12 The Capital Budgeting Decision Block, Hirt, and Danielsen Foundations of Financial Management 17th edition Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-1 Learning Objectives • A capital budgeting decision represents a long-term investment decision. • Cash flow rather than earnings is used in the capital budgeting decision. • The payback method considers the importance of liquidity, but fails to consider the time value of money. • The net present value and internal rate of return are generally the preferred methods of capital budgeting analysis. • The discount or cutoff rate is normally the cost of capital. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-2 Chapter Opening • Capital budgeting decision involves planning expenditures for project with minimum period of year or longer • Capital expenditure decision requires • Extensive planning, product design completion, patents acquired, and capital markets tapped for needed funds • Decisions affected by uncertainties involved in • Annual costs and inflows, product life, interest rates, economic conditions, and technological changes Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-3 Administrative Considerations • A good capital budgeting program requires steps to be taken in the decision-making process 1. Search for and discovery of investment opportunities 2. Data collection 3. Evaluation and decision making 4. Reevaluation and adjustment Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-4 Figure 12-1 Capital Budgeting Procedures Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-5 Accounting Flows versus Cash Flows • In capital budgeting decisions, emphasis is on cash flows rather than earnings • Depreciation (noncash expenditure) is added back to profit to determine cash flow generated • Emphasis is on proper evaluation techniques for best economic choices and maximizing long-term wealth Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-6 Table 12-1 Cash Flow for Alston Corporation Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-7 Table 12-2 Revised Cash Flow for Alston Corporation Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-8 Methods of Ranking Investment Proposals • Three widely used methods for evaluating capital expenditures 1. Payback method 2. Internal rate of return 3. Net present value Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-9 Payback Method and Table 12-3 Investment Alternatives • Time required to recoup initial investment • Investment A recoups $10,000 initial investment at end of second year, while Investment B takes 3.8 years Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-10 Payback Method • Advantages • Easy to understand • Emphasizes liquidity • Useful in industries characterized by dynamic technological developments • Shortcomings • Ignores cash inflows after the cutoff period • Does not consider time value of money • Cannot find optimum or most economic solution to capital budgeting problem Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-11 Net Present Value • Often the preferred investment selection method • Theoretically valid model • Well understood and widely used by real-world finance professionals • The net present value is the sum of present values of all outflows and inflows related to a project • Inflows that arrive in later years must provide a return that at least equals the cost of the invested capital Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-12 Table 12-4 Calculating Net Present Value for Investments A and B Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-13 Internal Rate of Return (IRR) • Measures investment profitability of investments as a return percentage • Find interest rate (i) in time value of money problem • The IRR is the interest rate (i) that makes NPV = 0 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-14 Table 12-5 Calculating IRR for Investments A and B Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-15 Selection Strategy • For project to be potentially accepted • Profitability must equal or exceed cost of capital • Mutually exclusive projects • Selecting one option precludes selection of other alternatives • Non–mutually exclusive projects • Would accept all alternatives providing return in excess of cost of capital selected Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-16 Selection Strategy Continued • For Investment A and B, assume 10 percent capital, Investment B accepted if alternatives mutually exclusive, both qualify if not • IRR and NPV methods call for same decision with some exceptions • Two rules 1. If investment has positive NPV, IRR exceeds of cost of capital 2. In certain cases, methods give different answers in selecting best investment Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-17 Reinvestment Assumption • IRR • All inflows from given investment can be reinvested at Internal Rate of Return (IRR) • May be unrealistic to assume reinvestment at equally high rate • NPV • Makes more conservative assumption that each inflow can be reinvested at cost of capital or discount rate • Allows for certain consistency as inflows from each project are assumed to have same investment opportunity Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-18 Tables 12-7 and 12-8 The Reinvestment Assumption— IRR and NPV ($10,000 Investment) Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-19 Modified Internal Rate of Return (MIRR) • Combines reinvestment assumption of NPV method (cost of capital) with IRR method • Discount rate that equates future value of inflows, each growing at the cost of capital with investment Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-20 Table 12-9 MIRR for Investment B Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-21 Capital Rationing • Artificial constraint on funds invested in given period • Only projects with highest NPV accepted • Reasons for capital rationing • Fear of too much growth • Hesitation to use external sources of financing • Can hinder firm from achieving maximum profitability Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-22 Net Present Value Profile • Graphical representation of net present value of project at different discount rates • Three characteristics to consider in applying • NPV at zero discount rate • NPV as determined by normal discount rate (such as cost of capital) • IRR for the investments Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-23 Figure 12-2 Net Present Value Profile Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-24 Figure 12-3 Net Present Value Profile with Crossover Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-25 The Rules of Depreciation • Assets classified into nine categories to determine allowable depreciation write-off • Each class referred to as Modified Accelerated Cost Recovery System (MACRS) category • Some references made to Asset Depreciation Range (ADR) • Expected physical life of asset or class of assets • Most assets can be written off more rapidly than the midpoint of their ADR Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-26 Table 12-11 Categories for Depreciation Write-Off Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-27 Table 12-12 Depreciation Percentages (Expressed in Decimals) Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-28 Table 12-13 Depreciation Schedule Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-29 The Tax Rate • Tax Cuts and Jobs Act of 2017 • Congress wants businesses to invest more in longlived assets, so it temporarily allows companies to take 100 percent bonus depreciation in the first year that an asset is placed in service. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-30 Actual Investment Decision • Assume • $50,000 depreciation of machinery with six-year productive life • Produces $18,500 income for first three years before deductions for depreciation and taxes • In last three years, income before depreciation and taxes $12,000 • Corporate tax rate 25 percent and cost of capital 10 percent • For each year • Depreciation subtracted from earnings before depreciation and taxes to arrive at earnings before taxes • Taxes subtracted to determine earnings after taxes • Depreciation added to earnings to arrive at cash flows Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-31 Table 12-14 Cash Flow Related to the Purchase of Machinery Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-32 Table 12-15 Net Present Value Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-33 The Replacement Decision • Many investment decisions occur due to new technology • Includes several additions to basic investment situation • Sale of old machine • Tax consequences • Replacement decision can be analyzed by • Total analysis of both old and new machines • Incremental analysis of cash flow changes between old and new machines Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-34 Sale of Old Asset • Cash inflow from sale of old asset based on sales price and related tax factors • For tax factors we compute the book value of old asset compared with sales price to find taxable gain or loss • Loss can be written off against other income for corporation • Add tax benefit to sale price to arrive at cash inflow from sale of old assets • Compute the net cost of new asset Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-35 Table 12-16 Book Value of Old Computer and Table 12-17 Net Cost of New Computer Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-36 Table 12-18 Analysis of Incremental Depreciation Benefits • Cash flow analysis on basis of • Incremental gain in depreciation • Related tax-shield benefits • Cost savings Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-37 Table 12-19 Analysis of Incremental Cost Savings Benefits Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-38 Table 12-20 Present Value of the Total Incremental Benefits Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-39 Elective Expensing • Businesses can write off tangible properties such as equipment, furniture, tools, and computers in purchased year for up to $1 million. • Tax provision called Section 179 elective expensing • Beneficial to small businesses • Allowance is phased out dollar for dollar on total property exceeding $2.5 million in a year • In 2023 the 100 percent bonus depreciation deduction begins to phase out. • Until then, larger capital purchases can be fully written off in the first year Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-40