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SU 8.1 – The Capital Budgeting Process

and controlling investment for long-term

projects.

– Will affect the company for many accounting

periods going forward

– Relatively inflexible once made

2

SU 8.1 – The Capital Budgeting Process

– Predicting the need for future capital assets is one

of the more challenging tasks

• Affected by

– Inflation

– Interest rates

– Cash availability

– Market demands

– Production capacity is a key driver

3

SU 8.1 – The Capital Budgeting Process

– Buying equipment

– Building facilities

– Acquiring a business

– Developing a product of product line

– Expanding into new markets

4

SU 8.1 – The Capital Budgeting Process

• Important to correctly forecast future changes in

demand in order to have the correct capacity.

• Planning is crucial to anticipate changes in

capital markets, inflation, interest rates and

money supply.

• Consider the tax consequences.

– All decisions should be done on an after tax basis

5

SU 8.1 – The Capital Budgeting Process

• Costs considered in capital budgeting

– Avoidable cost

• May be eliminated by ceasing or improving an activity.

– Common cost

• Shared by all options and is not clearly allocable.

– Deferrable cost

• May be shifted to the future.

– Fixed cost

• Does not very within relevant range.

– Imputed cost

• May not have a specific cash outlay in accounting

– Incremental cost continued

• Difference in cost of two options.

6

SU 8.1 – The Capital Budgeting Process

– Opportunity cost

• Maximum benefit forgone based on next alternative, including that of the

stockholders (which also establishes the firms hurdle rate).

– Relevant cost

• Vary with action.

• Constant cost don’t affect decision.

– Sunk cost

• Cannot be avoided.

– Weighted-average Cost of Capital

• Weighted average of the interest cost of debt (net of tax) and the costs

(implicit or explicit) of the components of equity capital to be invested in long-

term assets. It is also the “hurdle rate”.

7

SU 8.1 – The Capital Budgeting Process

• Stages in Capital Budgeting

1. Identification and definition

• Identify the strategy

• Define the projects

– Revenue, costs, and cash flow

– Most difficult stage

2. Search

• Each investment to be evaluated be each function

of the firms value chain.

8

SU 8.1 – The Capital Budgeting Process

3. Information-acquisition

• Costs and benefits of the projects are enumerated

• Quantitative financial factors have highest priority

• Nonfinancial measures (quantitative and qualitative)

4. Selection

• Increase shareholder value. NPV, IRR..

5. Financing

• Debt or equity

6. Implementation and monitoring

• Feedback and reporting

9

SU 8.1 – The Capital Budgeting Process

• Investment Ranking Steps

– Determine Net Investment Costs

• Gross cash requirement less cash recovered from trade or sale of existing

assets, adjusted for taxes

• Investment required includes funds to provide for increases in working capital,

i.e. additional receivables and inventories.

– Calculating estimated cash flows

• Capture increase in revenue, decrease costs

• Net cash-flow period by period from investment

• Economic life of the investment

• Depreciable life

– Comparing cash-flows to Net Investment Costs

• Evaluate the benefit

– Ranking investments

• NPV, IRR, Payback 10

SU 8.1 – The Capital Budgeting Process

• Book Rate of Return =

GAAP NI from Investment

Book Value of Investment

– Also called accrual accounting rate of return

– Don’t use accrual accounting numbers, instead use cash flow

• Net Income is affected by company’s choices of accounting methods

– Also, do not compare project book rate to company’s book rate

of return for investments which could be distorted

11

SU 8.1 – The Capital Budgeting Process

• Relevant Cash Flows

– Net initial investment

• New equipment cost

• Working capital requirements,

• After tax disposals proceeds

– Annual net cash flows

• After tax cash collections for operations

• Depreciation tax savings

– Project termination cash flows

• After tax disposal

• Working capital recovery

12

SU 8.1 – The Capital Budgeting Process

• Other Considerations

– Inflation

• Raises hurdle rate

– Post-audits – Deterrent of bad projects.

• Actual to expected cash flow

• Identify sources of unrealistic estimates

• Avoid premature evaluations of projects

• Non-quantitative benefits

13

SU 8.1 – The Capital Budgeting Process Practice

Question 1

The relevance of a particular cost to a decision is determined by

14

SU 8.1 – The Capital Budgeting Process Practice

Question 1 Answer

Correct Answer: D

Relevance is the capacity of information to make a difference in a decision by

helping users of that information to predict the outcomes of events or to

confirm or correct prior expectations. Thus, relevant costs are those expected

future costs that vary with the action taken. All other costs are constant and

therefore have no effect on the decision.

15

SU 8.1 – The Capital Budgeting Process Practice

Question 2

Lawson, Inc., is expanding its manufacturing plant, which requires an investment of

$4 million in new equipment and plant modifications. Lawson’s sales are expected to

increase by $3 million per year as a result of the expansion. Cash investment in

current assets averages 30% of sales; accounts payable and other current liabilities

are 10% of sales. What is the estimated total investment for this expansion?

A $3.4 million.

B $4.3 million.

C $4.6 million.

D $5.2 million.

16

SU 8.1 – The Capital Budgeting Process Practice

Question 2 Answer

Correct Answer: C

The investment required includes increases in working capital (e.g., additional

receivables and inventories resulting from the acquisition of a new

manufacturing plant). The additional working capital is an initial cost of the

investment, but one that will be recovered (i.e., it has a salvage value equal to

its initial cost). Lawson can use current liabilities to fund assets to the extent

of 10% of sales. Thus, the total initial cash outlay will be $4.6 million {$4

million + [(30% – 10%) × $3 million sales]}.

17

SU 8.1 – The Capital Budgeting Process Practice

Question 3

What is the net cash outflow at the beginning of the first year that

Dickins should use in a capital budgeting analysis?

A $(170,000)

B $(180,000)

C $(192,000)

D $(210,000)

18

SU 8.1 – The Capital Budgeting Process Practice

Question 3 Answer

Correct Answer: D

Delivery and installation costs are essential to preparing the machine for its

intended use. Thus, the company must initially pay $210,000 for the machine,

consisting of the invoice price of $180,000, the delivery costs of $12,000, and

the $18,000 of installation costs.

19

SU 8.2 – Risk Analysis and Real Options

In Capital Investments

• Risk analysis – Attempt to measure the variability of future returns from

proposed investment.

– Informal method – NPV is calculated and reviewed.

– Risk-adjusted discount rates – Adjust rate of return upwards as project

becomes more risky.

– Certainty equivalent adjustments- from Utility theory – the point where you

are indifferent to a choice between a certain sum of money and the expected

value of a risky sum.

– Simulation analysis – Computer is used to generate many results based upon

various assumptions.

• Pilot plants

– Sensitivity analysis – An iterative process of recalculated returns based on

changing assumptions.

20

SU 8.2 – Risk Analysis and Real Options

In Capital Investments

• Real (managerial or strategic) options

– Value of a real option – The difference between the projects NPV with

the option vs. without the option.

• Usually more valuable the later it is exercised.

– Types of real options:

• Abandonment (Put option)

• Follow-up investment

• Wait and Learn (call option)

• Flexibility option – vary an input

• Capacity option – vary an output

• New geographical markets

• New product option – follow on products

21

SU 8.2 – Risk Analysis and Real Options

In Capital Investments Question 1

Sensitivity analysis, if used with capital projects,

A Is used extensively when cash flows are known with certainty.

Measures the change in the discounted cash flows when using the

B discounted payback method rather than the net present value

method.

C

the original estimates of the capital budgeting model are changed.

22

SU 8.2 – Risk Analysis and Real Options

In Capital Investments Question 1 Answer

Correct Answer: C

After a problem has been formulated into any mathematical model, it may be

subjected to sensitivity analysis, which is a trial-and-error method used to

determine the sensitivity of the estimates used. For example, forecasts of

many calculated NPVs under various assumptions may be compared to

determine how sensitive the NPV is to changing conditions. Changing the

assumptions about a certain variable or group of variables may drastically

alter the NPV, suggesting that the risk of the investment may be excessive.

23

SU 8.2 – Risk Analysis and Real Options

In Capital Investments Question 2

When the risks of the individual components of a project’s cash flows are

different, an acceptable procedure to evaluate these cash flows is to

A Divide each cash flow by the payback period.

Compute the net present value of each cash flow using the firm’s cost of

B

capital.

C Compare the internal rate of return from each cash flow to its risk.

Discount each cash flow using a discount rate that reflects the degree of

D

risk.

24

SU 8.2 – Risk Analysis and Real Options

In Capital Investments Question 2 Answer

Correct Answer: D

Risk-adjusted discount rates can be used to evaluate capital investment

options. If risks differ among various elements of the cash flows, then

different discount rates can be used for different flows.

25

SU 8.2 – Risk Analysis and Real Options

In Capital Investments Question 3

Sensitivity analysis is used in capital budgeting to

A Estimate a project’s internal rate of return.

Determine the amount that a variable can change without generating

B

unacceptable results.

C Simulate probabilistic customer reactions to a new product.

Identify the required market share to make a new product viable and

D

produce acceptable results.

26

SU 8.2 – Risk Analysis and Real Options

In Capital Investments Question 3 Answer

Correct Answer: B

After a problem has been formulated into any mathematical model, it may be

subjected to sensitivity analysis, which is a trial-and-error method used to

determine the sensitivity of the estimates used. For example, forecasts of

many calculated NPVs under various assumptions may be compared to

determine how sensitive the NPV is to changing conditions. Changing the

assumptions about a certain variable or group of variables may drastically

alter the NPV, suggesting that the risk of the investment may be excessive.

27

SU 8.3 – Discounted Cash Flow Analysis

• Time Value of Money

– Concept: A dollar received in the future is worth less than today.

– Present Value (PV) – Value today of future payment

– Future Value (FV) – Future value of an investment today.

– Annuities – equal payments at equal intervals

• Ordinary annuity (in arrears)

• Annuity due (in advance) – PV & FV is always greater than ordinary

annuity

28

SU 8.3 – Discounted Cash Flow Analysis

– Hurdle rate

• Goal is for companies discount rate to be as low as

possible.

• WACC or Shareholder’s opportunity cost of capital.

• The lower the firm’s discount rate, the lower the

“hurdle” the company must clear to achieve

profitability

29

SU 8.3 – Discounted Cash Flow Analysis

– Project return in $$

– Positive NPV indicates a higher rate of return than

the company’s desired rate

30

SU 8.3 – Discounted Cash Flow Analysis

– Project return in %

– IRR shortcomings -

• Directional changes of cash flows

• Mutually exclusive projects

• Varying rates of return

• Multiple investments

31

SU 8.3 – Discounted Cash Flow Analysis

NPV = Cash flow0 + Cash flow1 + Cash flow2

(1 + r)0 (1 + r)1 (1 + r)2

32

SU 8.3 – Discounted Cash Flow Analysis

• NPV vs IRR comparison

– Reinvestment rate NPV assumes the cash flow can be reinvested at projects

discount rate.

– Independent projects:

• NPV and IRR give same accept/reject decision if projects are independent.

• All acceptable independent projects can be undertaken.

– Mutually exclusive projects.

• Cost of one greater than other

• Timing, amounts, and direction of cash flow are different

• Different useful lives

• IRR provides 1 rate, NPV can be used with multiple rates.

• Multiple investments. NPV is adaptable, IRR is not.

• IRR assumes cash flow is reinvested at IRR rate.

• NPV assumes reinvestment in the desired rate of return.

– NPV and IRR are most sound decision making tools for wealth maximization.

Ø NPV profile – Page 317

• Select greatest NPV over greatest IRR 33

SU 8.3 – Discounted Cash Flow Analysis

Question 1

The net present value (NPV) method of investment project analysis assumes

that the project’s cash flows are reinvested at the

A Computed internal rate of return.

34

SU 8.3 – Discounted Cash Flow Analysis

Question 1 Answer

Correct Answer: C

The NPV method is used when the discount rate is specified. It assumes that

cash flows from the investment can be reinvested at the particular project’s

discount rate.

35

SU 8.3 – Discounted Cash Flow Analysis

Question 2

The net present value of a proposed investment is negative; therefore, the

discount rate used must be

A Greater than the project’s internal rate of return.

B Less than the project’s internal rate of return.

C Greater than the firm’s cost of equity.

D Less than the risk-free rate.

36

SU 8.3 – Discounted Cash Flow Analysis

Question 2 Answer

Correct Answer: A

The higher the discount rate, the lower the NPV. The IRR is the discount rate

at which the NPV is zero. Consequently, if the NPV is negative, the discount

rate used must exceed the IRR.

37

SU 8.3 – Discounted Cash Flow Analysis

Question 3

Dr. G invested $10,000 in a lifetime annuity for his granddaughter Emily. The

annuity is expected to yield $400 annually forever. What is the anticipated

internal rate of return for the annuity?

A Cannot be determined without additional information.

B 4.0%

C 2.5%

D 8.0%

38

SU 8.3 – Discounted Cash Flow Analysis

Question 3 Answer

Correct Answer: B

The correct answer is 4.0%.

$10,000 = $400 ÷ IRR; IRR = 0.040 = 4.0%.

39

SU 8.4 – Payback and Discounted Payback

• Payback period is the number of years it take

for an asset to pay for itself

– Pro

• Simple

– Cons

• No consideration for time value of money

• Does not consider cash flow after payback period

40

SU 8.4 – Payback and Discounted Payback

Initial net investment

Payback =

Annual expected cash flow

• Variable cash flows

– Cumulative calculation

41

SU 8.4 – Payback and Discounted Payback

• Discounted payback method

– Used to overcome the payback methods disregard for

time value of money

– Pro

• More conservative yet still simple

– Con

• Does not consider cash flow after payback period.

Ø See example

42

SU 8.4 – Payback and Discounted Payback

• Other payback methods

– Bailout payback

• Considers salvage value

– Payback reciprocal

• 1 / payback

• Estimate of IRR

continued

43

SU 8.4 – Payback and Discounted Payback

– Breakeven time

• Time require for discounted cash flows to equal 0

• Alternative is to consider the time required for the

present value of the cumulative cash inflows to equal

the present value of all the expected future cash flows

44

SU 8.4 – Payback and Discounted Payback

Question 1

Which one of the following methods for evaluating capital projects is the

least useful from an investment analysis point of view?

D Payback.

45

SU 8.4 – Payback and Discounted Payback

Question 1 Answer

Correct Answer: A

The accounting, or book, rate of return is an unsatisfactory means of

evaluating capital projects for two major reasons. Because the accounting

rate of return uses accrual-basis numbers, the calculation is subject to such

accounting judgments as how quickly to depreciate capitalized assets. Also,

the accounting rate of return is an average of all of a firm’s capital projects; it

reveals nothing about the performance of individual investment choices.

46

SU 8.4 – Payback and Discounted Payback

Question 2

The payback reciprocal can be used to approximate a project’s

A Profitability index.

47

SU 8.4 – Payback and Discounted Payback

Question 2 Answer

Correct Answer: D

The payback reciprocal (1 ÷ payback) has been shown to approximate the

internal rate of return (IRR) when the periodic cash flows are equal and the

life of the project is at least twice the payback period.

48

SU 8.5 – Ranking Investment Projects

– Capital rationing

• Reasons

– Lack of financial resources

– Control estimation bias

– Unwillingness to issue new equity (to raise new capital)

49

SU 8.5 – Ranking Investment Projects

• Methods

– Profitability index =

NPV

Net Investment

Ø See example

– Internal capital markets – Internal funding

– Linear programming – Technique for optimizing

resource allocation.

50

SU 8.5 – Ranking Investment

Projects Question 1

The profitability index approach to investment analysis

A Fails to consider the timing of project cash flows.

Considers only the project’s contribution to net income and does not

B

consider cash flow effects.

C

as the net present value method.

D

projects as the net present value method.

51

SU 8.5 – Ranking Investment Projects Question

1 Answer

Correct Answer: C

The profitability index (excess present value index) of an investment is the

ratio of the present value of the future net cash flows (or only cash inflows) to

the net initial investment. It is a variation of the net present value (NPV)

method and facilitates the comparison of different-sized investments.

Because it is based on the NPV method, the profitability index will yield the

same decision as the NPV for independent projects. However, decisions may

differ for mutually exclusive projects of different sizes.

52

SU 8.5 – Ranking Investment Projects

Question 2

The method that divides a project’s annual after-tax net income by the

average investment cost to measure the estimated performance of a capital

investment is the

A Internal rate of return method.

C Payback method.

53

SU 8.5 – Ranking Investment Projects

Question 2 Answer

Correct Answer: B

The accounting rate of return uses undiscounted net income (not cash flows)

to determine a rate of profitability. Annual after-tax net income is divided by

the average carrying amount (or the initial value) of the investment in assets.

54

SU 8.5 – Ranking Investment Projects

Question 3

The technique that measures the estimated performance of a capital

investment by dividing the project’s annual after-tax net income by the

average investment cost is called the

A Bail-out payback method.

B Internal rate of return method.

C Profitability index method.

D Accounting rate of return method.

55

SU 8.5 – Ranking Investment Projects

Question 3 Answer

Correct Answer: D

The accounting rate of return (also called the unadjusted rate of return or

book value rate of return) measures investment performance by dividing the

accounting net income by the average investment in the project. This method

ignores the time value of money.

56

SU 8.6 – Comprehensive Examples

on page 253

57

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