11-1 copyright © 2004 by nelson, a division of thomson canada limited. capital investment decisions...

11-1Copyright © 2004 by Nelson, a division of Thomson Canada Limited.

Capital Capital Investment Investment DecisionsDecisions

1111

PowerPresentation® prepared by PowerPresentation® prepared by

David J. McConomy, Queen’s UniversityDavid J. McConomy, Queen’s University


Learning ObjectivesLearning Objectives

Explain what a capital investment decision is and distinguish between independent and mutually exclusive capital investment projects.

Compute the payback period and accounting rate of return for a proposed investment and explain their roles in capital investment decisions.


Learning ObjectivesLearning Objectives(continued)(continued)

Use net present value (NPV) analysis for capital investment decisions involving independent projects.

Use the internal rate of return (IRR) to assess the acceptability of independent projects.


Learning Objectives (continued)Learning Objectives (continued)

Explain why NPV is better than IRR for capital investment decisions involving mutually exclusive projects.

Explain the role and value of postaudits. Convert gross cash flows to after-tax cash

flows. Describe capital investment in an advanced

manufacturing environment.


Capital BudgetingCapital Budgeting

Capital budgeting is the process of making capital investment decisions.

Two types of capital budgeting projects:

1. Independent projects: Projects that, if accepted or rejected, will not affect the cash flows of another project.

2. Mutually exclusive projects:Projects that, if accepted, preclude the accepting all other competing projects.


Payback Method: Uneven Cash Payback Method: Uneven Cash FlowsFlows

Payback Period is the time required to recover a project’s original investment.Example: Investment = $100,000

Unrecovered Annual Cash

Investment Flow

(beg. Of Year)

Year 1: $100,000 $30,000

2: 70,000 $40,000

3: 30,000 $50,000

4: -- $60,000

5: -- $70,000

Payback = 2.6 years.

$30,000 (yr. 1) + $40,000 (yr. 2) + $30,000 (60% of yr. 3).


Payback MethodPayback Method Possible reasons for usePossible reasons for use

To help control the risks associated with the uncertainty of future cash flows

To help minimize the impact of an investment on the company’s liquidity

To help control the risk of obsolescence

To help control the effect of the investment on performance measures


Payback MethodPayback Method Major deficienciesMajor deficiencies

Ignores the performance

of the investment

beyond the payback

period

Ignores the time value

of money


Accounting Rate Of Return Accounting Rate Of Return (ARR)(ARR)

ARR = Average Income/Investment

Average income equals average annual net

cash flows, less average amortization.

Example: Suppose that some new equipment requires an

initial outlay of $80,000 and promises total cash

flows of $120,000 over the next five years (the life

of the machine). What is the ARR?


Accounting Rate Of Return Accounting Rate Of Return (ARR) (continued)(ARR) (continued)

Answer: The average cash flow is $24,000 ($120,000/5) and the average amortization is $16,000 ($80,000/5).

ARR = ($24,000 - $16,000)/$80,000= $8,000/$80,000= 10%



Possible reasons for usePossible reasons for use

A screening measure to ensure that new investment will not adversely affect financial ratios

To ensure a favourable effect on net income so that bonuses can be earned (increased)



The major deficiency of the accounting rate of return is that it ignores the time value of money.


Net Present Value (NPV)Net Present Value (NPV)

Definition:

NPV = P - I

where:P = the present value of the project’s future cash inflows

I = the present value of the project’s cost (usually the initial outlay)

NPV IS A MEASURE OF THE PROFITABILITY OF AN INVESTMENT, EXPRESSED IN CURRENT DOLLARS.


Net Present Value (NPV): Net Present Value (NPV): ExampleExample

Majestic Company has an opportunity to invest $360,000 for new equipment. The new equipment will generate an additional net income of $120,000 per year. Calculate the net present value of the project assuming a 12% discount rate.

Discount PresentYear Cash Flow Factor Value

0 $(360,000) 1.000 $(360,000)

1 120,000 0.893 107,160

2 120,000 0.797 95,640

3 120,000 0.712 85,440

4 120,000 0.636 76,3205 200,000 0.567 113,400

$117,960

=====


Decision Criteria for NPVDecision Criteria for NPV

If the NPV > 0 this indicates:

1. The initial investment has been recovered

2. The required rate of return has been recovered

3. A return in excess of 1. and 2. has been received

Thus, the project should be accepted.


Decision Criteria for NPV Decision Criteria for NPV (continued)(continued)

If NPV = 0, this indicates:

1. The initial investment has been recovered

2. The required rate of return has been recovered

Thus, break even has been achieved and we are indifferent about the project.


Decision Criteria for NPV Decision Criteria for NPV (continued)(continued)

If NPV < 0, this indicates:

1. The initial investment may or may not be recovered

2. The required rate of return has not been recovered

Thus, the project should be rejected.


Reinvestment AssumptionReinvestment Assumption

The NVP model assumes that all cash flows generated by a project are immediately reinvested to earn the required rate of return throughout the life of the project.


Internal Rate Of Return (IRR)Internal Rate Of Return (IRR)

The internal rate of return (IRR) is the discount rate that sets the project’s NPV at zero. Thus, P = I for the IRR.

Example: A project requires a $10,000 investment and will return $12,000 after one year. What is the IRR?

$12,000/(1 + i) = $10,000 1 + I = 1.2

I = 0.20


Internal Rate Of Return (IRR)Internal Rate Of Return (IRR)

Decision criteria:

If the IRR > Cost of Capital, the project should be accepted.

If the IRR = Cost of Capital, the project breaks even, and acceptance or rejection is equal.

If the IRR < Cost of Capital, the project should be rejected.


Internal Rate Of Return (IRR)Internal Rate Of Return (IRR) Reinvestment AssumptionReinvestment Assumption

The cash inflows received from the project are immediately reinvested to earn a return equal to the IRR for the remaining life of the project.


NPV versus IRRNPV versus IRR

There are two major differences between the two approaches:

• NPV assumes cash inflows are reinvested at the required rate of return whereas the IRR method assumes that the inflows are reinvested at the internal rate of return.

• NPV measures the profitability of a project in absolute dollars, whereas the IRR method measures the profitability in relative terms.


NPV versus IRR (continued)NPV versus IRR (continued)

Conflicting Signals (required rate of return) = 20%

Year Design A Design B0 $(180,000) $(210,000)1 60,000 70,000 2 60,000 70,000 3 60,000 70,0004 60,000 70,0005 60,000 70,000

IRR 20% 20%

NPV $ 36,300 $ 42,350


NPV versus IRR (continued)NPV versus IRR (continued)

Which project should be selected?

IRR signals either Design, whereas NPV signals Design B.

The terminal value of Design A is $36,300.

The terminal value of Design B is $42,350.

Design B provides the most wealth and should be selected (AS SIGNALED BY NPV).

IRR may be misleading.


Discount Rate: Discount Rate: The Cost Of CapitalThe Cost Of Capital

The appropriate discount rate to use for NPV computations is the cost of capital. The COST OF CAPITAL is the weighted average of the returns expected by the different parties contributing funds. The weights are determined by the proportion of funds provided by each source.


Discount Rate: Discount Rate: The Cost Of CapitalThe Cost Of Capital

Example: A company is planning on financing a project by borrowing $10,000 and by raising $20,000 by issuing capital stock. The net cost of borrowing is 6% per year. The stock carries an expected return of 9%. The sources of capital for this project and their cost are in the same proportion and amounts that the company usually experiences. Calculate the cost of capital.

Source Amount Cost Weight Cost x Weight

Debt $10,000 6% 1/3 2%

Stock 20,000 9% 2/3 6%

Weighted-Average Cost of Capital 8%===


Inflationary AdjustmentInflationary AdjustmentAn Illustrative ExampleAn Illustrative Example

Assume that the rate of inflation is 15% per year.

Analysis without Inflationary Adjustment (assumes a 20% discount rate)

Year Cash Flow Discount Factor Present Value

0 (5,000,000 ) 1.000 (5,000,000)

1-2 2,900,000 1.528 4,431,200

NPV (568,800)========

Analysis with Inflationary Adjustment

Year Cash Flow Discount Factor Present Value

0 (5,000,000 ) 1.000 (5,000,000)

1 3,335,000 * 0.833 2,778,055

2 3,835,250 **0.694 2,661,664

NPV 439,719========

* 1.15 x $2,900,000

** 1.15 x 1.15 x $2,900,000

Notice that adjustment for inflation can affect the decision.


After-Tax Operating Cash FlowsAfter-Tax Operating Cash Flows The Income ApproachThe Income Approach

After-tax cash flow = After-tax net income + Noncash expenses

Example:Revenues $1,000,000Less: Operating expenses* 600,000Income before taxes $ 400,000Less: Income taxes 136,000Net income $ 264,000

========

* Includes $100,000 amortization expense

After-tax cash flow = $264,000 + $100,000

= $364,000


After-Tax FlowsAfter-Tax FlowsDecomposition ApproachDecomposition Approach

After-tax cash revenues = (1 - Tax rate) x Cash revenuesAfter-tax cash expenses = (1 - Tax rate) x Cash expensesTax savings (noncash expenses) = (Tax rate) x Noncash expenses

Total operating cash = after-tax cash revenues

- after-tax cash expenses

+ tax savings on noncash expenses

Example:

Revenues = $1,000,000,

cash expenses = $500,000, and

amortization = $100,000.

Tax rate = 34%.After-tax cash revenues (1 - .34) x ($1,000,000) = $660,000 Less: After-tax cash expense (1 - .34) x ($500,000) = (330,000)Add: Tax savings (noncash exp.) .34 x ($100,000) = 34,000

Total $364,000 =======


AmortizationAmortizationTax-Shielding EffectTax-Shielding Effect

Amortization is a noncash expense and is not a cash flow. Amortization, however SHIELDS revenues from being taxed and, thus, creates a cash inflow equal to the tax savings.

Assume initially that tax laws DO NOT allow amortization to be deducted to arrive at taxable income. If a company had before-tax operating cash flows of $300,000 and amortization of $100,000, we have the following statement:

Net operating cash flows $ 300,000

Less: amortization 0

Taxable income $ 300,000

Less: Income taxes (@ 34%) (102,000) Net income $ 198,000

========


AmortizationAmortizationTax-Shielding EffectTax-Shielding Effect

Now assume that the tax laws allow a deduction for amortization:

Net operating cash flows $300,000 Less: Amortization 100,000

Taxable income $200,000 Less: Income taxes (@ 34%) (68,000) Net income $132,000

=======

Notice that the taxes saved are $34,000 ($102,000 - $68,000). Thus, the firm has additional cash available of $34,000.

This savings can be computed by multiplying the tax rate by the amount of amortization claimed:

.34 x $100,000 = $34,000


Tax Laws: Capital Cost AllowanceTax Laws: Capital Cost Allowance

In Canada, amortization is not allowed as a deduction in determining taxable income, but Capital cost allowance is allowed as a deduction instead. CCA is

similar to amortization but is governed by a special set of rules dictated by the income tax act and regulations. Each capital asset is assigned to a capital asset class along with other similar assets A pre-determined CCA rate applies to the balance of the capital cost in a particular class There are currently more than 40 separate classes, each with a specific maximum rate CCA applies a declining-balance system, and the size of the tax shield will be different for each year CCA applies to an asset pool in a given class. If there are other assets in the class, a project may continue to affect the firm’s cash flows even after the project’s assets are retired.


Capital Cost Allowance - Capital Cost Allowance - A Sample of Asset Tax ClassesA Sample of Asset Tax Classes

Class Examples of Assets Included Maximum Rate

Class 1 Buildings and other structures 4%

Class 7 Boats, ships 15%

Class 8 Equipment and machinery 20%

Class 9 Aircraft 25%

Class 10 Computer equipment, trucks 30%

Class 12 Small tools, computer software 100%

Class 33 Timber resource property 15%

Class 37 Amusement park buildings and equipment 15%


Capital Cost AllowanceCapital Cost Allowance

Present Value of CCA Tax Shield

= (R x C x T) / (R + i)

Where Example

R = CCA (R)ate 30%

C = Original (C)apital cost of the project $300,000

T = (T)ax rate 40%

i = Required rate of return [(i)nterest factor] 10%

PV of CCA Tax Shield = (30% x 300,000 x 40%) / (30% + 10%)

= $90,000


APPENDIX AAPPENDIX AAPPENDIX AAPPENDIX A


Future Value: Time Value of Future Value: Time Value of MoneyMoney

Let:F = future value

i = the interest rate

P = the present value or original outlay

n = the number or periods

Future value can be expressed by the following formula:

F = P(1 + i)n


Future Value: ExampleFuture Value: Example

Assume the investment is $1,000. The interest rate is 8%. What is the future value if the money is invested for one year? Two? Three?


Future Value (continued)Future Value (continued)

F = $1,000(1.08) = $1,080.00 (after one year)

F = $1,000(1.08)2 = $1,166.40 (after two years)

F = $1,000(1.08)3 = $1,259.71 (after three years)


Present ValuePresent Value

P = F/(1 + i)n

The discount factor, 1/(1 + i), is computed for various combinations of I and n. See Exhibit 11B-1.

Example: Compute the present value of $300 to be received three years from now. The interest rate is 12%.

Answer: From Exhibit 11B-1, the discount factor is 0.712. Thus, the present value (P) is:

P = F (df)

= $300 x 0.712

= $213.60


Present Value (continued)Present Value (continued)

Example: Calculate the present value of a $100 per year annuity, to be received for

the next three years. The interest rate is 12%.

Answer:

Discount Present

Year Cash Factor Value

1 $100 0.893 $ 89.30

2 100 0.797 79.70

3 100 0.712 71.20

2.402 * $240.20======

* Notice that it is possible to multiply the sum of the individual discount factors

(.40) by $100 to obtain the same answer. See Exhibit 11 B-2 for these sums which

can be used as discount factors for uniform series.

11-1 copyright © 2004 by nelson, a division of thomson canada limited. capital investment decisions...

Documents