8-Capital Budgeting
8-Capital Budgeting
8-Capital Budgeting
Capital Budgeting
The process of evaluating and ranking
alternative long-range projects for the
purpose of allocating limited resources
– Plan and prepare the capital budget
– Review past investments
• assess success of past decisions and
• enhance the decision process in the future
2
Investment vs. Financing
Investment Decision Financing Decision
Which assets to Debt or equity
acquire
Made by divisional
Made by Treasurer and
top management
managers and top
Interest is a financing
management
decision
3
True or False?
Project funding is an investing decision.
-False
4
Capital Budgeting:
Part of the Financial Budget
Statement of
Cash Budget
Cash Flows
Capital
Statement of Budget
Comprehensive Operating Budget
Income
Statement of
Retained Earnings Balance Sheet
5
Capital Budgeting Process
6
True or False?
Capital budgeting uses financial criteria
exclusively when evaluating projects.
-False
7
Selection
9
Capital Budgeting --Qualitative
Employee morale, safety, and
responsibility
Corporate image
Social responsibility
Market share
Growth
10
Capital Budgeting --Quantitative
11
1. Accounting Rate of Return
13
Example
OfficePro Industries is considering the
purchase of a P100,000 machine that is
expected to result in a decrease of P15,000
per year in expenses. This machine, which
has no residual value, has an estimated
useful life of 10 years and will be
depreciated on a straight-line basis. For this
machine, the accounting rate of return
would be
P15,000/(P100,000/2) = 30%
14
Example
Allen’s Retail is considering an investment in a
delivery truck. Allen has found a used truck that
he can purchase for P8,000. He estimates the
truck would last six years and increase his
store's net revenues by P2,000 per year. At the
end of six years, the truck would have no
salvage value and would be discarded. Allen
will depreciate the truck using the straight-line
method. What is the accounting rate of return
on the truck investment (based on average
profit and average investment)?
P2,000/P4,000 = 50%
15
Average Investment = (P8,000 + 0)/2 = P4,000
Cash Flow
Cash Receipts
1. Revenues earned and collected
2. Savings generated by reducing opex
3. Proceeds from sale of assets
Cash Disbursements
1. Expenditures for asset acquisition
2. Working capital investments
3. Costs for DM, DL, and FOH
16
2. A popular, but flawed,
measure...
Payback period
– number of years until the cash flows from a
project equal the project’s cost
Decision rule: Accept project if payback
period is less than a maximum desired
time period
17
Payback Period
Original Investment
= Payback Period
Annual Cash Inflows
(assuming equal cash flows)
Example:
Original Investment P25,000
Annual Cash Inflows P10,000
Payback Period 2.5 years
18
Example:
Cost of Investment needed: P20,000
Cash Cumulative Amount
YR Flow Cash flow Needed
1 5,800 5,800 14,200
2 5,800 11,600 8,400
3 5,800 17,400 2,600
4 5,800
Fraction of year: 2,600/5,800 = 0.45
Payback = 3.45 years
19
Payback’s Drawbacks
20
Discounted Cash Flow Methods
21
Discount Rate %
Discount rate should equal or exceed
the cost of capital
22
3. Net Present Value
23
Net Present Value
24
True or False
25
Cash Flow Data
27
28
NPV of Project B
CASH 10% PRESENT
YR FLOW x PVIF = VALUE
0 -P25,000 1.000 -P25,000
1 4,000 0.909 3,636
2 4,000 0.826 3,304
3 8,000 0.751 6,008
4 10,000 0.683 6,830
5 10,000 0.621 6,210
Net Present Value = P 988
29
(round off PV factors to three decimal places)
Example
Jolie Productions is considering the purchase of a
new movie camera, which will be used for major
motion pictures. The new camera will cost P30,000,
have an eight-year life, and create cost savings of
P5,000 per year. The new camera will require P700
of maintenance each year. Jolie Productions uses a
discount rate of 9 percent. Compute NPV. Round
off PV factors to the nearest four decimal places.
30
Reminder: Cash Flow
Cash Receipts
1. Revenues earned and collected
2. Savings generated by reducing opex
3. Proceeds from sale of assets
Cash Disbursements
1. Expenditures for asset acquisition
2. Working capital investments
3. Costs for DM, DL, and FOH
31
NPV: Decision Rule
33
NPV Profile
Figure 13.1 Relationship Between NPV and Discount Rates: NPV Profile
10000.00
8000.00
6000.00
NPV ($)
4000.00
2000.00
0.00
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12 0.13 0.14 0.15 0.16 0.17
-2000.00
Discount Rate (in decim al)
34
True or False
35
4. Profitability Index
Compares present value of net cash
flows to net investment
Measures efficiency of the use of capital
Does not calculate the rate of return
36
Profitability Index
Project 1 2
PV of net cash flows P900,000 P580,000
Net investment 720,000 425,000
Net present value P180,000 P155,000
Compute NPV
Profitability Index
and PI.
P900,000/P720,000 1.25
P580,000/P425,000 1.36
38
5. Internal Rate of Return
39
What Does the IRR Measure?
40
Solution Methods
41
Example
Houston Corporation is considering an investment in a
labor-saving machine. Information on this machine
follows:
•Cost, P30,000
•Salvage value in five years, P0
•Estimated life, 5 years
•Annual depreciation, P6,000
•Annual reduction in existing costs, P8,000
43
IRR: Issue
44
Relationships
45
NPV vs. IRR
They may rank projects differently
46
Modified Internal Rate of Return
47
Modified Internal Rate of Return:
Three step process
1. Find the present value of all cash outflows
2. Find the future value of all cash inflows at
the end of the project’s life at year n. This
lump sum is called the terminal value.
3. MIRR is the discount rate which equates the
present value of the outflows and the future
value of the inflows:
FV at year n = PV (1 + MIRR)n
48
MIRR for Project A
1. Present value of outflows = 20,000 (no
additional calculation needed)
2. Find FV as of year 5 for cash inflows from
years 1-5 if cash inflow per year = P5,800:
5800 (1.10)4 = 8491.78
5800 (1.10)3 = 7719.80
5800 (1.10)2 = 7018.00
5800 (1.10)1 = 6380.00
5800 (1.10)0 = 5800.00
Terminal value (sum of FV) = 35,409.58
49
MIRR for Project A
PV of outflows: 20,000
Terminal value (sum of FV of inflows) =
35,409.58
3. FV = PV(1 + MIRR)n
= P35,409.58= P20,000(1 + MIRR)5
Solving, we find the MIRR is 12.10 percent
Accept project as MIRR>10% required
return
50
Capital Budgeting: Limitations
Management preferences regarding
timing of cash flows are not included
Single, deterministic measures of cash
flow are used rather than probabilities
51
Payback
Assumptions Limitations
Speedy recovery of Ignores cash flows
investment is key after payback
Cash flows can be Ignores time value
accurately predicted of money
Risk is lower for the
shorter payback
project
52
Net Present Value
Assumptions Limitations
• Discount rate is valid • Alternative project
• Timing and size of cash rates of return are
flows can be predicted not known
• Life of project can be • Internal rate of
predicted return on project is
not reflected
53
Profitability Index
Assumptions Limitations
• Measures efficient use of • A relative answer is
capital given but pesos of NPV
• Discount rate is valid are not reflected
• Timing and size of cash • Alternative project rates
N of return are not known
N
flows can be predicted
P• P
Life of project can be • Internal rate of return on
V project is not reflected V
predicted
Internal Rate of Return (IRR)
Assumptions Limitations
• Hurdle rate is valid • Projects are ranked by
• Timing and size of cash IRR and not peso size
flows can be predicted • Net present value
• Project life can be pesos are not reflected
predicted • Multiple rates of return
• If shorter project can be calculated on
selected, proceeds of the same project
shorter project will
continue to earn the IRR
through theoretical
completion of longer
project
Comparing Techniques
Payback NPV PI
Uses time value money IRR Y or N?
Provides specific rate of return N Y Y
Y or N? Y
Uses cash flows N N N
Y or N? Y
Considers all returns Y Y Y
Y or N? Y
Uses discount rate N Y Y
Y or N? Y
N Y Y N
56
problem solving: ARR
The Arrival, Inc., is planning to spend
P600,000 for a machine that it will depreciate
on a straight-line basis over a ten-year period
with no terminal disposal price. The machine
will generate cash flow from operations of
P120,000 a year. Ignoring income taxes, what
is the accounting rate of return?
Answer: 40%
57
problem solving: ARR and payback
Ellis & Associates operates a rehabilitation center for individuals
with physical disabilities. The company is considering the
purchase of a P1,200,000 piece of equipment that has a five-
year life and no salvage value. The company depreciates
assets on a straight-line basis. The expected annual cash flow
on a before-tax basis for this equipment is P400,000. Ellis
requires that an investment be recouped in less than five years
and have a pre-tax accounting rate of return of at least 18
percent.
a. Compute the accounting rate of return.
c. Accept or reject?
Answers:
a. ARR = P160,000 ÷ (P1,200,000 ÷ 2) = 26.67%
b. Payback = P1,200,000 ÷ P400,000 per year = 3 years
c. Accept. 58
problem solving: ARR and payback
Fashion Foto is evaluating the purchase of a state-of-the-art desktop
publishing system that costs P40,000, has six-year life, and has no
salvage value at the end of its life. The company’s controller estimates
that the system will annually generate P14,000 of cash receipts and
create P2,000 of cash operating costs. The company’s tax rate is
expected to be 30 percent during the life of the asset, and the company
uses straight-line depreciation.
a. Determine the annual after-tax cash flows from the project.
b. Determine the after-tax payback period for the project.
c. Determine the after-tax ARR for the project.
Answers:
a. Annual cash receipts P14,000
Cash expenses (2,000)
Net cash flow before taxes 12,000
Depreciation (6,667)
Income before tax 5,333
Taxes (1,600)
Net income 3,733
Depreciation 6,667 59
problem solving: ARR and payback
Fashion Foto is evaluating the purchase of a state-of-the-art desktop
publishing system that costs P40,000, has six-year life, and has no
salvage value at the end of its life. The company’s controller estimates
that the system will annually generate P14,000 of cash receipts and
create P2,000 of cash operating costs. The company’s tax rate is
expected to be 30 percent during the life of the asset, and the company
uses straight-line depreciation.
a. Determine the annual after-tax cash flows from the project.
b. Determine the after-tax payback period for the project.
c. Determine the after-tax ARR for the project.
Answers:
b. Payback = P40,000 ÷ P10,400 per year = 3.85 years
c. ARR = P3,733 ÷ (P40,000 ÷ 2) = 18.66%
60
problem solving: ARR and payback
The Mais Company has invested in a machine that
cost P70,000, that has a useful life of seven years,
and that has no salvage value at the end of its useful
life. The machine is being depreciated by the straight-
line method, based on its useful life. It will have a
payback period of four years. Given these data, the
simple rate of return based on initial investment (to
the nearest tenth of a percent) on the machine will be
(ignore taxes)
Answer: 10.7%
61
problem solving: Payback
Resnick Inc. is considering a project that has the
following cash flow data. What is the project's
payback?
Year 0 1 2 3
Cash flows -$350 $200 $200 $200
a. 1.42 years
b. 1.58 years
c. 1.75 years
d. 1.93 years
e. 2.12 years
62
problem solving: Payback
Susmel Inc. is considering a project that has the
following cash flow data. What is the project's
payback?
Year 0 1 2 3
Cash flows -$500 $150 $200 $300
a. 2.03 years
b. 2.25 years
c. 2.50 years
d. 2.75 years
e. 3.03 years
63
problem solving: Payback
Fernando Designs is considering a project that has the
following cash flow and WACC data. What is the
project's discounted payback?
WACC: 10.00%
Year 0 1 2 3
Cash flows -$900 $500 $500 $500
a. 1.88 years
b. 2.09 years
c. 2.29 years
d. 2.52 years
e. 2.78 years
64
problem solving: Payback
Masulis Inc. is considering a project that has the
following cash flow and WACC data. What is the
project's discounted payback?
WACC: 10.00%
Year 0 1 2 3 4
Cash flows -$950 $525 $485 $445 $405
a. 1.61 years
b. 1.79 years
c. 1.99 years
d. 2.22 years
e. 2.44 years
65
problem solving: NPV
Anderson Systems is considering a project that has the
following cash flow and WACC data. What is the
project's NPV? Note that if a project's projected NPV is
negative, it should be rejected.
WACC: 9.00%
Year 0 1 2 3
Cash flows -$1,000 $500 $500 $500
Answer: P265.65
66
problem solving: NPV
Tuttle Enterprises is considering a project that has the
following cash flow and WACC data. What is the
project's NPV? Note that if a project's projected NPV is
negative, it should be rejected.
WACC: 11.00%
Year 0 1 2 3 4
Cash flows -$1,000 $350 $350 $350 $350
Answer: P85.86
67
problem solving: NPV
Last month, Lloyd's Systems analyzed the project whose cash
flows are shown below. However, before the decision to accept or
reject the project, the Federal Reserve took actions that changed
interest rates and therefore the firm's WACC. The Fed's action did
not affect the forecasted cash flows. By how much did the change
in the WACC affect the project's forecasted NPV? Note that a
project's projected NPV can be negative, in which case it should be
rejected.
Old WACC: 10.00% New WACC: 11.25%
Year 0 1 2 3
Cash flows -$1,000 $410 $410 $410
a. -$18.89
b. -$19.88
c. -$20.93
d. -$22.03
e. -$23.13
68
problem solving: NPV
Lasik Vision Inc. recently analyzed the project whose cash flows
are shown below. However, before Lasik decided to accept or
reject the project, the Federal Reserve took actions that changed
interest rates and therefore the firm's WACC. The Fed's action did
not affect the forecasted cash flows. By how much did the change
in the WACC affect the project's forecasted NPV? Note that a
project's projected NPV can be negative, in which case it should be
rejected.
Old WACC: 8.00% New WACC: 11.25%
Year 0 1 2 3
Cash flows -$1,000 $410 $410 $410
a. -$59.03
b. -$56.08
c. -$53.27
d. -$50.61
e. -$48.08
69
problem solving: IRR
Simms Corp. is considering a project that has the
following cash flow data. What is the project's IRR?
Note that a project's projected IRR can be less than the
WACC or negative, in both cases it will be rejected.
Year 0 1 2 3
Cash flows -$1,000 $425 $425 $425
a. 12.55%
b. 13.21%
c. 13.87%
d. 14.56%
e. 15.29%
70
problem solving: IRR
Warr Company is considering a project that has the
following cash flow data. What is the project's IRR?
Note that a project's projected IRR can be less than the
WACC or negative, in both cases it will be rejected.
Year 0 1 2 3 4
Cash flows -$1,050 $400 $400 $400 $400
a. 14.05%
b. 15.61%
c. 17.34%
d. 19.27%
e. 21.20%
71
problem solving: comprehensive
A firm is considering two projects, A and B. Both have the same initial cash
outlay and the same payback period. Project A is expected to generate
after-tax cash flows for 10 years, while Project B is expected to generate
after-tax cash flows for 15 years. Given that payback is the same for both
projects, will the firm be indifferent between these two projects? Explain
why or why not.
Answer:
72
problem solving: comprehensive
A company is reviewing an investment proposal whose initial cost and
related data for each year, are presented in the following schedule. All
cash flows are assumed to take place at the end of the year. The salvage
value of the investment at the end of each year is equal to its net book
value, and there will be no salvage value at the end of the investment’s life.
Annual
Initial Cost Net After-Tax Annual
Year and Book Value Cash Flows Net Income
0 P105,000 P -0- P -0-
1 70,000 50,000 15,000
2 42,000 45,000 17,000
3 21,000 40,000 19,000
4 7,000 35,000 21,000
5 -0- 30,000 23,000
The company uses a 24% after-tax target rate of return for new investment
proposals. Round off PV factors to two decimal places.
Answer: 2.25 73
problem solving: comprehensive
A company is reviewing an investment proposal whose initial cost and
related data for each year, are presented in the following schedule. All
cash flows are assumed to take place at the end of the year. The salvage
value of the investment at the end of each year is equal to its net book
value, and there will be no salvage value at the end of the investment’s life.
Annual
Initial Cost Net After-Tax Annual
Year and Book Value Cash Flows Net Income
0 P105,000 P -0- P -0-
1 70,000 50,000 15,000
2 42,000 45,000 17,000
3 21,000 40,000 19,000
4 7,000 35,000 21,000
5 -0- 30,000 23,000
The company uses a 24% after-tax target rate of return for new investment
proposals. (Round off PV factors to two decimal places.)
Answer: 18.1% 74
problem solving: comprehensive
A company is reviewing an investment proposal whose initial cost and
related data for each year, are presented in the following schedule. All
cash flows are assumed to take place at the end of the year. The salvage
value of the investment at the end of each year is equal to its net book
value, and there will be no salvage value at the end of the investment’s life.
Annual
Initial Cost Net After-Tax Annual
Year and Book Value Cash Flows Net Income
0 P105,000 P -0- P -0-
1 70,000 50,000 15,000
2 42,000 45,000 17,000
3 21,000 40,000 19,000
4 7,000 35,000 21,000
5 -0- 30,000 23,000
The company uses a 24% after-tax target rate of return for new investment
proposals. (Round off PV factors to two decimal places.)
77
problem solving: project ranking
Automobile Corp. is contemplating four projects: A, B, C, and D. The capital costs
for the initiation of each mutually-exclusive project and its estimated after-tax, net
cash flows are listed below. The company’s desired after-tax opportunity costs is
12%. It has P900,000 capital budget for the year. Idle funds cannot be reinvested at
greater than 12%.
In Thousand Pesos
A B C D
Initial cost 400 470 380 420
Annual cash flows
Year 1 113 180 90 80
Year 2 113 170 110 100
Year 3 113 150 130 120
Year 4 113 110 140 130
Year 5 113 100 150 150
Net present value P7,540 P59,654 P54,666 P(15,708)
IRR 12.7% 17.6% 17.2% 10.6%
Excess present value index 1.02 1.13 1.14 0.96
78
The company will choose
True or False
79
Conflicts Between NPV, IRR, MIRR,
Profitability Index
Different rankings may occur if projects
are mutually exclusive.
Most likely happens when projects have
different cash flow patterns
– Projects with larger and earlier cash flows
may have higher IRR rankings than those
with larger later cash flows
80
Conflicts Between NPV, IRR, MIRR,
Profitability Index
Different time horizons
– Project Long and Project Short require
P100 investment
– Short: returns P200 in 2 years
• IRR = 41.42%
• NPV (at 10% required return) = P65.29
– Long: returns P2,000 in 20 years
• IRR =16.16%
• NPV (at 10% required return) = P197.29
81
Conflicts Between NPV, IRR, MIRR,
Profitability Index
Different Sizes
– Projects with smaller initial investments may have
higher IRR and higher PI and smaller NPV than
projects with larger initial investments.
83
What Managers Use
84
Risk-related Considerations
85
Risk-related Considerations
86
Risk-adjusted Discount Rate
87
An Example
Average risk:
Discount rate = cost of capital
Below-average risk:
Discount rate = cost of capital –2%
Above-average risk:
Discount rate = cost of capital + 2%
High risk:
Discount rate = cost of capital + 5%
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End