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CH.

16
How to Make Capital
Budgeting Decisions

Capital budgeting is the process of


making long term investment
decisions that further the business
enterprises goals.
Business enterprises must make
many financial decisions in order to
grow, including selecting product
lines, disposing of business
segments, choosing to lease or buy
equipment, and selecting
investments.

Three tasks when evaluating


capital budgeting projects:
1. Estimate cash flows
2. Estimate the cost of capital (or
required rate of return)
3. Apply a decision rule to
determine whether a project
will be good for the business
enterprise.

2 Types of long-term investment


decisions:
1. Selection decisions deciding whether to
obtain new facilities or expand existing
facilities. These are the decisions involve:
(a)Investment in PPE and other types of assets
(b) Resources commitments in the form of new
product development, market research,
introduction of computer and etc.
(c)Mergers and acquisitions that is, buying
another business enterprise to acquire a new
product line.

2. Replacement decisions determining


to replace existing facilities with new
facilities, such as opting to replace an
old machine with a high-tech machine.

3 Vital Characteristics of Long-term


Investments
1. They typically involve a large initial cash
outlay, which usually has a long-term
impact on the business enterprises
profitability.
2. They generate recurring cash inflows (for
example, increased this income or
savings in cash operating expenses).
3. Income tax factors may be critical in
whether a project is cost-effective.

Measuring Investment Worth


1. Payback Period
2. Accounting rate of return (ARR)
3. Net present value (NPV)
4. Internal rate of return (IRR)
5. Profitability index (or cost/benefit
ratio)

1. Payback Period
The payback period is the length of time it will take the
business enterprise to recover its initial investment.
Example 16-1
Assume:
Cost of Investment
Annual after-tax cash savings

18,000
3,000

Payback period = initial investments = 18,000 = 6 years


cost savings
3,000
Note : It is wiser to choose the project with the shorter
payback period. Such projects are less risky and have
greater liquidity.

Example 16 2
Consider two projects with uneven after-tax
cash inflows. Assume each project costs
1,000.
Year
1
2
3
4
5
6

A(P)

B(P)
100
200
300
400
500
600

500
400
300
100

Advantages of Payback period:


It is simple to compute and easy to
understand
It handles investment risk effectively
Disadvantages of Payback period:
It does not recognize the time value of
money
It ignores the impact of cash inflows
received after the payback period, which
determine the projects profitability.

2. Accounting Rate of Return


Accounting rate of return (ARR) measures
profitability by relating either the required
invesment or the average investment to future
annual net income.
Example 16-3
Data: Initial Investment
P 6,500
Estimated life 20 years
Cash inflows per year P 1,000
Depreciation per year P 325

The accounting rate of return for this project


is:
ARR= net income = P1,000 P 325 = 10.4%
investment
P6,500
If average instrument (usually assumed to
be one-half the original investment) is
used, then:
ARR = P 1,000 P 325 = 20.8%
P 3,250

3.Net Present Value


Net present value (NPV) is the excess of
the present value of future cash inflows to
be generated by the project over the
amount of the initial investment(I):
NPV = PV I
Present value computation:
PV = A

Example 16-4
Initial investment
12,950
Estimated life
10 years
Annual cash inflows
3,000
Cost of capital
12%
Present value of the cash inflows is :
PV = A T4(i , n)
= P3,000 T4(12%,10yrs)
= P3,000(5,650) P16,250
less: Initial Invesment 12,950
NPV
P 4,000

4.Internal Rate of Return


Defined as that rate of interest that
equates the initial investment with the
present value of future cash inflows.
I = PV
or
NPV = 0

Example 16-5
Assume the same data given in Ex. 16-4, and
set the ff. equality(I = PV):

P 12,950 = P3,000 T4(i, 10yrs)


T4(i, 10yrs) = 12,950
P3,000

Can a computer help?


Spreadsheet programs can be use in
making IRR calculations, Excel
considers negative numbers as cash
flows and has function IRR (values,
guess).

Profitability Index
The profitability index is the ratio of
the total present value of future cash
inflows to the initial investments, that
is, PV/I. It is used as a means of
ranking projects in descending order
of attractiveness.

Example 16-6
Same data in 16-4

PV = P 16,950 = 1.31
I
P 12,950
The profitability index has the advantage of
putting all projects on the same relative
basis regardless of size.

Selecting the Best Mix of Projects for a


Limited Budget

Capital rationing is the process of


selecting that mix of acceptable
projects that provides the highest
overall net present value.

Zero-one programming, a special case of


linear programming, is a more general
approach to solving capital rationing
problems. The objective is to select that
mix of projects that maximizes the net
present value subject to a budget
constraint,
The strength of the use of zero-one
programming is its ability to handle
mutually exclusive and interdependent
projects.

16.7 Handling Mutually Exclusive


Investments
A mutually exclusive project is one whose acceptance
automatically precludes the acceptance of one or more
other projects.
NPV and IRR methods may result in contradictory
indications under certain conditions :
1. If the projects have different life expectancies
2. If the projects call for different amounts of investment
capital
3. If the projects are expected to yield different cash
flows over time-if, for example the cash flows of one
project will increase over time while those of the other
will decrease.

The NPV method discounts all cash flows at


the cost of capital, thus implicitly assuming
that these cash flows can be reinvested at
this rate. This method generally gives
corrective ranking, since the cost of capital
is the more realistic reinvestment rate; the
cost of capital usually closely approximates
the market rate of return.
The IRR method assumes that cash flows
are reinvested at the often unrealistic rate
specified by the projects internal rate of
return

16.8 The Modified Internal Rate of


Return (MIRR)
When the IRR and NPV methods produce
a contradictory ranking for mutually
exclusive projects, the modified IRR, or
MIRR, overcomes the disadvantage of
IRR.
The MIRR is defined as the discount rate
which forces
I = PV of terminal (future) value
compounded at
the cost of capital

The MIRR forces cash flow


reinvestment at the cost of capital
rather than the projects own IR,
which was the problem with the IRR.
1. MIRR avoids the problem of multiple
IRRs.
2. Conflict can still occur in ranking
mutually exclusive projects with
differing sizes. NPV should again be
use in such a case.

16.9 Comparing Projects with Unequal


Lives

A replacement decision typically


involving two mutually exclusive
projects.
2 approaches:
a. the replacement chain (common
life) approach
b. the equivalent annual annuity
approach

16.10 The Equivalent Annual Annuity


(EAA) Approach
3 Steps of Equivalent Annual Annuity Method:
1. Determine each projects NPV over its original
life.
2. Find the constant annuity cash flows or EAA,
using
NPV of each project
T4(n , i)
3. Assuming infinite replacement, find the infinite
horizon NPV of each projects, using
EAA of each
cost of capital

16.11 The Concept of Abandonment


Value
It recognizes that abandonment of a project
before the end of its physical life can have a
significant impact on the projects return and
risks.
2 types of abandonment
a. Abandonment of an asset since it is
being unprofitable.
b. Sale of the asset to some other party
who can extract more value than the
original owner

16.12 Real Options


Almost all capital budgeting proposals
can be viewed as real options.
Deciding when to take a project is
called the investment timing option.

16.13 The Effects Of Income Taxes On


Investment Decision
Income taxes make a different in many capital
budgeting decisions; often, projects that appear
attractive on a before-tax basis have to be rejected
when income taxes are factored in. It affect both
the amount and the timing of cash flows.
Let us define:
S= Sale
E= Cash operating expenses
d= Depreciation
t= Tax rate

Example 16-15
Assume:

S= P 12,000
E= P 10,000
d= P 500 per year using the
straight-line method
t= 30%

16.14 Depreciation Method


The most commonly used
depreciation methods are the straightline method and two accelerated
methods, sum-of-the-years
digit(SYD) and double-declining
balance.

Straight-Line Method
The most popular method of calculating
depreciation that results in equal periodic
depreciation deductions. It is also the most
appropriate when an assets use is uniform from
period to period, as is the case with furniture.
Formula:
Depreciation expense = Cost salvage value
# of years of useful life

Sum-of-the-Years-Digit Method
This method uses a ratio in which the
numerator is the number of years of
life expectancy in reverse order, and
the denominator is the sum of the
digits.
Formula:
SYD = (N)(N+1)
2

Double-Declining-Balance
Method
The depreciation expense is highest in the
early years of the assets life and
decreases in the later years. First, you
determine a depreciation rate by doubling
the straight-line rate. Second, you
calculate depreciation expense by
multiplying the depreciation rate by the
book value of the asset at the beginning of
each year.

Capital Budgeting Decisions and the


Modified Accelerated Cost Recovery System
The current rule is called the Modified Accelerated
Cost Recovery System (MACRS) rule, this rule is
characterized as follows:
1. It abandons the concept of useful life and
accelerates depreciation deduction by placing all
depreciable assets into one of the eight age
property classes.
2. Since the allowable percentages in Table 16.1
add up to 100 percent, there is no need to
consider the salvage value of an asset when
computing depreciation.

3. The business enterprise may elect the


straight-line method. The straight-line
convention must follow what is called the
half-year convention. This means that the
business enterprise can deduct only half
of the regular straight-line depreciation
amount in the first year.
4. If an asset is disposed before the end of
the class life, the half-year convention
allow the half the depreciation for that
year(early disposal rule).

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