CHAPTER M7

1
CHAPTER M7

• The Capital Budget
• Evaluating Capital Expenditures

2
Capital Investments

• Acquisitions of significant long-term assets are
  called capital investments (or capital
  projects).
  
• Due to the large amount of money being spent and
  the relative importance of these expenditures,
  managers spend a great deal of time evaluating
  the viable alternatives available to them.

3
Capital Budgeting

• The decision-making process that encompasses such
  expenditures is called capital budgeting.
  
• Individuals practice their own form of capital
  budgeting when they decide to buy a new car,
  house, or make some other major purchase.

4
Business Planning Process

• An organization needs to have a system of
  planning and control in order to achieve its
  goals.
  
• Organization goals represent the companys
  long-term aspirations as determined by upper
  management. Goal setting is THE WHY of the
  business.

WHY WHAT HOW WHO
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Nonfinancial Goals

• A company typically has many goals that are not
  centered around money.
  
• The nonfinancial goals are often highlighted in a
  mission statement or a similar document.

6
Financial Goals

• The main financial goal for most businesses is to
  turn a profit. Business owners have substantial
  amounts of capital at risk in most ventures, so
  they are concerned with earning an adequate
  return.
• This might be stated as fulfilling earnings
  potential, building shareholder value, or
  something similar.

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Mission Statement

• The mission statement for ProcterGamble is
  quoted below

PURPOSE We will provide products of superior qual
ity and valuethat improve the lives of the
worlds consumers.As a result, consumers will
reward us with leadershipsales and profit
growth, allowing our people, ourshareholders,
and the communities in which we liveand work to
prosper.
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Strategic Plan

• After goals have been set, a strategic plan or
  long-range budget need to be set.
  
• This plan will identify those actions that the
  firm will take to achieve its goals. It is
  important that these plans support, rather than
  conflict with, the companys goals.
• This is THE WHAT of doing business.

WHY WHAT HOW WHO
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Preparing the Capital Budget

• The capital budget identifies scarce resource
  allocations over the next several years. A budget
  period of five years, ten years, or even longer
  is not unusual.
• This is THE HOW of the business.
• The capital budget focuses on acquiring and
  replacing the significant long-lived assets.

WHY WHAT HOW WHO
10
The Operating Budget

• The day-to-day operations of the company also
  must be planned for and budgeted.
  
• An operating budget is used for this type of
  short-term planning, usually one year at a time,
  but possibly for more than one year.
  
• The operating budget is THE WHO of the business.

WHY WHAT HOW WHO
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Planning Interrelationships
Goals WHY
Strategic Plan WHAT
Capital Budget HOW
Operating Budget WHO
12
Capital Assets

• Long-lived assets are commonly referred to as
  capital assets. Whenever an expenditure is made
  to purchase something, the cost of that item will
  either be shown as an expense or as an asset.
• Capitalizing the expenditure is the process of
  recording the expenditure as an asset rather than
  an expense.

13
Capitalization Threshold

• Not all long-lived assets will be capitalized.
  This is essentially an application of the
  materiality principle in accounting.
  
• For very large companies, an asset may have to
  cost 5,000 or more before it will be
  capitalized. Smaller companies would have a
  significantly lower threshold, maybe something in
  the vicinity of 500.

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Characteristics of Capital Projects

• Long Lives Capital projects are more than one
  year in length. For example, a new office
  building may have an expected useful life of
  fifty years or more.
• High Cost The cost needs to be high enough to
  exceed the companys threshold for
  capitalization. Long-lived items with a small
  cost will be expensed immediately.

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Characteristics of Capital Projects

• Quickly Sunk Costs Expenditures involved in
  capital projects typically become sunk costs at
  an early stage. Sunk costs are costs that cannot
  be recovered.
• High Degree of Risk Do to the uncertainty in the
  long-range planning process, capital projects are
  inherently risky.

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Cost of Capital

• A business cannot raise funds without incurring a
  cost. The cost of capital represents a firms
  cost of acquiring debt or equity financing.
  
• The cost of capital is often used as a minimum
  desired rate of return on projects.
  
• Also called the cost of capital rate, required
  rate of return, or the hurdle rate.

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Blended Cost of Capital

• Many companies rely on financing from both debt
  and equity sources.
  
• Combining the cost of debt financing with the
  cost of equity financing is called the blended
  cost of capital.
  

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Cost of Debt Capital

• The cost of debt capital is basically equal to
  the effective interest rate on the long-term
  debt. The debt is typically in the form of
  either notes payable or bonds payable.
• If a company issues bonds, there is a cost
  involved in making the bond issuance, and this
  cost should also be included when determining the
  cost of debt capital.

19
Cost of Equity Capital

• The cost of equity capital can be a rather
  complicated concept. There is a cost of issuing
  the equity securities, but most of the cost is
  related to the rate of return on the securities
  for the investor.
• Dividends paid are included in the cost of
  capital, as is the investors expected amount of
  appreciation in the stock value.

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Example of Blended Cost of Capital

• The following example illustrates the calculation
  of the blended cost of capital
  
• Financing of Total Cost Rate
  Weighted Debt 30 X 9 2.7
  Equity 70 X 18 12.6 Weighted
  cost of capital 15.3

21
Scarce Resources

• If you have ever had the desire to spend or
  invest more money that you have available, then
  you understand the concept of scarce resources.
  
• A very important management job is to properly
  allocate the scarce resources that the company
  has available to them.

22
Evaluating Potential Projects

• Managers will evaluate capital projects by
• Identifying possible capital projects.
• Determining the relevant cash flows for the
  alternative projects.
  
• Selecting a method of evaluating the projects.
• Evaluating the projects and selecting one or
  more of the acceptable alternatives.

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Identifying Possible Projects

• A potential capital project is one that has the
  possibility of increasing revenues, decreasing
  expenses, or some combination of both. In other
  words, a capital project should have a positive
  impact on profits.
• Occasionally, a project is considered that will
  have a negative impact on profits. Some projects
  may even be forced upon the company.

24
Evaluation Methods

• We will consider four different methods for
  evaluating capital projects
  
• Net Present Value
• Internal Rate of Return
• Payback Period
• Accounting Rate of Return
• These four methods will often produce conflicting
  results regarding acceptability of the capital
  projects under consideration.

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Selecting Capital Projects

• The first step in selecting a capital budgeting
  project is to determine which projects are
  acceptable and which are not. This step is often
  called screening.
• The next step would be to rank the acceptable
  alternatives according to some criteria.
  Typically, the first choice would be the project
  with the highest ranking.

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Discounted Cash Flows

• Since these projects are long term in nature, it
  is wise to consider the time value of money in
  the capital budgeting analysis.
  
• Determining the present value of future cash
  flows is called discounting cash flows.
  
• The discounted cash flows methods are
• Net present value
• Internal rate of return

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Net Present Value

• The net present value (NPV) of a capital project
  is calculated by subtracting the present value of
  future cash outflows from the present value of
  future cash inflows.
• The future cash flows will be discounted to
  present value using the firms blended cost of
  capital (unless the project will be funded solely
  by debt or by equity).

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Net Present Value

• Generally speaking, any project that has a
  positive or net present value will be considered
  to be an acceptable project.
  
• Even with an NPV of zero, the project is earning
  the companys cost of capital. If the company
  wants to ensure that they will earn more than the
  cost of capital, then the cash flows should be
  discounted at a higher rate.

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NPV Example

• Assume that the ASU Company is considering a
  capital outlay of 60,000. This project should
  result in net cash inflows of 20,000 per year
  for the next four years.
• ASU has a blended cost of capital equal to 12.
  We will discount the future cash flows at the 12
  discount rate.

30
NPV Example
31
Extended NPV Example

• Most capital projects dont have equal cash
  inflows as illustrated in the previous example.
  
• Lets assume that ASU expects to generate only
  15,000 in year one, with the cash inflow
  increasing by 5,000 in each of the succeeding
  three years. Now the uneven cash flows must be
  separately discounted.

32
Extended NPV Example
33
Profitability Index

• Using NPV to compare different projects is
  appropriate if the projects require equal or
  similar amounts of initial investment.
  
• However, if the initial investments are not
  comparable, then the NPVs should be used to
  calculate the profitability index (PI) for each
  project.

34
Profitability Index Example

• Project 1 has future cash inflows with a present
  value of 110,500 and an initial investment of
  100,000. Thus, the NPV is 10,500 on project
  1.
• Project 2 has future cash inflows with a present
  value of 79,000 and an initial investment of
  70,000. Thus, the NPV is 9,000 on project 2.

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Profitability Index Example

• Project 1 appears to be the best investment
  because it has a higher NPV. However, the PI for
  each project should be calculated since the
  investments required are unequal.
• PI 1 110,500 / 100,000 1.105
• PI 2 79,000 / 70,000 1.129
• Using this measure, 2 is the preferable project.

36
Internal Rate of Return

• The NPV method provides a dollar answer, but it
  is impossible to tell what the percentage rate of
  return is on the project.
  
• The internal rate of return (IRR) is the expected
  percentage return promised by a capital project.
  It is also called the real rate of return or the
  time-adjusted rate of return.

37
IRR Example

• The BYU Company is considering two alternative
  projects.
  
• Project A1 requires an initial investment of
  50,000 and has expected annual cash inflows of
  15,750 for four years.
  
• Project B2 requires an initial investment of
  75,000 and has expected annual cash inflows of
  25,750 for four years.

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IRR Example

• Step 1 Calculate the present value factor.
  Initial investment Expected annual return
  PV factor
  
• Step 2 Find the PV factor on the appropriate
  row of the present value of an annuity of 1
  table.

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IRR Example

• Project A1 50,000 15,750 3.175For 4
  years, the factor 3.175 is very close to the
  factor for the 10 rate of return.

• Project B2 75,000 25,750 2.913For 4
  years, the factor 2.913 is very close to the
  factor for the 14 rate of return.

40
Comparing NPV and IRR

• If a capital project has a positive NPV, then the
  IRR will be above the companys required rate of
  return.
  
• If a capital project has a negative NPV, then the
  IRR will be below the companys required rate of
  return.
  
• If a capital project has an NPV of zero, then the
  IRR equals the required rate of return.

41
Non-Discounted Cash Flow Methods

• Discounted cash flow methods are generally
  considered to be the preferable methods for
  capital budgeting. However, two non-discounted
  cash flow methods are also used.
• Non-discounted cash flow methods do not factor
  the time value of money into the analysis. One
  method doesnt focus on cash flows at all.

42
Payback Period Method

• The payback period method is a measure of the
  time that will pass before a capital project will
  have generated cash inflows equal to the amount
  of cash outflows.
• Since the major cash outflow is typically the
  initial investment in the project, the payback
  period is calculated by dividing the initial
  investment by the annual cash inflow.

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Payback Period Example

• Using the previous data for the BYU Company, the
  payback periods are
  
• Project A1 50,000 15,750 3.175 years
• Project B2 75,000 25,750 2.913 years

44
Accounting Rate of Return

• The expected increase in accounting income
  divided by the initial capital investment is
  called the accounting rate of return.
  
• This is the only capital budgeting method that
  uses accrual accounting information rather than
  cash flows.

45
Accounting Rate of Return Example

• Lets again use the data about projects A1 and B2
  for the BYU Company. Both of these projects have
  4 years useful lives.
  
• Lets assume that project A1 will have
  depreciation expense of 10,000 per year, and
  project B2 will have depreciation expense of
  15,000 per year.

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Accounting Rate of Return Example

• Project A1 15,750 - 10,000 50,000
  5,750 50,000 11.5

• Project B2 25,750 - 15,000 75,000
  10,750 75,000 14.3

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Factors Leading to Poor Capital Project Selection

• Due to the natural optimism that managers often
  possess, they tend to overestimate future cash
  inflows and underestimate future cash outflows.
  
• Some managers play capital budgeting games by
  manipulating the numbers to put a more favorable
  light on the projects that have been proposed.

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Appendix Time Valueof Money

• If you have a dollar in hand today, you can
  invest it and earn a return on it in the future.
  This is the concept of interest and is the basis
  for the time value of money.
• To properly understand the time value of money,
  you first must be able to distinguish between
  simple interest and compound interest.
  

49
Interest Example

• You go to the bank and negotiate a five-year
  loan. They will loan you 5,000 at 10 annual
  interest. Principal plus interest is due at the
  end of the term (five years from now).
• Your parents decide that they will match the
  offer from the bank. You will choose between the
  bank loan and the family loan. The only
  difference is that the bank charges compound
  interest and your parents charge simple interest.

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Compound Interest on Loan

• The following schedule shows how much interest
  will accrue on the bank loan, and the final
  payoff amount in five years.

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Simple Interest on Loan

• The following schedule shows how much interest
  will accrue on the family loan, and the final
  payoff amount in five years.

52
Future Value

• In each of the previous examples, the payoff
  amount at the end of five years could be called
  the future value of the loan.
  
• In all of the business examples, we will assume
  that interest is compounded unless specifically
  told otherwise. Additionally, the four time-value
  tables that are provided are all based on
  compound interest.

53
Future Value Using Tables

• Assume you deposit 5,000 in an account that you
  believe will earn an average of 10 per year. You
  plan to leave the money alone for 20 years. What
  will the account be worth at that time?
• Use the Future Value of 1 table that is provided
  on page M-244.
  
• Answer 5,000 X 6.727 33,635

54
Future Value of an Annuity

• An annuity is a series of equal cash payments.
  Assume that instead of investing 5,000 all at
  once, you decide to deposit 500 per year for 20
  years into the account.
• Use the table on page M-244. At a 10 return,
  what is the account worth after 20 years?
  
• Answer 500 X 57.275 28,637.50

55
Present Value

• Using the same investment account, assume that
  you want a total equal to 50,000 at the end of
  the 20th year. How much would you have to deposit
  in the account right now?
• This is a present value problem. You need to
  discount 50,000 to be received 20 years from
  now, to its current value, at a 10 annual rate.

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Present Value

• To solve this problem, use the table on page
  M-245. The factor for 20 years at 10 interest
  is 0.149. In other words, if you multiply the
  desired future amount by 14.9, you will see the
  size of deposit required now.
• Answer 50,000 X 0.149 7,450

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Present Value of an Annuity

• As a final example, assume that you will want to
  withdraw 2,500 per year from the account for 20
  years. How much should you deposit into the
  account?
• Use the present value of an annuity table on page
  M-236.
  
• Answer 2,500 X 8.514 21,285

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THE END

• Up Next
• The Operating Budget