methods for evaluating projects.
Comparing the Methods
Feature of Method
Net
Present
Value
Considers time value of
money
Yes
Yes
No
Yes
No
Considers all cash flows
Yes
Yes
No
No
No
Return earned on
invested cash inflows
Cost of capital
IRR
Ease of computations
Moderate
Moderate
to difficult
Easy
Easy to
moderate
Easy to moderate
No
No
Yes
Yes
No
No
No
No
No
Yes
Greater focus on
avoiding losses than on
making profit
Integrates well with
accounting performance
measures
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Internal
Modified
Rate of Payback
Payback
Return
Not
Not
applicable applicable
Accounting
Rate of
Return
Not applicable
LO4: Compare various methods for evaluating projects.
Test Your Knowledge!
The only method not used to evaluate capital
projects is:
a) Payback/modified payback
b) Net present value
c) Internal rate of return
d) Regression analysis
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Usage Patterns
Often or
Always
Sometimes
Rarely or
Never
NPV
85.1%
10.9%
4.0%
IRR
76.7
15.4
7.9
Payback
52.6
21.9
25.5
Modified Payback
37.6
19.1
43.3
ARR
14.7
18.6
66.7
Source: P.A. Ryan and G. P. Ryan, Capital Budgeting Practices of the Fortune 1000: How have Things
Changed? Journal of Business and Management, Volume 8 (4), 2002.
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LO4: Compare various methods for evaluating projects.
The Effect of Taxes
• We can depreciate the cost of a capital asset
over time
• Accounting income = Operating cash flow –
depreciation – other non-cash items
 We focus on effect of depreciation
• Taxes paid on accounting income. NOT cash
flow
 Depreciation lowers income and thus taxes
 Provides a tax shield
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LO5: Explain the role of taxes and depreciation tax shields.
Calculating the Tax Shield
• Method 1:
 Depreciation tax shield = tax rate * depreciation
 Tax on operating cash flow = t * operating cash flow
 After-tax cash flow = (1-t)* operating cash flow +
depreciation tax shield
• Method 2
(Same answer as method 1):
 Calculate Income = Cash flow – depreciation
 Calculate taxes = t * income
 After-tax cash flow = (1-t) * income + depreciation
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LO5: Explain the role of taxes and depreciation tax shields.
Salvage Value and Taxes
• Need to pay taxes on any gain or loss due to
disposal of asset
 Gain/ loss may arise because accounting
depreciation is not always the same as decline in
economic value
• Calculation
 Gain or loss = sale proceeds – Net Book Value
 Net Book Value = Initial investment – accumulated
depreciation
 Note: Tax is paid on the gain / loss and NOT on the
proceeds
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LO5: Explain the role of taxes and depreciation tax shields.
Example
Data
Investment
$15,000
Estimate salvage value
Tax rate
$1,000
30%
Actual sales prices at end of 6 years
$3,500
Straight-line depreciation method
•
Calculations
 Annual depreciation = ($15,000 -$1,000) / 7 years = $2,000/year
 Book value (after 6 years) = $3,000 [$15,000 – (6 yrs *$2,000/yr)]
 Gain due to sale = $500 ($3,500 -$3,000)
 Taxes paid = 0.30 * $500 = $150
 Cash flow at end of 6 years = $3,500 - $150 = $3,350.
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LO5: Explain the role of taxes and depreciation tax shields.
$304,000 in year 5 = $370,000 net cash inflow from Exhibit 11.2 –
[($370,000 – $150,000 depreciation expense) x 0.30 in taxes due].
Alternatively, $370,000 – $150,000 = $220,000 in taxable income;
$220,000 x 0.30 = $66,000 in taxes.
Thus, $304,000 = $220,000 in income – $66,000 in taxes + $150,000 in
depreciation in expense. $346,000 in year 10 = $430,000 net cash
inflow from Exhibit 11.2 – [($430,000 – $150,000 depreciation
expense) x 0.30 in taxes due].
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Allocating Capital Among Projects
• Most firms have limited access to capital,
managerial talent, and other organizational
resources
 Use hurdle rate to select projects
• Hurdle rate > Cost of capital. Why?
 Risk inherent in estimation process
 Reduce slack built into budgets
 Force managers to come up with “best” projects
45
LO6: Describe issues in allocating scarce capital among projects
Non-financial Costs and Benefits
•
Many benefits are hard to assess
 Environmental impact
 Worker / consumer safety
 Quality of products (image in marketplace)
•
Costs can be difficult as well
 Training
 On-going maintenance
 Effect on other products
•
The benchmark is usually the status quo
 But, difficult to evaluate cash flow under status quo
46
LO6: Describe issues in allocating scarce capital among projects
Pick The Right Benchmark
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LO6: Describe issues in allocating scarce capital among projects
Flexibility
• All projects involve some degree of
uncertainty
• Some projects inherently have more
flexibility than others
 Smaller upfront commitment (“dipping toe in water”)
 These projects let firms adjust more rapidly to any
new information they may obtain
• Such flexibility (or the option to change
one’s mind) has value
 Usually called a “real” option
48
LO6: Describe issues in allocating scarce capital among projects
Real Option Analysis
Value of Flexibility
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LO6: Describe issues in allocating scarce capital among projects
Exercise 11.31
Present value calculations (LO3).
Refer to the data in the following table:
Setting
Initial outlay
1
Life
Discount rate
Future value
(years)
(compounded
annually)
(at the end of life)
$225,000
5
10%
?
2
?
10
12%
$400,000
3
$157,950
8
?
450,000
4
$150,000
?
12%
$371,400
Required:
Treating each row of the table independently, compute the
missing information. Use the present value/future value
tables at the end of the book.
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Exercise 11.31 (Continued)
Treating each row of the table independently, compute the missing information.
Use the present value/future value tables at the end of the book.
For each setting, we use the appropriate present value factors from
the tables in Appendix B. The relevant table and the factor are given
in parentheses for each setting.
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Setting
Initial outlay
1
2
Life
Discount rate
Future value
(years)
(compounded
annually)
$225,000
5
10%
$128,800
10
12%
$400,000
(Table 1: Factor 0.322)
(at the end of life)
$362,475
(Table 2: Factor 1.611)
3
$157,950
8
14%
450,000
4
$150,000
8
12%
$371,400