Week 11 Capital Budgeting Analysis

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Athabasca University, Athabasca *

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Jan 9, 2024

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Learning Objectives After completing Lesson 11, you should be able to 1. explain why the capital budget process should be related to a firm’s mission, vision, and strategies. 2. identify and describe the steps in the capital budgeting process. 3. calculate and describe the net present value (NPV) capital budgeting technique, and explain why it is the best budgeting criterion. 4. calculate and explain the following capital budgeting techniques: IRR, MIRR, profitability index, and payback. 5. explain the conflicts that may arise when ranking projects using the various techniques. 6. explain how managers determine relevant cash flows for capital budgeting and how managers can be held accountable for their project’s cash flow estimates. 7. discuss how a project’s risk can be incorporated into capital budgeting analysis. Learning Activities Reading Assignment  Chapter 17: Capital Budgeting Analysis, including Learning Extension 17 (textbook)  Lesson Notes 1–6 End-of-Chapter Problems 1. Complete the Chapter 17 Problems, questions 6, 10, 11, 12, 14, 16, 17*, and 20. * Note: For question 17, use the variables from question 16. 2. Complete the Chapter 17 Learning Extension Problems, questions 2, 4, 6, and 7. 3. After you complete these questions, compare your work to the Suggested solutions. Lesson Notes

Note 1: Net Present Value Net present value (NPV) is the sum of the present values (PVs) of all the cash flows (CFs) of a project (the benefit) minus the present value (PV) of the project cash outflow (the project cost). Positive NPV implies that from a present perspective (now), the benefit exceeds the cost; therefore, the project is value creating. Negative NPV implies that from a present perspective, the costs exceed the benefit, so the project is decreasing value for the company. NPV = sum of PV of CFs – Project cost Note 2: Why NPV Is the Best Capital Budgeting Criterion NPV is the best capital budgeting criterion for the following reasons:  NPV considers all of a project’s cash flows, including any ending value (terminal value).  NPV considers time value of money by getting the value of the expected cash flows in today’s dollars.  NPV factors in risk, since the discount rate used for getting the present values is based on the riskiness of the project’s cash flows, not on the source of funding.  NPV criteria is objective: either value is being created (positive NPV) or it is being destroyed (negative NPV). Note 3: Internal Rate of Return Internal rate of return (IRR) is essentially the return that a project generates. For example, an IRR of 10% implies that the project will generate a return of 10% per year. IRR is also defined as the discount rate that makes a project’s NPV equal to zero. Recall that the PV of a CF = CF/(1 + rate )^t. Therefore, the IRR is just the rate that makes the sum of PV of CFs equal the project cost. If the IRR is greater than the discount rate, you expect the project to generate more return than required to absorb its costs. The NPV will be positive. If the IRR is less than the discount rate, you expect the project to generate less return than is required to absorb its costs. The NPV will be negative. Note 4: Considerations for Conflicting Valuation Criteria Both NPV and IRR criteria lead to the same conclusion except in two situations:  When comparing mutually exclusive projects. For example, you are proposing to build an office tower or a car parkade on the same piece of land. The one with

higher IRR may not necessarily have the higher NPV. In such a case you should use NPV to make your decision.  When a project has abnormal cash flows. For example, you could have steady cash outflows at the start irregular cash outflows (or negative cash flows) in the future. Abnormal cash flows result in multiple IRRs, which can lead to the wrong conclusion. To make a better decision, map the NPV profiles and accept the project if it falls in the range of positive NPV values. A modified IRR (MIRR) can also inform your decision. The modified internal rate of return (MIRR) is the discount rate that equates the future value (at the terminal date) of a project’s cash inflows to the present value of the cash outflows. That is, all inflows are valued to a future date, while all outflows are valued to the present using required return. Using the MIRR, a project is acceptable if the MIRR is greater than the required return. The resulting decision will be the same as the NPV decision. Rule of thumb: If decision-making criteria conflict, use NPV to inform your decision. Example of a capital budget analysis: FNCE_ECON300v3_L11_CapitalBudgExample. xlsx Note 5: Estimating Cash Flows The most difficult part of capital budget analysis is estimating cash flows. Cash flows can only be forecast with probability; no certainty or accuracy is guaranteed. Therefore, decisions on project analysis are only certain to the degree that cash flow forecasting is accurate. Positive NPV projects may turn sour because of errors in cash flow forecasting and other reasons. Usually, additional analyses such as best/worst case (or scenario analysis) and assessing the impact of a change one variable at a time (or sensitivity analysis) are used in project analysis to minimize the risk of making a poor capital budgeting decision. Note 6: The Stand-Alone Principle Project analysis should be based on the stand-alone principle , meaning it focuses on the project’s own cash flow, uncontaminated by cash flows from the firm’s other activities. This means that a project should be evaluated based on its incremental cash flows, defined as the difference between a firm’s cash flows if the project goes ahead and its cash flows if the project is not pursued. Suggested Solutions to End-of-Chapter Problems Problems 6. The Sanders Electric Company is evaluating two projects for possible inclusion in the

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firm’s capital budget. Project M will require a $37,000 investment, while project O will require a $46,000 investment. After-tax cash inflows for the two project are estimated as follows: Year Project M Project O 1 $12,000 $10,000 2 12,000 10,000 3 12,000 15,000 4 12,000 15,000 5 15,000 a. Determine the payback period for each project. Payback (M) = $37,000/12,000 = 3.08 years Payback (O) = 3 years + 11,000/15,000 = 3.73 years b. Calculate the net present value and profitability index for each project based on a 10% cost of capital. Which, if either, of the projects is acceptable? NPV(M) = $12,000 × PVIFA (10%, 4) –37,000 = $12,000 × 3.170 – 37,000 = $1,040 PI(M) = $38,040/37,000 = 1.028 NPV(O) = $10,000 × PVIFA (10%,5) + 5,000 (PVIF(10%,3) + PVIF(10%,4) + PVIF(10%,5)) – 46,000 = 10,000 × 3.791 + 5,000(.751 + .683 + .621) – 46,000 = $48,185 – 46,000 = $2,185 PI(O) = 48,185/46,000 = 1.048 Both projects have positive NPVs, so both are acceptable. c. Determine the internal rate of return and modified internal rate of return for Projects M and O. IRR(M): PVIFA = 37,000/12,000 = 3.083 For four years, the IRR falls between 10% (3.170) and 12% (3.037). Calculator or spreadsheet solution: 11.29% IRR(O): calculator or spreadsheet solution: 11.69%

MIRR(M): Present value of outflows: $37,000 Future value of inflows is a four-year annuity; its future value is given, via financial calculator, using PMT = 12,000; N = 4; I = 10%, which results in FV = $55,692. MIRR: $55,692 = $37,000(1 + MIRR) 4 ; solving, the MIRR = 10.76%. MIRR(O): Present value of outflows: $46,000 Future value of inflows can be computed several ways. Here, we will compute the future value of a five-year annuity of $10,000 and a three-year annuity of $5,000 (note than the cash flow pattern is the same as project O’s cash flow pattern). The five-year annuity future value is given, via financial calculator, using PMT = 10,000; N = 5; I = 10%, which results in FV = $61,051. The three-year annuity future value is given, via financial calculator, using PMT = 5,000; N = 3; i = 10%, which results in FV = $16,550. MIRR: ($61,051 + 16,550) = $46,000(1 + MIRR) 5 ; solving, the MIRR = 11.03%. 10 . A machine can be purchased for $10,500, including transportation charges, but installation costs will require $1,500 more. The machine is expected to last four years and produce annual cash revenues of $6,000. Annual cash-operating expenses are expected to be $2,000, with depreciation of $3,000 per year. The firm has a 30% tax rate. Determine the relevant after-tax cash flows and prepare a cash-flow schedule. Cash revenues and cash expenses imply no change in net working capital for this project. Revenues $6,000 Expenses –2,000 Depreciation –3,000 Earnings before taxes $1,000 Taxes (30%) –300 Earnings after taxes $700 Operating cash flow = (Sales – Costs – Depreciation) (1 – t ) + Depreciation – change in net working capital = ($6,000 – $2,000 – $3,000) (1 – 0.30) + $3,000 – $0 = $3,700.00. Year Cash Flow 0 $ –12,000 1 3,700 2 3,700

3 3,700 4 3,700 11 . Use the information in Problem 10 to do the following: a. Calculate the payback period for the machine. Payback = $12,000/$3,700 = 3.24 years b. If the project’s cost of capital is 10%, would you recommend buying the machine? NPV = 3,700 × PVIFA (10%,4) – 12,000 = 3,700 × 3.170 – 12,000 = $ –271 (Exact financial calculator answer: -$271.50) Since NPV < 0, reject the project. c. Estimate the internal rate of return for the machine. PVIFA = PV annuity / Annual receipt = $12,000 / 3,700 = 3.243 When n = 4, IRR is approximately 9% (calculator or spreadsheet solution: 8.95%). 12 . The Brassy Fin Pet Shop is considering an expansion. Construction will cost $90,000 and will be depreciated to zero, using straight-line depreciation, over five years. Earnings before depreciation are expected to be $20,000 in each of the next five years. The firm’s tax rate is 34%. a. What are the project’s cash flows? Depreciation = $90,000/5 = $18,000 Earnings before depreciation $20,000 – depreciation 18,000 Earnings before taxes $2,000 – taxes 680 Net income $1,320 Cash flow = NI + Depreciation = $1,320 + $18,000 = $19,320 b. Should the project be undertaken if the firm’s cost of capital is 11%? PV of cash inflows = $19,320 × PVIFA (11%, 5 years) = $19,320 × 3.696 = $71,406.72 NPV = $71,406.72 – 90,000 = $ –18,593.28 (Exact financial calculator answer: –$18,595.27) The NPV is negative, so the project should be rejected. 14 Annual savings from Project X include a reduction in 10 clerical employees with

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. annual salaries of $15,000 each, $8,000 from reduced production delays, $12,000 from lost sales due to inventory stockouts, and $3,000 in reduced utility costs. Project X costs $250,000 and will be depreciated over a five-year period using straight-line depreciation. Incremental expenses of the system include two new operators with annual salaries of $40,000 each and operating expenses of $12,000 per year. The firm tax rate is 34%. a. Find Project X’s initial cash outlay. Initial cash outlay = initial investment = $250,000 b. Find the project’s operating cash flows over the five-year period. Cash flows: Benefits: Sales increase: Reduced lost sales from stockouts $12,000 cost reduction: Salary reduction $150,000 10 employees at $15,000 each Reduced production delay $8,000 Reduction in utility cost $3,000 Change in earnings before depreciation: change in sales + cost reductions $173,000 Depreciation expense $50,000 5 years, straight-line depreciation Benefits from the project: change in sales + cost $123,000

reductions - depreciation Cost increases: annual salary $80,000 2 operators at $40,000 each operating expense $12,000 increase in costs $92,000 Earnings before taxes: (benefits less cost increases) $31,000 Less: taxes $10,540 34% Earnings after taxes $20,460 Annual cash flows = net income + depreciation = $70,460 Annuity cash flows, no changes in working capital accounts c. If the project’s required return is 12%, should it be implemented? Year Cash flow PV at 12% 0 $ (250,000) $ (250,000) 1 $ 70,460 $ 62,911

2 $ 70,460 $ 56,170 3 $ 70,460 $ 50,152 4 $ 70,460 $ 44,779 5 $ 70,460 $ 39,981 NPV = $ 3,993 NPV is positive, so the project is expected to enhance shareholder wealth. 16 . The ice cream shop described in the text (Example 17.9.2.4) has been a smash success. Customers from the next college town are pleading with you to open one closer to them. Based on your operating experience and knowledge of local real estate, you believe that opening a new ice cream shop will require an investment of $20,000 in fixed assets and $3,000 in working capital. Fixed assets will be straight- line depreciated over five years. Preliminary market research indicates that sales revenue in the first year should be about $50,000 and that variable costs, excluding depreciation, will be about 80% of sales. To be on the safe side, you assume sales revenue will not change over the next five years. At the end of five years, you estimate you can sell your business, after-tax, for $25,000. Using a 28% tax rate and a 12% required return, should you expand? Year 0 1 2 3 4 5 Initial outlay Fixed assets $20,00 0 Working capital $3,000 Revenues/inflo ws: Sales income $50,00 0 $50,00 0 $50,00 0 $50,00 0 $50,00 0 Sale of business (after tax) $25,00 0 Expenses: Variable operating costs $40,00 0 $40,00 0 $40,00 0 $40,00 0 $40,00 0

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Depreciation $4,000 $4,000 $4,000 $4,000 $4,000 Earnings before tax $6,000 $6,000 $6,000 $6,000 $6,000 Income tax (28%) $1,680 $1,680 $1,680 $1,680 $1,680 Net income $4,320 $4,320 $4,320 $4,320 $4,320 Sale of business (after tax) $25,000 Net cas h flow – $23,000 $8,320 $8,320 $8,320 $8,320 $33,320 Net income + depreciation + investing cash flow (no change in working capital) Note: The after-tax price of $25,000 includes the purchase of working capital such as remaining inventory. In effect, the shop’s remaining working capital is sold to the shop’s buyer, so there is no separate working capital inflow at the end of the project. Required rate of return: 12% NPV = $21,177.41 Based on this information, this business should consider expanding. This opportunity can be expected to increase the investor’s personal wealth, since the NPV is greater than 0. 17 . Sensitivity analysis involves changing one variable at a time in a capital budgeting situation to see how NPV changes. Perform sensitivity analysis on the each of the following variables from problem 16 to determine its effect on NPV. a. Sales can be 10% higher or lower than expected each year. Using the spreadsheet with annual sales of $55,000, NPV = $23,772.85 Using the spreadsheet with annual sales of $45,000, NPV = $18,581.97 b. Expenses may be 10% higher or lower than expected each year. Using the spreadsheet with expenses that are 88% of sales, NPV = $10,795.65

Using the spreadsheet with expenses that are 72% of sales, NPV = $31,559.16 c. Your initial investment in fixed assets and working capital may be 50% higher than originally estimated. Using the spreadsheet with an initial investment of $34,500, NPV = $9,677.41 20 . The BioTek Corporation has a basic cost of capital of 15% and is considering investing in either or both of the following projects. Project HiTek will require an investment of $453,000, while Project LoTek’s investment will require $276,000. The following after-tax cash flows (including the investment outflows in year zero) are estimated for each project. Year HiTek LoTek 0 $ – 453,000 $ – 276,000 1 132,000 74,000 2 169,500 83,400 3 193,000 121,000 4 150,700 54,900 5 102,000 101,000 6 0 29,500 7 0 18,000 a. Determine the present value of the cash inflows for each project and then calculate their net present values by subtracting the appropriate dollar amount of capital investment. Which, if either, of the projects is acceptable? By calculator or spreadsheet: HiTek PV inflows = $506,724.83; NPV = $53,724.83 LoTek PV inflows = $308,094.31; NPV = $32,094.31 HiTek and LoTek both have positive NPVs. If they are independent from

each other, both should be accepted. If they are mutually exclusive, HiTek should be accepted because of its higher NPV. b. Calculate the internal rates of return for Project HiTek and Project LoTek. Based on IRR, which project would be preferred? By calculator or spreadsheet: HiTek IRR = 20.0% LoTek IRR = 19.3% Both HiTek and LoTek have IRRs exceeding the 15% cost of capital. If the projects are independent from each other, both should be accepted. If they are mutually exclusive, HiTek is preferred because its IRR is higher. c. Now assume that BioTek uses risk-adjusted discount rates to adjust for differences in risk among different investment opportunities. BioTek projects are discounted at the firm’s cost of capital of 15%. A risk premium of three percentage points is assigned to LoTek types of projects, while a six-percentage point risk premium is used for projects similar to the HiTek project. Determine the risk-adjusted present value of the cash inflows for both LoTek and HiTek and calculate their risk-adjusted net present values. Should BioTek invest in either or both HiTek and LoTek projects after applying risk-adjusted PVs? HiTek required return = 15% + 6% = 21% NPV of HiTek by (calculator or spreadsheet) = $ –10,887.61 LoTek required return = 15% + 3% = 18% NPV of LoTek (by calculator or spreadsheet) = $20,376.95 After factoring in risk-adjusted PVs, only LoTek has a positive NPV, so it is the only acceptable project. Learning Extension Problems 2. Hammond’s Fish Market just purchased a $30,000 fork-lift truck. It has a five-year useful life. The firm’s tax rate is 25%. a. If the fork-lift is straight-line depreciated, what is the firm’s tax savings from depreciation? Depreciation expense: $30,000/5 = $6,000 Depreciation tax shield: 0.25 × $6,000 = $1,500. b. What will be the fork-lift’s book value at the end of Year 3? After three years, the accumulated depreciation is 3 x $6,000 = $18,000, so the truck’s book value is $30,000 – $18,000 = $12,000. 4. Preston Industries’ current sales volume is $100 million a year. Preston is examining the advantages of EDI (electronic data interchange). This technology will allow Preston to communicate electronically with suppliers and customers, and send and

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receive purchase orders, invoices, and cash. It will save Preston money by lowering costs in the purchasing, customer service, accounts payable, and accounting departments. Initial estimates are that savings will equal $100,000 a year. Investment in EDI technology will include $500,000 in depreciable expenses and $100,000 in non-depreciable expenses. Assets will be depreciated on a straight-line basis for four years. Implementation of EDI is expected to reduce Preston’s net working capital by $200,000Preston’s president, Carol, wants to estimate the effect of switching to EDI on shareholder wealth over a four-year time horizon, assuming that advances in technology will make the equipment worthless at the end of four years. At a 30% tax rate and 13% required rate of return, should Preston Industries switch to EDI? Project life: four years Tax rate: 30% Required rate of return: 13% Investing cash flow: Depreciable expenses: $500,000 Non- depreciable expenses: $100,000 Total expenses: $600,000 Depreciatio n per year: $125,000 Operating cash flow: Year 1 Year 2 Year 3 Year 4 Sales1 $0 $0 $0 $0 less costs2 –$100,000 – $100,000 – $100,000 – $100,000 less depreciatio n $125,000 $125,000 $125,000 $125,000 equals earnings before taxes3 ($25,000) ($25,000) ($25,000) ($25,000)

x (1–t) 70% 70% 70% 70% equals net income4 ($17,500) ($17,500) ($17,500) ($17,500) plus depreciatio n $125,000 $125,000 $125,000 $125,000 less change in net working capital5 ($200,000) $0 $0 $200,000 equals OCF $307,500 $107,500 $107,500 ($92,500) 1. No change in sales 2. Cost savings 3. Subtracting a cost savings results in adding the number 4. Loss leads to lower taxes 5. Reduction in Year 1 only; restored in Year 4 Salvage cash flow (Year 4): Market value: $0 Book value: $0 (fully depreciated) After-tax salvage value: $0 Cash flow summary: Initial: ($600,000) Year 1: $307,5000 Year 2: $107,500 Year 3: $107,500 Year 4: ($92,500) NPV at 13% (225,917) No, Preston Industries should not switch to EDI. 6. Casey’s Baseball Bats is planning to begin exporting its product to the Asian market. They estimate up-front expenses of $1 million this year (Year 0) and $3 million next year (Year 1). Operating cash flows in Years 2, 3, and 4 will be (in dollars) $100,000; $200,000; and $400,000, respectively. After Year 4, they expect operating cash flows to grow at 10% a year indefinitely. If 15% is the required return on the project, what is its NPV? Required rate of return: 15% Cash flow data given: Year Cash flow Terminal value TOTAL

0 - $1,000,000 - $1,000,000 1 - $3,000,000 - $3,000,000 2 $100,000 $100,000 3 $200,000 $200,000 4 $400,000 $8,800,000 $9,200,000 Constant growth rate: 10% Terminal value: $400,000(1.10)/(0.15 – 0.10) in Year 4 NPV: $1,858,552 7. The No-Shoplift Security Company is interested in bidding on a contract to provide a new security system for a large department store chain. The new security system would be phased into 10 stores per year for five years. No-Shoplift can purchase the hardware for $50,000 per installation. The labour and material cost per installation is approximately $15,000. In addition, No-Shoplift will need to purchase $100,000 in new equipment for the installation, which will be depreciated to zero using the straight-line method over five years. This equipment will be sold in five years for $25,000. Finally, an investment of $50,000 in net working capital will be needed. Assume that the relevant tax rate is 34%. If the No-Shoplift Security Company requires a 10% return on its investments, what price should it bid? Tax rate: 34% Required return: 10% Project life: 5 years Initial investment: New equipment: $100,000 Depreciation: $20,000 Salvage value: $25,000 Installation cost: Hardware: $50,000 per installation Labour and materials: $15,000 per installation NWC investment: $50,000 (Year 1 only, recovered at end) Initial cash flows: Year Investing Operatin g (Sales, Costs) NWC Salvage Total Cash Flow 0 (100,000)1 ($100,000) 1 X (50,000)2 X – $50,000

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2 X X 3 X X 4 X X 5 X $50,000 $16,5003 X + $66,500 1. Initial investment 2. Increase in NWC of $50,000 3. Salvage is $25,000 – (0.34)($25,000 – 0) Converting known cash flows to present values at a 10% discount rate: Total Cash Flow: Year 0: ($104,163) Year 1: X Year 2: X Year 3: X Year 4: X Year 5: X We need to determine what five-year annuity has a present value of $104,163 so that the project’s NPV = 0. Financial calculator: PV: –$104,163 I: 10% N: 5 PMT or CPT PMT: $27,478.01 This is the operating cash flow without NWC effects, as they are already incorporated into the previous analysis. Using this operating cash flow, we need to work backwards to estimate the bid price. We must work from the bottom (step 1) to the top (step 8) to determine the minimum bid price for 10 stores per year that will generate operating cash flows (excluding net working capital) sufficient to equal a zero NPV. Step 8: Sales must equal the sum of pre-tax earnings, depreciation, and costs. Step 7: Expenses are estimated at $65,000 per store; 10 stores/year. Step 6: Depreciation was estimated at $20,000 per year. Step 5: Before-tax sum = the after-tax sum divided by (1 – t) when the tax rate is 34%. Step 4: As OCF is the sum of net income, depreciation, and the change in NWC, this number must equal OCF – change in NWC – depreciation. Step 3: Depreciation was estimated at $20,000 per year. Step 2: There is no change in net working capital (already incl. in OCF determination). Step 1: Start here with operating cash flow (OPF) of $27,478.01

Sales: $681,330.32 (Step 8) – Cost: $650,000.00 (Step 7) – Depreciatio n $20,000.00 (Step 6) Earnings before tax $11,330.32 (Step 5) Net income $7,478.01 (Step 4) + Depreciatio n $20,000.00 (Step 3) – Change NWC $0.00 (Step 2) Operating CF $27,478.01 (Step 1) Working backward, from bottom to top (Step 1 to Step 8), we see that sales revenue must equal $681,330.32. This equals the annual bid price. Bid price/store (@10 stores): $68,133.03 Key Terms  base case  benefit/cost ratio  cannibalization  capital budgeting  cost of capital  depreciation tax shield  development stage  enhancement  follow-up stage  identification stage  implementation stage  incremental cash flows  independent projects  internal rate of return (IRR) method

 mission, objectives, goals, and strategies (MOGS)  modified internal rate of return (MIRR)  mutually exclusive projects  net present value (NPV)  NPV profile  opportunity cost  payback period method  profitability index (PI)  risk-adjusted discount rate (RADR)  selection stage  stand-alone principle  SWOT analysis  sunk cost

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