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Seven Capital Budgeting Capital Budgeting

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									Chapter Seven




           Capital Budgeting




                        PPT 7-1
      Capital Budgeting Decisions


 require sizable commitments of cash.

 are expected to generate returns that will last
   more than one year.
 involve time value of money.




                                                    PPT 7-2
           Importance of Capital
            Budgeting Decisions
Capital budgeting
decisions commit
companies to courses of
action. The success or
failure of a particular
strategy, or even of the
company itself, can hinge
on one or a series of such
decisions.

                                   PPT 7-3
  Importance of Capital Budgeting
       Decisions (continued)
 In addition, capital budgeting decisions are
   generally riskier than short-term ones for the
   following reasons.
 The company expects to recoup its investment
   over a longer period.
 Reversing a capital budgeting decision is much
   more difficult than reversing a short-term
   decision.

                                                    PPT 7-4
Types of Capital Budgeting Decisions


 Investments mandated by law or policy

 Investments made to further strategic goals

 Investments made to increase capacity or reduce
  costs
 Investments made for non-financial reasons




                                                PPT 7-5
                  Cost of Capital


Cost of capital is the cost, expressed as a percentage,
of obtaining the money needed to operate the
company.
   Capital is obtained from two sources, creditors and owners,
   corresponding to divisions of liabilities and owners’ equity
   on the balance sheet.




                                                           PPT 7-6
  Weighted Average Cost of Capital

 Average costs of debt and equity components


 Example - debt with after tax cost of 5% is 40%
  of capital structure and equity with after cost of
  15% is 60% of capital structure
 Cost of capital is:
       40% * 5% =      2%
       60% * 15% =     9%
       Total           11%

                                                  PPT 7-7
                   Cutoff Rate

Because of the practical
difficulties of determining
cost of capital, managers
might simply use their
judgment to set a
minimum acceptable
rate, called a cutoff rate,
hurdle rate, or target rate.


                                 PPT 7-8
The Capital Budgeting Decision Models

  Discounted Cash Flow (DCF) Techniques:
       Net present value (NPV)
       Internal rate of return (IRR)


  Nondiscounted Cash Flow Techniques:
       Payback period
       Book rate of return


                                            PPT 7-9
       Net Present Value Method


The net present value method (NPV) uses the
minimum acceptable rate to find the present value
(PV) of the future returns and compares that value
with the cost of the investment.




                                               PPT 7-10
   Internal Rate of Return Method

The internal rate of return
method (IRR) finds the
rate of return associated
with the project and
compares that rate with
the minimum acceptable
rate.

      NPV = PV of future
        returns - Cost of the
        investment              PPT 7-11
               Decision Rules

 Under the NPV method, a project having a
  positive NPV should be accepted; others should
  be rejected.
 Under the IRR method, a project having an IRR
  greater than the company’s cost of capital should
  be accepted.




                                               PPT 7-12
    Purchase of Machine Example

 Machine costs $60,000

 Sell 3,000 units per year at $14 for the next 5 years

 Variable costs are $5 per unit

 Annual fixed costs are $5,000

 Cutoff rate of 12 percent




                                                   PPT 7-13
  Annual Incremental Cash Inflows

                                      Annual
                                   Cash Flows
Revenues ($14 x 3,000)                $42,000
Variable costs ($5 x 3,000)            15,000
Contribution margin ($9 x 3,000)      $27,000
Cash fixed costs                        5,000
Expected increase in net cash         $22,000



                                         PPT 7-14
      Net Present Value Example

Expected increase in net cash        $22,000
Present value factor                 x 3.605
Present value of future cash flows   $79,310
Investment required                   60,000
Net present value                    $19,310




                                         PPT 7-15
         Internal Rate of Return


Factor = PV of future flows/Annual cash flows
Factor = $60,000/$22,000 = 2.727
  The 2.727 corresponds to an interest rate between 24 and 25
  percent when the number of periods is five.
  The IRR is between 24 and 25 percent.




                                                        PPT 7-16
         Taxes and Depreciation


Additional information:
  Tax rate is 40 percent.
  Straight-line depreciation is used.




                                        PPT 7-17
      Annual Incremental After-Tax
              Cash Inflows
                                            Tax       Annual
                                     Computation   Cash Flows
Revenues                                 $42,000      $42,000
Cash expenses (variable and fixed)        20,000       20,000
Cash inflow before taxes                 $22,000      $22,000
Depreciation                              12,000
Increase in taxable income               $10,000
Income taxes (40 percent)                  4,000        4,000
Net increase in annual cash inflow                    $18,000

OR add depreciation back to net income to get cash
                                                         PPT 7-18
Net Present Value of After-Tax Example


 Expected increase in net cash inflows   $18,000
 Present value factor                    x 3.605
 Present value of future cash flows      $64,890
 Investment required                      60,000
 Net present value                        $4,890




                                            PPT 7-19
         Internal Rate of Return


Factor = PV of future flows/Annual cash flows
Factor = $60,000/$18,000 = 3.333
  The 3.333 corresponds to an interest rate between 14 and 16
  percent when the number of periods is five.
  The IRR is between 14 and 16 percent.




                                                        PPT 7-20
              Payback Period

Payback
  Period = Investment required/Annual cash
  returns
         = $60,000/$18,000 = 3.333 years




                                             PPT 7-21
              Book Rate of Return


Average book
   rate of return = Net income/Average book investment
   = $6,000/($60,000/2) = 20 percent

This is the only method discussed that does not use cash flows.




                                                           PPT 7-22
              Tax Depreciation

 For Tax, depreciation is computed using either
  the Modified Accelerated Cost Recovery System
  (MACRS) or optional straight line.
 MACRS gives rapid depreciation according to
  tables published by the IRS
 Optional straight line uses a shorter life than the
  actual life and a half year convention
 Tax deprecation will almost always end up with
  uneven cash flows.
                                                  PPT 7-23
                  Cash Flow
 Problem Information - A company is offered an
  8 year contract that will yield an annual gross
  cash flow of $450,000 with cash expenses of
  $261,500.
 Working capital investment is $90,000, and of
  machinery costing for $700,000 is required.
 The equipment is 5 year property for MACRS
  depreciation, and has a useful life of 9 years,
  but will be sold at the end of year 8 for $25,000.
 The tax rate is 30% and the cost of capital is
  14%.
                                                PPT 7-24
  Calculating Annual Cash Flow


Year                                0

Equipment Cost           -700000
Working Capital           -90000
Cash Flow                -790000
Cum Cash Flow            -790000
                                 PPT 7-25
        Calculating Cash Flows

Year                      1       2   3, 4, 5
Gross Rev            450000 450000 450000
Cash Expense        -261500 -261500 -261500
Less Depreciation    -70000 -140000 -140000
Plus Salvage
Taxable Income      118500    48500    48500
Tax                 -35550   -14550   -14550
Net                  82950    33950    33950
DEP                  70000   140000   140000
Working Capital
Cash Flow           152950   173950   173950
                                         PPT 7-26
              Final Cash Flows

                           6       7       8
Gross Rev             450000 450000 450000
Cash Expense         -261500 -261500 -261500
Less Depreciation     -70000
Plus Salvage                           25000
Taxable Income        118500 188500 213500
Tax                   -35550 -56550 -64050
Net                    82950 131950 149450
DEP                    70000       0       0
Working Capital                        90000
Cash Flow             152950 131950 239450
                                        PPT 7-27
                               MACRS Example
  MACRS Example
Year            0                 1           2          3            4         5         6         7         8

Equipment       -700000
Cost

Gross Rev                    450000     450000     450000         450000    450000    450000    450000    450000
cash expense                -261500    -261500    -261500        -261500   -261500   -261500   -261500   -261500
Less Depreciation           -140000    -224000    -134400         -80500    -80500    -40600
Plus Salvage                                                                                              25000
Taxable Income               48500     -35500       54100        108000    108000    147900    188500    213500
Tax                         -14550      10650      -16230        -32400    -32400    -44370    -56550    -64050
Net                          33950     -24850       37870         75600     75600    103530    131950    149450
DEP                         140000     224000      134400         80500     80500     40600         0         0
Working            -90000                                                                                 90000
Capital
Cash Flow        -790000     173950     199150     172270        156100    156100    144130    131950    239450
Cum Cash         -790000    -616050    -416900    -244630        -88530     67570    211700    343650    583100
Flow
Net Present Value            $7,939 Do this using NPV function
Internal rate of ret        14.30% Do this using IRR function




                                                                                                         PPT 7-28
                       Straight Line Example
                                 Capital Budgeting Example Using Straight Line
Year                        0            1        2        3        4          5         6         7         8

Equipment Cost         -700000

Gross Rev                          450000    450000    450000    450000    450000    450000    450000    450000
Cash Expense                      -261500   -261500   -261500   -261500   -261500   -261500   -261500   -261500
Less Depreciation                  -70000   -140000   -140000   -140000   -140000    -70000
Plus Salvage                                                                                             25000
Taxable Income                     118500    48500     48500     48500     48500    118500    188500    213500
Tax                                -35550   -14550    -14550    -14550    -14550    -35550    -56550    -64050
Net                                 82950    33950     33950     33950     33950     82950    131950    149450
DEP                                 70000   140000    140000    140000    140000     70000         0         0
Working Capital         -90000                                                                           90000
Cash Flow              -790000     152950 173950 173950 173950            173950    152950    131950    239450
Cum Cash Flow          -790000    -637050 -463100 -289150 -115200          58750    211700    343650    583100
Net Present Value                 ($4,881) Do this using NPV function
Internal rate of ret               13.82% Do this using IRR function




                                                                                                         PPT 7-29

								
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