cb integrative case spr14

7/21/2019 CB Integrative Case SPR14

http://slidepdf.com/reader/full/cb-integrative-case-spr14 1/31

Capital BudgetingIntegrative Case Analysis: Lasting Impressions

Dr. C. Bulent Aybar

Professor of International Finance



Capital Budgeting Process

Proposal

Generation

Review

&

Analysis

Decision

Making

Implementation

an

!ollow"up

Proposal Generationis the origination of proposed

capital projects for the firm byindividuals at various levels of

the organization.

is the formal process ofassessing theappropriateness and

economic viability of theproject in light of thefirm’s overall objectives.This is done byestimating cash flowsarising from the projectand evaluating themthrough capital budgetingtechniques. Ris factorsare also incorporatedinto the analysis phase.

Decision making is thestep where the proposal iscompared againstpredetermined criteria andeither accepted orrejected.

Implementation of the projectbegins after the project hasbeen accepted and funding ismade available.Follow-up is the post!implementation audit ofe"pected and actual costs andrevenues generated from theproject to determine if thereturn on the proposal meetspre!implementation projections



© Dr. C. Bulent Aybar

Integrative Capital Budgeting Case

• Lasting Impressions (LI) Company is a medium- sized commercial

printer of promotional advertising brochures, boolets, and other direct-

mail pieces!

• "he firms# ma$or clients are ad agencies based in %e& 'or and Chicago!"he typical $ob is characterized by high uality and production runs of

more than *,*** units! LI has not been able to compete effectively &ith

larger printers because of its e+isting older, inefficient presses! "he firm

is currently having problems in meeting demand cost effectively and

uality reuirements of the industry!• "he general manager has proposed the purchase of one of t&o large, si+-

color presses designed for long, high- uality runs! "he purchase of a

ne& press &ould enable LI to reduce its cost of labor and therefore the

price to the client, putting the firm in a more competitive position!




Existing Equipment (Old Equipment)

• ld press riginally purchased years ago at an installed

cost of . /**,***, it is being depreciated under 01C23

using a - year recovery period!

• "he old press has a remaining economic life of years! It

can be sold today to net . /4*,*** before ta+es5 if it is

retained, it can be sold to net . 6*,*** before ta+es at the

end of years!




Alternative!: PressA

• "his highly automated press can be purchased for . 7*,*** and &ill

reuire . /*,*** in installation costs!

• It &ill be depreciated under 01C23 using a - year recovery period! 1t

the end of the years, the machine could be sold to net . /**,*** before

ta+es!• If this machine is acuired, it is anticipated that the follo&ing current

asset changes &ould result8

Cash $25,400

A/R $120,00

0

Inventorie

s

($20,00

0)

A/P $35,000




Alternative": PressB

• "his press is not as sophisticated as press 1! It costs

.9/*,*** and reuires .4*,*** in installation costs!

•

It &ill be depreciated under 01C23 using a - yearrecovery period!

• 1t the end of years, it can be sold to net . *,*** before

ta+es!

• 1cuisition of this press &ill have no effect on the firm:s net&oring capital investment!



Earning Pro#ections Be$ore %epreciation Interest and &axes

EBITDA

ear !"# Press Press A Press B1 $120,000 $250,000 $210,000

2 $120,000 $270,000 $210,000

3 $120,000 $300,000 $210,000

4 $120,000 $330,000 $210,000

5 $120,000 $370,000 $210,000

The firm is subject to a #$% ta" rate. The firm’s cost ofcapital& r& applicable to the proposed replacement is '#%.


http://slidepdf.com/reader/full/cb-integrative-case-spr14 8/31© Dr. C. Bulent Aybar

&as's

• For each of the t&o proposed replacement presses, determine8

– ( 6) Initial investment! ( 4) perating cash inflo&s ( ) "erminal cash flo&

• ;sing the data developed in part a, find and depict on a time line the relevant cash flo&

stream associated &ith each of the t&o proposed replacement presses, assuming that each is

terminated at the end of years!

• ;sing the data developed in part b, apply each of the follo&ing decision techniues8 – ( 6) Paybac period (4) <iscounted Paybac Period () %P= (/) I22 () 0I22 (9) Profitability Inde+

• <ra& net present value profiles for the t&o replacement presses on the same set of a+es,

and discuss conflicting ranings of the t&o presses, if any, resulting from use of %P= and

I22 decision techniues!

• 2ecommend &hich, if either, of the presses the firm should acuire if the firm has

( 6) unlimited funds ( 4) capital rationing!

• >hat is the impact on your recommendation of the fact that the operating cash inflo&s

associated &ith press 1 are characterized as very risy in contrast to the lo&- ris operating

cash inflo&s of press ?@



Initial Investment Outlay

Item Press A Press B

(ost of )ld *achine $400,000 $400,000

(ost of +ew *achine$870,000 $660,000

Proceeds from )ld *achine $420,000 $420,000

,oo -alue of )ld *achine $116,000 $116,000

Gains from ale $304,000 $304,000

Ta" /iability $121,600 $121,600

+0( 1nvestment $90,400 $0

et Initial Outlay $2,000 $31,00



%epreciation o$ &e e* and Old Equipment

Depreciation MACR"#$r Press A Press B %isting Press

6 4*A .6B/,*** .64,*** ./7,***4 4A .4B7,/** .466,4** ./7,***

6A .69,** .64,/** .4*,***

/ 64A .6*/,/** .B,4** .*

64A .6*/,/** .B,4** .*

9 A ./,** .,*** .*



et Operating Cas +lo*s: Old ,acine

%isting Mac'ine ( ) * + #

D?I"<1 64**** 64**** 64**** 64**** 64****

<epreciation ./7,*** ./7,*** .4*,*** .* .*

D?" .B4,*** .B4,***.6**,*** .64*,*** .64*,***

"a+es .47,7** .47,7** ./*,*** ./7,*** ./7,***

%et Income ./,4** ./,4** .9*,*** .B4,*** .B4,***

<epreciation ./7,*** ./7,*** .4*,*** .* .*

,-C! /(0)11 /(0)11 210111 3)0111 3)0111



et Operating Cas +lo*s: PressA

PR%44"A5 ( ) * + #

D?I"<1 .4*,*** .4B*,*** .**,*** .*,*** .B*,***

<epreciation 6B/*** 4B7/** 69** 6*//** 6*//**

D?" .B9,*** -.7,/** .6/,B** .44,9** .49,9**

"a+es */** -9* 77* *4/* 6*94/*

%et Income ./,9** -.,*/* .7*,74* .6,9* .6,9*

<epreciation 6B/*** 4B7/** 69** 6*//** 6*//**

,-C! )(/0611)3*0*61 )+60()1 )*/0361 )6*0361



et Operating Cas +lo*s: PressB

PR%44"B5 ( ) * + #

D?I"<1 .46*,*** .46*,*** .46*,*** .46*,*** .46*,***

<epreciation 64*** 4664** 64/** B4** B4**

D?" .B7,*** -.6,4** .7/,9** .6*,7** .6*,7**

"a+es 64** -/7* 7/* 44* 44*

%et Income ./9,7** -.B4* .*,B9* .B7,/7* .B7,/7*

<epreciation 64*** 4664** 64/** B4** B4**

,-C! (320211 )(10+21 (360(61 (#30621 (#30621



Incremental Operating Cas +lo*s $or Press A - B

Column( ( ) * + #

D+isting 0achine .6,4** .6,4** .7*,*** .B4,*** .B4,***Press-1 .46,9** .4B,9* .4/9,64* .4,B9* .49,B9*

Press-? .6B7,7** .46*,/7* .6B9,69* .6B,97* .6B,97*

Press 1 ICF ()20+11 (2)0(61 (660()1 (630361 (/(0361

Press ? ICF 230611 ((/0)21 /60(61 2#0621 2#0621

1)(231ncremental )perating (ash 2lows



&erminal Cas +lo*s

7erminal Cas' !lows Press A Press B -l Mac'.

Proceeds from Liuidation ./**,*** .*,*** .6*,***

?= at Liuidation ./,** .,*** .*

Profit from 3ale .9,** .4B,*** .6*,***

"a+ Liability .6/4,9** .667,7** .9*,***

%et Proceeds from 3ale .4B,/** .466,4** .*,***

2ecall %>C Investment .*,/** .* .*

%et "erminal Cash Flo&s ./B,7** .466,4** .*,***

%et Incremental "CF .4B,7** .646,4**

4#5&6$$!7$&$$$3895&6$$ 8''&8$$!7$&$$$3'8'&8$$



.elevant Cas +lo* $or te Pro#ects

'ear Press 1 Press ?

* "66)0111 "*6(0611

6 .647,/** .7B,9**

4 .674,69* .66,47*

.699,64* .9,69*

/ .69B,B9* .7,97*

.//,9* .4*9,77*

:ear 9 cash flows include terminal cash flows



Cas +lo*s on a &ime Line



Pay Bac' Period Analysis

PA$BAC8 P%RI-DA,A9$4I4 Press A Press B

6 .647,/** .7B,9**

4 .6*,9* .4*9,77*

./B9,97* .*,*/*

/ .9//,//* .77,B4*

.6,*/,*** .,9**

Cumulative Cas +lo*s

%ote that the cost for Press 1 (994,***) can be recovered only sometime

bet&een /th and th year! "he portion recovered in the th year is

(994,***-9//,//*)E//,9**!*6! "herefore paybac period for the

Press 1 is / years G *!* 'ears or /!*/ years! "he recovery for press ? is faster

as initial investment of 96,9** can be recovered in !97 years!



%iscounted Pay/ac' Period

ear

Press A Press BC%&%"ativeCash '"os

A

C%&%"ative

Cash'"os B

0

(662,000) (361,600) (662,000)

(361,600)

1

112,632 76,842 112,632 76,842

2

140,166 91,782 252,798 168,624

3

112,126 64,905 364,924 233,529

4 99,327 50,729 464,251 284,259

5

233,487 107,447 697,739 391,706DiscountedPayback Period 4*5 4+2

<iscounted Paybac period reuires discounted value of each cash

flo&! Dach cash flo& is discounted to time * at the cost of capital,

and paybac period is calculated by using these discounted cash

flo&s! In this particular case, method favors pro$ect H? as in the

standard Paybac Period method.



P0 Analysis

$ear Press A Press B

* -.994,***-.96,9**

6 .647,/** .7B,9**

4 .674,69* .66,47*

.699,64* .9,69*

/ .69B,B9* .7,97*

.//,9* .4*9,77*

%P=Press-1,B7!74J%P=Press-?*,6*!77

3ince both pro$ects have year life spans there is no need to consider

1nnualized %P=, but have &e had done it, 1%P=-1 &ould have been

higher than 1%P=-?!

6 4 -

/

647,/** 674,69* 699,64*

(6 *!6/) (6 *!6/) (6 *!6/)

69B,B9* //C,9*994,*** -,B-7!74

(6 *!6/) (6 *!6/)

A NPV = + + +

+ + +

+ − =+ +

6 4 -

/

7B, 9** 66C, 47* C9,69*

(6 *!6/) (6 *!6/) (6 *!6/)

7,79* 4*9,77*-96, 9** -*,6*!77

(6 *!6/) (6 *!6/)

B NPV = + + +

+ + +

+ − =+ +




I..

• Pro$ect 1:s I22 is 6!7,

•

Pro$ect ?:s I22 is 6B!*9!

• ?oth pro$ects have I22 above cost of Capital! If &e used I22 to choose the

pro$ects, Press ? &ould be favored by the I22 method! %ote that I22 assumes

that cash flo&s can be reinvested at the I22!

• 1 consideration of reinvestment at cost of capital (0I22) suggest that raning

does not change! 0I22-16A 0I22-?69A

6 4 - /

647, /** 674,69* 699,64* 69B, B9* //C, 9*994,***

(6 ) (6 ) (6 ) (6 ) (6 ) A A A A A

IRR IRR IRR IRR IRR= + + + +

+ + + + +

6 4 - /

7B,9** 66,47* 9,69* 7,79* 4*9,77*96,9**

(6 ) (6 ) (6 ) (6 ) (6 ) B B B B B

IRR IRR IRR IRR IRR= + + + +

+ + + + +



Cost o$ Capital and P0

Cost o Ca-ita" .B Press A .P Presss B

011 $100,287 $63,65389

012 $77,808 $51,98882

013 $56,309 $40,81489

014 $35,739 $30,10588

015 $16,046 $19,83723

016 !$2,816 $9,98592

017 !$20,891 $53034

018 !$38,221 !$8,54978

019 !$54,843 !$17,27348

1s the above table sho&s, &hen cost of capital is appro+imately

?elo& 6A, press 1 has higher %P= than Press ?!

?ut this changes &hen the cost of capital Increases to 6A and

?eyond! "his suggest a cross-over point bet&een 6/ and 6A (6/!)

cost of capital!



P0 and Cost o$ Capital

Cost of Capital*!*9 *!*7 *!6 *!64 *!6/ *!69 *!67 *!4 *!44 *!4/ *!49 *!47 *!

-.**,***

-.4**,***

-.6**,***

.*

.6**,***

.4**,***

.**,***

%P=K1 %P=K?

(ross!over point3'#.97%Project ;

Project ,




Pro$ita/ility Index

• Profitability inde+ reflects the benefit cost ratio of a pro$ect!

It is the ratio of P= of pro$ect cash flo&s to the pro$ect cost!

• LI:s t&o pro$ects have PI1

6!* and PI?

6!*7 ! >hile

profitability inde+ suggests that pro$ect ? generates more

value per dollar invested, the total value created by pro$ect 1

is higher!

6 (6 )

N

t

t WACC

CF

k PI

I

= +=

∑




Impact o$ Capital .ationing on te %ecision

• In this case &e are considering mutually e+clusive pro$ects! It does

not mae sense for the firm to implement both pro$ects

simultaneously!

• o&ever, if had &e considered pro$ects that are not necessarily

mutually e+clusive, &e could use t&o methods8

• I22 0ethod

– 2an Pro$ects &rt their I22, select the pro$ects &ith I22s e+ceeding

cost of capital up to a point &here the capital budget is consumed! If

the last ualified pro$ect partially e+ceeds capital budget, drop that pro$ect as &ell!

• %P= 0ethod

– 2an Pro$ects &rt their %P=, select all the positive %P= pro$ects in

order until the capital budget is consumed




,utually Exclusive Pro#ects and Capital .ationing

• >hen investments are independent and decision is simply to

adopt or abandon, decision rules lie %P=, I22 and

Profitability Inde+ provide competent guidance!

•o&ever &hen investments are mutually e+clusive, theguidance provided by these decision rules should be

carefully considered!

• ne reason for possible conflicting recommendations is the

insensitivity of PI and I22 to the scale of investment!

• "his may lead to decisions that are not consistent &ith value

ma+imization ob$ective!



Example

Consider the t&o pro$ects above &ith different initial outlays and cash

flo& structures! "he company in uestion should choose one of these

t&o service station pro$ects! >hich one should company adopt@3ince these are mutually e+clusive pro$ects, it does not mae sense to

adopt both!

%P= at 6*A PI at 6*A I22

Ine+pensive Pro$ect 4,** 6!67 6/A

D+pensive Pro$ect 7,4** 6!* 64A




,utually Exclusive Pro#ects and P0

%P= at 6*A PI at 6*A I22

Ine+pensive Pro$ect 4,** 6!67 6/A

D+pensive Pro$ect 7,4** 6!* 64A

0hile the e"pensive project’s direct contribution to shareholder wealth islarger& ine"pensive project earns higher return on each dollar invested&and has a higher return. The impressive performance of ine"pensiveproject documented in P1 and 1RR obviously in conflict with the valuema"imization objective.0hat should company do< 1f company invests ='.'m it creates =5&5$$

more value> ?owever& investing =988&$$$ maes =956&$$$ available. 1fthe company had an opportunity to deploy this amount to create +P- ine"cess of =5&5$$ by taing same level of ris& ine"pensive project wouldbe viable. )therwise& the firm should go for the e"pensive project. caleinsensitivity of P1 and 1RR confirms the use of +P- as appropriate figureor merit.




Capital .ationing

• ;nder capital rationing, the company has a fi+ed investment budget that

it may not e+ceed!

• Capital rationing reuires us to ran investments rather than simply

accept or re$ect them!

• In mutually e+clusive alternatives, capital is available but, for technical

reasons, the company cannot mae all investments!

• ;nder capital rationing, it may be technically possible to mae all

investments, but there is limited capital! "his has a fundamental impact

on the raning processes!• >hen capital is constrained, the ob$ective is to get best possible benefit

per dollar!




Example: ,utually Exclusive Pro#ects

• If the company can raise large amounts of money at an annual cost of

6A, and if the investments are mutually e+clusive, &hich pro$ect should

the company undertae@

1ns&er8

;ndertae investment 1 because it has the highest %P=, and %P= is a direct

measure of the increase in &ealth from undertaing the investment

Investment 1 ? C

Initial Cost . ,**,*** . ,***,*** . 4,***,***

D+pected Life (yr) 6* 6* 6*

%P= M6A . /*,*** . **,*** . 4**,***

PI M 6A 6!*9 6!6* 6!6*

I22 4*A *A /*A



Example: Capital .ationing

• Considering only these three investments, if the company has a fi+ed

capital budget of .! million, and if the investments are independent of

one another, &hich pro$ects should the company undertae@

If the capital budget is fi+ed at .! million, invest in C and ?, and put theremaining .**,*** in 1 if possible! "his is the bundle of investments &ith

the highest total %P=! ne can select this bundle by raning investments by

their I22, or occasionally more accurately by their PI (or ?enefit Cost 2atio

or ?C2)

Investment 1 ? C

Initial Cost . ,**,*** . ,***,*** . 4,***,***

D+pected Life (yr) 6* 6* 6*

%P= M6A . /*,*** . **,*** . 4**,***

PI M 6A 6!*9 6!6* 6!6*

I22 4*A *A /*A

cb integrative case spr14

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