CAPITAL BUDGETING

• Capital Budgeting


  Any decision that involves an outlay NOW in order to obtain a FUTURE return
• Categories of Capital Budgeting Decisions

  • Screening Decisions
  • Preference Decisions
• Screening Decisions


  Relate to whether a proposed project is acceptable - whether it passes a preset hurdle
• Preference Decisions


  Relate to selecting from among several ACCEPTABLE alternatives
• Types of Cash Flows in Capital Budgeting

  • Cash Inflows (Future)
  • Cash Outflows (Now)
• Cash Inflows (Future)


  • Savings in operating costs / Incremental revenue less cash receipts
  • Depreciation tax shield
  • Salvage value (of new) at the end of the asset's life
  • Release of working capital at the end of the asset's life
• Cash Outflows (Now)


  • Initial investment (including installation costs & other capitalizable costs)
  • Working capital required
• Salvage value (of old) in a replacement decision


  Deducted from cash outflows
• How to Compute Annual Cash Inflow After Tax (ACIAT)

  1. Annual Cash Inflow Before Tax

  2. Less: Depreciation

  3. Annual Net Income Before Tax

  4. Less: Income Tax

  5. Annual Net Income After Tax (ANIAT)

  6. Add back: Depreciation
• How to Compute Annual Cash Inflow After Tax (ACIAT)

  1. ACI before tax x (1-tax rate)

  2. Add: Depreciation Tax Shield (DTS) = Depreciation x tax rate
• Depreciation Tax Shield (DTS)


  Tax savings due to depreciation
• Time Value of Money


  Cash flows that are received at different times must be valued differently
• How to compute Net Present Value

  1. PV of Cash Inflows, net = ACI before tax x (1-tax rate) + Depreciation Tax Shield + Salvage Value (new) x (1-tax rate) + Working capital released - Cost of major repairs/overhauling

  2. PV of Cash Outflows, net = Cost of investment + Working capital required - Salvage value of old

  3. NPV = PV of Cash Inflows, net - PV of Cash Outflows, net
• How to compute Salvage Value (old) NOW

  Salvage value (old) NOW = Book value (old) NOW + Gain/Loss on sale x tax rate
• How to determine increase or decrease in units given an NPV

  If NPV is positive: Divide by PVA factor, then divide by (1-tax rate), then divide by CM per unit

  If NPV is negative: Increase in units
• How to determine Internal Rate of Return (IRR)

  Compute the Factor of IRR = Investment required / Annual net cash flow

  Locate the IRR factor in the Annuity Table
• Methods to determine NPV and IRR

  • Present Value tables
  • Spreadsheet (Excel)
• Cost of Capital as a Screening Tool

  The Net Present Value Method: Use cost of capital as the discount rate, reject projects with negative NPV

  The Internal Rate of Return Method: Use cost of capital as the hurdle rate, reject projects with IRR less than cost of capital
• Ranking of Investment Projects

  Using IRR: Higher IRR is more desirable

  Using NPV: Need to use Profitability Index = NPV / Investment, Higher Profitability Index is more desirable
• Capital budgeting techniques that ignore the Time Value of Money

  • Payback Period
  • Simple rate of return / Accounting rate of return / Unadjusted rate of return
• How to calculate Payback Period

  Payback Period = Investment required / Annual net cash inflow
• Simple Rate of Return Method


  Focuses on accounting net operating income rather than cash flows

  SRR = ANIAT / Initial Investment (reduced by any salvage value)
• Determining Relevant Cash Flows