Accounting 6310

Chapter 3 – Opportunity Cost of Capital and Capital Budgeting

Opportunity Cost of Capital

• Accounting profits do not include the time value of money

• Economic profits are adjusted for the time value of money

• Capital budgeting generally should involve the use of time value of money

Time Value of Money

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• Present value Future value

• Present value = current value of a sum in the future

• Future value = worth of a sum in the future

• Future value always > than present value due to the interest it can earn

• Annuities – series of equal payments

Capital Budgeting

• Long-term commitments of large amounts of money

• Stages:– Selection stage

• Capital budgeting methods used• Qualitative factors considered

– Financing stage• Done by treasurer

– Implementation and control stage• Get projects underway• Monitor performance• Perform postinvestment audits

Capital Budgeting Methods

• Discounted cash flows (Net present value)

• Payback

• Accounting rate of return

• Internal rate of return

Capital Budgeting Methods

• Discounted cash-flow methods– All cash flows included– Time value of money considered– Expects cash amount to be greater in the

future than the cash invested now– Required rate of return

• Minimum acceptable rate of return• Also called discount or hurdle rate

Discounted Cash Flow (Net Present Value) Method

• 1 - Using present value tables at a chosen discount rate, compute the present value of net cash flows

• 2 - Compare (1) to investment• 3 - Value in (2) should be positive in order to

consider investment further • Problems - NPV varies based on discount rate

chosen; the higher the discount rate, the lower the net present value of cash flows

• Theoretically best to choose the weighted average cost of capital.

Net Present Value

• NPV index: – NPV/Initial investment– Allows different size projects to be compared– Highest NPV index would be chosen

Payback Method

• Time it takes to recover cash investment• Based exclusively on cash flows• Cash flows = net income + depreciation +amort.• Initial investment• Annual cash flows/savings = Payback period• Ex.: $300,000/ $100,000 = 3 years• Pros: simple, highlights liquidity• Cons: ignores time value of money, disregards

cash flows after payback, may produce short-lived projects

Accounting Rate of Return

• Average Return on project investment• Net Income/ Average investment = ROI• Average investment = (Cost + Salvage value) / 2• Ex.: $25,000/(($300,000 + 0)/2)• $25,000/150,000 = 16.7%

• Simple to use• Problems: Ignores time value of money

Internal Rate of Return

• Interest rate computed such that the net present value of the investment is zero.

• IRR assumes that the cash flows will be reinvested at the internal rate of return.

• Often not as reliable as net present value• End product is a percentage that can be compared to

minimum rate of return.• Widely used but hard to calculate if cash flows are not

equal

• When an annuity, you can calculate as such:• Investment/Annual cash flows = factor• Look up factor in the PV of annuity table to determine IRR.

Relevant Cash Flows

• Net initial investment– Purchase of project– Working capital changes– Salvage value of old investment (if sold)– Tax effects of sale of old investment

• Cash flows from operations– Cash savings or payments after taxes– Cash flows from tax advantages of

depreciation

Depreciation Savings

• Depreciation is a non-cash expense; however depreciation expenses reduce the amount of taxes paid

• Thus tax savings from depreciation is a cash flow

• Example: 10,000 asset (3 yrs.), 40% tax rate• MACRS – 1- 33%, 2- 45%, 3 – 14%, 4-8%• 1 – 10,000 x .33 = 3300 tax deduction yields

x .40 = $1,320 cash flows from taxes

Relevant Cash Flows

• Cash flows from disposal of investment– Proceeds from sale– Tax savings (payments) from sale based on

sales price – book value

Other Considerations

• Managers and goal-congruence issues– Managers may be rewarded on short-term

income – Thus they may want to invest in short-term

quick return assets that may not be in the best long-term interest of the company

Postinvestment Audit

• Compares actual results for a project to the costs and benefits expected at the time the project is selected

• Provides feedback about performance– Original estimates may have been overly

optimistic– There may have been problems in

implementing the project

Estimates

• All future cash flows/savings are based on estimates

• Initial cash flows are real

• Be careful with estimates

Analyzing Proposed New Programs

• Can be proactive (take advantage of an opportunity) or reactive (reaction to perceived threat)

• Opportunities emerge from several sources:– New technologies– New markets– Upgrading of equipment– New or existing regulations

Asset allocation system – set of formal routines and procedures designed to process and evaluate requests to acquire new assets or start a new program; often called capital budget plan.

Capital Acquisitions

• Managers need to define– Procedures for capital proposal– Process by which proposals will be gathered and

reviewed by management– Time period for submission

• Strategic acquisitions often must be approved by top managers

• Investments to enhance existing operations often approved by lower-level managers

Capital Acquisitions

• Assets to meet safety/health regulatory needs

• These projects often must be implemented.• Ex: Environmental protection or pollution-controls.• No need to do cost/benefit analyses or capital

budgeting techniques since the projects must be implemented

• Evaluation: engineering studies• Lower-level managers often can approve these

projects

Capital Acquisitions

• Assets to enhance operating efficiency and/or increase revenue

• New technologies• Better equipment• New plants• Evaluation: cost/benefit, capital budgeting

techniques often employed• Lower-level managers often can approve these

projects up to a certain amount

Capital Acquisitions

• Assets to enhance competitive effectiveness

• Funds strategy of business• Must make sure these proposals are in line with

the strategy of the business• New product lines, acquire existing companies,

acquire suppliers, new markets• Approval reserved for highest levels of

management• Can use traditional capital budgeting techniques

but must be very careful due to estimates being very uncertain

Additional Influencing Factors

• Alignment of proposal with existing strategy

• Risks in acquiring the assets/programs

• Risks in deciding not to acquire the asset/programs

• Quality of information supporting proposal

• Track record and ability of people involved

• Feasibility and cost of reversing decision

Problems

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