Session 16 - Capital Budgeting

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Nov 24, 2024

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1 Accounting 102 Session 16 Capital Budgeting and Evaluation of Investment Opportunities
2 Capital Budgeting An important element of capital budgeting involves choosing which, from among a group of investments opportunities, should be undertaken and how that (those) selected investment(s) should be financed. – From financial economics we know that, in general, the investment decision can and should be separated from the financing decision. And, we are concerned only with the former.
3 The Investment Decision The most appropriate method to evaluate long-term investments and to choose among them is on the basis of the Net Present Value (NPV) of their cash flows using Discounted Cash Flow (DCF ) Analysis: 1) Estimate the amounts and timing of future cash inflows and outflows (CF t ) for each alternative 2) Determine the Net Present Value (NPV) of the cash flows by discounting them to the present using the firm's cost of capital (r) and summing them. (The discount rate is the cost of capital, i.e., the required rate of return to the firm's assets.) 3) Choose from among the alternatives based on the NPV a) For a single project, choose if and only if its NPV is positive ; b) For several mutually exclusive alternatives, choose the alternative with the highest positive NPV . Clearly, using the NPV criterion is equivalent to choosing investment projects that maximize shareholder value. t t r CF NPV ) 1 (
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4 Example : A project has an initial cash outflow of $90. It’s expected to yield cash inflows of $55 at the end of the first year and $60.50 at the end of the second year. The firm's cost of capital is 10%. Should the firm accept the project? Using the firm’s cost of capital as the discount rate, the NPV for the project is NPV = – 90 + 55 + 60.50 (1 +0.10) 0 (1 +0.10) 1 (1 +0.10) 2 = 10 Accept project The fact that the NPV is greater than zero means that if the firm accepts the project it can expect to earn a return in excess of the cost of capital (i.e. greater than 10%). > 0
Are There Other Criteria That Can Serve in Place of NPV?
6 Using the cash flows for the preceding example, we get: 1) Internal Rate of Return (IRR) The internal rate of return is the discount rate which equates the NPV of a stream of cash flows to zero. If the IRR can be determined, then, in general, choosing IRR > r often leads to the same decision as choosing NPV > 0 . 1 The IRR criterion is useful for choosing among projects with the same NPV. 0 = – 90 + 55 + 60.50 (1 + IRR) 1 (1 + IRR) 2 IRR = 18% > 10% Accept the project 1 Refer to the appendix for a discussion of some of the shortcomings of IRR as an investment criterion (different time horizons and scales, cash flows with different signs, multiple IRRs). t t IRR CF ) 1 ( 0
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7 2) Payback Period (PP) The NPV and IRR criteria focus on one aspect of an investment – the opportunity to benefit – the upside potential. However, there is another – the risk of loss (downside risk) For example, an investment requiring an initial cash outlay of $500, that is expected to yield $300, $100, $200 and $50 over the subsequent four years offers the investor the opportunity to benefit if the future cash flows are realized. However, if they are not, the investor may suffer a loss. And, if the risk of not receiving a payment increases as the timing of the payment moves further out into the future, then the downside risk increases, the longer it takes for the investor to recover the initial investment. The payback period criterion is focused on the downside risk and on minimizing that risk.
8 The payback period is the length of time required for the investor to recover, from the cash inflows derived from an investment, the amount of the initial investment. And, the decision rule is: If Payback Period < Predetermined cut-off period Then Accept Project Example : A investment opportunity requires an initial cash investment of $500, and is expected to yield $300, $100, $150 and $75 and $125 over the subsequent five years. What is its payback period? 2 years < Payback Period ≤ 3 years Other things equal, the shorter the payback period, the lower the downside risk.
9 Using the payback period as the basis for choosing among investment opportunities generally will not result in the optimal (value maximizing) decision (because the payback period does not take the time value of money into account nor does it take into account any cash flows that might arise after the initial outflows have been recovered). Nevertheless, the payback period criterion is very popular because it is easy to implement, because it does not require the estimation of cash flows far into the future, and because it addresses the risk aspect of the investment decision. Typically, the payback period criterion is used in conjunction with NPV (rather than in isolation) to identify desirable investment opportunities.
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10 3) Breakeven Time (BET) The breakeven time, which is related to the payback period, takes the time value of money into account. The breakeven time is the length of the interval from the initial implementation of a project to the point at which the cumulative present value of the cash flows from the project equals zero. i.e. the breakeven time is the t that solves the equation I ̶̶ ∑ C t = 0 (1+r) t Clearly, shorter BETs are better for 0 NPV projects, BUT the ordering does not hold for positive-NPV projects . (i.e. a project with the shortest BET will not necessarily have the highest NPV because the BET criterion ignores any cash flows that occur after breakeven.) where I = initial investment C t = cash inflow (outflow) in period t r = required rate of return (cost of capital)
11 Example : A investment opportunity requires an initial cash investment of $500, and is expected to yield $300, $100, $150, $75, and $125 over the subsequent five years. If the firm’s cost of capital is 10%, what is its breakeven time? Year Expected Future Payment NPV @ 10% Cumulative NPV 1 $300 300 = 272.73 272.73 (1 + 0.10) 1 2 $100 100 = 82.65 355.38 (1 + 0.10) 2 3 $150 150 = 112.70 468.08 (1 + 0.10) 3 4 $ 75 75 = 51.23 519.31 (1 + 0.10) 4 125 From above, BET = 4 yrs ≥ 500
12 4) Accounting Rate of Return There is less agreement about exactly how the accounting rate of return is to be measured than there is for NPV, IRR, PP, and BET. But, generally, it is a variant of the Return on Assets (ROA): ROA = Income from Investment Average Book Value of Invested Assets Note that, unlike NPV, IRR, PP and BET, ROA is not based, at least not directly based, on the (estimated) cash flows from the investment. We will discuss this measure of performance more extensively in a later class when we talk about divisional performance evaluation.
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What effect do taxes have on the investment decision?
14 Capital Budgeting, Taxes and Cash Flows • How are a firm’s periodic income taxes payments determined? – Not on the basis of cash flows, or revenues, or volume sales or number of employees, – But rather on the basis of its Income! • AND, not on the basis of its accounting income, according to GAAP, • But rather, on the basis of its income determined in accordance with the income tax code . • Consequently, whenever an investment affects the firm’s income, we need to consider the tax effects of that investment on its cash flows. Simply put, if the investment results in more (less) taxable income, the firm will have to pay more (less) taxes. And, those taxes will have to be paid in the period when the income is reported to the IRS. So, income taxes can have an effect on both the amount and the timing of the cash flows attributable to an investment.
15 • Typically, the initial investments made for capital projects represent expenditures made to acquire resources which are accounted for as assets. As a result, the investment, itself, has no immediate affect on the firm’s income tax payments . (Remember inventory costs are capitalized as assets. They become expenses when the inventory is sold - COGS). (WE ARE IGNORING ANY INVESTMENT TAX CREDITS THAT MAY BE AVAILABLE) • The expenses resulting from an investment occur as the asset(s) is (are) used (e.g., depreciation, COGS, etc.). It is that expense that affects the firm’s income tax payments. • There also may be tax consequences when the assets are disposed of. The firm will be taxed not on the proceeds from the disposal, but rather on the amount of resulting gain or loss. • Specifically: Gain (Loss) from disposal = Proceeds from disposal – Net book value • And, the tax effect of the disposal will be: TAX EFFECT = Gain (loss) from disposal x Tax Rate
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16 Example Wharton Publishing must either overhaul or replace one of its printing presses. The following information relates to those two alternatives: Wharton’s income tax rate is 35%. Wharton will choose between these two alternative by comparing the NPV of their cash flows. Its objective is to earn a return on its investments of 20%. Old Machine New Machine Purchase price, new $80,000 $100,000 Current book value 30,000 Current salvage value 20,000 Cost of overhaul 40,000 Annual cash operating cost 70,000 40,000 Expected Salvage value in 5 years 5,000 20,000 Actual Salvage value in 5 years 5,000 20,000
17 To simplify our analysis, we will assume that: a) Wharton will depreciate its printing press using the straight-line method, so the net book value at the end of the project (5 years) equals the expected salvage value. b) The accounting and IRS depreciation schedules are the same. In reality, they usually are not . In particular, the IRS requires the use of an accelerated depreciation method known as the Modified Accelerated Cost Recovery System (MACRS). c) Any gain or loss resulting from the disposal of the printing press is taxable at the time of the disposal. In reality, the IRS has specific rules that may require a firm to “roll over” any gains or losses resulting from the disposal of a particular asset so that they do not become taxable until all of the assets in the class have been disposed of . d) Overhaul costs are tax deductible when they are incurred. This means that the overhaul will have no effect on depreciation. (That is, the cost of the overhaul is not capitalized as an asset. In some cases, capitalization of overhaul costs may be required.)
Overhaul the Old Machine
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Cost of Overhaul Annual Operating Cost Proceeds from Disposal ($40,000) ($70,000) ($70,000) ($70,000) ($70,000) ($70,000) $ 5,000 0 1 2 3 4 5 Time Timeline of Cash Inflows (Outflows) To Overhaul Old Machine Annual Depreciation (Overhauled Machine) = 30,000 – 5,000 = 5,000 5yrs Annual Depreciation for Overhauled Machine 19
20 NPV of Cash Inflows (Outflows) from : Overhaul of Old Machine Cash Flow PV Factor (@20%) Present Value a b a x b Cash Inflows (Outflows) Before Taxes: Initial Overhaul Cost (40,000) 1.0000 (40,000) Annual Operating Costs (70,000) 2.9906 (209,342) Disposal/Residual Value 5,000 0.4019 2,010 Net Cash Flow – before tax effects (247,332) Income Tax Saving (Cost) Attributable to: Overhaul Cost 40,000 x 35% = 14,000 1.0000 14,000 Annual Operating Costs 70,000 x 35% = 24,500 2.9906 73,270 Annual Depreciation 5,000 x 35% = 1,750 2.9906 5,234 Disposal of Machine 0 0.4019 0 92,504 Net Cash Inflow (Outflow) (154,828) Why is there no tax effect when the machine is sold?
Replace the Old Machine
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Cost of New Machine Proceeds from Disposal of old Annual Operating Cost Proceeds from Disposal of new ($100,000) $ 20,000 ($40,000) ($40,000) ($40,000) ($40,000) ($40,000) $20,000 0 1 2 3 4 5 Time Timeline of Cash Inflows (Outflows) To Replace Old Machine Annual Depreciation (New Machine) = 100,000 – 20,000 = 16,000 5yrs Annual Depreciation for New Machine 22
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23 NPV of Cash Inflows (Outflows) from : Replacement of Old Machine Cash Flow PV Factor Present Value a b a x b Cash Inflows (Outflows) Before Taxes: Cost of New Machine (100,000) 1.0000 (100,000) Disposal of Old Machine (Salvage Value) 20,000 1.0000 20,000 Annual Operating Costs (40,000) 2.9906 (119,624) Disposal of New Machine (Salvage Value) 20,000 0.4019 8,038 Net Cash Flow – before tax effects (191,586) Income Tax Saving (Cost) Attributable to: Loss on Sale of Old Machine 10,000 x 35% = 3,500 1.0000 3,500 Annual Operating Costs 40,000 x 35% = 14,000 2.9906 41,868 Annual Dep’n tax saving 16,000 x 35% = 5,600 2.9906 16,747 Disposal of new machine 0 0 62,115 Net Cash Inflow (Outflow) (129,471) Note: Profit/loss from disposal of old machine is: $20,000 – $30,000 = $10,000 loss
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24 Repair Replace NPV of Cash Inflow (Outflow) Before Taxes (247,332) (191,586) NPV of Tax Effects 92,504 62,115 NPV (154,828) (129,471) Summarizing the Results of the Analysis CHOOSE
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25 Example Revised Let’s change the previous example by assuming that the IRS’s depreciation schedule for the new machine is based an estimated salvage value of $0: How would this change affect the analysis? Taking the effect of taxes into account, which of the two alternatives should Wharton choose in this case (tax rate 35%, rate of return 20%)? For the overhaul of the old machine, the cash flows will be the same, so let’s focus only on the effects of replacing it. Old Machine New Machine Purchase price, new $80,000 $100,000 Current book value 30,000 Current salvage value 20,000 Cost of overhaul 40,000 Annual cash operating cost 70,000 40,000 Estimated Salvage value in 5 years 5,000 0 (for taxes) Actual Salvage value in 5 years 5,000 20,000
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Effects of Changing Estimated Salvage Value Changing the estimated salvage value will 1) Change the annual depreciation from $16,000 to Revised Annual Depreciation (New Machine) = 100,000 – 0 = 20,000 5yrs 2) Change the gain from the disposal (at the end of the 5 th year) from $0 to Gain from Disposal = Proceeds – Net Book Value = 20,000 – 0 = 20,000 So, cumulatively , over the 5 years, the depreciation deduction will increase by $20,000 (= (20,000 – 16,000) x 5), and will be offset by the $20,000 increase in the gain from the disposal at the end of year 5. It appears that the net effect is a wash. Or, is it ??? 27
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27 Replace Old Machine Cash Flow PV Factor Present Value a b a x b Cash Inflows (Outflows) Before Taxes: Cost of New Machine (100,000) 1.0000 (100,000) Disposal of Old Machine (Salvage Value) 20,000 1.0000 20,000 Annual Operating Costs (40,000) 2.9906 (119,624) Disposal of New Machine (Salvage Value) 20,000 0.4019 8,038 Net Cash Flow – before tax effects (191,586) Income Tax Saving (Cost) Attributable to: Loss on Sale of Old Machine 10,000 x 35% = 3,500 1.0000 3,500 Annual Operating Costs 40,000 x 35% = 14,000 2.9906 41,868 Annual Dep’n tax saving 16,000 x 35% = 5,600 2.9906 16,747 Disposal of new machine 0 0 62,115 Net Cash Inflow (Outflow) (129,471) Annual Dep’n tax saving 20,000 x 35% = 7,000 2.9906 Gain on Sale of Machine 20,000 x 35% = (7,000) 0.4019 ( 2,813) 63,489 Net Cash Inflow (Outflow) (128,097)
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So, the effect of reducing the estimated residual value of the new machine is to alter the timing of the tax-related cash flows for the investment. The increase in the depreciation tax deduction reduced the firm’s tax payments by $1,400 per year (a total of $7,000 over the 5 years). The increase in the gain from the disposal increased its tax payments by $7,000 in the 5 th year. The net effect of the changes on the firm’s total tax payments is 0 (= + 7,000 - 7,000), but, because of the timing, the NPV of those changes is not zero 28 NPV of additional depreciation tax saving 1,400 x 2.9906 = 4,187 NPV of tax on gain 7,000 x 0.4019 = (2,813) Net benefit from delaying payment of taxes 1,374
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Capital Budgeting Problem What are some of the difficulties that might come up in actual applications of the various criteria we discussed in this chapter? Which one would be the easiest to implement in actual applications? The most difficult?
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How to analyze capital budgeting decisions? Which measures are important and why?
What is capital budgeting? Explain various steps in its preparation and throw light on its limitations.
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