Download Capital Budgeting Goal of Every Business? How This All Fits Capital

MOS 372: Capital Budgeting Part One
Goal of Every Business?
Capital Budgeting
Introduction
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How This All Fits
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Capital Budgeting
Last term we developed understanding of
costs, allocations, variances etc. ending with
making decisions with that data
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Our goal has always been to increase shareholder
value
Short-term decision-making looked for a “Net
Benefit” or “Reduce Costs”
 Now we are ready to move on to longer term
The actions of evaluating and deciding which
outlays a firm should pursue such as new
equipment, expand, etc.
 This type of analysis is crucial to the longterm profitability of a firm
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The numbers get much more complicated and
with time value of money…you need better tools.
This is an extension of using costs and
revenues for evaluation and decision-making
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Typical Decisions
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Screening Decisions
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Nature of Problems
Replacement
 Expansion
 Cost reduction
 Choice of equipment
 New product
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Does this decision meet our standard of
acceptance? Minimum need for return?
Preference Decisions
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Does this decision select from a group of
competing courses of action?
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MOS 372: Capital Budgeting Part One
Differences From What We
Did At the End of Last Term…
1. Working with Depreciable Assets

Differences From What We
Did At the End of Last Term…
2. Time Value of Money
 The time horizon of these decisions is
much longer therefore the value of the
cash changes over time.
Making investment decisions with assets that
have little or no value at the end of their useful
lives is more complex because:
Cash flows must recover the original
investment AND “make money” – there
is a minimum over and above the initial
investment that isn’t always considered.
i.e. Decisions with returns sooner are more
attractive those later.
3.
Taxes (not an issue now but will be…)
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Approach One – Net Present
Value Method
Evaluation
This method considers the sum of all of the
cash flows for each alternative in current
dollars.
 Similar to what we did with short-term
decisions – we looked at ALL cash flows and
picked the one with best positive cash flow
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Positive…then accept the project. It provides a
return greater than the required rate
 Zero…then accept the project. It provides a
return equal to the required rate
 Negative…run away!
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“Cash is King”
Some Typical Cash OUTFLOWS
The key to this analysis is ensuring you focus
on ALL of the cash flows.
 Similar to short-term decisions, being aware
of all relevant cash flows is crucial.
 Due to the time horizon this can be very
difficult.
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If the Net Present Value is…
Estimating revenues and costs years from now is
hard to do…try 10 years down the line…
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The immediate cash outflow (cost of asset,
material, labour, installation, freight, etc.)
 Increase need for working capital (cash,
A/R, Inventory etc.) and its financing cost
 Disposal costs (if not net of salvage value)
 Repairs and maintenance or other operating
cost

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John Siambanopoulos
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MOS 372: Capital Budgeting Part One
Some Typical Cash INFLOWS
Additional revenues or contribution
Reductions in cost (savings over the current
situation)
 Salvage value received
 Release of working capital
 Sale of unnecessary assets
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Note: Occasionally, some of these
costs are “netted against each other”
meaning they have been included in
another cost or benefit.
If it isn’t stated…
Make sure you do.
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Choosing a Rate
Choosing A Rate
Very important decision
 Represents the minimum return that any
investment should be for the firm
 Developed using principles from Finance
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This is viewed as the overall cost (as a %) of
borrowing money (both debt and equity!)
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If you can pay the interest on your debt and
give a reasonable return to equity, everything
after that is BONUS
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The Cost of Capital (or Weighted Average Cost
of Capital, WACC) is used
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It’s the overall cost of “money” for a firm
Therefore, the firm’s value will grow…
It is the “break-even level” of return
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Cost of Capital
Cost of Capital (cont’d)
WACC blends or “weights” the cost of
borrowing debt AND equity depending on
how much of each the firm uses
 This is called the Capital Structure of a firm
(the balance of debt and equity)
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This is covered in most Finance courses
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Many firms spend a lot of time figuring this
number out because every firm and industry
is slightly different
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Knowing this cost, gives you an idea of what
your minimum return needs to be
i.e. to break even on any investment in which
you borrowed money
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This can be very complicated
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MOS 372: Capital Budgeting Part One
Example
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Cost of capital is also known as:
Krusty Corporation wants to buy a machine
for $5,000 with a life span of 5 years and a
zero salvage value. This machine saves
$1,800 per year in labour costs. Krusty
requires a 20% return on investment on all
projects.
Hurdle rate
 Required rate of return
 Cutoff rate
 Discount rate
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
In MOS 372 you will be given this rate
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Approach Two – Internal Rate
of Return (IRR)
Solution
Item
Year(s) Cash Flow
20%
Factor
P.V. of
Cash Flow
Cost
Savings
1-5
1,800
2.991
5,384
Initial
Investment
Now
5,000
1.000
(5,000)
NPV
$384
This method also helps determine if a project
should be undertaken or not
 It considers all of the cash flows for each
alternative and gives you a yield or interest rate
representing the amount of potential return
 IRR gives the discount rate that will cause the
NPV of a project to equal zero

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Example
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Solution
Krusty Corporation wants to buy a machine
for $5,000 with a life span of 5 years and a
zero salvage value. This machine saves
$1,800 per year in labour costs. Krusty
requires a 20% return on investment on all
projects.
Investment required/Net annual cash inflow
5,000 / 1,800 = 2.78
Look on for 2.78 under the 5 periods line of a
PV of an annuity, you will see:
For 22% = 2.864 and 24% = 2.745
Therefore it’s in between these percentages
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John Siambanopoulos
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MOS 372: Capital Budgeting Part One
Solution (cont’d)
22% factor
2.864
True factor
24% factor
2.780
Difference
0.08
IRR
2.864
The idea is that you compare the IRR to the
hurdle rate (the minimum) to test it
 IRR is used frequently in firms because
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2.745
0.12
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= 22% (base) + (0.08/0.12) x 2% (difference)
= 22% + 1.34%
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= 23.34%
It’s one number and its comparison is easy
People are used to saying “what’s the return on
your investment?” or “Dude, what’s your IRR?”
Since the IRR is greater than our required rate
(20%), this project is a go.
This is A LOT easier on a calculator or computer!
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Major Assumptions for DCF
Models
NPV vs IRR
Cash flows are certain
We can borrow or lend money at the same
interest rate (as the WACC). Therefore
interest rates are assumed to be steady.
Despite how somewhat improbable these are,
this is the best we have and you can work
in sensitivity and flexibility to
accommodate these issues.
NPV is still easy to understand because it’s
an amount of cash, right now
 NPV can adjust for risk more easily (i.e.
you can change cash flows, use different
discount rates over the project’s life, etc.)

1.
2.
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What About Inflation?
Reinvestment Assumption
Over the long term inflation will erode
actual cash flows – it should be considered
 Two sides:
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Realize that NPV finds the total flows at the
cost of capital rate
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It can be considered as “part” of the WACC
calculation: Cost of Debt = Risk-free rate +
(business) risk premium + inflation element
 You can adjust cash flows with an assumption
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HOWEVER, IRR assumes that all funds are
invested back in at the IRR rate (which may
be different)
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Therefore, any inflows in the future are
assumed to be reinvested at THAT rate
Is that realistic?
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MOS 372: Capital Budgeting Part One
NPV and IRR
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Potential conflicts can occur between these
methods for mutually exclusive projects:
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Modified IRR (MIRR)
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The projects differ in size (or scale)
They differ in time periods
This is the same as IRR but all inflows are
assumed to be invested at the cost of capital
NOT the IRR
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NPV gives you raw total dollar improvement
to the firm (how much value is truly realized)
This is (in my opinion) the best method for
evaluating the profitability and attractiveness of
a capital project
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Competing Projects
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Least-Cost Decisions
You can use (as we did in 1st term) either a
Total-Cost Approach – All costs and revenues
are considered. This is a better approach when
you have many alternatives. Then ALL can be
compared (vs. only two).
 Incremental-Cost Approach – Only differential
costs and revenues are considered
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When no revenues are involved
 Look for the NPV with the lowest number
(i.e. the lowest cost) as most desirable
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Both arrive at the same decision
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Intangible Benefits
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Intangible Benefits
When a negative NPV or below cost of
capital IRR is revealed qualitative benefits
can still push a company to pursue an
alternative if:

If you have a negative net present value,
consider this:
What amount amount (in a positive sense) would
make that negative NPV into a zero or positive?
 What does that number represent?
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Allows more flexibility
Higher quality and/or safety
 Easier process/better working conditions
 Capital decay/Your competition is doing it*
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MOS 372: Capital Budgeting Part One
Intangible Costs (Qualitative)
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Qualitative Analysis
There are also costs that may or can not be
accurately measured. Such as:
This is the other half of the Capital
Budgeting (after the NPV)
 If the alternatives are close, this section may
be the tipping point
 Consider the internal and external
environment in addition to the Advantages
and Disadvantages of the alternatives
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Management of change and implementation (cost
overruns, project management, etc.)
 True accuracy of benefits vs costs
 The further away the cash flows the greater the
risk (this isn’t always considered in the WACC)
 Unions and other stakeholders
 Other external environmental factors
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Other Approaches - Payback
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Other Approaches
Payback – The length of time it takes for an
investment to pay for itself
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Payback period: Investment Required
Net annual cash flow
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This is not a measure of profit but time
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Simple Rate of Return (also doesn’t
involve discounted cash flows) – also
known as the Accounting Rate of Return
Incremental
Revenues
Issues:
Doesn’t take into account the life-span of the
project (total flows)
 Time value of money isn’t considered

-
Incremental
expenses including
depreciation
=
Net income
Initial investment
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Example
Simple Rate of Return
Initial investment is $6,075, 4-year useful
life, zero salvage value and expected cash
flow of $2,000/year.
Incremental revenues: 2,000 – (6,075/4)
6,075
= 7.9%

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If it’s a cost reduction
Cost savings -
Depreciation on
new equipment
Initial investment
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MOS 372: Capital Budgeting Part One
Issues
Profitability Index
This is based on accrual accounting ideas
Unlike payback, profit is the objective
(which is good)
 However, it ignores the time value of
money
Testing an alternatives profitability (to
compare to others)
 Formula:
NPV of Cash Inflows
NPV of Cash Outflows
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
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Therefore if the index is 1, then the NPV = 0
If the index is greater than 1 then it’s a go
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Profitability Index Benefits
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Negates the time issue
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Time frame of projects becomes irrelevant
Similar to using % or ratios on an Income
Statement; makes everything relative to each part
Size doesn’t matter
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Size of project (amounts used) is irrelevant
Same reason as the previous point
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John Siambanopoulos
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