Basic Capital Budgeting
Transcript of Basic Capital Budgeting
-
7/27/2019 Basic Capital Budgeting
1/42
THE BASICS OF CAPITALBUDGETING
Should we
build this
plant?
-
7/27/2019 Basic Capital Budgeting
2/42
What is Capital Budgeting?
Is a summary of planned investments in long
term assets.
Is the whole process of analyzing projects and
deciding which ones to include in the Capital
BudgetingThe process of planning expenditures on assets
whose cash flows are expected beyond one year.
OVERVIEW OF CAPITAL BUDGETING
-
7/27/2019 Basic Capital Budgeting
3/42
1.) The results of Capital Budgeting decisions
continue for many years, the firm loses some of
its flexibility.
2.) Timing is also important- Capital assets must
be available when they are needed.
3.) Can improve both the timing and the quality of
asset acquisitions.
IMPORTANCE OF CAPITAL BUDGETING
-
7/27/2019 Basic Capital Budgeting
4/42
Strategic Business Plan
- A long run plan that outlines in broad terms
the firms basic strategy for the next five to ten years.
-This involves the creation of strategies that are
aimed in maximizing the entitys future position
taking into consideration the various elements and
factors that may pervade the companys internal andexternal environment.
- It involves TOWS (threats, opportunities,
weakness and strength).
WHAT IS STRATEGIC BUSINESS PLAN?
-
7/27/2019 Basic Capital Budgeting
5/42
1.) Replacement: needed to continue current operations One category consists of expenditures to replace worn out or damaged equipment required in the production ofprofitable products.
2.) Replacement: cost reduction- This category includesexpenditures to replace serviceable but obsoleteequipment and thereby to lower costs.
3.) Expansion of existing products or markets These areexpenditures to increase out-put of existing products or toexpand retail outlets or distribution facilities in marketsnow being served.
4.) Expansion into new products or markets Theseinvestments relate to new products or geographic areas,and they involve strategic decisions that could change thefundamental nature of the business.
PROJECT CLASSIFICATION
-
7/27/2019 Basic Capital Budgeting
6/42
5.) Safety and / or environmental projects
Expenditures necessary to comply with
government orders, labor agreements, or
insurance policy terms fall into this category.
6.) Other projects This catch all includes items
such as office buildings, parking lots, and
executive aircraft.
7.) Mergers One firm buys another one. Buying a
whole firm is different from buying an asset such
as a machine or investing in a new airplanes, but
the same principles are involved.
PROJECT CLASSIFICATION
-
7/27/2019 Basic Capital Budgeting
7/42
1. Finding Investment Opportunities
2. Collect Relevant Information about
Opportunities
3. Select Discount Rate
4. Financial Analysis of Cash Flows
5. Decision
6. Project Implementation
7. Project Evaluation and Appraisal
STEPS TO CAPITAL BUDGETING
-
7/27/2019 Basic Capital Budgeting
8/42
1.) Independent projects if the cash flows of
one are unaffected by the acceptance of the
other.
2.) Mutually exclusive projects if the cash
flows of one can be adversely impacted by the
acceptance of the other.
WHAT IS THE DIFFERENCE BET WEEN
INDEPENDENT AND MUTUALLY EXCLUSIVE
PROJECTS?
-
7/27/2019 Basic Capital Budgeting
9/42
1.) Normal cash flow stream Cost (negative CF)
followed by a series of positive cash inflows. One
change of signs.
2.) Non normal cash flow stream Two or more
changes of signs. Most common: Cost (negative
CF), then string of positive CFs, then cost to closeproject. Nuclear power plant, strip mine, etc.
WHAT IS THE DIFFERENCE BET WEEN
NORMAL AND NON NORMAL CASH FLOW
STREAMS?
-
7/27/2019 Basic Capital Budgeting
10/42
1. Cash Inflows
Periodic cash inflows from operations, net of taxes
Investment tax credit
Proceeds from sale of old asset being replaced, net
of taxes
Avoidable costs, net of taxes
Return of some working capital invested in theproject
Cash inflow from salvage of the new long term
asset at the end of its useful life. This will be net of
tax consequence
CATEGORIES OF PROJECT CASH FLOWS
-
7/27/2019 Basic Capital Budgeting
11/42
2. Cash Outflows
Acquisition cost of purchasing and installing
assets
Additional working capital
Other cash flows such as severance payments,
relocation costs, restoration costs and similar
costs.
CATEGORIES OF PROJECT CASH FLOWS
-
7/27/2019 Basic Capital Budgeting
12/42
Initial cash outlay Pxxx
Add: Additional cash outlay
related to the asset Pxxx
Additional working capital xxx xxx
Total Pxxx
Less: Cash inflow arising from
sale of old assetbeing replaced Pxxx
Avoidable costs xxx xxx
Net investment Pxxx
NET INITIAL INVESTMENT OR PROJECT
COST
-
7/27/2019 Basic Capital Budgeting
13/42
A new sorter can be purchased for P96,000. The
dealer will grant a trade in allowance of P16,000
on the old machine. If a new machine is not
purchased, Maingat Company will spend P10,000to repair the old machine. Gains and losses on
trade in transactions are not subject in income
taxes. The cost to repair the old machine can be
deducted in computing income taxes. Income
taxes are estimated at 40% of the income subject
to tax. Additional working capital required is
P50,000.
NET INITIAL INVESTMENT OR PROJECT
COST
-
7/27/2019 Basic Capital Budgeting
14/42
Solution: Maingat Company
Purchase price of new sorter P 96,000
Add: Additional working capital 50,000
Total P146,000
Less: Trade in allowance on old
sorter P16,000
Avoidable repairs cost on
old sorter 6,000 22,000
Net Investment P124,000
COMPUTATION OF NET INITIAL
INVESTMENT
-
7/27/2019 Basic Capital Budgeting
15/42
Annual incremental revenue from the project
Less: incremental cash operating costs
Annual cash inflow before taxes
Less: Taxes
(Tax rate (Annual cash inflow before taxes
Depreciation)
Annual net cash inflow after taxes
ANNUAL CASH INFLOWS AND OUTFLOWS
(NET CASH RETURNS)
-
7/27/2019 Basic Capital Budgeting
16/42
Annual incremental revenue from the project
Less: Incremental cash operating costs
Annual cash inflow before taxes
Less: Incremental depreciation
Net income before taxes
Less: Income after taxes
Net income after taxes
Add: Incremental depreciation
Annual net cash inflow after taxes
ANNUAL CASH INFLOWS AND OUTFLOWS
(NET CASH RETURNS)
-
7/27/2019 Basic Capital Budgeting
17/42
Cash operating costs
Less: Annual cash operating cost
Cash savings before taxes
Less: Incremental depreciation
Increase in income before taxes
Less: income taxes
Increase in income after taxesAdd: Incremental depreciation
Net cash savings after taxes
ANNUAL CASH INFLOWS AND OUTFLOWS
(NET CASH RETURNS)
-
7/27/2019 Basic Capital Budgeting
18/42
1. Tax Savings on Loss on sale of old
machinery
2. Additional Tax on Gain on sale of oldmachinery
3. Recovery of Working Capital
TERMINAL CASH FLOWS
-
7/27/2019 Basic Capital Budgeting
19/42
1.) Payback
2.) Discounted payback
3.) NPV (Net Present Value)
4.) IRR (Internal Rate of Return)
5.) MIRR (Modified Internal Rate of Return)
METHODS TO EVALUATE CAPITAL
PROJECTS
-
7/27/2019 Basic Capital Budgeting
20/42
The number of years required to recover a
projects cost, or How long does it take to
get our money back?
Calculated by adding projects cash inflows
to its cost until the cumulative cash flow
for the project turns positive
Net Investment
Annual Cash Returns
WHAT IS THE PAYBACK PERIOD?
-
7/27/2019 Basic Capital Budgeting
21/42
Strengths
1.) Provides an indication of a projects risk
and liquidity.
2.) Easy to calculate and understand.
Weaknesses
1.) Ignores the time value of money.
2.) Ignores CFs occurring after the payback
period.
STRENGTHS AND WEAKNESSES OF
PAYBACK
-
7/27/2019 Basic Capital Budgeting
22/42
Sum of the PVs of all cash inflows and
outflows of a project :
NET PRESENT VALUE (NPV)
-
7/27/2019 Basic Capital Budgeting
23/42
NPV = PV of inflows Cost
= Net gain in wealth
If projects are independent, accept if the project
NPV > 0.
If projects are mutually exclusive, accept projects
with the highest positive NPV, those that add the
most value.
RATIONALE FOR THE NPV METHOD
-
7/27/2019 Basic Capital Budgeting
24/42
An investment of P50,000 will yield an average
annual cash return of P7,500 a year for a period
of 10 years.
1.) Investment = Annual Cash Returns (PV factor)
50,000 = 7,500x
x = 50,000/7500
= 6.66667
COMPUTING FOR IRR METHOD
-
7/27/2019 Basic Capital Budgeting
25/42
2.) 8% = 6.710
? = 6.667 .043 .565
10% = 6.145
Exact discounted rate of return = 8% + .043 x
2%
.565
= 8% + .15%
= 8.15%
COMPUTING FOR IRR METHOD
-
7/27/2019 Basic Capital Budgeting
26/42
If IRR > WACC, the projects rate of return is
greater than its costs. There is some return left
over to boost stockholders returns.
RATIONALE FOR THE IRR METHOD
-
7/27/2019 Basic Capital Budgeting
27/42
Accept> k, accept project.
If IRR < k, reject project.
If projects are independent, accept both
projects, as both IRR > k
IRR ACCEPTANCE CRITERIA
-
7/27/2019 Basic Capital Budgeting
28/42
If projects are independent, the two methods
always lead to the same accept/reject
decisions.
If projects are mutually exclusive
If k > crossover point, the two methods lead to
the same decision and there is no conflict.
If k < crossover point, the two methods lead todifferent accept/reject decisions.
COMPARING THE NPV AND IRR METHODS
-
7/27/2019 Basic Capital Budgeting
29/42
MIRR correctly assumes reinvestment at
opportunity cost = WACC. MIRR also avoids the
problem of multiple IRRs.
Managers like rate of return comparisons, and
MIRR is better for this than IRR.
WHY USE MIRR VERSUS IRR?
-
7/27/2019 Basic Capital Budgeting
30/42
NPV method assumes CFs are reinvested at k, the
opportunity cost of capital.
IRR method assumes CFs are reinvested at IRR.
Assuming CFs are reinvested at the opportunity
cost of capital is more realistic, so NPV method is
the best. NPV method should be used to choosebetween mutually exclusive projects.
Perhaps a hybrid of the IRR that assumes cost of
capital reinvestment is needed.
REINVESTMENT RATE ASSUMPTIONS
-
7/27/2019 Basic Capital Budgeting
31/42
If an independent project is being evaluated, then the NPV and
IRR criteria always lead to the same accept/reject decision.
For mutually exclusive projects (choosing among acceptable
alternative) especially those that differ in scale (project size)
and / or timing a conflicts of ranking may arise.The IRR method may favor one alternative over another while
the NPV method may indicate otherwise.
If conflicts arise, the NPV method should be used.
The NPV method assumes the cash flows will be reinvested atthe firms cost of capital while the IRR method assumes
reinvestment at the projects IRR. Because reinvestment at the
cost of capital is generally a better (closer to reality)
assumption, the NPV is superior to the IRR.
COMPARING THE PREFERENCE RATES
-
7/27/2019 Basic Capital Budgeting
32/42
The management of Dawn Company plans to replace a
sorting machine that was acquired several years ago
at a cost of P850,000. The machine has been
depreciated to its residual value of P90,000. A new
sorter can be purchased for P2,940,000, 3/10, n/30.
The dealer wil l grant a trade in allowance of P176,000
on the old machine. If the new machine is not
purchased, Dawn wil l spend P745,000 to repair the old
machine. Gains and losses on trade in transactionsare not subject to income tax. The old to repair the old
machine can be deducted in the first year for
computing income tax. Income tax is estimated at
40% of the income subject to tax.
EXAMPLE: COMPUTE FOR THE INITIAL
INVESTMENT
-
7/27/2019 Basic Capital Budgeting
33/42
The Horizons Corporation is planning to add a new
product line to its present business. The new productwill require a new equipment costing P12,000,000,
having a five year useful life with no residual value.
Tax rate is 30%. The following est imates are madeavailable:
Annual Sales P20M
Annual costs & expenses;
Materials P4.8MLabor 6.2M
Factory overhead(excluding depreciation on new
equipment) P2,540,000
Selling and Admin P1,700,000
EXAMPLE: COMPUTE FOR THE NET
RETURNS
-
7/27/2019 Basic Capital Budgeting
34/42
Project A has a cost of P52,125, its expected net cash
inflows are P12,000 per year for 8 years, and its cost
of capital is 12 percent. Calculate the Projects
1. Payback period.2. Discounted Payback period
3. NPV
4. Internal Rate of Return
EXAMPLE OF METHODS OF EVALUATION
-
7/27/2019 Basic Capital Budgeting
35/42
Sunshine Corporation is planning to purchase a new
machine costing P2,800,000, with freight andinstallation costs amounting to P135,000. The old
unit to be traded in will be given a trade in allowance
of P260,000. Other assets that are to be retired as aresult of the acquisition of the new machine can beresidual and sold for P52,000. The loss on retirement
of these other assets is P50,000 and will reduce
taxes by P20,000. If the new machine is not
purchased, extensive repairs on the old machine willhave to be made at an estimated cost of P400,000.
This cost can be avoided by purchasing the new
machine. Additional gross working capital of
P350,000 will be needed to support operations with
the new machine.
SEATWORK: COMPUTE FOR THE INITIAL
INVESTMENT
-
7/27/2019 Basic Capital Budgeting
36/42
The Mabuhay Corporation plans to acquire a newequipment costing P1,340,000 to replace theequipment that is now being used. Freightcharges on the new equipment are estimated at
P75,000 and it will cost P90,000 to install.Special attachment to be used with this unit willbe needed and will cost P64,000. If the newequipment is acquired, operations will beexpanded and this will require additional working
capital of P310,000. The old equipment had anet book value of P45,000 and will be sold forP25,000. If the new equipment is not purchased,the old equipment must be overhauled at a costof P320,000. This is deductible for tax purposes
in the year incurred. Tax rate is 30%
SEATWORK: COMPUTE FOR THE INITIAL
INVESTMENT
-
7/27/2019 Basic Capital Budgeting
37/42
SEATWORK: COMPUTE FOR THE INITIAL
INVESTMENT
The JT Company plans to open a new branch office
wherein the company shall invest P2,500,000 infurnishings and equipment. Construction and other
related outlays are estimated at P4,550,000. Sales
from this new branch are estimated at P9,000,000 ayear. One third of these sales will be in the form ofaccounts receivable at any given time. Cost of goods
sold is estimated to be sixty percent of sales. The
investment in merchandise inventory is
approximately P400,000 at any time during the year.Cash of P120,000 will be needed to meet payments
for operating expenses. Accounts payable and other
current liabil ities are expected to increase by 5% of
sales.
-
7/27/2019 Basic Capital Budgeting
38/42
SEATWORK: COMPUTE FOR THE
INCREASE IN ANNUAL NET INCOME
Frelins Corporation is p lanning to replace its present
printing equipment with a more efficient unit. The new
equipment will cost P400,000 with five year useful life,
no salvage value.
The old unit was acquired three years ago for P500,000.
The company uses the straight line method in
appreciating its depreciable assets. The old unit is being
depreciated at P62,500 per year. If the new equipment is
acquired, the old one will be sold for P100,000.
Otherwise, the company will just continue using for 5
years.
Saving in cash operating costs are P100,000 and
P220,000 for the new and old equipments, respectively.
Income tax is at the rate of 32% of income before tax.
-
7/27/2019 Basic Capital Budgeting
39/42
SEATWORK: COMPUTE FOR THE PAYBACK
PERIOD, NPV, DISCOUNTED PAYBACK, IRR
The Liquid Corporation contemplates the replacement
of an old machinery. The annual cost of operating
the old machinery is P138,600, excluding
depreciation, while the estimate for the newmachinery is P91,300. The cost of the new
machinery is P160,000, net of the trade in
allowance, with an estimated useful life of 8 year, no
residual value. The effective income tax rate of 40%
and the cost of capital is 8%. The old machinery has
an annual depreciation of P15,000 while the new
machinery is estimated to have an annual
depreciation of P20,000. The book value of the old
machine is zero.
-
7/27/2019 Basic Capital Budgeting
40/42
COMPUTE WHAT IS REQUIRED
The following data pertain to a five year project being
considered by Alen C. Corporation:
1. A new equipment costing P1.8 million will be
acquired on January 1, 200A. It will be depreciated
using the straight line method over a five yearperiod, with a salvage value of P200,000 at the
end of 5 years.
2. The new equipment will replace an old one that has
been fully depreciated to its salvage value of P220.Another company has offered to buy this old
equipment for P250,000 on the replacement date.
-
7/27/2019 Basic Capital Budgeting
41/42
COMPUTE WHAT IS REQUIRED
3. The project is expected to generate incremental
sales of P50,000 units per year. The contribution
margin per unit is P10. Incremental project fixed
costs, excluding depreciation, is P130,000.
4. The project requires additional investment inworking capital of P70,000. This amount is fully
recoverable at the end of the fif th year.
Alen C. Corporation is subject to an income tax rate of
32%. Its cost of capital (hurdle rate) is 10%.
-
7/27/2019 Basic Capital Budgeting
42/42
REQUIRED:
1. Compute the net cost of investment in the
new equipment.
2. The present value of expected incremental
contribution margin.(net of tax)3. The new equipment is expected to generate
annual cash inflows, net of income taxes of?
4. The new equipments net present value?