Capital Budgeting

Typical capital budgeting decisions include:

- Equipment selection - Equipment replacement - Lease or buy - Plant expansion

Typical Cash Inflows

- Increase in revenues - Reduction of costs - Salvage value - Release of working capital

Typical Cash Inflows - After Tax

- Increase in revenues (tax effect) - Reduction in costs (tax effect) - Salvage value (tax effect) - Release of working capital (no tax effect) - Depreciation deduction ( x tax rate)

Typical Cash Outflows - After Tax

- Initial Investments (no tax effect) - Working capital needed now (no tax effect) - Increase in costs (tax effect) - Repairs, maintenance, overhauls (no tax effect)

Typical Cash Outflows

- Initial investment - Increase in variable costs - Repairs, maintenance and overhauls - Working capital needed now

Disadvantages of Payback Method

- It ignores the time value of money - It ignores all information that occurs after the payback period has been reached

4 Capital Budgeting Techniques

- Net present value (NPV) method - Internal rate of return (IRR) method - Payback period - Accounting rate of return method

The cost of capital is also referred to as:

- minimum required rate of return - discount rate - hurdle rate

To calculate the IRR:

2-step process

Accounting Rate of Return =

Annual Net Income From Project/Initial Investment

Step 1:

Calculate the IRR Factor = Initial Investment/Annual Cash Inflows

Working Capital =

Current Assets - Current Liabilities

Accounting Rate of Return includes:

Depreciation

Payback Period equation same as:

IRR Factor

Depreciation Deduction =

Initial Investment/Life

Payback Period =

Initial Investment/Net Annual Cash Inflow

Why is there no tax effect on the initial investment?

Initial investment does not effect revenues or expenses thus it does not effect the taxes owed by a company. The initial investment is giving up an asset for an asset.

Advantage of Accounting Rate of Return Method

It basically represents the return on investment

Disadvantage of Accounting Rate of Return Method

It ignores the time value of money

Advantage of Payback Method

It is very easy to use, calculate, and understand

Net Present Value

NPV = Present Value of Cash Inflows - Present Value of Cash Outflows

Internal Rate of Return (IRR)

Represents the actual or real rate of return generated by an investment project

Cost of Capital

Represents the smallest rate of return the company is willing to accept on its investment projects

After-Tax Cash Flow =

Tax Effect x Amount of Cash Flow

Payback Period

The length of time that it takes for a project to generate enough cash inflows to recover the initial cost of the project

Capital Budgeting

The process of planning and evaluating investments in plant assets (equipment and machinery)

Given the glaring problems with payback, how should it be used in business?

Use it as a screen or filter to narrow the choices down to a reasonable number, then use the NPV to decide between the leftover choices.

Step 2:

Use the IRR Factor and the present value of an annuity table to determine the IRR

A cash flow net of its income tax effect is known as an:

after-tax cash flow

By reducing net income, expenses also reduce the:

amount of income taxes the company owes

Initial investment should be reduced by:

any salvage received from the sale of old equipment

Net present value analysis emphasizes:

cash flows

Accounting Rate of Return does not focus on:

cash flows -- rather it focuses on accounting net income

Use the:

cost of capital to find present values of the cash flows

While depreciation is not a cash flow it is an:

expense and thus does effect the taxes that mus the paid and therefore has an indirect effect on a company's cash flows

Capital projects that involve new products or capacity expansion will usually require:

increases in accounts receivable and inventories. This working capital increase is treated as an additional investment (cash outflow) with the expected recovery of the working capital at the end of the project treated as a cash inflow

Depreciation:

is not deducted in computing the net present value of a project because it is not a cash outflow

A salvage value:

is not subtracted in calculating depreciation for income tax purposes

They typically involve analyzing:

long term investments and deciding which assets to acquire or sell

Capital budgeting decisions tend to be:

long-run in nature

The shorter the payback period:

the better

When the cash flows associated with an investment project change from year to year:

the payback formula introduced earlier cannot be used

If IRR is greater than the cost of capital:

the project earns a return that is larger than the minimum acceptable return and the NPV > 0 (accept)

If IRR is less than cost of capital:

the project earns a return that is smaller than the minimum acceptable return and the NPV < 0 (reject)

If the NPV is zero:

the project is acceptable, since it promises a return equal to the minimum required rate of return

If the NPV is positive:

the project is acceptable, since it promises a return greater than the minimum required rate of return

If the NPV is negative:

the project is not acceptable, since it promises a return less than the required minimum rate of return

Instead:

the un-recovered investment must be tracked year by year

If the IRR is greater than or equal to the minimum required rate of return (cost of capital):

then the project is acceptable

If the IRR is less than the minimum required rate of return (cost of capital):

then the project is rejected