The Capital Budgeting Decision.ppt

1、The Capital Budgeting Decision,12,1-2,Chapter 12 - Outline,What is Capital Budgeting? 5 Methods of Evaluating Investment Proposals Average Accounting Return Payback Period Net Present Value Internal Rate of Return Profitability index,PPT 12-2,Accept/Reject Decision Capital Rationing Net Present Valu

2、e Profile Capital Cost Allowance Determining Whether to Purchase a Machine Summary and Conclusions,1-3,What is Capital Budgeting?,Capital Budgeting: represents a long-term investment decision for example, buy a new computer system or build a new plant involves the planning of expenditures for a proj

3、ect with a life of 1 or more years emphasizes amounts and timing of cash flows and opportunity costs and benefits investment usually requires a large initial cash outflow with the expectation of future cash inflows considers only those cash flows that will change as a result of the investment all ca

4、sh flows are calculated aftertax,PPT 12-3,1-4,Administrative Considerations,Steps in the decision-making process: Search for and discovery of investment opportunities Collection of data Evaluation and decision making Reevaluation and adjustment,1-5,Capital Budgeting Procedures,1-6,Accounting Flows v

5、ersus Cash Flow,The capital budgeting process focuses on cash flows rather than income on an aftertax basis. Evaluation involves the incorporation of all incremental cash flows in the capital budgeting analysis. Sunk costs are ignored. Opportunity costs included. Accounting flows are not totally dis

6、regarded in the capital budgeting process. Investors emphasis on EPS. Top management may elect to glean the short-term personal benefits of income effect.,1-7,Earnings before amortization and taxes (cash inflow) . $20,000 Amortization (non-cash expense). 5,000 Earnings before taxes. 15,000 Taxes (ca

7、sh outflow) .7,500 Earnings aftertaxes .7,500 Amortization. + 5,000 Cash flow .$12,500 Alternative method of cash flow calculation Cash inflow (EBAT) . $20,000 Cash outflow (taxes) .- 7,500 Cash flow .$12,500,PPT 12-5,Table 12-1Cash flow for Alston Corporation,1-8,Earnings before amortization and ta

8、xes .$20,000 Amortization .20,000 Earnings before taxes. .0 Taxes .0 Earnings aftertaxes. 0 Amortization . + 20,000 Cash flow .$20,000,PPT 12-6,Revised cash flow for Alston Corporation,1-9,5 Methods of Evaluating Investment Proposals,Average Accounting Return (AAR) Payback Period (PP) Internal Rate

9、of Return (IRR) Net Present Value (NPV) Profitability Index (PI),PPT 12-7,1-10,Average Accounting Return,AAR Equals: Average Earnings Aftertax Average Book Value of Investment Advantage:Relatively easy to calculate Disadvantages: Uses accounting earnings, not cash flows Ignores the timing of the ear

10、nings Uses book value, not market value of investment Does not suggest an an evaluation yardstick,PPT 12-8,1-11,Payback Period,Payback Period (PP): computes the amount of time required to recoup the initial investment a cutoff period is established Advantages: easy to use (“quick and dirty” approach

11、) emphasizes liquidity one measure of the risk of an investment Disadvantages: ignores inflows after the cutoff period and fails to consider the time value of money better measures of risk,PPT 12-9,1-12,Net Present Value,Net Present Value (NPV): the present value of the cash inflows minus the presen

12、t value of the cash outflows the future cash flows are discounted back over the life of the investment the basic discount rate is usually the firms cost of capital (WACC)(assuming similar risk),PPT 12-11,1-13,Internal Rate of Return,Internal Rate of Return (IRR): represents a yield on an investment

13、or an interest rate requires calculating the discount rate that equates the initial cash outflow (cost) with the future cash inflows (benefits) is the discount rate where the cash outflows equal the cash inflows (or NPV = 0),PPT 12-12,1-14,Accept/Reject Decision,Payback Period (PP): if PP cutoff per

14、iod, reject the project Internal Rate of Return (IRR): if IRR cost of capital, accept the project if IRR 0, accept the project if NPV 0, reject the project,PPT 12-14,1-15,NetCash Inflows (of a $10,000 investment) YearInvestment AInvestment B 1 $5,000 $1,500 25,0002,000 32,0002,500 45,000 55,000,. .

15、. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .,PPT 12-10,Table 12-3Investment alternatives,1-16,Investment AInvestment BSelection Payback period . . . .2 years3.8 yearsQuickest payback: Investment A Net present value . . . $180 $1,414Highest net present value: Investment B Interna

16、l rate of return 11.16%14.33%Highest yield: Investment B Profitability Index . .1.01801.1414Highest relativeprofitability:Investment B,PPT 12-13,Table 12-4Capital budgeting results,1-17,NPV method versus IRR method,The NPV method and the IRR method always agree on the accepted-reject decision on a c

17、apital proposal. ( a project having a NPV=0 also means IRR or =cost of capital) A disagreement may arise between the NPV and IRR methods when a choice must be made from mutually exclusive proposals or all acceptable proposals cannot be taken due to capital rationing. The primary cause of disagreemen

18、t is the differing discounting assumptions. The NPV method of discounts cash flows at the cost of capital. The IRR method discounts of cash flows at the internal rate of return. The more conservative NPV technique is usually the recommended approach when a conflict in ranking arises.,1-18,Investment

19、 A (11.16% IRR) Investment A YearCash FlowYearCash Flow 1 . . . $5,0001 . . . $5,000 10% 2 . . .5,0002 . . . 5,000 11% 3 . . .2,0003 . . . 2,000 12% discounted at discounted 11.16% at various rates if desired NPV = 0 NPV = $27,PPT 12-15,Internal rate of return and net present value ($10,000 investme

20、nt),1-19,Table 12-6Multiple IRRs,PPT 12-16,1-20,Modified Internal Rate of Return (MIRR),Combines reinvestment assumption of the net present value method with the internal rate of return,1-21,Modified Internal Rate of Return (MIRR) (contd),Assuming $10,000 produces the following inflows for the next

21、three years: The cost of capital is 10% Determining the terminal value of the inflows at a growth rate equal to the cost of capital: To determine the MIRR: PVIF = PV = $10,000 = .641 (Appendix B) FV $15,610,1-22,Capital Rationing,Artificial restraint set on the usage of funds that can be invested in

22、 a given period May be adopted because of: Fear of too much growth Hesitation to use external sources of funding Hinders a firm from achieving maximum profitability,1-23,Capital Rationing,1-24,Net Present Value Profile,Allows graphical representation of net present value of a project at different di

23、scount rates To apply the net present value profile, three characteristics need to be looked into: The net present value at a zero discount rate The net present value as determined by a normal discount rate (such as cost of capital) The internal rate of return for the investments,1-25,Net Present Va

24、lue Profile Graphic Representation,1-26,Net Present Value Profile with Crossover,1-27,The Rules of Depreciation,Assets are classified according to nine categories Determine the allowable rate of depreciation write-off Modified accelerated cost recovery system (MACRS) represent the categories Asset d

25、epreciation range (ADR) is the expected physical life of the asset or class of assets,1-28,Categories for Depreciation Write-Off,1-29,Depreciation Percentages(Expressed in Decimals),1-30,Depreciation Schedule,1-31,The Tax Rate,Corporate tax rates are subject to changes Maximum quoted federal corpora

26、te tax rate is now in the mid-30 percent range Smaller corporations and others may pay taxes only between 15 20% Larger corporations with foreign tax obligations and special state levies may pay effective taxes of 40% or more,1-32,Actual Investment Decision,Assumption: $50,000 depreciation analysis

27、allows purchase of machinery with a six-year productive life Produces an income of $18,500 for first three years before deductions for depreciation and taxes In the last three years, income before depreciation and taxes will be $12,000 Corporate tax rate taken at 35% and cost of capital 10% For each

28、 year: The depreciation is subtracted from “earnings before depreciation and taxes” to arrive at earnings before taxes Taxes then subtracted to determine earnings after taxes Depreciation is added to earnings to arrive at cash flow,1-33,Cash Flow Related to the Purchase of Machinery,1-34,Net Present

29、 Value Analysis,1-35,The Replacement Decision,Investment decision for new technology Includes several additions to the basic investment situation The sale of the old machine Tax consequences Decision can be analyzed by using a total or an incremental analysis,1-36,Book Value of Old Computer,1-37,Net

30、 Cost of New Computer,1-38,Analysis of Incremental Depreciation Benefits,1-39,Analysis of Incremental Cost Savings Benefits,1-40,Present Value of the Total Incremental Benefits,1-41,Elective Expensing,Businesses can write off tangible property, in the purchased year for up to $100,000 Includes: equi

31、pment, furniture, tools, computers etc. Beneficial to small businesses: Allowance is phased out dollar for dollar when total property purchases exceed $200,000 in a year,Risk and Capital Budgeting,13,1-43,Chapter Outline,Concept of risk based on uncertainties Investors and their averseness to risk I

32、nvestors expected higher rate of return on risky projects Simulation models and decision trees Consequences of risky projects both individually and for the firm as a whole,1-44,Definition of Risk in Capital Budgeting,Risk is defined in terms of variability of possible outcomes from a given investmen

33、t Risk is measured not only in terms of losses but also in terms of uncertainty,1-45,Variability and Risk,1-46,The Concept of Risk-Averse,Based on the assumption that most investors and managers are risk-averse Preference: relative certainty as opposed to uncertainty Expectation: higher value or ret

34、urn for risky investments,1-47,Actual Measurement of Risk,Basic statistical devices used Expected value: D = DP Standard deviation: = (D D)2 P Co-efficient of Variation: (V) = D,1-48,Profitability Distribution with Differing Degrees of Risk,1-49,Profitability Distribution with Differing Degrees of R

35、isk (contd),1-50,Risk measure beta (),Beta is a risk measure widely used with portfolios of common stock Beta measures the volatility of returns on an individual stock relative to the stock market index of returns,1-51,Betas for Five-Year Period (Ending January 2006),1-52,Risk and the Capital Budget

36、ing Process,Informed investors and managers need to decide between: Investments that produce certain returns Investments that produce an expected value of return, apart from having a high coefficient of variation,1-53,Risk-Adjusted Discount Rate,Using different discount rates for proposals with diff

37、erent risk levels Investment with normal amount of risk may be discounted at the cost of capital Investments carrying greater than normal risk will be discounted at a higher rate and so on Risk is assumed to be measured by the coefficient of variation (V),1-54,Relationship of Risk to Discount Rate,1

38、-55,Increasing Risk over Time,Accurate forecasting becomes more obscure farther out in time Unexpected events: Create a higher standard deviation in cash flows Increase risk associated with long-lived projects Using progressively higher discount rates to compensate for risk tends to penalize late fl

39、ows more than early flows,1-56,Qualitative Measures,Setting up of risk classes based on qualitative considerations,1-57,Risk Categories and Associated Discount Rates,1-58,Example: Risk-adjusted Discount Rate,Assumption (Table 13-4): An investment calls for an addition to normal product line and is a

40、ssigned discount rate of 10% Another investment represents a new product in foreign market and must carry 20% discount rate to adjust for a large risk component First investment is the only acceptable alternative,1-59,Capital Budgeting Analysis,1-60,Capital Budgeting Decision Adjusted for Risk,1-61,

41、Simulation Models,Help in dealing with uncertainties involved in forecasting the outcome of capital budgeting projects or other decisions Computers enable the simulation of various economic and financial outcomes, using a number of variables A Monte Carlo simulation model uses random variable for in

42、puts,1-62,Simulation Models (contd),Rely on repetition of the same random process as many as several hundred times Have the ability to test various combinations of events Are used to test possible changes in variable conditions included in the process Are driven by sales forecasts, with assumptions

43、to derive income statements and balance sheets Generate probability acceptance curves for capital budgeting decisions,1-63,Simulation Flow Chart,1-64,Decision Trees,Help lay out a sequence of decisions that can be made Present a tabular or graphical comparison between investment choices Provide an i

44、mportant analytical process,1-65,Decision Trees (contd),Assuming that a firm is considering two choices: Expanding the production for sale to end users Entering the highly competitive personal computer market using the firms technology Cost of both projects is $60 million, with different net present

45、 value (NPV) and risk Project A: high likelihood of positive rate of return and the long-run growth is a reasonable expectation Project B: stiff competition may result in loss of more money or higher profit if sales are high,1-66,Decision Trees (contd),1-67,The Portfolio Effect,Considers the impact of a given investment on the overall risk of the firm A firm may plan to invest in the building products industry carrying a high degree of risk The overall risk exposure of that firm might diminish The investing firm could alter cyclical fluctuations inherent in its business and reduce