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Capital Budgeting

Determing Future Cash Flows

In evaluating investment alternatives, one of the first challenges is determining the future cash flows that are relevant to the decision. Simply stated, relevant cash flows are those that are expected to differ among the alternatives. Examples of relevant cash flows include a. The initial investment in long-term tangible or intangible assets for each investment alternative b. Any initial investment in working capital for each investment alternative, (e.g., inventories, accounts receivable, etc.) c. Cash flow from the sale of any assets being replaced

d. Differences in cash flow from operations under the alternatives, (e.g., cash inflow from sales and/or cash outflows for operating costs) Remember to focus on cash flows not accounting income Payments for incremental income taxes should be included

Depreciation expense does not affect cash flows but the firm receives a tax savings (shield) from depreciation expense. It reduces taxable income and therefore reduces tax payments. Remember it is tax depreciation that generates the tax shield, and book depreciation may differ from tax depreciation. e. Cash flows at the end of the expected life of the project.

Terminal disposal price of any long-term tangible or intangible assets. If the tax basis (Initial cost Tax depreciation taken) is expected to be different from the disposal price, the tax gain or loss will generate a tax inflow or outflow. Recovery of any working capital investmentThis investment will be recovered at the end of the project by liquidation of inventories, accounts receivable, etc. There are generally no tax implications of this recovery because it is assumed that the cash received will be equal to the book value (tax basis) of the working capital items.

Internal Rate of Return The internal (time-adjusted) rate of return (IRR) method is another discounted cash flow method. It determines the rate of discount at which the present value of the future cash flows will exactly equal the investment outlay (i.e., the rate that results in a NPV of zero). This rate is compared with the minimum desired rate of return to determine if the investment should be made. The internal rate of return is determined by setting the investment today equal to the discounted value of future cash flows. The discounting factor (rate of return) is the unknown. The TVMF for the previous example is PV (investment today) $10,000 TVMF = = 4.00 = TVMF Cash flows

TVMF $2,500

The interest rate of a TVMF of 4.00 where n = 5 is approximately 8%. The after-tax rate of return is de-termined using the $23,000 after-tax cash inflow amount as follows: $10,000 TVMF = = 4.35 TVMF $2,300

The interest rate of a TVMF of 4.35 where n = 5 is approximately 5%. The answers are worded less than 5%, but greater than 0%, less than 7%, but greater than 5%, etc. The relationship between the NPV method and the IRR method can be summarized as follows: NPV IRR IRR > Discount rate IRR = Discount rate IRR < Discount rate

NPV > 0 NPV = 0 NPV < 0

If the firm has sufficient funds to undertake all projects, the calculated internal rate of return on a project is compared to a prespecified hurdle rate which is the firms minimum acceptable rate of return for the project. The hurdle rate is determined based on the market rate of return for projects with similar levels of risk.
If the project has a positive net present value it has a return greater than the required return.

1.

The advantages of the internal rate of return method include

a. b.

Adjusts for the time value of money The hurdle rate is based on market interest rates for similar investments

c. The results tend to be a little more intuitive than the results of the net present value method 2. Limitations of the internal rate of return method include

a. Depending on the cash flow pattern there may be no unique internal rate of return for a particular projectthere may be multiple returns depending on the assumptions used b. Occasionally, there may be no real discount rate that equates the projects NPV to zero c. The technique also has limitations when evaluating mutually exclusive investments The Term Structure of Interest Rates The term structure of interest rates describes the relationship between long-and short-term rates. These relationships are important in determining whether to use long-term fixed or variable rate financing. A yield curve is used to illustrate the relative level of short-term and long-term interest rates at a point in time. At any point in time yield curves may take any one of the following three forms: a. Normal yield curveAn upward sloping curve in which short-term rates are less than intermediate-term rates which are less than long-term rates. b. Inverted (abnormal) yield curveA downward-sloping curve in which short-term rates are greater than intermediate-term rates which are greater than long-term rates. c. Flat yield curveA curve in which short-term, intermediate-term, and longterm rates are all about the same. d. Humped yield curveA curve in which intermediate-term rates are higher than both short-term and long-term rates.
depreciation is considered in the determination of the net present value of an investment. This answer is correct because depreciation is a noncash expense that affects future cash flows through its effect on income taxes.

NPV assumes that cash inflows from the investment project can be reinvested at the cost of capital while IRR assumes that cash flows from each project can be reinvested at the IRR for that particular project. This underlying assumption is considered to be a weakness of the IRR technique.

Net Present Value The net present value (NPV) method is a discounted cash flow method which calculates the present value of the future cash flows of a project and compares this with the investment outlay required to im-plement the project. The net present value of a project is defined as NPV = (Present value of future cash flows) (Required investment) The calculation of the present value of the future cash flows requires the selection of a discount rate (also referred to as the target or hurdle rate). The rate used should be the minimum rate of return that management is willing to accept on capital investment projects. The rate used should be no less than the cost of capitalthe rate management currently must pay to obtain funds. A project which earns exactly the desired rate of return will have a net present value of 0. A positive net present value identifies projects which will earn in excess of the minimum rate. For example, if a company desires a minimum return of 6% on an investment of $10,000 that has an expected return of $2,500 for five years, the present value of the cash flows is $10,530 ($2,500 4.212: 4.212 is the TVMF for the present value of an annuity, n = 5, i = 6%; see the previous section on Present Value Concepts). The net present value of $530 ($10,530 $10,000) indicates that the project will earn a return in excess of the 6% minimum desired. If the requirements were for a netof-tax return of 6%, and the net-of-tax cash flow were $2,300, that amount would be multiplied by 4.212. This would result in a present value of $9,688 for the cash inflows, which is less than the $10,000 initial outlay. Therefore, this investment should not be made. The NPV method is based on cash flows and would ignore depreciation if taxes were not considered. As shown earlier, however, depreciation results in a tax savings (tax shield) that must be factored into the evaluation. For example, assume that a company is considering the purchase of equipment costing $20,000 for use in a new project. MACRS is used to depreciate equipment for tax purposes, under which the machine has a useful life of seven years. The required rate of return of the company is 8%. The pres-ent value of the tax savings from depreciation would be as follows:

Year Income tax deduction for depreciation at 30% tax rate 8% Discount factor Present value at 8%* 1 2 3 4 5 6 7 8 $ 2,858 4,898 3,498 2,498 1,786 1,784 1,786 892 $ 857 1,469 .857 1,049 .794 749 .735 536 .681 535 .630 536 .583 268 .540 $ 4,596 * Tax savings Discount factor Therefore, $4,596 would be included in the NPV computation as a cash inflow from the equipment. The excess present value (profitability) index computes the ratio of the present value of the cash in-flows to the initial cost of a project. It is used to implement the net present value method when there is a limit on funds available for capital investments. Assuming other factors are equal, this is accomplished by allocating funds to those projects with the highest excess present value indexes. .926 $ 794 Income tax savings

1,259 833 551 365 337 312 145

, the net present value of each alternative is calculated using the minimum required rate of return. Then the excess present value index is computed (Present value of futurenet cash inflows) 100 = Divded by (Initial investment) If the index is equal to or greater than 100%, the project will generate a return equal to or greater than the required rate of return. Net present value methods are the most widely accepted methods of evaluating a capital expenditure. Their advantages include Presents results in dollars which are easily understood Adjusts for the time value of money Considers the total profitability of the project Excess present value index

Provides a straightforward method of controlling for the risk of competing projectshigher-risk cash flows can be discounted at a higher interest rate Provides a direct estimate of the change in shareholder wealth resulting from undertaking a project The limitations of net present value methods include

May not be considered as simple or intuitive as some other methods

Does not take into account the management flexibility with respect to a projectmanagement may be able to adjust the amount invested after the first year or two depending on the actual returns.
When a company is considering exchanging an old asset for a new asset, the only factors that are economically relevant to the decision are those that differ between the two alternatives. When income tax considerations are ignored, the original cost of the old asset is irrelevant because the amount is unavoidable. It is a sunk cost. Sunk costs are irrelevant because they are the result of the past decision and, thus, will not affect the decision at hand. Fair market value of the old asset is relevant because, if the company decides to exchange the old asset, its fair market value could represent a reduction of the investment or cash outlay to acquire the new asset.

Hedging EXAMPLE: Several years ago a firm entered into a $20,000,000, ten-year noncallable debt agreement. The agreement calls for variable interest payments tied to the London Interbank Offered Rate (LIBOR). LIBOR is currently 4.5% but management is concerned about the volatility of current rates and wants to lock in a fixed rate for this debt. The firm enters into an interest rate swap to pay 7% fixed interest for the remaining term of the loan instead of the variable rate. In this way it is able to hedge its interest rate risk. Instead of having a variable interest expense over the life of the loan, the firm will have a fixed rate of 7%. The financial statement effects of this transaction would be recognition of a 7% fixed rate of interest over the life of the loan as opposed to the variable rate. If firm has variable rate interest loan and wants to hedge against Can do following:

1.) Interest Rate Swap 2.) Forward Contract to sell T-bonds in future 3.) Purchase a short position in T-bills future market IRR This means that the present value of future net cash inflows, discounted at 12%, is exactly equal to the cost of the project. The project provides an annual inflow of $20,000 for 8 years. The relationship can be shown as:

Project cost/annual cash inflow = x = 4.968

PV of ordinary annuity factor for 12%

$20,000 x x = = 4.968 $20,000 $99,360

Note that in practice, the project cost is ordinarily known and the annuity factor is the unknown. Once the factor is derived, the rate is found in an ordinary annuity table.

The net present value consistently provides the best solutions even when considering mutually exclusive projects. Net present value works better than the internal rate of return in a situation in which a choice must be made among a group of investments. The internal rate of return method is based upon an important assumption when comparing investments of different lives and different cash flow patterns. The method implicitly assumes that the cash inflows from an investment can be reinvested at the same internal rate of return. For example, assume a company must choose between two projects, C and D. The IRR on project C is 15% with a life of five years, while the IRR of project D is 13% with a life of ten years. Project C would be the one selected under the IRR criteria. However, the internal rate of return method assumes that the cash inflows from the project can be reinvested at 15%. If the cash inflows can only be reinvested at 9%, then project B may be the better alternative. Therefore, we see that traditional IRR criteria may not arrive at the best solution in all cases. As a result, many firms rely on net present value criteria when evaluating competing proposals.

Return on a Single Asset 1. Investment return is the total gain or loss on an investment for a period of time. It consists of the change in the assets value (either gain or loss) plus any cash distributions (e.g., cash flow, interest, or dividends). The return is illustrated by the following equation: Rt+1 Pt Where Rt+1 Pt+1 Pt = = = The investment return from time t to t +1 The assets price (market value) at t+1 The assets price (market value) at t Cash flow received from the asset from t to t +1 = Pt+1Pt+CFt+1

CFt+1 =

This formula measures return on an ex post basis (after the fact) and, therefore, does not consider risk. Managers have to evaluate investments on an ex ante basis and, therefore, must use expected returns and estimates of risk. Economic Rate of Return for Common Stock (Dividends + change in price) divided by beginning price

While project B does have the highest relative profitability, as measured using the profitability index in question 14 above, it does not have the highest absolute profitability as measured using net present value. When ranking mutually exclusive projects, net present value must be used. An exception is if there is a capital rationing constraint, but no such constraint exists in this case since the company has sufficient financing available for any of the four projects.

Measuring the Systematic Risk of an Individual Investment The variance of an individual investment captures the total risk of the investment, both systematic and unsystematic. However, since unsystematic risk can be eliminated by diversification, the variance of a specific investment is not a particularly useful measure when considering a portfolio of assets. A standardized measure
The beta of a particular asset equals the covariance of the assets returns with the returns of the overall portfolio divided by the portfolios variance. It measures how the value of the investment moves with changes in the value of the total portfolio. Therefore, it can be used to evaluate the effect of an individual investments risk on the risk of the entire portfolio.

The following chart summarizes the strengths and weaknesses of the capital budgeting methods.

Methods Payback Strengths 1. Easy to understand and use Weaknesses** 1. Ignores time value of money

2. Emphasizes liquidity

2. Ignores cash flows after payback period

3. Does not measure profitability

Net Present Value (NVP) Strengths 1. Emphasizes cash flows 2. Recognizes time value of money return Weaknesses** 1. Favors larger, longer projects 2. Assumes no change in required rate of

3. Assumes discount rate is reinvestment rate* 4. Easy to apply 5. Concerned with maximizing shareholder value

Internal Rate of Return (IRR) Strengths 1. Emphasizes cash flows 2. Recognizes time value of money 3. Computes true return of projects Weaknesses** 1. Assumes IRR is the reinvestment rate* 2. Favors shorter projects

Accounting rate of Return (ARR) Strengths 1. Easy to understand and use Weaknesses** 1. Does not emphasize cash flows 2. Ignores time value of money 2. Ties in with income statement and performance evaluation 3. Misstates the true return of projects * Note that assuming the discount rate is the reinvestment rate results in using the same reinvestment rate for projects of similar risk, while assuming the IRR is the reinvestment rate assumes higher reinvestment rates for projects with higher true returns, regardless of the risk involved. ** All methods share the weakness of assuming future cash flows are certain.
The internal rate of return (IRR) of a project is the discount rate at which the present value of the projects cash flows will exactly equal its initial investment (i.e., net present value = $0). Under this method, the cash flow over the entire life of the project, as well as the time value of money as expressed in a time value of money factor (TVMF) are taken into consideration. The accounting rate of return (ARR) computes an approximate rate of return, but ignores the time value of money. It is computed as follows: Expected increase in annual net income Investment * The numerator used for ARR is the increase in annual net income (not cash flows). ARR = Stated Versus Effective Annual Interest Rates Management must make objective comparisons of loan costs or investment returns over different compounding periods. In order to put interest rates on a common basis for comparison, management must distinguish between the stated interest rate and the effective annual interest rate. While the stated rate is the contractual rate charged by the lender, the effective annual rate is the true annual return to the lender. The simple annual rate may vary from the effective annual rate because interest is often compounded more often than annually. The formula for calculating the effective annual rate from the stated rate is presented below.

r = The stated interest rate m = Compounding frequency EXAMPLE: Assume that management is evaluating a loan that has a stated interest rate of 8% with compounding of interest quarterly. Since compounding is quarterly, m is equal to 4 because interest is compounded 4 times each year. Using the following equation, the effective annual rate may be computed as follows:

The frequency of compounding - explains the difference between the stated rate and the effective rate. Payback and Discounted Payback The payback method evaluates investments on the length of time until recapture (return) of the investment. For example, if a $10,000 investment were to return a cash flow of $2,500 a year for eight years, the payback pe-riod would be four years. If the payback period is to be computed after income taxes, it is necessary to calculate cash flow as shown below, remembering that depreciation itself does not consume cash. Assuming an eight-year life with no salvage value and a 40% income tax rate, the aftertax payback period would be computed as follows: Cash flow: $2,500 (1 40%) = $1,500 Tax savings from depreciation: $1,250 40% = $500 Cash flow after tax: $1,500 + $500 = $2,000 $10,000 $2,000 = 5 years The payback method has a number of limitations. 1.) it ignores total project profitability and therefore has little or no connection to maximization of shareholder value. 2.) the method is not really effective in taking into account the time value of money.

The discounted payback method is essentially the same as the payback method except that in calculating the payback period, cash flows are first discounted to their present value. This is only a minor improvement over the conventional payback method. It still ignores any cash flows after the cutoff period and therefore does not consider total project profitability. Using the above example, assume that the cost of capital for the firm is 8%. The discounted payback would be calculated as shown below. Discounted payback Cash flow after taxes = $2,000 Year 1 1 2 3 4 5 6 7 8 Cash flow $2,000 Present value factor .926 $2,000 .926 2,000 .857 2,000 .794 2,000 .735 2,000 .681 2,000 .630 2,000 .583 2,000 .540 Present value of Cumulative present cash flow $1,852 value $1,852 $1,852 $1,852 1,714 3,566 1,588 5,154 1,470 6,624 1,362 7,986 1,260 9,246 1,166 10,412 1,080 11,492

From the table we see that the discounted payback occurs in year 7. Specifically, it occurs when $754 ($10,000 $9,246) of cash flow is received in that year. By dividing the $754 needed cash flow by the total $1,166 cash flows in year 7, we see that we need .65 of year 7 cash flows. Therefore, the discounted payback period is 6.65 years. The profitability index is calculated as the ratio of the net present value of the project to its initial cost Profitability Index = NPV / Initial Cost

Probability The set of all possible outcomes from an investment with a probability assigned to each outcome is referred to as a probability distribution. Probability distributions may be discrete or continuous. A discrete distribution identifies a limited number of potential outcomes and assigns probabilities to each of the outcomes. A continuous distribution theoretically defines an infinite number of possible outcomes. A commonly used continuous distribution is the normal distribution (bellshaped curve). The normal distribution is useful because it approximates many real-world situations and it can be completely described with only two statistics, its mean and its standard deviation. Normal distributions have the following fixed relationships between distance from the mean and area under the curve: Distance in standard deviations from the mean 1.00 1.64 1.96 2.00 2.57

Area under the curve 68.3% 90.0% 95.0% 95.4% 99.0%

Therefore, by knowing the mean (expected value) and the standard deviation, management can construct a confidence interval for a particular outcome. As an example, 95% of the outcomes will fall within the mean (expected value) plus or minus 1.96 standard deviations. The following chart illustrates this point in graphic form:

Capital budgeting is based on predictions of an uncertain future. all capital budgeting methods are based on predictions of future income or cash flows

Capital budgeting is a technique to evaluate and control long-term investments. There are six

1. 2. 3. 4. 5. 6.

Identification stage. Management determines the type of capital projects that are n and strategies. Search stage. Management attempts to identify alternative capital investments that w Information-acquisition stage. Management attempts to revaluate the various inve Selection stage. Management chooses the projects that best meet the criteria establi Financing stage. Management decides on the best source of funding for the project. Implementation and control stage. Management undertakes the project and monito

This section will focus primarily on the techniques management uses to evaluate various proje used to monitor their performance. Capital budgeting alternatives are typically evaluated usin techniques involve evaluation of an investment today in terms of the present value of future c objective is to identify the most profitable or best investment alternative. The cash returns ca the project. If the project will produce revenue, the return is the difference between the cash r (outflows). Other projects generate cost savings (e.g., cash outflows for labor that are not ma efficient). The latter are, in effect, reductions in outflows, which for simplicity, can be treated both type of projects are the same. The entity ends up with more cash by making the initial ca The following terminology is useful to the understanding of capital budgeting analysis:

a. Sunk, past, or unavoidable costs are committed costs that are not avoidable and are the b.Avoidable costs are costs that will not continue to be incurred if a department or product i c. Committed costs arise from a companys basic commitment to open its doors and engage management salaries). d.Discretionary costs are fixed costs whose level is set by current management decisions (e e. Relevant costs are future costs that will change as a result of a specific decision. f. Differential (incremental) cost is the difference in cost between two alternatives. g.Opportunity cost is the maximum income or savings (benefit) foregone by rejecting an alte h.Outlay (out-of-pocket) cost is the cash disbursement associated with a specific project. The choice among alternative investing decisions can be made on the basis of several capital b payback; (2) Accounting rate of return; (3) Net present value, (4) Excess present value index, Sensitivity Analysis Most capital budgeting problems require management to make many assumptions before arriving at the investments net present value. For example, forecasting projected cash flows may require assumptions about demand, costs of production, selling price, etc. When using sensitivity analysis, managers explore the importance of these assumptions. First, managers compute the expected (most likely) results. Then, management allows one variable to change while holding the others constant, and the net present value is recomputed. By repeating the process with all the important variables, management can determine how sensitive the net present value is to changes in each major assumption. Therefore, sensitivity analysis involves exploring what if situations to determine the variables to which the outcomes are particularly sensitive. Management can then challenge its assumptions about these sensitive variables.

Compounding For any given quoted nominal rate, the least frequent compounding is associated with the lowest effective annual percentage cost. Annual compounding is less frequent than semiannual, quarterly, or monthly. Note that the term of the loan is not relevant to the calculation of the effective annual percentage cost of financing.