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SCREENING TECHNIQUES USED IN CAPITAL

INVESTMENT DECISIONS

TYPES OF CAPITAL INVESTMENT DECISIONS

THE CAPITAL BUDGETING PROCESS

TECHNIQUES FOR CAPITAL BUDGETING

o PAYBACK

o DISCOUNTED CASH FLOW METHODS

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TYPES OF CAPITAL INVESTMENT DECISIONS

REPLACEMENT DECISIONS:

Old machinery wears out. How do we decide when to replace and

which alternatives to purchase? What are the relevant costs and

revenues?

EXPANSION DECISIONS:

Current capacity is no longer sufficient. How do we

decide when and how to expand?

Which alternatives do we choose?

DIVERSIFICATIONDECISIONS:

Is the movement into new markets justified?

What are the implications to our current markets in terms of risk

and return?

DECISIONS INVOLVING R&D, POLLUTION CONTROL, ETC.

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CAPITAL BUDGETING

IDEAS

I. TYPES OF PROJECTS A. Expansion

B. Replacement

C. Other

II. CASH FLOW ANALYSIS A. Collect Data and Information

B. Initial Cash Outlay

C. Interim Cash Flows

D. Terminal Year Cash Flow

III. TECHNIQUES A. Payback Period

B. Internal Rate of Return

C. Net Present Value

D. Profitability Index

IV. SPECIAL ISSUES

A. Ranking B. Scale C. Pattern D. Life

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TYPES OF PROJECTS

1. INDEPENDENT - Acceptance of one doesn't eliminate others - can have capital constraints. 2. MUTUALLY EXCLUSIVE - Acceptance of one eliminates the other. "Old vs. New" 3. CONTINGENT - Acceptance of one requires acceptance of others. System/Sorter/Proof/Software/Hard ware

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ESTIMATING CASH FLOWS

I. INITIAL CASH OUTLAY

II. INTERIM CASH FLOWS

III. TERMINAL YEAR

REMEMBER:

A. Measured on and Incremental Basis

Old $20,000 New $30,000

Incremental

B. Measure After Tax

C. Include Indirect Effects

Effects on Working Capital

D. Sunk Costs are NOT considered

They are costs incurred “no matter what”

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INITIAL CASH OUTLAY "ICO"

COST OF NEW ASSETS

$ _ _ _ _ _ _ _ _ _

+ CAPITALIZED EXPENSES (e.g. installation, shipping, etc.)

$ _ _ _ _ _ _ _ _ _

+(-) INCREASED (Decreased) Level of working capital **

$ _ _ _ _ _ _ _ _ _

-PROCEEDS FROM SALE OF OLD ASSETS (When replacement decision)

$ _ _ _ _ _ _ _ _ _

+(-) TAXES (Savings) DUE TO GAIN (Loss) ON SALE OF OLD ASSETS (Replacement)

$ _ _ _ _ _ _ _ _ _

= INITIAL INVESTMENT (ICO)

$ _ _ _ _ _ _ _ _ _

*Asset cost plus capitalized expenses form the basis upon

which depreciation is computed.

** Any change in working capital should be considered "net" of

any automatic change in current liabilities (such as accounts

payable) which occur because the project is adopted and

which have no explicit (cash) cost to the firm.

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INTERIM CASH FLOWS (Per Period)

+ (-) Net increase (or decrease) in operating revenue less (or

plus) any net increase (or decrease) in operating expenses,

excluding depreciation

-(+)

Net increase (or decrease) in depreciation charge

= Net change in income before taxes

-(+)

Net increase (or decrease) in taxes

= Net change in income after taxes

+ (-)

Net increase (or decrease) in depreciation charge

= INCREMENTAL CASH FLOW FOR PERIOD

NOTE: Our concern is with projected related cash flows (initial,

interim and terminal) and not financing flows; therefore,

interest payments, principal payments, and cash dividends

are not considered here. They will not be ignored, however,

the hurdle rate (or discount rate) used for the project will

capture the financing cost dimension.

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TERMINAL YEAR NET CASH FLOW

Terminal year after-tax "net" change in "operating" Cash flow due

to use of "new" asset

* Any change in working capital should be considered "net" of

any automatic changes in current liabilities (such as accounts

payable) which occur because the project is terminated.

+ Final salvage value of "new" asset

-(+) Taxes (or tax savings) due to gain (or loss) on sale of

"new" asset

+ (-) Decreased (or increased) level of "net" working capital*

= TERMINAL YEAR NET CASH FLOW

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THE CAPITAL BUDGETING PROCESS

Definition:

THE ENTIRE PROCESS OF PLANNING EXPENDITURES WHOSE

RETURNS ARE EXPECTED TO EXTEND BEYOND ONE YEAR

CHOOSING AMONG ALTERNATIVE PROPOSALS:

**Usually, there are more proposals than the firm, bank, company can

accept.

Some are MUTUALLY EXCLUSIVE;

Some are NOT PROFITABLE;

Sometimes firms suffer from LACK OF

FINANCINGfor good projects;

**We need a method for RANKING projects:

We want to be sure the ranking method results in

selection of the Best Set of alternatives;

The Best Set should be that combination which results

in the largest increase in the value of our firms, bank's

stock in the long run;

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METHODS TO RANK

CAPITAL BUDGETING

PAYBACK PERIOD -TIME Number of periods required to recover initial investment;

INTERNAL RATE OF RETURN - % The interest rate that equates the present value of cash inflows and cash

outflows;

NET PRESENT VALUE - $ The dollar ($) difference between the present value of after-tax cash

inflows and cash outflows; NPV>O

PROFITABILITY INDEX - # The ratio of the present value of after-tax cash inflows to

the initial cost PI>1

PI = PV of inflows

Outflow

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T = The last full year in which cumulative net cash inflows are less

than the initial cash outlay

B = The initial cash outlay

C = The cumulative cash inflow during the last full year when it was

less than the initial cash outlay (year T)

D = The cumulative cash inflow in year T + 1

E = Cash inflow in year T + 1

Time Cash Flows Cumulative Inflows

0 (B) -9,400

1 3,400 3,400

(T) 2 3,920 (C) 7,320

3 (E) 3,880 (D) 11,200

4 3,600 14,800

3) Cutoff Point is a subjective decision.

PAYBACK PERIOD (PB)

Definition: The period of time required for the

cumulative cash inflows from a project

to equal the initial cash outlay.

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QUESTION: How would we use PB?

ANSWER: Accept a project if payback < a cutoff

number of periods

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INTERNAL RATE OF RETURN (IRR)

Definition: The Discount Rate that equates the present value of the future net cash flows from a project with the project’s initial cash outlay.

\

Therefore…

THE IRR, TOGETHER WITH THE COST OF CAPITAL,

DETERMINES THE PROFITABILITY OF THE

INVESTMENT CONSIDERED BY ITSELF.

IRR > K, ACCEPT

IRR <K, REJECT

WHERE K = THE COST OF CAPITAL

NET PRESENT VALUE (NPV)

Definition: The Present Value of a Project's Net After-tax

cash flows less the Project's initial cash outlay.

INTERNAL RATE OF

RETURN (IRR)

Definition: The discount rate that gives a

project a net present value equal to zero.

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Why is IRR Popular?

"Managers like the IRR, since they consider it important to know the

differential between the proposed investments internal rate of return and the

required return. This is a measure of safety that allows an evaluation of the

investment's return compared to its risk. If an investment has an IRR of .30 when

the required return is .12, this is a large margin, which allows for error. A net

present value measure does not give the same type of information to

management."

Source: Harold Bierman 1r. and Seymour Smidt, The Capital Budgeting Decision: Economic

Analysis of Investment Projects, 75th ed., Macmillan Publishing Company (1988), p. 109.

PROFITABILITY INDEX (PI) (or Benefit/Cost ratio)

Definition:

The ratio of the present value of a

project's future net cash flows to

the project's initial cash outlay.

PI atK>1, ACCEPT

PI at K, <1, REJECT

Where K= THE COST OF

CCAPITAL

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BRICKS & MORTAR NATIONAL BANK

Exhibit 1: Start Up Expenses

Supplies Software Network Costs:

$

$

Implementation Fee $ ATM Installation $ Internet Installation $ Network Membership $

Total Network Costs $ Personnel Training Expense $ Training Travel Expense

$

Building &Equipment:

ATM cost Building Modifications

$

$ Building Depreciation $

Heating/Cooling Equipment $ Signage $

Total Depreciable Costs $

Initial Cash Outlay(Total Startup) $

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BRICKS & MORTAR NATIONAL BANK

Exhibit 3: Ongoing Expenses Per Month

ATM Maintenance Contract Employee Costs

$

$

Card Issuance Terminal Fees Network Management ATM Replenishment Fees Marketing Support Fees Network Fees Intangible s Tax

$

$

$

$

$

$

$

Other Pass Through: Data Line Modem Rental Monthly Miscellaneous Supplies

$

$

$

Net Cost Per Month

$

Annual Costs $