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Chapter Nine

Capital Budgeting

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Capital Budgeting Decisions

require sizable commitments of cash.

are expected to generate returns that will last more than one year.

involve time value of money.

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Importance of Capital Budgeting DecisionsCapital budgeting decisions commit companies to courses of action. The success or failure of a particular strategy, or even of the company itself, can hinge on one or a series of such decisions.

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Importance of Capital Budgeting Decisions (continued) In addition, capital budgeting decisions are

generally riskier than short-term ones for the following reasons:

The company expects to recoup its investment over a longer period.

Reversing a capital budgeting decision is much more difficult than reversing a short-term decision.

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Types of Capital Budgeting Decisions

Investments made to further strategic goals

Investments made to increase capacity or reduce costs

Investments made for non-financial reasons

Investments mandated by law or policy

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Cost of Capital

Cost of capital is the cost, expressed as a percentage, of obtaining the money needed to operate the company.

Capital is obtained from two sources, creditors and owners, corresponding to divisions of liabilities and owners’ equity on the balance sheet.

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Weighted Average Cost of Capital Average costs of debt and equity

components Example - debt with after tax cost of 5% is

40% of capital structure and equity with after cost of 15% is 60% of capital structure

Cost of capital is:40% * 5% = 2%

60% * 15% = 9%

Total 11%

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Cutoff Rate

Because of the practical difficulties of determining cost of capital, managers might simply use their judgment to set a minimum acceptable rate, called a cutoff rate, hurdle rate, or target rate.

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The Capital Budgeting Decision Models Discounted Cash Flow (DCF) Techniques:

Net present value (NPV)

Internal rate of return (IRR)

Nondiscounted Cash Flow Techniques

Payback period

Book rate of return

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Net Present Value Method

The net present value method (NPV) uses the minimum acceptable rate to find the present value (PV) of the future returns and compares that value with the cost of the investment.

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Internal Rate of Return Method

The internal rate of return method (IRR) finds the rate of return associated with the project and compares that rate with the minimum acceptable rate.

NPV = PV of future returns - Cost of the investment

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Decision Rules

Under the NPV method, a project having a positive NPV should be accepted; others should be rejected.

Under the IRR method, a project having an IRR greater than the company’s cost of capital should be accepted.

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Purchase of Machine Example

Machine costs $60,000

Sell 3,000 units per year at $14 for the next 5 years

Variable costs are $5 per unit

Annual cash fixed costs are $5,000

Cutoff rate of 12 percent

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Annual Incremental Cash Inflows

Annual Cash Flows

Revenues ($14 x 3,000) $42,000

Variable costs ($5 x 3,000) 15,000

Contribution margin ($9 x 3,000) $27,000

Cash fixed costs 5,000

Expected increase in net cash $22,000

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Net Present Value ExampleExpected increase in net cash $22,000

Present value factor (PVA 5 12%) x 3.6048

Present value of future cash flows $79,306

Investment required 60,000

Net present value $19,306

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Internal Rate of Return

Factor = PV of future flows/Annual cash flows

Factor = $60,000/$22,000 = 2.727

The 2.727 corresponds to an interest rate between 20 and 30 percent when the number of periods is five.

The IRR is about 25%.

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Taxes and Depreciation

Additional information:

Tax rate is 40 percent.

Straight-line depreciation is used.

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Annual After-Tax Cash InflowsIncome Cash Flow

Revenues $42,000 $42,000

Cash expenses 20,000 20,000

Cash inflow before taxes $22,000 $22,000

Depreciation 12,000

Increase in taxable income $10,000

Income taxes (40 percent) 4,000 4,000

Net Income $6,000

Depreciation 12,000

Net increase in cash inflow $18,000 $18,000

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Net Present Value of After-Tax ExampleExpected increase in net cash inflows $18,000

Present value factor x 3.6048

Present value of future cash flows $64,887

Investment required 60,000

Net present value $4,887

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Internal Rate of Return

Factor = PV of future flows/Annual cash flows

Factor = $60,000/$18,000 = 3.333

The 3.333 corresponds to an interest rate between 15 and 16 percent when the number of periods is five.

The IRR is between 15 and 16 percent.

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Payback Period

Payback Period = Investment /Annual cash return

= $60,000/$18,000 = 3.333 years

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Book Rate of ReturnAverage book rate of return = Net income/Average book investment = $6,000/($60,000/2) = 20 percent

Net income is cash flow less depreciation

Average investment is (investment +residual)/2

This is the only method discussed that does not use cash flows.

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Tax Depreciation

For Tax, depreciation is computed using either the Modified Accelerated Cost Recovery System (MACRS) or optional straight line.

MACRS gives rapid depreciation according to tables published by the IRS

Optional straight line uses a shorter life than the actual life and a half year convention

Tax deprecation will almost always end up with uneven cash flows.

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Cash Flow Problem Information - A company is offered an

8 year contract that will yield an annual gross cash flow of $450,000 with cash expenses of $261,500.

Working capital investment is $90,000, and machinery costing $700,000 is required.

The equipment is 5 year property for MACRS depreciation, and has a useful life of 9 years, but will be sold at the end of year 8 for $25,000.

The tax rate is 30% and the cost of capital is 14%.

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Calculating Annual Cash Flow

Year 0

Equipment Cost -700000Working Capital -90000Cash Flow -790000Cum Cash Flow -790000

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Calculating Cash FlowsYear 1 2 3, 4, 5Gross Rev 450000 450000 450000Cash Expense -261500 -261500 -261500Less Depreciation -140000 -224000 -134400Plus SalvageTaxable Income 48500 -35500 54100Tax -14550 10650 -16230Net 33950 -24850 37870DEP 140000 224000 134400Working CapitalCash Flow 173950 199150 172270

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Final Cash Flows6 7 8

Gross Rev 450000 450000 450000Cash Expense -261500 -261500 -261500Less Depreciation -40600Plus Salvage 25000Taxable Income 147900 188500 213500Tax -44370 -56550 -64050Net 103530 131950 149450DEP 40600 0 0Working Capital 90000Cash Flow 144130 131950 239450

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MACRS ExampleMACRS Example

Year 0 1 2 3 4 5 6 7 8

Equipment Cost

-700000

Gross Rev 450000 450000 450000 450000 450000 450000 450000 450000 cash expense -261500 -261500 -261500 -261500 -261500 -261500 -261500 -261500 Less Depreciation -140000 -224000 -134400 -80500 -80500 -40600 Plus Salvage 25000 Taxable Income 48500 -35500 54100 108000 108000 147900 188500 213500 Tax -14550 10650 -16230 -32400 -32400 -44370 -56550 -64050 Net 33950 -24850 37870 75600 75600 103530 131950 149450 DEP 140000 224000 134400 80500 80500 40600 0 0 Working Capital

-90000 90000

Cash Flow -790000 173950 199150 172270 156100 156100 144130 131950 239450 Cum Cash Flow

-790000 -616050 -416900 -244630 -88530 67570 211700 343650 583100

Net Present Value $7,939 Do this using NPV function Internal rate of ret 14.30% Do this using IRR function

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Straight Line ExampleCapital Budgeting Example Using Straight Line

Year 0 1 2 3 4 5 6 7 8

Equipment Cost -700000

Gross Rev 450000 450000 450000 450000 450000 450000 450000 450000Cash Expense -261500 -261500 -261500 -261500 -261500 -261500 -261500 -261500Less Depreciation -70000 -140000 -140000 -140000 -140000 -70000Plus Salvage 25000Taxable Income 118500 48500 48500 48500 48500 118500 188500 213500Tax -35550 -14550 -14550 -14550 -14550 -35550 -56550 -64050Net 82950 33950 33950 33950 33950 82950 131950 149450DEP 70000 140000 140000 140000 140000 70000 0 0Working Capital -90000 90000Cash Flow -790000 152950 173950 173950 173950 173950 152950 131950 239450Cum Cash Flow -790000 -637050 -463100 -289150 -115200 58750 211700 343650 583100Net Present Value ($4,881) Do this using NPV functionInternal rate of ret 13.82% Do this using IRR function