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CHAPTER 11 Managing Long-Lived Resources: Capital Budgeting Learning Objectives After studying this chapter, you will be able to: 1. Understand the reasons for capital budgeting. 2. List the components of a project’s cash flows. 3. Apply discounted cash flow techniques. 4. Compare various methods for evaluating projects. 5. Explain the role of taxes and the depreciation tax shield in project evaluation. 6. Describe issues in allocating scarce capital among projects. Overview In Chapters 9–10, we examined a number of long-term decisions involving the acquisition and disposal of capacity resources. In our discussions, however, we did not consider that money has a time value: a dollar today is worth more than a dollar tomorrow. We also did not consider that capacity resources are ―lumpy.‖ That is, capacity resources come in discrete sizes—we cannot buy part of a car or an MRI machine. These considerations are especially important in the acquisition of long-lived resources. In this chapter, we discuss capital budgeting, a tool that explicitly incorporates the time value of money and the lumpy nature of resources in decisions involving significant long-term investments. We begin this chapter by examining why organizations use capital budgets to evaluate expenditures on long-lived, or capacity, resources and list the features of capital budgets. We then illustrate techniques such as net present value (NPV) and internal rate of return (IRR) analyses that firms use to evaluate projects. Next, we consider how taxes affect project value and address some qualitative issues that often do not enter into financial cost-benefit calculations. Finally, we discuss how a firm might allocate scarce capital among competing projects. Learning Objective 1 Understand the reasons for capital budgeting. Roles of Capital Budgets 1. Capital budgeting refers to the set of tools companies use to evaluate such large expenditures. 2. Before describing the mechanics of capital budgeting, let us first place capital budgeting in the context of earlier topics that we studied, including cost allocations and budgeting. Capital Budgeting and Cost Allocations 1. In Chapters 9 and 10, we learned that cost allocations help us estimate the cost of capacity resources for long-term decisions 2. However, they do not account for either the time value of money or the lumpy nature of capacity resources. 3. The time value of money arises because a dollar today is worth more than a dollar tomorrow. 1 4. Time value of money helps us put different cash flows from different time periods on an equal footing so that we can compare them. (e.g., Present value of ALL future cash flows) 5. It is difficult to match the supply and demand for capacity resources over a period of months or even years. 6. The difficulty arises because many capacity resources are ―lumpy.‖ 7. Unlike capital budgeting techniques, cost allocations ignore the lumpy nature of capacity resources and estimate costs as if we can match supply and demand continuously and smoothly. . 8. Capital budgeting techniques consider all cash flows. Capital Budgets and Budgeting 1. Most companies prepare budgets for different time horizons—from short-term operating budgets to long-term strategic plans. 2. These plans specify how the company intends to achieve its long-term objectives, and dictate what resources the firm needs to execute its plans. (e.g., St. Vincent Hospital’s MRI equipment). 3. A capital budget links strategic and operating budgets. It helps determine how much of each capacity resource an organization should acquire and how it should invest its capital in specific assets such as plant, equipment, building, and technology. a. First, it identifies and evaluates individual investment proposals. b. Second, it prioritizes the proposals and decides which ones to execute. 4. Just as operating budgets allocate the firm’s productive capacity among products, capital budgets allocate scarce capital among available investment opportunities. Learning Objective 2 List the components of a project’s cash flows. Elements of Project Cash Flows Exhibit 11.1 highlights the four important elements of a capital-expenditure decision about a single project: 1. Initial Outlay 2. Estimated Life and Salvage Value. 3. Timing and Amounts of Operating Cash Flows. 4. Cost of Capital. Initial Outlay 1. The initial outlay includes all costs incurred to ready the asset for its intended use. 2. These costs include the purchase price, shipping and delivery costs, taxes, and any installation and training charges. Estimated Life and Salvage Value 1. Assets lose their productivity with use. 2. They also become obsolete as new, more efficient technologies emerge. 3. Using a reasonable and realistic estimate of life expectancy is important. 2 4. Too low of an estimate understates the profitability of the investment and could result in the firm rejecting profitable opportunities. 5. Too high of an estimate overstates the profitability of the investment and could lead to a wasteful use of scarce capital. 6. Salvage value must be considered. Timing and Amounts of Operating Cash Flows 1. Operating cash inflows increase directly through increased revenues. 2. They also may increase indirectly through decreased outflows due to cost savings. 3. A reduction in outflow is equivalent to an increase in inflow. 4. Operating cash outflows typically include a. increases in variable costs that are proportional to the increase in revenue, b. increases in annual fixed costs related to hiring additional personnel, c. and costs associated with periodic repairs and maintenance. 5. It is important to note that Exhibits 11.2 and 11.3 focus on before-tax cash flows and not accounting expenses. 6. Additionally, depreciation is not associated with a cash flow. Cost of Capital 1. The cost of capital is the opportunity cost for money. 2. We measure the cost of capital as the rate of return that providers of capital (such as shareholders, lenders, and banks) expect from their investments. 3. We use this rate of return as the discount rate to calculate the present value of future cash inflows and outflows. 4. Estimating the cost of capital is difficult because the return expected by capital providers varies with the risks they face and other investment opportunities they have. (e.g., inflation, the economy, creditworthiness of a borrower). Learning Objective 3 Apply discounted cash flow techniques. Discounted Cash Flow Techniques in Capital Budgeting 1. Cash outflows and inflows associated with capital investments are spread over many years. 2. Therefore, most firms use discounted cash flow (DCF) techniques to state future cash flows in terms of their respective present values. 3. These techniques make all cash inflows and outflows comparable. Net Present Value 1. The net present value (NPV) of an investment is the total present value of all of its cash flows. 2. An investment is desirable if its NPV is positive. 3. As you go further out in time, the discount factor (also known as the present value factor), the amount by which we need to multiply the future cash flow to obtain the present value, decreases. 4. Firms often use larger discount rates to evaluate riskier projects. 3 Sensitivity Analysis 1. Like the Cost-Volume-Profit model of Chapter 5, the NPV method allows the user to perform ―what if‖ sensitivity analysis with respect to various estimates and assumptions, and to examine alternative scenarios. 2. Using the text example, the net present value with the revised MRI charge and increased maintenance expense is higher than the amount determined earlier. Why? 3. The present value of a dollar is lower as we go farther into the future. 4. The higher cash inflows in the earlier years of a project yield a higher present value, all else being equal. Assumptions in NPV Analysis 1. In performing the NPV calculations illustrated above, we made some assumptions that affect our calculations. 2. The initial cash outflow takes place at the beginning of the period. 3. Subsequent cash inflows and outflows occur at the end of the relevant period. 4. NPV calculations assume that firms reinvest future cash inflows in projects that yield a return that equals the cost of capital. 5. While the third assumption is acceptable, the first two assumptions may seem unrealistic. Internal Rate of Return 1. The internal rate of return (IRR) is the discount rate at which a project has zero NPV. 2. A project is profitable if its IRR exceeds its opportunity cost of capital. Unequal Cash Flows 1. Manually computing the IRR for a project with unequal operating cash flows spread over many years used to be difficult because the process involves a lot of trial and error. 2. Fortunately, electronic spreadsheet programs greatly simplify this task. IRR with Equal Cash Flows The internal rate of return is easier to compute when the net cash flow is the same every year. Assumptions in IRR Analysis 1. Like the NPV method, the IRR method assumes that the initial cash outflow takes place at the beginning of the period, and that subsequent cash flows occur as a lump sum at the end of the respective periods. 2. The IRR method assumes that firms reinvest future cash inflows in projects that yield a return equaling the project’s IRR. Comparing NPV and IRR 1. Many people prefer the NPV method to the IRR method because NPV is simpler to compute and provides a unique value for each project. 2. In contrast, it turns out that the IRR method could result in multiple values of IRR for the same projects. 3. Another key difference between the methods is their assumption about reinvestment of subsequent cash flows. 4 4. The IRR method assumes that the firm has other investment opportunities that will yield the same rate of return as the project under consideration. 5. In contrast, the NPV method assumes that a firm reinvests interim project cash flows at its cost of capital. 6. Finally, NPV ranks projects based on the magnitude of the net present value, while IRR ranks projects based on the rate of return. 7. NPV tends to favor larger projects with higher absolute profit while IRR tends to favor smaller projects that have greater profitability. Learning Objective 4 Compare various methods for evaluating projects. Other Evaluation Criteria for Capital Budgeting Payback Method 1. Under the payback method, we compute how long it takes to recoup the initial investment using undiscounted cash flows. 2. We refer to this length of time as the payback period. 3. The greatest advantage of the payback method is that the payback period is easy to compute and to understand. 4. As you know, the payback method ignores the time value of money and thus overvalues the future cash inflows it considers. 5. Accordingly, the payback method understates the length of time actually required to recoup initial investment. 6. Moreover, it ignores all cash flows that occur after the payback period, and thus favors projects that yield more cash inflows in earlier years. Modified Payback 1. The modified payback method computes the payback period using discounted cash flows, meaning that the method accounts for the time value of money. 2. Under this method, we accumulate the present value of future cash flows over time and compare the cumulative value with the initial cash outlay. 3. The traditional payback method understates the true length of time required to recoup the initial investment. 4. However, it does not consider all future cash flows from a project as the NPV method does. Accounting Rate of Return 1. Some firms compute an accounting rate of return (ARR) to evaluate long-lived resources. (Formula shown in text) 2. Like the payback methods, ARR is relatively straightforward to compute. 3. However, like the traditional payback method, it ignores the time value of money. 5 Popularity of Discounted Cash Flow Techniques 1. Exhibit 11.12 provides a comparison of the various methods for evaluating projects. 2. As you can tell, the discounted cash flow (DCF) techniques are the conceptually correct way to evaluate projects, although they are computationally intensive. Learning Objective 5 Explain the role of taxes and the depreciation tax shield in project evaluation. Taxes and Capital Budgeting 1. Taxes affect both the amount and timing of cash flows. 2. A firm pays taxes on accounting income, not on cash flows. 3. Therefore, it needs to compute accounting income to determine taxes. 4. Depreciation offers a tax shield that reduces the cash outflow associated with tax payments. Let us explore this idea further. Depreciation Tax Shield 1. We compute the depreciation tax shield as Depreciation tax shield in a year = Tax rate X Depreciation deduction in that year 2. We add back depreciation to after-tax income when we calculate this after-tax cash flow. 3. We do this because depreciation is a noncash expense, but we deducted it earlier to compute taxable income. Salvage Value and Taxes 1. Even though an asset may have lost its productive use, a company may be able to sell some parts of the asset in the replacement market. 2. If a company can estimate the salvage value of an asset when acquiring it, it should include it in present value calculations. 3. Ignoring the salvage value will understate the net present value of the asset. 4. The value of an asset in the firm’s books frequently differs from its economic or market value which would can give rise to a gain or loss on sale. 5. Gains and losses have tax implications. a. Gains increase taxes. b. Losses lower taxes. Learning Objective 6 Describe issues in allocating scarce capital among projects. Allocating Capital Among Projects 1. Firms have limited access to the capital, managerial talent, and other organizational resources needed to undertake new projects. 2. They cannot undertake all positive NPV projects. 6 3. The hurdle rate is the minimum expected rate of return of the management from any project. Thus, any project that has an IRR greater than the hurdle rate (which means that the project will have a positive NPV when discounted at the hurdle rate) would be acceptable. 4. Different firms will use varied methods for deciding which projects will be undertaken. Nonfinancial Costs and Benefits 1. In addition to estimating future cash inflows and outflows, and identifying the appropriate discount rate for present value calculations, companies also need to determine the future nonfinancial costs and benefits from a capital expenditure. 2. This is not an easy task. 3. Ignoring future benefits because they are hard to quantify can lead to lost opportunities. 4. The use of judgment by management is an important resource for decision making. Fit with Overall Strategy 1. Firms must consider how proposed projects affect the firm’s ability to compete in the evolving marketplace. 2. By virtue of their longevity, capital investments entail substantial risk, as it is hard to predict many years into the future. 3. Some firms demand a high return rate which leads to conservative investments affecting the firm’s ability to compete. 4. The status quo may not be a viable option. Flexibility and Real Options 1. Flexibility is the ability to defer, abandon, expand, or contract an investment. 2. Investments differ greatly in the flexibility they afford. 3. Many firms subjectively incorporate flexibility into project evaluation and capital allocation decisions. 4. A study known as real options analysis, complements standard techniques such as NPV and IRR. 5. It allows companies to blend strategic intuition with analytic rigor. 7 CHAPTER 11 REVIEW QUESTIONS TRUE/FALSE 1. The time value of money arises because a dollar today is worth more than a dollar yesterday. 2. Operating budgets allocate the firm’s productive capacity among products, whereas capital budgets allocate scarce capital among available investment opportunities. 3. A project is profitable if its IRR is less than its opportunity cost of capital. 4. The modified payback method computes the payback period using undiscounted cash flows, meaning that the method does not account for the time value of money. 5. The accounting rate of return equals the average annual income from a project divided by the average annual investment in the project. 6. The hurdle rate is maximum expected rate of return of the management from any project. 7. The initial outlay of an investment can include the purchase price, shipping and delivery costs, taxes, and any other installation and training charges. MULTIPLE CHOICE 1. Which is not one of the four important elements of a capital expenditure decision? A. Estimated life and salvage value. B. Cost of Capital. C. Timing and amounts of initial outlay. D. Initial outlay. 2. Operating cash outflows include: A. Increases in annual fixed costs related to hiring additional personnel. B. Costs associated with periodic repairs and maintenance. C. Increases in variable costs that are proportional to the increase in revenue. D. All of the above. 3. If an investment is desirable, then NPV will be: A. Negative. B. Positive. C. Both positive and negative. D. None of the above. 4. The two main discounted cash flow techniques are: 8 A. NPV and Modified Payback Method. B. IRR and Modified Payback Method. C. NPV and IRR. D. None of the above. 5. Which methods to evaluate capital expenditures on long-lived resources ignore the time value of money? A. Accounting rate of return. B. IRR. C. NPV. D. Modified payback method. 6. Capital budgeting: A. Provides a link between strategic and operating budgets. B. Refers to the set of tools companies use to evaluate such large expenditures. C. Considers the time value of money and the "lumpy" nature of capacity resources. D. All of the above. 7. The payback method: A. Focuses on the project upside risk. B. Is easy to use and understand. C. Does require us to determine opportunity cost of capital. D. None of the above. 8. The minimum expected rate of return of the management from any project is the: A. IRR. B. NPV. C. Cost of capital. D. Hurdle rate. 9. If a investment project has a initial outlay of $200,000, life of five years, with a discount rate of 10% (compounded annually), what is the future value of this project? A. $322,200 B. $222,200 C. $220,000 D. $354,312 10. What is the present value of an investment project that has a future value of $300,000, life of ten years and a discount rate of 12% (compounded annually)? A. $96,900 B. $99,600 C. $96,600 D. $98,400 MATCHING 9 1. Match the items below by entering the appropriate code letter in the space provided. A. Present Value F. Capital Budgets B. Hurdle Rate G. Discount Factor C. NPV H. IRR D. Salvage Value I. Cost of Capital E. Time Value of Money J. Initial Outlay ____ 1. One of the two main discounted cash flow techniques. ____ 2. The value of today of a future cash flow. ____ 3. Opportunity cost for money. ____ 4. The discount rate at which a project NPV is equal to zero. ____ 5. All costs connected with purchasing an asset and getting it ready for its intended use. ____ 6. Provides the link between strategic and operating budgets by determining how much capacity to require. ____ 7. "A dollar today is worth more than a dollar tomorrow." ____ 8. Minimum required rate of return chosen by management. ____ 9. The residual value from disposing of the asset at the end of its useful life. ____ 10. Also known as the "present value factor.‖ SHORT PROBLEMS 1. (L03) Due to a sudden increase in competition in the auto industry, Thomas Automotive, Inc., is considering several cost-savings proposals to remain profitable. One such proposal promises an expected cost savings of $325,000 annually over the next 3 years. The required rate of return on the investment is 11%. Ignore the tax effects. Required: What is the project's internal rate of return? 2. (L04) Duke and Company is planning to invest $10 million in a new, stand-alone project. Before depreciation, it expects this project to yield a positive cash flow of $1.5 million each year for eight years. The firm expects to depreciate the investment on a straight-line basis over eight years and with zero salvage value. The applicable discount rate is 10% and the tax rate is 35%. 10 Required: What is the payback period on this project? CHAPTER 11 REVIEW QUESTIONS ANSWER KEY TRUE/FALSE 1. L01 – False 2. L01 – True 3. L03 – False 4. L04 – False 5. L04 – True 6. L06 – False 7. L02 – True MULTIPLE CHOICE 1. L02 – C 2. L02 – D 3. L03 – B 4. L03 – C 5. L03 – A 6. L01 – D 7. L04 – B 8. L06 – D 9. L03 – A (Table 2: 1.611 x 200,000 = $322,200) 10. L03 – C (Table 1: 0.322 x 300,000 = $96,600) MATCHING 1. C 6. F 2. A 7. E 3. I 8. B 4. H 9. D 5. J 10. G SHORT PROBLEMS 1. (L03) First, using the financial calculator, you must calculate the net present value, which is $794,207.28 (npv(11,0,L1) -> L1: 325,000, 325,000,325,000). Then, calculate the IRR, which equals 11% (using the financial calculator: irr(-794207.28,L1)). Note that the internal rate of return is also 11% because the net present value would exactly be zero if Thomas invests $794,207.28. 11 SHORT PROBLEMS (CONT’D) 2. (L04) Initial investment for the project is $10,000,000. Because the project has a life of eight years, depreciation for tax purposes is $1,250,000 using the straight-line method. Because the tax rate is 35%, depreciation gives rise a tax saving of $437,500 (= 35% × $1,250,000) every year. The after-tax annual cash flow expected from the project is $1,500,000 × (1 – 0.35) = $975,000. Thus, the net cash flow per year is $1,412,500 (= $975,000 + $437,500). Therefore, Payback period = $10,000,000/$1,412,500 = 7.08 years = 7 years (rounded). 12