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21NotesCapitalBudget..

  1. 1. Capital Budgeting and Cost Analysis Chapter 21
  2. 2. Introduction <ul><li>Capital budgeting methods deal with how to select projects (or programs) that increase rather than decrease the “capital” (value) of a business. </li></ul><ul><li>These methods assist managers in analyzing projects that span multiple years. </li></ul>
  3. 3. Learning Objectives <ul><li>Adopt the project-by-project orientation of capital budgeting when evaluating projects spanning multiple years </li></ul><ul><li>Follow the six stages of capital budgeting for a project </li></ul><ul><li>Use and evaluate the two main discounted cash-flow (DCF) methods – the net present value (NPV) method and the internal rate-of-return (IRR) method </li></ul>
  4. 4. Learning Objectives <ul><li>Identify relevant cash inflows and outflows for capital-budgeting decisions that use DCF methods </li></ul><ul><li>Use and evaluate the payback method </li></ul><ul><li>Use and evaluate the accrual accounting rate-of-return (AARR) method </li></ul>
  5. 5. Learning Objectives <ul><li>Identify and reduce conflicts from using DCF for capital budgeting and accrual accounting for performance evaluation </li></ul><ul><li>Incorporate depreciation deductions into the computation of after-tax cash flows in capital budgeting </li></ul>
  6. 6. Learning Objective 1 <ul><li>Adopt the project-by-project orientation of capital budgeting when evaluating projects spanning multiple years </li></ul>
  7. 7. Cost Analysis <ul><li>There are two different dimensions of cost analysis: </li></ul><ul><li>A project dimension </li></ul><ul><li>An accounting period dimension </li></ul><ul><li>The accounting system that corresponds to the project dimension is termed life-cycle costing. </li></ul>
  8. 8. Cost Analysis <ul><li>Life-cycle costing accumulates revenues and costs on a project-by-project basis. </li></ul><ul><li>This accumulation extends the accrual accounting system that measures income on a period-by-period basis to a system that computes cash flow or income over the entire project covering many accounting periods. </li></ul>
  9. 9. Cost Analysis 2000 2001 2002 2003 2004 Project A Project B Project C Project D
  10. 10. Cost Analysis <ul><li>The life of the project is usually longer than one year, so capital budgeting decisions consider revenues and costs over relatively long periods. </li></ul>
  11. 11. Capital Budgeting <ul><li>Capital budgeting is the making of long-run planning decisions for investments in projects and programs. </li></ul><ul><li>It is a decision-making and control tool that focuses primarily on projects or programs that span multiple years. </li></ul>
  12. 12. Capital Budgeting <ul><li>Capital budgeting is a six-stage process: </li></ul><ul><li>Identification stage. To distinguish which types of capital expenditure projects are necessary to accomplish organization objectives. </li></ul><ul><li>Search stage. To explore alternative capital investments that will achieve organization objectives. </li></ul>
  13. 13. Capital Budgeting <ul><li>Information-acquisition stage. To consider the expected costs and the expected benefits of alternative capital investments. </li></ul><ul><li>Selection stage. To choose projects for implementation. </li></ul><ul><li>Financing stage. To obtain project funding. </li></ul><ul><li>Implementation and control stage. To get projects underway and monitor their performance. </li></ul>
  14. 14. Capital Budgeting <ul><li>Healthy Living is a non-profit organization. </li></ul><ul><li>One of its goals is to improve the diagnostic capabilities of its Miami facility. </li></ul><ul><li>Management identifies a need to consider the purchase of new, state-of-the-art equipment. </li></ul><ul><li>The search stage yields several alternative models, but management focuses on one machine as being particularly suitable. </li></ul>
  15. 15. Capital Budgeting <ul><li>The administration next begins to acquire information to do more detailed evaluation. </li></ul><ul><li>The required net initial investment consists of the cost of the new machine ($245,000) plus an additional cash investment in working capital (supplies and spare parts) of $5,000. </li></ul><ul><li>Management expects the new machine to have a three-year useful life and a $0 terminal disposal price at the end of the three years. </li></ul>
  16. 16. Capital Budgeting <ul><li>This proposed investment will yield net cash savings of $125,000, $130,000, and $110,000 over its life. </li></ul><ul><li>The working capital investment of $5,000 is expected to be recovered at the end of year 3. </li></ul><ul><li>Operating cash flows are assumed to occur at the end of the year. </li></ul>
  17. 17. Capital Budgeting <ul><li>Management also identifies the following nonfinancial quantitative and qualitative benefits of investing in the new diagnostic machine. </li></ul><ul><li>Improved diagnoses and patient care </li></ul><ul><li>Reduced inconvenience of transporting patients to other facilities for diagnoses </li></ul>
  18. 18. Capital Budgeting <ul><li>Nonfinancial benefits are not incorporated into the analysis. </li></ul><ul><li>In the selection stage , management must decide whether Healthy Living should purchase the new machine. </li></ul><ul><li>Assume that the required rate of return for Healthy Living is 10%. </li></ul>
  19. 19. Learning Objective 3 <ul><li>Use and evaluate the two main discounted cash-flow (DCF) methods – the net present value (NPV) method and the internal rate-of-return (IRR) method </li></ul>
  20. 20. Discounted Cash Flow <ul><li>Discounted cash-flow (DCF) methods measure all expected future cash inflows and outflows of a project as if they occurred at a single point in time. </li></ul><ul><li>The discounted cash-flow methods incorporate the time value of money. </li></ul>
  21. 21. Discounted Cash Flow <ul><li>The time value of money means that a dollar received today is worth more than a dollar received at any future time. </li></ul><ul><li>Why? </li></ul><ul><li>Because it can earn income and become greater in the future. </li></ul>
  22. 22. Discounted Cash Flow <ul><li>There are two main DCF methods: </li></ul><ul><li>Net present value (NPV) method </li></ul><ul><li>Internal rate-of-return (IRR) method </li></ul>
  23. 23. Net Present Value <ul><li>The NPV method computes the expected net monetary gain or loss from a project by discounting all expected cash flows to the present point in time, using the required rate of return. </li></ul><ul><li>Management’s minimum desired rate of return is also called the discount rate, hurdle rate, required rate of return, or cost of capital. </li></ul>
  24. 24. Net Present Value <ul><li>Only projects with a zero or positive net present value are acceptable. </li></ul><ul><li>What is the the net present value of the diagnostic machine? </li></ul>
  25. 25. Net Present Value Sketch of Relevant Cash Flows Net initial investment ($250,000) Annual cash inflow $125,000 $130,000 $115,000 0 1 2 3
  26. 26. Net Present Value <ul><li> Net Cash NPV of Net Year 10% Col. Inflows Cash Inflows </li></ul><ul><li>1 0.909 $125,000 $113,625 </li></ul><ul><li>2 0.826 130,000 107,380 </li></ul><ul><li>3 0.751 115,000 86,365 Total PV of net cash inflows $307,370 Investment 250,000 Net present value of project $ 57,370 </li></ul>
  27. 27. Net Present Value <ul><li>This project is acceptable because its net present value is $57,370. </li></ul><ul><li>Assume that Healthy Living is considering another investment that will generate $80,000 per year for three years, and have a residual value of $4,000 at the end of the third year. </li></ul>
  28. 28. Net Present Value <ul><li>The cost of this investment is $250,000 including working capital. </li></ul><ul><li>The working capital investment of $5,000 is expected to be recovered at the end of year 3. </li></ul><ul><li>Healthy Living expects a return of 10%. </li></ul><ul><li>Should the investment be made? </li></ul>
  29. 29. Net Present Value <ul><li>No, the net present value is negative. </li></ul><ul><li>Net Cash NPV of Net Years 10% Col. Inflows Cash Inflows 1-3 2.487 $80,000 $198,960 3 0.751 9,000 6,759 Total PV of net cash inflows $205,719 Investment 250,000 Net present value of project ($44,281) </li></ul>
  30. 30. Internal Rate of Return... <ul><li>is another model using discounted cash flows. </li></ul><ul><li>The internal rate-of-return (IRR) method calculates the discount rate at which the present value of expected cash inflows from a project equals the present value of expected cash outflows. </li></ul>
  31. 31. Internal Rate of Return <ul><li>Investment = Expected annual net cash inflow × PV annuity factor </li></ul><ul><li>Investment ÷ Expected annual net cash inflow = PV annuity factor </li></ul>
  32. 32. Internal Rate of Return <ul><li>Assume that Healthy Living is considering investing $303,280 in a scanning machine that will yield net cash savings of $80,000 per year over its five-year life. </li></ul><ul><li>What is the IRR of this project? </li></ul><ul><li>$303,280 ÷ $80,000 = 3.791 (PV annuity factor) </li></ul>
  33. 33. Internal Rate of Return <ul><li>The annuity table shows that 3.791 is in the 10% column for a 5 period row in this example. </li></ul><ul><li>Therefore, 10% is the internal rate of return of this project. </li></ul><ul><li>If the minimum desired rate of return is 10% or less, Healthy Living should undertake this project. </li></ul>
  34. 34. Comparison of NPV and IRR <ul><li>The NPV method has the important advantage that the end result of the computations is expressed in dollars and not in a percentage. </li></ul><ul><li>Individual projects can be added to see the effect of accepting a combination of projects. </li></ul><ul><li>It can be used in situations where the required rate of return varies over the life of the project. </li></ul>
  35. 35. Comparison of NPV and IRR <ul><li>The IRR of individual projects cannot be added or averaged to derive the IRR of a combination of projects. </li></ul>
  36. 36. Learning Objective 4 <ul><li>Identify relevant cash inflows and outflows for capital-budgeting decisions that use DCF methods </li></ul>
  37. 37. Relevant Cash Flows <ul><li>Relevant cash flows are expected future cash flows that differ among the alternatives. </li></ul><ul><li>Capital investment projects typically have three major categories of cash flows: </li></ul><ul><li>Net initial investment </li></ul><ul><li>Cash flow from operations </li></ul><ul><li>Cash flow from terminal disposal of assets and recovery of working capital </li></ul>
  38. 38. Relevant Cash Flows <ul><li>Typically, net initial investment components are: </li></ul><ul><li>Initial asset investment </li></ul><ul><li>Initial working capital investment </li></ul><ul><li>Current disposal value of old asset </li></ul>
  39. 39. Net Initial Investment <ul><li>The original Healthy Living example included the following: </li></ul><ul><li>Initial machine investment $245,000 Initial working capital investment $ 5,000 Current disposal value of old machine 0 </li></ul>
  40. 40. Cash Flow From Operations <ul><li>Cash inflows may result from producing and selling additional goods or services, or, as in the Healthy Living example, from savings in cash operating costs. </li></ul><ul><li>Depreciation is irrelevant in DCF analysis because it is a noncash allocation of costs. </li></ul><ul><li>DCF is based on inflows and outflows of cash. </li></ul>
  41. 41. Terminal Disposal Price <ul><li>At the end of the machine’s useful life the terminal disposal price may be zero or an amount considerably less than the initial machine investment. </li></ul><ul><li>The original Healthy Living example assumed zero disposal value of the new diagnostic machine. </li></ul>
  42. 42. Working Capital Recovery <ul><li>The initial investment in working capital is usually fully recouped when the project is terminated. </li></ul><ul><li>The relevant working capital cash inflow is the $5,000 that Healthy Living will recover in year 3. </li></ul>
  43. 43. Learning Objective 5 <ul><li>Use and evaluate the payback method </li></ul>
  44. 44. Payback Method <ul><li>Payback measures the time it will take to recoup, in the form of expected future cash flows, the initial investment in a project. </li></ul>
  45. 45. Payback Method <ul><li>Assume that Healthy Living is considering buying some equipment (Machine 1) for $210,000, with an estimated useful life of 11 years, and zero predicted residual value. </li></ul><ul><li>Managers expect use of the equipment to generate $35,000 of net cash inflows from operations per year. </li></ul>
  46. 46. Payback Method <ul><li>How long would it take to recover the investment? </li></ul><ul><li>$210,000 ÷ $35,000 = 7 years </li></ul><ul><li>7 years is the payback period. </li></ul>
  47. 47. Payback Method <ul><li>Suppose that an alternative to the $210,000 piece of equipment, there is another one (Machine 2) that also costs $210,000 but will save $42,000 per year during its five-year life . </li></ul><ul><li>What is the payback period? </li></ul><ul><li>$210,000 ÷ $42,000 = 5 years </li></ul><ul><li>Which piece of equipment is preferable? </li></ul>
  48. 48. Payback Method <ul><li>Machine 1 is preferable because it will continue to generate net cash inflows for four years after its payback period. </li></ul><ul><li>This will give the company an additional net cash inflow of $140,000. </li></ul>
  49. 49. Payback Method <ul><li>When cash flows are uneven, calculations must take a cumulative form. </li></ul><ul><li>Assume that Healthy Living’s diagnostic machine investment is going to yield net cash savings of $160,000, $180,000, and $110,000 over its life. </li></ul><ul><li>The initial investment is $250,000. </li></ul><ul><li>What is the payback period? </li></ul>
  50. 50. Payback Method <ul><li>Year 1 brings in $160,000. </li></ul><ul><li>Recovery of the amount invested occurs in Year 2. </li></ul>
  51. 51. Payback Method <ul><li>Payback </li></ul><ul><li>1 year </li></ul><ul><li>$90,000 needed to complete recovery $180,000 net cash inflow in Year 2 </li></ul><ul><li>1 year + 0.5 year = 1.5 years or, </li></ul><ul><li>1 year and 6 months </li></ul>
  52. 52. Learning Objective 6 <ul><li>Use and evaluate the accrual accounting rate-of-return (AARR) method </li></ul>
  53. 53. Accrual Accounting Rate-of-Return Method <ul><li>The accrual accounting rate-of-return (AARR) method divides an accounting measure of income by an accounting measure of investment. </li></ul><ul><li>This method is also called the accounting rate of return. </li></ul>
  54. 54. Accrual Accounting Rate-of-Return Method <ul><li>Recall the scanning machine with a cost $303,280, no residual value, expected annual net cash savings of $80,000, and a useful life of 5 years. </li></ul><ul><li>The IRR of this machine is 10%. </li></ul><ul><li>What is the average operating income? </li></ul>
  55. 55. Accrual Accounting Rate-of-Return Method <ul><li>Straight-line depreciation is $60,656 per year. </li></ul><ul><li>Average operating income is $19,344. </li></ul><ul><li>$80,000 – $60,656 = $19,344 </li></ul><ul><li>What is the AARR? </li></ul><ul><li>AARR = $80,000 – $60,656 = 6.38% $303,280 </li></ul>
  56. 56. Accrual Accounting Rate-of-Return Method <ul><li>An AARR of 6.38% indicates the rate at which a dollar of investment generates operating income. </li></ul><ul><li>Projects whose AARR exceeds an accrual accounting required rate of return for the project are considered desirable. </li></ul>
  57. 57. Accrual Accounting Rate-of-Return Method <ul><li>The AARR method is similar to the IRR method in that both methods calculate a rate-of-return percentage. </li></ul><ul><li>While the AARR calculates return using operating income numbers after considering accruals, the IRR method calculates return on the basis of cash flows and the time value of money. </li></ul>
  58. 58. Learning Objective 7 <ul><li>Identify and reduce conflicts from using DCF for capital budgeting and accrual accounting for performance evaluation </li></ul>
  59. 59. Performance Evaluation <ul><li>A manager who uses DCF methods to make capital budgeting decisions can face goal congruence problems if AARR is used for performance evaluation. </li></ul><ul><li>Suppose top management uses the AARR to judge performance if the minimum desired rate of return is 10%. </li></ul><ul><li>A machine with an AARR of 6.38% will be rejected. </li></ul>
  60. 60. Performance Evaluation <ul><li>The AARR is low because the investment increases the denominator and, as a result of depreciation, also reduces the numerator (operating income) in the AARR computation. </li></ul><ul><li>Frequently, the optimal decision made using a DCF method will not report good “operating income” results in the project’s early years on the basis of the AARR. </li></ul>
  61. 61. Performance Evaluation <ul><li>The conflict between using AARR and DCF methods to evaluate performance can be reduced by evaluating managers on a project-by-project basis. </li></ul>
  62. 62. Income-Tax Considerations <ul><li>Although depreciation is a noncash expense, it is a deductible cost for calculating tax outflow. </li></ul><ul><li>Taxes saved as a result of depreciation deductions increase cash flows in discounted cash-flow (DCF) computations. </li></ul>
  63. 63. Income-Tax Considerations <ul><li>Assume Miami Transit is considering the replacement of an old piece of equipment with new, more modern equipment. </li></ul><ul><li>The income tax rate is 40%. </li></ul><ul><li>The company uses straight-line depreciation. </li></ul><ul><li>The tax effects of cash inflows and outflows occur at the same time that the inflows and outflows occur. </li></ul>
  64. 64. Income-Tax Considerations <ul><li>Old equipment: Current book value $50,000 Current disposal price $ 3,000 Terminal disposal price (5 years) 0 Annual depreciation $10,000 Working capital $ 5,000 </li></ul>
  65. 65. Income-Tax Considerations <ul><li>Current disposal price of old equipment $ 3,000 Deduct current book value of old equipment 50,000 Loss on disposal of equipment $47,000 </li></ul><ul><li>How much is the tax savings? </li></ul><ul><li>$47,000 × 0.40 = $18,800 </li></ul>
  66. 66. Income-Tax Considerations <ul><li>What is the after-tax cash flow from current disposal of old equipment? </li></ul><ul><li>Current disposal price $ 3,000 Tax savings on loss 18,800 Total $21,800 </li></ul>
  67. 67. Income-Tax Considerations <ul><li>New equipment Current book value $225,000 Current disposal price is irrelevant Terminal disposal price (5 years) 0 Annual depreciation $ 45,000 Working capital $ 15,000 </li></ul>
  68. 68. Income-Tax Considerations <ul><li>How much is the net investment for the new equipment? </li></ul><ul><li>Current cost $225,000 Add increase in working capital 10,000 Deduct after-tax cash flow from current disposal of old equipment – 21,800 Net investment $213,200 </li></ul>
  69. 69. Income-Tax Considerations <ul><li>Assume $90,000 pretax annual cash flow from operations (excluding depreciation effect). </li></ul><ul><li>What is the after-tax flow from operations? </li></ul><ul><li>Cash flow from operations $90,000 Deduct income tax (40%) 36,000 Annual after-tax flow from operations $54,000 </li></ul>
  70. 70. Income-Tax Considerations <ul><li>What is the difference in depreciation deduction? </li></ul><ul><li>Annual depreciation of new equipment $45,000 Deduct annual depreciation of old equipment 10,000 Difference $35,000 </li></ul>
  71. 71. Income-Tax Considerations <ul><li>What is the annual increase in income tax savings from depreciation? </li></ul><ul><li>Increase in depreciation $35,000 Multiply by tax rate × .40 Income tax cash savings from additional depreciation $14,000 </li></ul>
  72. 72. Income-Tax Considerations <ul><li>What is the cash flow from operations, net of income taxes? </li></ul><ul><li>Annual after-tax flow from operations $54,000 Income tax cash savings from additional depreciation 14,000 Cash flow from operations, net of income taxes $68,000 </li></ul>
  73. 73. Income-Tax Considerations <ul><li>Miami Transit requires 14% rate of return on its investments. </li></ul><ul><li>What is the net present value of the new equipment incorporating income taxes? </li></ul>
  74. 74. Income-Tax Considerations <ul><li> Net Cash NPV of Net Years 14% Col. Inflows Cash Inflows </li></ul><ul><li>1-5 3.433 $68,000 $233,444 </li></ul><ul><li>5 0.519 10,000 5,190 Total PV of net cash inflows $238,636 Investment 213,200 Net present value of new equipment $ 25,436 </li></ul>
  75. 75. Intangible Assets <ul><li>Intangible assets are critical to most organizations. </li></ul><ul><li>These assets have the potential to yield net cash inflows many years into the future. </li></ul><ul><li>Top management can use a capital budgeting tool, such as NPV, to summarize the difference in the future net cash inflows from an intangible asset at two different points in time. </li></ul>
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