2. Cap Budgeting - 2
IMPORTANCE OF LONG-TERM
INVESTMENT ANALYSIS
Commitment of large amounts of
resources
Long period of risk
– Capital assets often mean technological risk
– Strategic considerations
– Exit barriers
• Time value of money considerations
• Important analytical tool
• Not the primary consideration of analysis
3. Cap Budgeting - 3
Before we
let you buy that new
machine you wanted, we
want to know what return
we are going to get
out of it?
4. Cap Budgeting - 4
LONG-TERM INVESTMENT
ANALYSIS
vs. CAPITAL BUDGETING
“Capital Budgeting”
Planning for long-term investment decisions regarding
capital assets (facilities) including considerations
for financing the investment
“Long-term Investment Analysis”
Planning for ALL TYPES of long-term investment decisions,
regardless of whether capital assets are involved
The major difference is that long-term investment analysis
is a broader “strategic” consideration
5. Cap Budgeting - 5
CAPITAL INVESTMENT
DECISION MODELS
Non-discounted cash flow models
– Payback period
– Accounting rate of return
Discounted cash flow models
– Internal rate of return
– Net present value
6. Cap Budgeting - 6
PAYBACK METHOD
Payback period = length of time
needed to recover the initial
investment in the asset
Cash outflow for investment
Annual net cash benefit
7. Cap Budgeting - 7
PAYBACK METHOD
Possible reasons for use:
– Help evaluate risks associated with
uncertain future cash flows
– Minimize impact of an investment on
liquidity
– Help control risk of obsolescence
– Relatively simple
Limitations
– Ignores time value of money
– Ignores total profitability of the project
8. Cap Budgeting - 8
NET PRESENT VALUE
(NPV)
This model is the most widely recommended
approach to capital budgeting since it
specifically considers the time value of money
and provides a basis for valuing the firm
Net Present Value =
Σ PV Cash Inflows - Σ PV Cash Outflows
9. Cap Budgeting - 9
NET PRESENT VALUE
(NPV)
Decision criteria:
– If NPV > 0, a return in excess of the cost
of capital has been earned, and the
project is acceptable
– If NPV < 0, a return less than the cost of
capital has been earned, and the project
is unacceptable
Reinvestment assumption
All cash flows generated by the project are
immediately reinvested at the cost of
capital
10. Cap Budgeting - 10
COST OF CAPITAL
The weighted average of the returns
expected by the different parties
contributing funds (debt and equity).
The weights are determined by the
proportion of funds provided by each
source.
It is sometimes known as the
“hurdle rate.”
11. Cap Budgeting - 11
INTERNAL RATE OF RETURN
(IRR)
The interest rate that results
in the present values of the
cash outflows equaling the
present value of the cash
inflows.
12. Cap Budgeting - 12
INTERNAL RATE OF RETURN
(IRR)
Decision criteria:
– If the IRR > Cost of capital, the project is
acceptable
– If the IRR < Cost of capital, the project is
not acceptable
Reinvestment assumption
Cash inflows from the project are
immediately reinvested to earn the IRR
13. Cap Budgeting - 13
DISCOUNTED CASH FLOW
ANALYSIS
Strengths
– Cash flows vs. Accrual income
– Time value of money is considered
– Incorporation of financing costs
Limitations
– Accuracy of cash flow projections
– Possible misapplications of DCF analysis
– Ability to determine “cost of capital”
– Difficulty of estimating opportunity costs
– Lack of integration of qualitative factors
14. Cap Budgeting - 14
DISCOUNTED CASH FLOWS
Specific Items
Initial and subsequent investments
Taxable cash flows
– Revenues
– Expenses
Deductible noncash expenses (Depreciation,
etc.)
Residual (salvage) values
– Existing assets
– Assets at termination of project
– Tax considerations (gains or losses)
Working capital investments
15. Cap Budgeting - 15
AFTER-TAX CASH FLOWS
Rule for taxable cash benefits
(1-tax rate) x cash receipt = After-tax cash flow
Example: Increased sales or reduced costs
Rule for taxable cash expenses
(1-tax rate) x cash payment = After-tax cash flow
Example: Labor costs
Rule for tax shield for noncash expenses
(tax rate) x noncash expense = tax shield (cash inflow)
Example: Depreciation on equipment
16. Cap Budgeting - 16
AFTER-TAX CASH FLOWS
Continued
Rule for sale of assets
Proceeds from sale (+/-) Tax book value =
Taxable gain/loss
Taxable gain/loss x Tax rate = Net tax
effect
Proceeds from sale (+/-) Net tax effect =
Net cash flow from sale of asset
18. Cap Budgeting - 18
Justifying capital expenditures in a
new manufacturing environment
CAD/CAM
19. Cap Budgeting - 19
Capital expenditures in a new
manufacturing environment
Traditional investment analysis tools
may not be adequate to make these
type decisions. The day-to-day
operating impact (tactical) may not be
the key factor in making a decision.
Less tangible benefits may be the
deciding factor in whether or not to
invest in new technology.
20. Cap Budgeting - 20
EXAMPLES OF INTANGIBLES
Competitive advantage
– Producing a product or providing a service
that competitors cannot
Quality
– Improving the quality of a product by
reducing the potential to make mistakes
Process simplification
– Enhanced production capabilities
Reduced time to produce
– Reducing the cycle time needed to make a
product or provide a service
21. Cap Budgeting - 21
Capital investment decisions have
potential pitfalls
22. Cap Budgeting - 22
WHAT TO DO?
Consider the opportunity cost of not
making an investment
Give full consideration to costs that may
be hidden
Don’t set the barriers to strategic
investment too high
23. Cap Budgeting - 23
Find the hidden costs
warranty
costs
Training
costs
Cost of
faulty
assumptions
24. Cap Budgeting - 24
POST-IMPLEMENTATION AUDITS
An opportunity to re-evaluate a
past decision to purchase a long-
term asset by comparing
expected and actual inflows and
outflows
25. Cap Budgeting - 25
POST-IMPLEMENTATION AUDITS
Benefits
By comparing estimates with results,
planners can determine why their
estimates were incorrect and can avoid
making the same mistakes in the future
Rewards can be given to those who
make good capital budgeting decisions
If the audit is not done, there are no
controls on planners who might be
tempted to inflate the benefits in order
to get their projects approved
