Capital Budgeting

This lecture provides an overview of the capital budgeting process and shows how to
estimate the relevant cash flows associated with an investment project and evaluate those
cash flows

I. Capital expenditures are important to a firm both because they require sizable
outlays and because they have a significant impact on the firm’s long-term
performance.

A. Capital budgeting is the process of planning for purchases of assets whose

returns are expected to continue beyond one year.

B. A capital expenditure is a cash outlay, which is expected to generate a

flow of future cash benefits. Normally, a capital project is one with a life
of more than one year.

C. Capital budgeting models are used to evaluate a wide variety of capital

expenditure decisions, including:

1. investments in assets to expand an existing product line or to enter

a new line of business.
2. replacement of an existing capital asset.
3. expenditures for an advertising campaign.
4. expenditures for research and development.
5. investments in permanent increases in inventory or receivables
levels.
6. investments in education and training.
7. refunding an old bond issue with new bonds paying a lower
interest rate.
8. leasing decisions.
9. merger and acquisition decisions.

D. The firm's cost of capital is the combined cost of funds from all sources.
The cost of capital is also called the investors' required rate of return
(RRR), because it is the minimum rate of return that must be earned
on the capital invested in the firm. The required rate of return helps
provide a basis for evaluating capital investment projects.

E. Projects under consideration may be independent of each other or have

some types of interdependencies.

1. An independent project is one whose acceptance or rejection has

no effect on other projects under consideration.

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 2. Two projects are mutually exclusive if one or the other can be
accepted, but not both.

3. A contingent project is one whose acceptance is contingent upon

the adoption of one or more other projects.

4. One additional complication is capital rationing, which occurs

when the firm has a limited total amount of dollars available for
investment and the outlay for profitable investments exceeds this
limit. On the other hand, when the firm has sufficient funds
available to invest in all profitable projects, we say the firm is
operating without a funding constraint.

III. We are going to discuss the general theory of capital budgeting, before we do
an actual example. Don't spend too much time on the theory, it's mainly for
support of the example that follows.

The initial step in the capital budgeting process is generating capital investment
project proposals.

A. The process of soliciting and evaluating investment proposals varies

greatly among firms.

B. Investment projects can be classified as:

1. projects generated by growth opportunities in existing product

lines or new lines.

2. projects generated by cost reduction opportunities.

3. projects required to meet legal requirements and health and

safety standards.

C. The size of an investment proposal frequently determines who has

authority to approve the project. A very large outlay might require
approval of the corporation president or board of directors, where smaller
outlays can be authorized by lower and lower levels of management.

D. If an investment decision is critical and must be made fast, a lower level

manager can approve it or it can by-pass the normal time-consuming
review process to reach the appropriate responsible manager as fast as
possible.

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IV. Estimating the cash flows associated with investment projects is crucial to the
capital budgeting process. The cash flows associated with a project are the basis
for evaluation rather than the project's accounting profits. Typically, capital
expenditures are associated with a net investment (at time 0) and a series of net
(operating) cash flows expected to be received over a number of future periods.
Several principles should be kept in mind when determining project cash flows.
These principles include:

A. Cash flows should be measured on an incremental basis. The cash flow

stream for a project is the difference between the cash flows to the firm
with the project compared to the cash flows to the firm without adopting
the project.

B. Cash flows should be measured on an after-tax basis.

C. All the indirect effects of a project should be included in the cash flow
estimates. For example, increases in cash balances, receivables, and
inventory necessitated by a capital project should be included in the
project's net investment.

D. Sunk costs should not be considered since sunk costs result from previous
decisions, they are not truly incremental costs.

E. Resources should be measured in terms of their opportunity costs. The

opportunity costs of resources are the cash flows they would generate if
not used in the project under consideration.

V. The net cash investment (NINV) is the initial cash outlay for a project (usually at
time zero).

A. A project’s net cash investment is estimated as:

The new project cost

PLUS any installation, shipping or other costs associated with
acquiring the asset and putting it into service;
THESE TWO ITEMS ARE ADDED TOGETHER AND
CALLED THE CAPITALIZED COST OF THE ASSET.
PLUS Any increases in net working capital initially required as a
result of the new investment
MINUS The net after-tax (A/T) proceeds from the sale of existing
assets when the investment is a replacement decision;
EQUALS Net cash investment (NINV).

B. Most projects involve outlays over more than one year. The NINV for a
multiple-period investment is the present value of the series of outlays
discounted at the firm's cost of capital.

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VI. The future net operating cash flows (NCF) are computed using the proposed
project’s accounting information:

A. After-tax net operating cash flow is:

NCF = OEAT + Dep - NWC

where,
NCF = net operating cash flow,
OEAT = change in operating earnings after tax,
Dep = change in depreciation, and
NWC = increase in the net working capital investment.

VII. There are two potential cash flows at the end of a project's life.

A. Cash inflow due to the incremental salvage must be included at the end of
the project.

B. Recovery of net working capital can be a cash inflow. There are no tax
consequences of liquidating working capital.

VIII. It is important to note that interest charges are not considered in estimating a
project's net cash flows. This was done so that measures of the value of a
project (in the next chapter) can be constructed independent of how a project is
financed. Furthermore, if interest charges are deducted from cash flows and then
the remaining cash flows are discounted to adjust for the time value of money,
this would constitute a double counting of the time value of money when
evaluating the value of an asset.

XI. Next, we have to decide what capital budgeting criteria. Four capital budgeting
criteria are widely known and used. These are the net present value (NPV),
internal rate of return (IRR), profitability index (PI), and the payback period (PB).

A. The net present value (NPV) of an investment project is defined as the

present value of the stream of future net cash flows from a project minus
the project's net investment

1. The net present value is:

NPV = Present Value of the Cash Flows - Net Cash Investment

2. The NPV decision rule is to accept a project when the NPV is

positive or zero and to reject a project when its NPV is
negative. If the present value of the project's net cash flows
exceeds the project's net investment outlay, the project contributes
to the total value of the firm.

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 3. The benefits of using the NPV criterion include: (1) It accurately
accounts for the magnitude and timing of a project's cash flows
over its entire life. (2) It shows whether a proposed project yields
the rate of return required by the firm’s investors and, therefore,
consistent with the goal of shareholder wealth maximization. (3) It
adheres to the principle of value additivity.

4. A disadvantage of the NPV criterion is that it is not as easily

understood by untrained decision-makers as the payback or
internal rate of return.

B. The internal rate of return (IRR) is defined as the rate of discount that
equates the present value of net cash flows of a project with the present
value of the net investment. In other words, the IRR is the discount rate
that makes a project's NPV equal zero.

1 The IRR decision rule is to accept a project when its IRR

exceeds or equals the cost of capital (k) and to reject a project
when its IRR is less than the cost of capital.

2. Like the NPV, the IRR takes account of the magnitude and timing
of a project's net cash flows over its entire life.

C. The profitability index (PI) or benefit-cost ratio is the ratio of the present
value of future net cash flows over the life of the project to the net
investment.

1. Algebraically, the profitability index is

Present value of Cash Flows / Net Cash Investment

2. The PI decision rule is to accept a project whose PI is greater

than or equal to one and to reject a project whose PI is less
than one. If one or more mutually exclusive projects have a PI
above one, the project with the highest PI is chosen. (Assuming
the firm has capital rationing).

3. The PI has the same advantages and disadvantages as the NPV

criterion.

4. The NPV is an absolute measure of the amount of wealth

increase from a project, whereas the PI is a relative measure
showing the wealth increase per dollar of investment.

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 D. The payback period (PB) of an investment is the number of years required
for the cumulative net cash inflows from a project to equal the initial cash
outlay.
1. If the future net cash inflows are equal in each year, the payback
period is simply the ratio of the net investment to the annual cash
inflows.

When the future net cash flows are unequal, interpolation is

frequently used in the final period to get an accurate payback
period.

2. The advantages of the payback method are that it is simple, it

provides a measure of project liquidity, and, in a sense, and it may
also be a measure of risk.

3. On the other hand, the payback period is not a true measure of

profitability and, therefore, is not a good criterion for decision
making. The payback period ignores cash flows after the
payback is reached and it ignores the time value of money of
the cash flows occurring within the payback period.

4. It usually only used either if two mutually exclusive projects have

very similar NPVs and IRRs as a tiebreaker; or if a project has an
extremely short horizon period due to extraordinarily high risk.

Let's do an example now using the theory we just learned. This example is fairly
simple and is similar to the one you will receive for your project.

 The type of example we are going to do is an asset replacement problem. In an asset

replacement problem, the firm currently has a working asset, but the firm is
considering a newer model that may either produce more units with less resources
(cost reduction) or produce more units with the same amount of resources (increase
revenue) or a combination of both. In any event, the firm is willing to spend
additional money today to have an increase of profit in the future.

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Current Machine
- Bought two years ago and has a capitalized cost of $100,000 , 5 yr. MACRS depreciation
life (see next page for what this means); 7 year useful (actual) life
- it can be sold today for $70,000

New Machine
- cost $200,000; plus $3,000 installation, 8% sales tax.
- It will reduce costs by $40,000/yr
- 5 yr. MACRS, 7 year useful (actual) life
- the estimated salvage at end of yr. 7 will be $5,000
- Tax Rate = 30%
- RRR (Required Rate of Return) 15%. (This sometimes referred to cost of capital in
your text). This RRR is the rate of return we need the asset to earn. We do this by
using the PVIF discount rate to discount back the cash flows.

STEP 1 Determine the Net Cash Investment

Cost of asset $200,000 cost

+ any costs needed to get asset ready for use + 16,000 sales tax (8%)
+ 3,000 installation
Capitalized Cost $219,000
- A/T proceeds of sale of current mach. (63,400)***see page 9
CASH INVESTMENT $155,600

***The first step in calculating the A/T proceeds is to find the book value of the current
machine. The book value is calculated by:

Capitalized Cost - Accumulated Depreciation = Book Value

The accumulated depreciation is the total depreciation that has been expensed for the
machine over its life. Some firms use straight-line depreciation, which is calculated by:

Capitalized Cost - Salvage Value = Depreciation Expense each year

# years of useful life

But most firms use the IRS method of depreciation which is called MACRS
(Modified Accelerated Cost Recovery System). For tax purposes the use of
accelerated depreciation methods is desirable since it reduces tax outlays in the initial
years thereby increasing the present value of the cash flows. To use this method, we
simply look up the percentage depreciation that needs to be expensed each year,
using the schedules provided by the IRS. (The IRS provides guidelines on how firms
should classify assets. For this class, you will be provided with the appropriate
depreciation schedule, so you don't have to worry about that.)

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Here is the MACRS schedule for 5-year asset below (you'll also be given the schedule you need on
your exam): Year MACRS%
1 20.00%
2 32.00%
3 19.20%
4 11.52%
5 11.52%
6 5.76%
100.00%
At this point, you may think I have made a mistake by having a year 6, for a 5 year asset. But all the
schedules have an extra year added to them. This is known as the "mid-year convention". It just
means the IRS assumes the firm bought the machine in the middle of year 1 (regardless of when the
firm actually did buy the asset), so 5 years of full depreciation encompass 6 tax years. Again, you
don't need to worry about this, it is just another example of arbitrary U.S. tax laws.

So let’s calculate how much depreciation has been taken for this machine. We've had the
machine for 2 years, so 2 years of deprecation have been expensed:

current machine capitalized cost x MACRS% = Depreciation Expense

Year 1 100,000 x .2 = $20,000

Year 2 100,000 x .32 = 32,000
Accumulated Depreciation (A/D) = $52,000

So the book value for the current machine is:

$100,000 capitalized cost - $52,000 A/D = $48,000 Book Value (BV)

Now that we have determined the book value of the current asset, we need to see what tax
consequences will arise. There are 3 possibilities that could occur:

Case 1: Sale of an asset for book value. There are no tax consequences.

Case 2: Sale of an asset for less than book value. The loss is treated as an
operating loss to offset operating income. The tax saving is the marginal tax rate times
the amount of the loss.

Case 3: Sale of an asset for more than book value. The IRS considers the gain a
recapture of depreciation. The gain is taxed as operating income, with taxes due equal to
the marginal tax rate times the amount of the gain.

So let's look to see how each of these three cases are treated. The first two scenarios are just
theoretical to show what you would do if that scenario fit the problem. The last scenario is
the one that actually applies to our specific problem. Remember that in every problem only
one scenario will fit, but we must discuss all three possibilities so you will know what to do
under any circumstance.

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BV = selling price (old) BV(old)>selling price (old) BV(old)<sell. price (old)

$48,000 = $48,000 $48,000 > $30,000 $48,000< $70,000

(example) (example) (given)

Since BV is the Since BV is more Since BV is less

same as the selling price; than the selling price; than the selling price;
there is no gain or loss, a loss arises and a gain arises and
so there are no tax since the loss is tax since the gain
consequences and there is deductible, the firm is taxable, the firm
is no effect on saves taxes and this pays taxes and this
A/T proceeds. increases the A/T proceeds. decreases the A/T proceeds.

$18,000 loss $22,000 gain

x 30% tax rate x 30% tax rate
$5400 tax savings ($6600) taxes paid
+30,000 selling price +70,000 selling price
$48,000 A/T proceeds $35,400 A/T proceeds $63,400 A/T proceeds***(page 7)

STEP 2 Determine the After-Tax Cash Flow (ATCFs)

The first thing to do is to set up a chart with the number of columns equal to the
useful life of the asset or project. In our example this is 7 years.

Then we need to calculate each type of cash flow the asset will contribute:

(1) The first cash flow is the cash flow of either the reduction of costs or increase of
revenues (or both) from the asset. In our case it is a reduction of costs. Since a
reduction of costs will increase taxable income, that increase is taxable.
 So for us, the $40,000 reduction in costs is taxed at 30% , so the after-tax cash
flow from the cost savings is $28,000 each year.

(2) The second cash flow is the tax savings to the firm from depreciation on the new
machine. This is calculated as the capitalized cost of the new machine x MACRS
% x tax rate.
 So for our problem we take $219,000 capitalized cost and multiply it by each of
the 5 year MACRS % and then multiply it by our tax rate of 30%.

(3) The third cash flow is the lost tax savings to the firm from depreciation of the
current machine. Since we were already getting tax savings from the depreciation
from this current machine, we will loose these savings if we sell the current machine,
and we need to subtract these lost savings from the overall cash flows from the new
machine. The total effect of cash flow 2 and cash flow 3 is the net increase in cash
flow due to depreciation. We calculate these lost tax savings by: capitalized cost of
the current machine x MACRS% remaining x tax rate.

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 So for our problem we take $100,000 capitalized cost of the current machine and
multiply it by each of MACRS % still remaining for the current machine (years
3, 4, 5, 6) and then multiply that by our tax rate of 30%.

(4) The last cash flow is the after-tax cash flow from the salvage. Since by the end
of the 6th year the book value of the machine is zero (remember the total MACRS%
equal 100%), any salvage received is gain and taxed at our tax rate. A shorthand
calculation for this is salvage x (1-tax rate).
 So for our problem the after-tax salvage is $5000 (1-.30) = $3500

(5) Finally we sum all our cash flows to obtain the ATCFs for each year.

Here is the actual spreadsheet:

STEP 2 : ATCFs
1 2 3 4 5 6 7
(1) reduce costs 40,000 40,000 40,000 40,000 40,000 40,000 40,000

less: taxes 30% (12,000) (12,000) (12,000) (12,000) (12,000) (12,000) (12,000)
A/T savings 28,000 28,000 28,000 28,000 28,000 28,000 28,000

0
(2) tax savings [219000x [219000x [219000x [219000x [219000x [219000x
from depreciation .2 x.3] .32 x.3] .192x .3] .1152 x .3] .1152 x.3] .0576x.3]
[cap. cost (new) x 13140 21024 12614 7567 7567 3784 0
MACRS x T%]

(3) Less: Tax

savings lost from [100000x [100000x [100000x [100000x
dep
on current .192x.3] .1152x.3] .1152x.3] .0576x.3]
machine
[cap cost(current) (5,760) (3,456) (3,456) (1,728)
x remain MACRS
% X T]

(4) A/T salvage [5000x

[salvage (1-T)] (1-.3)]
3500
(5) ATCFs $35,380 45,568 37,158 33,839 35,567 31,784 31500

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STEP 3 Evaluate the After-Tax Cash Flows
We are going to use the Net Present Value method to evaluate the ATCFs.
Recall that what we do in this method is to take the present value of the ATCFs .
NPV is obtained by:

PV of CASH FLOWS
- Net Cash Investment (step 1)
NPV

 If the NPV is > 0 : Accept the project

 If the NPV is < 0 : Reject the project

Using our financial calculator (HP 10BII) you can calculate the NPV by:

 enter the cash investment of -155,600 and then push CFj key (which is located in the
third column of buttons and the third row of buttons from the top of the calculator)
 enter each of the ATCFs and then push CFj key after each ATCF is entered.
 enter 15; then press the I/YR key (this enters the RRR)
 press the yellow second function key; then press the NPV key (one key above and to the
right of the CFj key)
 You get an answer of NPV of -3333.

STEP 4 IRR - Internal Rate of Return Recall that the Internal Rate of
Return is the discount rate that equates the PV of CF’s with the net cash
investment.

Now you might be wondering what the return that the project actually earned was. The
IRR (Internal rate of Return) will tell us this. Calculating an IRR with uneven cash flows
by hand is too tedious.

Using our financial calculator (HP 10BII) you can calculate the IRR by:

 enter the cash investment of -155,600 and then push CFj key (which is located in the
third column of buttons and the third row of buttons from the top of the calculator)
 enter each of the ATCFs and then push CFj key after each ATCF is entered.
 enter 15; then press the I/YR key (this enters the RRR)
 press the yellow second function key; then press the IRR key (directly above the CFj
key)

You should obtain an answer of 14.2529%; lower than the RRR of 15%

 If you have already obtained the NPV by using the calculator, you do not need to enter
the cash flows again , just press the yellow second function key; then press the IRR key
(directly above the CFj key) after you obtain the NPV.

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 PI - Profitability Index

What do you do if two or more mutually exclusive (so we only chose one) projects have
positive NPVs?

Example:

Machine 1 Machine 2
PV of CF $ 100 $ 50
- investment -50 -20
NPV $ 50 $ 30

If the firm has capital rationing, a good way to solve the dilemma is the Profitability Index:

1 2
PV of CF = Profitability Index $100 $50
investment $50 = 2x $20 = 2.5x

 Recall that the PI is a relative measure of return , so for the above example, it is
interpreted that Machine 1 returns $2 of PVCF for each $1 invested and Machine 2
returns $2.50 of PVCF for each $1 invested. Therefore, Machine 2 has a higher
relative return and should be chosen.

 When using the calculator, you would add the NPV to the investment to
obtain the PVCF. So for our original example:
NPV $-3333
+ Investment 155,600
PVCF $152,267 so the Profitability Index is:

PVCF $152,267
Investment $155,600 = .978

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Conflict in Rankings Between NPV and IRR

Machine 1 Machine 2
NPV (assume same investment) $30,000 $25,000
IRR 15% 17%

This illustrates a conflict in ranking. NPV infers that we should accept Machine 1, while IRR
infers we should accept Machine 2. When two or more mutually exclusive projects are
acceptable using the IRR and NPV criteria, and if the two criteria disagree on which is
best, the NPV criterion is generally preferred. Both the NPV and IRR criteria will
always agree on accept/reject decisions even if the NPV and IRR do not rank the projects
the same. But the NPV is superior because:

1. One occasional difficulty with the IRR is that an unusual cash flow pattern (cash
flows switching signs from positive to negative and vice versa) can result in multiple
rates of return.

2. Different rankings result from the implicit reinvestment rate assumptions of the
two techniques: the NPV assumes that cash flows over the project's life may be
reinvested at the cost of capital k while the IRR assumes that cash flows may be
reinvested at the IRR.

Therefore: The firm should choose machine 1.

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