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TheCapitalBudgetingDecision
ChapterOutlineTheCapitalbudgetingdecisionCashflowsinCapitalbudgetingPaybackmethodNetPresentValueandInternalrateofReturnDiscountorcutoffrateasCostofCapitalCapitalBudgetingDecision–AdministrativeConsiderationsInvolvesplanningofexpendituresforaprojectwithaminimumperiodofayearorlongerCapitalexpendituredecisionrequires:ExtensiveplanningCoordinationofdifferentdepartmentsThesedecisionswouldbeaffectedbecauseofuncertaintiesinvolvedin:AnnualcostsandinflowsProductlifeInterestratesEconomicconditionsTechnologicalchangesCapitalBudgetingDecision–AdministrativeConsiderations(cont’d)Stepsinthedecision-makingprocess:SearchforanddiscoveryofinvestmentopportunitiesCollectionofdataEvaluationanddecisionmakingReevaluationandadjustmentCapitalBudgetingProceduresAccountingFlowsversus
CashFlowsIncapitalbudgetingdecisions,emphasisisoncashflowsratherthanearningsDepreciation(noncashexpenditure)isaddedbacktoprofittodeterminetheamountofcashflowgeneratedExampleprovidedinthefollowingslideEmphasisisonuseofproperevaluationtechniquestomakebesteconomicchoicesandassurelongtermwealthmaximizationCashFlowandRevisedCashFlowforAlstonCorporationNetearningsbeforeandaftertaxesarezero,butthecompanyhas$20,000cashinthebankMethodsofRanking
InvestmentProposalsThreemethodsused:PaybackmethodInternalrateofreturnNetpresentvaluePaybackMethodTimerequiredtorecoupinitialinvestmentfromTable12-3:InvestmentAisbetterInvestmentArecoups$10,000InitialInvestmentattheendofthesecondyear,whileInvestmentBtakeslonger
PaybackMethod(cont’d)Advantages:EasytounderstandEmphasizesliquidityUsefulinindustriescharacterizedbydynamictechnologicaldevelopmentsShortcomings:DoesnotconsiderTimeValueofMoneyIgnorescash-flowsafterthecutoffperiodFailstodiscernoptimumormosteconomicsolutiontocapitalbudgetingproblemInternalRateofReturn(EvenCash-Flows)Requiresthedeterminationoftheyieldonaninvestmentthatequatesthecashoutflows(cost)ofaninvestmentwithsubsequentcashinflowsAssumingthata$1,000investmentreturnsanannuityof$244perannumforfiveyearsProvidesaninternalrateofreturnof7%asindicated:
(Investment)=$1,000=4.1(PVIFA)(Annuity)$244Thepresentvalueofanannuity(giveninAppendixD)showsthatthefactorof4.1forfiveyearsindicatesayieldof7%InternalRateofReturn-UnevenCash-FlowsCashInflows(of$10,000investment)YearInvestmentAInvestmentB1………………$5,000$1,5002………………5,0002,0003………………2,0002,5004………………5,0005………………5,000Tofindabeginningvaluetostartthefirsttrial,theinflowsareaveragedoutasthoughannuitywasreallybeingreceived$5,0005,000
2,000$12,000÷3=$4,000InternalRateofReturn-UnevenCash-Flows(cont’d)Dividingtheinvestmentbythe‘assumed’annuityvalueinthepreviousstep,wehave:
(Investment)=$10,000=2.5(PVIFA)(Annuity)$4,000Thefirstapproximation(derivedfromAppendixD)oftheinternalrateofreturnusing: PVIFAfactor=2.5n(period)=3Thefactorfallsbetween9and10percentAveragingwouldeitherunderstateoroverstatetheIRRbymovingthecash-flowseithertotheendorbeginningoftheprojectCashflowsinearlyyearsareworthmoreandincreasethereturnInternalRateofReturn-UnevenCash-Flows(cont’d)Usingthetrialanderrorapproach,weuseboth10%and12%toarriveattheanswer:
Year10% 1…….$5,000X0.909=$4,545 2…….$5,000X0.826=4,130 3…….$2,000X0.751=1,502 $10,177At10%,thepresentvalueoftheinflowsexceeds$10,000–wethereforeuseahigherdiscountrate
Year12% 1…….$5,000X0.893=$4,464 2…….$5,000X0.797=3,986 3…….$2,000X0.712=1,424 $9,874At12%,thepresentvalueoftheinflowsislessthan$10,000–thusthediscountrateistoohighInterpolationoftheResultsTheinternalrateofreturnisdeterminedwhenthepresentvalueoftheinflows(PVI)equalsthepresentvalueoftheoutflows(PVO)Thetotaldifferenceinpresentvaluesbetween10%and12%is$303 $10,177……PVI@10%$10,177…….PVI@10%
-9,874…....PVI@12%-10,000……(cost)$303$177Thesolutionis($177/$303)percentofthewaybetween10and12percent.Duetoa2%difference,thefractionismultipliedby2%andtheanswerisaddedto10%forthefinalanswerof:
10%+($177/$303)(2%)=11.17%IRRInInvestmentBthesameprocesswillyieldananswerof14.33percent.InterpolationoftheResults(cont’d)UseofinternalrateofreturnrequirescalculatedselectionofInvestmentBinpreferencetoInvestmentA,theconclusionbeingexactlytheoppositeunderthepaybackmethodThefinalselectionofanyprojectwillalsodependonyieldexceedingsomeminimumcoststandard,suchascostofcapitaltothefirm
InvestmentAInvestmentBSelection Payback method……. 2years3.8yearsQuickerpayback:“A” Internal Rateof Return………11.17%14.33% Higheryield:”B”NetPresentValueDiscountingbacktheinflowsoverthelifeoftheinvestmenttodeterminewhethertheyequalorexceedtherequiredinvestmentBasicdiscountrateisusuallythecostofthecapitaltothefirmInflowsmustprovideareturnthatatleastequalsthecostoffinancingthosereturnsNetPresentValue(cont’d) $10,000Investment,10%DiscountRateYearInvestmentAYearInvestmentB1………$5,000X0.909=$4,5451……….$1,500X0.909=$1,3642………$5,000X0.826=4,1302……….$2,000X0.826=1,6523………$2,000X0.751=1,5023……….$2,500X0.751=1,878$10,1774……….$5,000X0.683=3,4155……….$5,000X0.621=3,105$11,414Presentvalueofinflows…..$10,177Presentvalueofinflows…..$11,414Presentvalueofoutflows-10,000Presentvalueofoutflows-10,000Netpresentvalue…………$177Netpresentvalue…………...$1,414ComparisonofCapitalBudgetingResultsAsummaryofthevariousconclusionsreachedunderthethreemethodsispresentedinthefollowingtable:SelectionStrategyForaprojecttobepotentiallyaccepted:ProfitabilitymustequalorexceedcostofcapitalProjectsthataremutuallyexclusive:SelectionofonealternativewillprecludeselectionofanyotheralternativeProjectsthatarenotmutuallyexclusive:AlternativesthatprovideareturninexcessofcostofcapitalwillbeselectedSelectionStrategy(cont’d)InthecaseofpriorInvestmentAandB,assumingacapitalof10%,InvestmentBwouldbeacceptedifthealternativesweremutuallyexclusive,whilebothwouldclearlyqualifyiftheywerenotso,asdepictedbelow:TheIRRandNPVmethodswillcallforthesamedecisionwithsomeexceptionsTworules:IfaninvestmenthasapositiveNPV,itsIRRwillbeinexcessofthecostofcapitalIncertainlimitedcases,however,thetwomethodsmaygivedifferentanswersinselectingthebestinvestmentReinvestmentAssumptionIRRAllinflowsfromagiveninvestmentcanbereinvestedattheInternalRateofReturn(IRR)MaybeunrealistictoassumethatreinvestmentcanoccurataequallyhighrateNPVMakesthemoreconservativeassumptionthateachinflowcanbereinvestedatthecostofcapitalordiscountrateAllowsforcertainconsistencyasinflowsfromeachprojectareassumedtohavethesameinvestmentopportunityTheReinvestmentAssumption–IRRandNPVModifiedInternalRateofReturn(MIRR)CombinesreinvestmentassumptionoftheNPVmethodwiththeIRRmethodMIRRisthediscountratethatequatestheterminal(final)valueoftheinflowswiththeinvestmentIntermsofaformula:ModifiedInternalRateofReturn(cont’d)Assuming$10,000producesthefollowinginflowsforthenextthreeyears:Thecostofcapitalis10%Determiningtheterminalvalueoftheinflowsatagrowthrateequaltothecostofcapital:TodeterminetheMIRR:PVIF=PV=$10,000=.641(AppendixB)FV$15,610ModifiedInternalRateofReturn(cont’d)AppendixBshows:Foratabularvalueof.641,theYieldorMIRRis16percentTheconventionalIRRcomputedwouldhavebeen21percentMIRRusesamorerealisticassumptionofre-investmentatthecostofcapitalCapitalRationingArtificialconstraintsetontheusageoffundsthatcanbeinvestedinagivenperiodbyManagementOnlythoseprojectswiththehighestpositiveNPVareaccepted.Reasonsforcapitalrationing:FearoftoomuchgrowthHesitationtouseexternalsourcesoffinancingCapitalrationingcanhinderafirmfromachievingmaximumprofitabilityNetPresentValueProfileAgraphicalrepresentationofnetpresentvalueofaprojectatdifferentdiscountratesToapplytheNPVprofile,thefollowingaspectsneedtobeconsidered:NPVatazerodiscountrateNPVasdeterminedbyanormaldiscountrate(suchascostofcapital)IRRfortheprojectNetPresentValueProfile–
GraphicRepresentationInvestmentBispreferredasbothNPVandIRRarehigherincaseofInvestmentBascomparedtoInvestmentANetPresentValueProfile
withCrossoverBelowthecrossoverpointof8.7%InvestmentBispreferredAbovethecrossoverpointof8.7%InvestmentCispreferredTheRulesofDepreciation
AssetsareclassifiedintoninecategoriestodetermineallowabledepreciationEachclassisreferredtoasModifiedAcceleratedCostRecoverySystem(MACRS)categorySomereferencesarealsomadetoAssetDepreciationRange(ADR),ortheexpectedphysicallifeoftheassetorclassofassetsCategoriesfor
DepreciationWrite-OffDepreciationPercentages
(ExpressedinDecimals)Table12–9DepreciationScheduleTable12–10ActualInvestmentDecision-ExampleAssumption:$50,000depreciation(Table12–10)ofmachinerywithasix-yearproductivelifeProducesanincomeof$18,500forfirstthreeyearsbeforedeductionsfordepreciationandtaxesInthelastthreeyears,incomebeforedepreciationandtaxeswillbe$12,000Corporatetaxratetakenat35%andcostofcapital10%Foreachyear:Thedepreciationissubtractedfrom“Earningsbeforedepreciationandtaxes”toarriveatEarningsbeforeTaxesTaxesthensubtractedtodetermineEarningsafterTaxesDepreciationisaddedtoearningstoarriveatCashFlowsActualInvestmentDecision–Example(cont’d)ActualInvestmentDecision–Example(cont’d)Netpre
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