the capital budgeting decision iqs 2009

8/14/2019 The Capital Budgeting Decision IQS 2009

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The Capital Budgeting The Capital Budgeting

DecisionDecisionChapter 12Chapter 12


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Chapter 12 - OutlineChapter 12 - Outline

What is capital budgeting ?What is capital budgeting ?3 methods of Evaluating Investment3 methods of Evaluating InvestmentProposalsProposalsAccept / Reject DecisionAccept / Reject DecisionCapital RationingCapital Rationing

Net Present Value ProfileNet Present Value ProfileDetermining Whether to Purchase aDetermining Whether to Purchase aMachine.Machine.


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What is Capital Budgeting?What is Capital Budgeting?

Capital Budgeting:Capital Budgeting:- Represents a long-term investmentRepresents a long-term investment

decisiondecision- Involves the planning of expendituresInvolves the planning of expenditures

for a project with a life of many yearsfor a project with a life of many years- Usually requires a large initial cashUsually requires a large initial cash

outflow with the expectation of futureoutflow with the expectation of futurecash inflowscash inflows

- Uses the present value analysisUses the present value analysis- EmphasizesEmphasizes cash flowscash flows rather thanrather than


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3 Methods of Evaluation3 Methods of Evaluation

There are 3 widely used methods of There are 3 widely used methods of evaluating investment proposals:evaluating investment proposals:

- Payback Method (PB)Payback Method (PB)- Internal Rate of Return (IRR)Internal Rate of Return (IRR)- Net Present Value (NPV)Net Present Value (NPV)


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Payback MethodPayback Method

Payback Method (PB):Payback Method (PB): - Computes the amount f time required toComputes the amount f time required torecoup the initial investmentrecoup the initial investment

- AA cutoff cutoff period is establishedperiod is establishedAdvantages:Advantages:- Ease to useEase to use- Emphasizes liquidityEmphasizes liquidity

Disadvantages:Disadvantages:- Ignores inflows after the cutoff period andIgnores inflows after the cutoff period andfails to consider the time value of moneyfails to consider the time value of money

- Is inferior to the other 2 methodsIs inferior to the other 2 methods


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Internal Rate of ReturnInternal Rate of Return

Internal Rate of Return (IRR):Internal Rate of Return (IRR):- Represents a yield (or rate of return)Represents a yield (or rate of return)

on an investment.on an investment.- Requires calculating the interest rateRequires calculating the interest rate

that equates the cash outflows (cost)that equates the cash outflows (cost)

with the cash inflows.with the cash inflows.- Is the interest rate where cashIs the interest rate where cashoutflows equals the cash inflows (oroutflows equals the cash inflows (orNPV = 0)NPV = 0)


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Net Present ValueNet Present Value

Net Present Value (NPV):Net Present Value (NPV):- The present value of the cash inflows The present value of the cash inflows

minus the present value of the cashminus the present value of the cashoutflowsoutflows

- The cash inflows are discounted back The cash inflows are discounted back

over the life of the investmentover the life of the investment- The basic discount rate is usually the The basic discount rate is usually thefirms cost of capital (WACC)firms cost of capital (WACC)


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Accept / Reject DecisionAccept / Reject Decision

Payback Method:Payback Method:- If PB period < cutoff period,If PB period < cutoff period, acceptaccept thethe

project. (Vice versa)project. (Vice versa)

Internal Rate of Return:Internal Rate of Return:- If IRR > WACC,If IRR > WACC, acceptaccept the project (Vicethe project (Vice

versa)versa)

Net Present Value:Net Present Value:-- If NPV > 0,If NPV > 0, acceptaccept the project (Vice versa)the project (Vice versa)


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How to Calculate the Cash flow?How to Calculate the Cash flow?

Cash flow 14000

+ Depreciation 5000

Earning after taxes (NI)

9000

- Taxes 40% (cash outflows) (6000)

Earning Before taxes 15,000

-Depreciation (non cash expense) (5000)

Earning before depreciation andtaxes (Cash inflow) $20,000


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Investment AlternativesInvestment Alternatives

5,0005

5,00042,5002,0003

2,0005,0002

$1,500$5,0001

Investment BInvestment A Year

Cash inflows (of $10,000investment)


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Capital Budgeting ResultsCapital Budgeting Results

NPV $177 $1,414 Higher NPV:Investment B

IRR 11.17% 14.33% Higher yield:Investment B

Payback 2 years

3.8years

Quicker payback:investment A

ProjectA

ProjectB

Selection(Decision)


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Capital RationingCapital Rationing

A limit or constraint on the amount of A limit or constraint on the amount of funds that can be invested.funds that can be invested.

The Firm must The Firm must rank rank investmentsinvestmentsbased on their NPVsbased on their NPVs

Those with positive NPVs are Those with positive NPVs areaccepted until all funds areaccepted until all funds areexhausted (used)exhausted (used)


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Capital Rationing: exampleCapital Rationing: example

F 800,000 (30,000)

Best solution E 800,000 6,800,000 40,000D

1,000,000 100,000

Capitalrationingsolution

C 1,000,0005,000,00

0 150,000

B2,000,00

0 380,000

A $2,000,000$400,00

0

Project

Investment

TotalInvestment

NPV Totalamount of capital

available is$5,000,000


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Net Present Value ProfileNet Present Value Profile

Net Present Value Profile:Net Present Value Profile:A graph of the NPV of a project at 3A graph of the NPV of a project at 3different discount rates:different discount rates:

- A zero discount rateA zero discount rate- The normal discount rate (cost of The normal discount rate (cost of

capital)capital)

- The IRR for the investment The IRR for the investmentIt is a tool that allows us to visualizeIt is a tool that allows us to visualize

whether or not an investment shouldwhether or not an investment should


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Net Present Value Profile:Net Present Value Profile:graphgraph

Discount% rate

NPV

$1500

$950Crossover point

Project A

Project BIRR A

IRR B

Crossover rate


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Determining Whether toDetermining Whether to

Purchase a MachinePurchase a Machine To Make the actual investment To Make the actual investment

decision, we need the following:decision, we need the following:

- Calculate a depreciation scheduleCalculate a depreciation scheduleusing the appropriate MACRS classusing the appropriate MACRS class

- Figure earnings and cash flowFigure earnings and cash flow

- Discount the cash flows back to theDiscount the cash flows back to thepresent to determine whether thepresent to determine whether themachine should be purchased (machine should be purchased ( onlyonlyif NPV > 0if NPV > 0 ))


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Buying a machine:Buying a machine:

depreciation scheduledepreciation schedule

Total depreciation 1 50,0006 50,000 0.058 2,9005 50,000 0.115 5,7504 50,000 0.115 5,750

3 50,000 0.192 9,6002 50,000 0.32 16,0001 $ 50,000 0.2 $10,000

Year Depreciation base

Percentagedepreciatio

n

Annualdeprecation

(1) (2) (3) (4)


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Cash flows related to the purchaseCash flows related to the purchaseof the Machineof the Machine

CF 15,525 17,625 15,385 9,812 9,812 8,815

+ Dep 10,000 16,000 9,600 5,750 5,750 2,900

NI 5,525 1,625 5,785 4,062 4,062 5,915

- Tax(35%) (2,975)

(875) (3,115) (2,188) (2,188) (3,185)

EBT 8,500 2,500 8,900 6,250 6,250 9,100

-Dep (10,000

)

(16,000

)(9,600) (5,750) (5,750) (2,900)

EBDT 18,500 18,500 18,500 12,000 12,000 12,000

Year 1 Year 2 Year3 Year

4 Year

5 Year

6


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Net present Value analysisNet present Value analysis

Net present value 7,991P.V of cash outflows (50,000)

P.V of cash inflows 57,9916 8,815 0.564 4,972

5 9,812 0.621 6,0934 9,812 0.683 6,7023 15,385 0.751 11,554

2 17,625 0.826 14,5581 15,525 0.909 14,112

Year Cashinflows P.V. Factor(at 10%) PresentValue


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End of End of chapterchapter

the capital budgeting decision iqs 2009

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