Capital Budgeting

Capital Budgeting

Professor Peter Chung

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Capital Budgeting

IHow to appraise a capital project?

(Investment Decision)

II.Net incremental Cash Flow

III.How to measure Cash Flow?

1. Initial outlay

2. Differential of C/Fs

3. Terminal C/Fs

4. C/F Diagram

IV.Methods of evaluating project

1. NPV4. PP

2. PI5. a comprehensive example

3. IRR

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I. Investment Decision

Capital budgeting

= investing on long term assets, and involves:

Measuring the incremental CFs

Evaluating the attractiveness

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II. Net Incremental CFs

The difference between CFs for the firm with AND without the projects

What are the elements of the cos CFs that would be affected

What would be the expected level of these CFs in each period

What would be the expected level of these CFs in each period

e.g. With without net incremental

Maintenance$ 3,000$ 8,000$ 5,000

CEO salary$1,000,000$980,000$20,000

Criteria: 1.

2.

3.

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III. How do we Measure CFs?

Initial outlay

C/O=

C/I =

C/I or C/O =

Differential after tax CFs each year

C/I =

C/O=

C/I - C/O = differential after tax

Terminal CF

C/I=

C/O=

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Handout Example: Measuring Cash flows for Capital Budgeting Decision

ABC company is considering the purchase of a new machine for $30,000, which will be depreciated over the five years. The new machine will replace an existing machine originally purchase for $30,000 ten years ago and currently has five years of expected useful life. The existing machine will generate $2,000 of depreciation expenses for each of the new five years at which time the book value will be equal to zero. In order to put the new machine in running order, it is necessary to pay shipping charges or $2,000 and installation charges of $3,000. Because the new machine will work faster than the old one, it will require an increase in goods in process inventory of $5,000. Finally, the old machine can be sold for 15,000 to a scrap dealer.

Suppose that purchasing the new machine is expected to reduce salaries by $10,000 per year and fringe benefits by $1,000 annually, because it will take only one man to operate whereas the old machine requires two operators. In addition, the cost of defects will fall from $8,000 per year to $3,000. However, maintenance expenses will increase by $4,000 annually.

Recall that the depreciated book value and salvage value of the machine at the termination date will equal to zero. There will be a cash flow associated with the recapture of the initial outlay of work in process inventory of $5,000. This flow is generated from the liquidation of the $5,000 investment in work in process inventory. Therefore, the expected total terminal cash flow equals $5,000

Assume that the company is in 34% tax bracket.

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Handout Example for measuring CF

Initial Outlay

C/Opurchase price$30,000

shipping$ 2,000

installation$ 3,000 +

$

Increased tax ($15,000-$10,000)x34%$ 1,700

Increase in inventory$ 5,000 +

$

C/Iselling price of old machine$15,000

Net initial outlay$

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Handout example (cont)

Differential after tax CF each year

Profit CF

Saving

Reduced salary$10,000$10,000

Reduced fringe benefit$ 1,000$ 1,000

Reduced defect ($8,000-$3,000)$ 5,000$ 5,000

Costs

Maintenance-$ 4,000-$ 4,000

Depreciation -$ 5,000

increase profit $ 7,000

Increase in tax = $ 2,380-$ 2,380

Differential after tax each year$

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Handout example (Cont)

Terminal CF:

0 1 2 34 5

-$26,700 $5,000

Initial outlay$9,620 /yrTerminal CF

Annual net after tax each year

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IV. Methods for Evaluating Projects

1. NPV Project

a. NPV= PV of the projects annual net at CFs Initial Outlay

=

0 1 2 34 n

Initial ACF1 ACF2 ACF3 . . . . . ACFn

outlay

b. Decision criteria

if NPV > 0, then

if NPV < 0, then

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NPV Project

e.g.

0 1 2 34 n

-$25,700 $5,000

Initial outlay$9,620 /yr Terminal CF

NPV, assuming r = 10%

NPV =PV of C/I PV of C/O

=$

=$ accept the project

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Method of Evaluating Project

2. PI = Profitability Index (Benefit/Cost Ratio)

a.

b. if PI > 1

PI < 1 to see which dominances and by how much

c. NPV vs. PIwhen there are more than one positive

absoluterelative measure NPV projects, we may want to see PIs

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Method of Evaluating Project

3. Internal Rate of Return

a. IRR = the discount rate that equates the PV of C/I with PV of C/O

b. if IRR > RRR (hurdle rate), then

IRR < RRR, then

c. How do we compute IRR?

012345

I/OACF1 ACF2 ACF3 . . . . ACFn

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3. Internal Rate of Return

e.g. 01234

-$45,555n=4 yrs

RRR = 10%ACF $15,000 /yr

(answer): PV of C/I = PV of C/O

IRR = RRR= =>

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3. Internal Rate of Return

0 12 3 -$3,817 $1,000 $2,000 $3,000

Trial & Error Method uneven CFs

1. pick an arbitrary discount rate and see if

2. if PV of C/I > PV of C/O then

PV of C/I < PV of C/O then

(answer):

1. Try i=PV of C/I > PV of C/O $ 3,817

2. Try i=PV of C/I < PV of C/O $ 3,817

3. Try i=PV of C/I = PV of C/O $ 3,817

The IRR is then

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Interpolation

012345

-$350 $100 $100 $100 $200 $200

IRR.?

(answer):Discount RateNPV

0%$350.00

10%$159,48

20%$ 37.47

30%($44.50)

IRR should be between 20% and 30 %

20%$37.47

10% x $37.44 $0 $81.97

30 % ($44.50)

X=?

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Problems with IRR method

(1) Multiple Rates of Returns

e.g.Initial outlay$1,600

yr 1 ACF$10,000

yr 2 ACF($10,000)

There will be 2 IRRs (25%, 400%) which make

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Non Discounted CF Method

1. Payback Period (PP) Method

a. PP = the # of years required to recover the initial outlay

b. e.g.0-$10,000

1$2,000recover

2$4,000PP = 3.33 years

3$3,000

4$3,000

5$1,000

c. problem

1.

2.

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PP Method

e.g. Year A B

0 -10,000 -10,000

16,0005,000

24,0005,000

33,000 0

42,000 0

51,000 0

PP = 2 yrs

PP = 2 yrs

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A Summary

A Comparison of Project Evaluation Methods

Table 8-3 in BMM (page 258)

NPV

PI

IRR

PP

Project Evaluation Methods used in Practice

Table 8-4 in BMM (page 259)

NPV PIIRRPP

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A Comprehensive example of Capital Budgeting Decision (Handout)

Existing situation:

one full-time operator-salary $12,000

Variable overtime-$1,000 /yr

Fringe benefit - $1,000 /yr

Cost of defects - $6,000 /yr

Depreciable value of old machine - $30,000

Current book value $10,000

Expected life - 15 year

Expected salvage value $0

Age10 years

Annual depreciation - $2,000 /yr

Current market value of old machine $12,000

Annual maintenance - $0

Marginal tax rate 34%

Required rate of return 15%

Proposed situation:

Fully automated operation-no operator necessary

Cost of machine - $50,000

Shipping fee - $1,000

Installation costs - $5,000

Expected economic life 5 years

Depreciation method straight line over 5 yr

Salvage value after 5 yr - $0

Annual maintenance - $ 1,000

Cost of defects - $1,000 /yr

Calculate NPV, PI, IRR, and PP for this potential project and show your decision according to each method of project evaluation

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Comprehensive example (Cont)

a. Initial Outlay

cash outflow

Cost of machine$50,000

Shipping$ 1,000

Installation$ 5,000

capital gain tax

$ 680

cash inflow

Market price of

old machine$12,000

Net initial outlay

Step 1. Calculate relevant CFs

b. After tax differential CF each year

Saving Profit CF

reduced salary12,00012,000

reduced over time 1,000 1,000

reduced fringe benefit 1,000 1,000

reduced defect 5,000 5,000

Cost

Increased maintenance1,000 1,000

Increase in depreciation

(w/ old machine: )

(w/ new machine: )

Net differential each year

Tax at 34% 2,992 2,992

AT differential CF each year

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Comprehensive example (Cont)

c. Terminal Cash Flow = $0

0 1 23 4 5

-$44,680 $0

$15,008 / yr

Step 2. Draw the Cash Flow Diagram

NPV = PV of C/I PV of C/O

=

=

= accept

Step 3. Evaluate the Project

PI = PV of C/I =

PV of C/O

= accept

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Comprehensive example (Cont)

c. IRR = the discount rate that makes PV of C/I exactly the same as PV of C/O

IRR = 15,008 (PVAFx%,5) = 44,680

at 20% 2.991

1% x% 0.014 2.977 0.065

21% 2.926

Do interpolation

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Comprehensive example (Cont)

d. years 3 years (the number of years that take to recover the initial outlay)

In sum,

For such a comprehensive capital budgeting question, follow steps:

Step 1. Calculate relevant CFs and put them into three categories

1. Initial outlay

2. Net Incremental CF per year

3. Terminal CF

Step 2. Draw a CF Diagram

Step 3. Compute

NPV, PI, IRR, & PP

And show your decision following your decision criteria

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O

C

of

PV

I

C

of

PV

PI

/

/

=

98

.

2

008

,

15

680

,

44

=

=

PP