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Capital Budgeting and Cost

Analysis

- AIM 4343 04/12/2004

Introduction

- Capital budgeting methods deal with how to

select projects (or programs) that increase

rather than decrease the capital (value) of

a business. - These methods assist managers in analyzing

projects that span multiple years.

Cost Analysis

- Life-cycle costing accumulates revenues and

costs on a project-by-project basis. - This accumulation extends the accrual accounting

system that measures income on a

period-by-period basis to a system that computes

cash flow or income over the entire project

covering many accounting periods.

Cost Analysis

Project D

Project C

Project B

Project A

2000

2001

2002

2003

2004

Cost Analysis

- The life of the project is usually longer than

one year, so capital budgeting decisions consider

revenues and costs over relatively long periods.

Capital Budgeting

- Capital budgeting is the making of long-run

planning decisions for investments in projects

and programs. - It is a decision-making and control tool that

focuses primarily on projects or programs that

span multiple years.

Capital Budgeting

- Capital budgeting is a six-stage process
- Identification stage. To distinguish which types

of capital expenditure projects are necessary to

accomplish organization objectives. - Search stage. To explore alternative capital

investments that will achieve organization

objectives.

Capital Budgeting

- Information-acquisition stage. To consider the

expected costs and the expected benefits of

alternative capital investments. - Selection stage. To choose projects for

implementation. - Financing stage. To obtain project funding.
- Implementation and control stage. To get projects

underway and monitor their performance.

Capital Budgeting

- Healthy Living is a non-profit organization.
- One of its goals is to improve the diagnostic

capabilities of its Miami facility. - Management identifies a need to consider the

purchase of new, state-of-the-art equipment. - The search stage yields several alternative

models, but management focuses on one machine as

being particularly suitable.

Capital Budgeting

- The administration next begins to acquire

information to do more detailed evaluation. - The required net initial investment consists of

the cost of the new machine (245,000) plus an

additional cash investment in working capital

(supplies and spare parts) of 5,000. - Management expects the new machine to have a

three-year useful life and a 0 terminal disposal

price at the end of the three years.

Capital Budgeting

- This proposed investment will yield net cash

savings of 125,000, 130,000, and 110,000 over

its life. - The working capital investment of 5,000 is

expected to be recovered at the end of year 3. - Operating cash flows are assumed to occur at the

end of the year.

Capital Budgeting

- Management also identifies the following

nonfinancial quantitative and qualitative

benefits of investing in the new diagnostic

machine. - Improved diagnoses and patient care
- Reduced inconvenience of transporting patients to

other facilities for diagnoses

Capital Budgeting

- Nonfinancial benefits are not incorporated into

the analysis. - In the selection stage, management must decide

whether Healthy Living should purchase the new

machine. - Assume that the required rate of return for

Healthy Living is 10.

Discounted Cash Flow

- Discounted cash-flow (DCF) methods measure all

expected future cash inflows and outflows of

a project as if they occurred at a single point

in time. - The discounted cash-flow methods incorporate the

time value of money.

Discounted Cash Flow

- The time value of money means that a dollar

received today is worth more than a

dollar received at any future time. - Why?
- Because it can earn income and become greater in

the future.

Net Present Value

- The NPV method computes the expected net

monetary gain or loss from a project by

discounting all expected cash flows to the

present point in time, using the required rate of

return. - Managements minimum desired rate of return is

also called the discount rate, hurdle rate,

required rate of return, or cost of capital.

Net Present Value

- Only projects with a zero or positive net present

value are acceptable. - What is the the net present value of the

diagnostic machine?

Net Present Value

Sketch of Relevant Cash Flows

0

1

2

3

Net initial investment

(250,000)

125,000

130,000

115,000

Annual cash inflow

Net Present Value

- Net Cash

NPV of Net Year 10 Col. Inflows

Cash Inflows - 1 0.909 125,000 113,625
- 2 0.826 130,000 107,380
- 3 0.751 115,000 86,365

Total PV of net

cash inflows 307,370 Investment 250,000

Net present value of project 57,370

Net Present Value

- This project is acceptable because its net

present value is 57,370. - Assume that Healthy Living is considering another

investment that will generate 80,000 per year

for three years, and have a residual value of

4,000 at the end of the third year.

Net Present Value

- The cost of this investment is 250,000 including

working capital. - The working capital investment of 5,000 is

expected to be recovered at the end of year 3. - Healthy Living expects a return of 10.
- Should the investment be made?

Net Present Value

- No, the net present value is negative.
- Net Cash

NPV of Net Years 10 Col. Inflows

Cash Inflows 1-3 2.487 80,000 198,960

3 0.751 9,000 6,759 Total

PV of net cash inflows 205,719 Investment

250,000 Net present value of project

(44,281)

Internal Rate of Return...

- is another model using discounted cash flows.
- The internal rate-of-return (IRR) method

calculates the discount rate at which the present

value of expected cash inflows from a project

equals the present value of expected cash

outflows.

Internal Rate of Return

- Investment Expected annual net cash inflow PV

annuity factor - Investment Expected annual net cash inflow

PV annuity factor

Internal Rate of Return

- Assume that Healthy Living is considering

investing 303,280 in a scanning machine that

will yield net cash savings of 80,000 per year

over its five-year life. - What is the IRR of this project?
- 303,280 80,000 3.791 (PV annuity factor)

Internal Rate of Return

- The annuity table shows that 3.791 is in

the 10 column for a 5 period row in this

example. - Therefore, 10 is the internal rate of return of

this project. - If the minimum desired rate of return is 10 or

less, Healthy Living should undertake this

project.

Comparison of NPV and IRR

- The NPV method has the important advantage that

the end result of the computations is expressed

in dollars and not in a percentage. - Individual projects can be added to see the

effect of accepting a combination of projects. - It can be used in situations where the required

rate of return varies over the life of the

project.

Comparison of NPV and IRR

- The IRR of individual projects cannot be added or

averaged to derive the IRR of a combination of

projects.

Relevant Cash Flows

- Relevant cash flows are expected future cash

flows that differ among the alternatives. - Capital investment projects typically have three

major categories of cash flows - Net initial investment
- Cash flow from operations
- Cash flow from terminal disposal of assets and

recovery of working capital

Relevant Cash Flows

- Typically, net initial investment components are
- Initial asset investment
- Initial working capital investment
- Current disposal value of old asset

Net Initial Investment

- The original Healthy Living example included the

following - Initial machine investment 245,000

Initial working capital investment 5,000

Current disposal value of old machine 0

Cash Flow From Operations

- Cash inflows may result from producing and

selling additional goods or services, or, as in

the Healthy Living example, from savings in cash

operating costs. - Depreciation is irrelevant in DCF analysis

because it is a noncash allocation of costs. - DCF is based on inflows and outflows of cash.

Terminal Disposal Price

- At the end of the machines useful life the

terminal disposal price may be zero or an amount

considerably less than the initial machine

investment. - The original Healthy Living example assumed zero

disposal value of the new diagnostic machine.

Working Capital Recovery

- The initial investment in working capital is

usually fully recouped when the project is

terminated. - The relevant working capital cash inflow is the

5,000 that Healthy Living will recover in year

3.

Payback Method

- Payback measures the time it will take to recoup,

in the form of expected future cash flows, the

initial investment in a project.

Payback Method

- Assume that Healthy Living is considering buying

some equipment (Machine 1) for 210,000, with an

estimated useful life of 10 years, and zero

predicted residual value. - Managers expect use of the equipment to generate

35,000 of net cash inflows from operations per

year.

Payback Method

- How long would it take to recover the investment?
- 210,000 35,000 6 years
- 6 years is the payback period.

Payback Method

- Suppose that an alternative to the 210,000 piece

of equipment, there is another one (Machine 2)

that also costs 210,000 but will save 42,000

per year during its five-year life. - What is the payback period?
- 210,000 42,000 5 years
- Which piece of equipment is preferable?

Payback Method

- Machine 1 is preferable because it will continue

to generate net cash inflows for four years

after its payback period. - This will give the company an additional net

cash inflow of 140,000.

Payback Method

- When cash flows are uneven, calculations must

take a cumulative form. - Assume that Healthy Livings diagnostic machine

investment is going to yield net cash savings

of 160,000, 180,000, and 110,000 over its

life. - The initial investment is 250,000.
- What is the payback period?

Payback Method

- Year 1 brings in 160,000.
- Recovery of the amount invested occurs in Year

2.

Payback Method

- Payback
- 1 year
- 90,000 needed to complete recovery 180,000

net cash inflow in Year 2 - 1 year 0.5 year 1.5 years or,
- 1 year and 6 months

Income-Tax Considerations

- Although depreciation is a noncash expense, it

is a deductible cost for calculating tax outflow. - Taxes saved as a result of depreciation

deductions increase cash flows in discounted

cash-flow (DCF) computations.

Income-Tax Considerations

- Assume Miami Transit is considering the

replacement of an old piece of equipment with

new, more modern equipment. - The income tax rate is 40.
- The company uses straight-line depreciation.
- The tax effects of cash inflows and outflows

occur at the same time that the inflows and

outflows occur.

Income-Tax Considerations

- Old equipment

Current book value 50,000

Current disposal price 3,000

Terminal disposal price

(5 years) 0

Annual depreciation 10,000 Working

capital 5,000

Income-Tax Considerations

- Current disposal price of

old equipment 3,000

Deduct current book value

of old equipment 50,000

Loss on disposal of equipment 47,000 - How much is the tax savings?
- 47,000 0.40 18,800

Income-Tax Considerations

- What is the after-tax cash flow from current

disposal of old equipment? - Current disposal price 3,000

Tax savings on loss 18,800

Total 21,800

Income-Tax Considerations

- New equipment

Current book value 225,000

Current disposal price is irrelevant

Terminal disposal price (5 years)

0 Annual depreciation 45,000 Working

capital 15,000

Income-Tax Considerations

- How much is the net investment for the new

equipment? - Current cost 225,000 Add

increase in working capital 10,000 Deduct

after-tax cash flow from current

disposal of old equipment 21,800 Net

investment 213,200

Income-Tax Considerations

- Assume 90,000 pretax annual cash flow from

operations (excluding depreciation effect). - What is the after-tax flow from operations?
- Cash flow from operations 90,000 Deduct income

tax (40) 36,000 Annual after-tax flow from

operations 54,000

Income-Tax Considerations

- What is the difference in depreciation deduction?
- Annual depreciation of new

equipment 45,000 Deduct annual depreciation

of old equipment

10,000 Difference 35,000

Income-Tax Considerations

- What is the annual increase in income tax savings

from depreciation? - Increase in depreciation 35,000

Multiply by tax

rate .40 Income tax cash

savings from

additional depreciation 14,000

Income-Tax Considerations

- What is the cash flow from operations, net of

income taxes? - Annual after-tax flow from

operations 54,000 Income tax cash savings

from additional

depreciation 14,000 Cash flow from

operations, net

of income taxes 68,000

Income-Tax Considerations

- Miami Transit requires 14 rate of return on

its investments. - What is the net present value of the new

equipment incorporating income taxes?

Income-Tax Considerations

- Net Cash

NPV of Net Years 14 Col. Inflows

Cash Inflows - 1-5 3.433 68,000 233,444
- 5 0.519 10,000 5,190

Total PV of net cash inflows 238,636

Investment 213,200 Net present value of

new equipment 25,436

Postinvestment Audit

- A postinvestment audit compares the actual

results for a project to the costs and benefits

expected at the time the project was selected. - It provides management with feedback about

performance.

Intangible Assets

- Intangible assets are critical to most

organizations. - These assets have the potential to yield net cash

inflows many years into the future. - Top management can use a capital budgeting tool,

such as NPV, to summarize the difference in the

future net cash inflows from an intangible asset

at two different points in time.

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