Transcript Document

Cap Budgeting - 1
Long-Term
Investment
Decisions
Cap Budgeting - 2
IMPORTANCE OF LONG-TERM
INVESTMENT ANALYSIS
 Commitment of large amounts of
resources
 Long period of risk
– Capital assets often mean technological risk
– Strategic considerations
– Exit barriers
• Time value of money considerations
• Important analytical tool
• Not the primary consideration of analysis
Cap Budgeting - 3
Before we
let you buy that new
machine you wanted, we
want to know what return
we are going to get
out of it?
Cap Budgeting - 4
LONG-TERM INVESTMENT ANALYSIS
vs. CAPITAL BUDGETING
“Capital Budgeting”
Planning for long-term investment decisions regarding
capital assets (facilities) including considerations
for financing the investment
“Long-term Investment Analysis”
Planning for ALL TYPES of long-term investment decisions,
regardless of whether capital assets are involved
The major difference is that long-term investment analysis
is a broader “strategic” consideration
Cap Budgeting - 5
CAPITAL INVESTMENT
DECISION MODELS
 Non-discounted cash flow models
– Payback period
– Accounting rate of return
 Discounted cash flow models
– Internal rate of return
– Net present value
Cap Budgeting - 6
PAYBACK METHOD
 Payback period = length of time needed
to recover the initial investment in the
asset
Cash outflow for investment
Annual net cash benefit
Cap Budgeting - 7
PAYBACK METHOD
 Possible reasons for use:
– Help evaluate risks associated with
uncertain future cash flows
– Minimize impact of an investment on
liquidity
– Help control risk of obsolescence
– Relatively simple
 Limitations
– Ignores time value of money
– Ignores total profitability of the project
Cap Budgeting - 8
NET PRESENT VALUE
(NPV)
Net Present Value =
PV Cash Inflows -  PV Cash Outflows
This model is the most widely recommended
approach to capital budgeting since it
specifically considers the time value of money
and provides a basis for valuing the firm
Cap Budgeting - 9
NET PRESENT VALUE
(NPV)
 Decision criteria:
– If NPV > 0, a return in excess of the cost of
capital has been earned, and the project is
acceptable
– If NPV < 0, a return less than the cost of
capital has been earned, and the project is
unacceptable
 Reinvestment assumption
All cash flows generated by the project are
immediately reinvested at the cost of capital
Cap Budgeting - 10
COST OF CAPITAL
 The weighted average of the returns
expected by the different parties
contributing funds (debt and equity).
The weights are determined by the
proportion of funds provided by each
source.
It is sometimes known as the
“hurdle
rate.”
Cap Budgeting - 11
INTERNAL RATE OF RETURN
(IRR)
 The interest rate that results in
the present values of the cash
outflows equaling the present
value of the cash inflows.
Cap Budgeting - 12
INTERNAL RATE OF RETURN
(IRR)
 Decision criteria:
– If the IRR > Cost of capital, the project is
acceptable
– If the IRR < Cost of capital, the project is
not acceptable
 Reinvestment assumption
Cash inflows from the project are immediately
reinvested to earn the IRR
Cap Budgeting - 13
DISCOUNTED CASH FLOW ANALYSIS
 Strengths
– Cash flows vs. Accrual income
– Time value of money is considered
– Incorporation of financing costs
 Limitations
–
–
–
–
–
Accuracy of cash flow projections
Possible misapplications of DCF analysis
Ability to determine “cost of capital”
Difficulty of estimating opportunity costs
Lack of integration of qualitative factors
Cap Budgeting - 14
DISCOUNTED CASH FLOWS
Specific Items
 Initial and subsequent investments
 Taxable cash flows
– Revenues
– Expenses
 Deductible noncash expenses (Depreciation,
etc.)
 Residual (salvage) values
– Existing assets
– Assets at termination of project
– Tax considerations (gains or losses)
 Working capital investments
Cap Budgeting - 15
AFTER-TAX CASH FLOWS
 Rule for taxable cash benefits
(1-tax rate) x cash receipt = After-tax cash flow
Example: Increased sales or reduced costs
 Rule for taxable cash expenses
(1-tax rate) x cash payment = After-tax cash flow
Example: Labor costs
 Rule for tax shield for noncash expenses
(tax rate) x noncash expense = tax shield (cash inflow)
Example: Depreciation on equipment
Cap Budgeting - 16
AFTER-TAX CASH FLOWS
Continued
 Rule for sale of assets
 Proceeds from sale (+/-) Tax book value =
Taxable gain/loss
 Taxable gain/loss x Tax rate = Net tax effect
 Proceeds from sale (+/-) Net tax effect =
Net cash flow from sale of asset
Cap Budgeting - 17
Strategic
Considerations
Cap Budgeting - 18
Justifying capital expenditures in a
new manufacturing environment
CAD/CAM
Cap Budgeting - 19
Capital expenditures in a new
manufacturing environment

Traditional investment analysis tools
may not be adequate to make these
type decisions. The day-to-day
operating impact (tactical) may not be
the key factor in making a decision.
Less tangible benefits may be the
deciding factor in whether or not to
invest in new technology.
Cap Budgeting - 20
EXAMPLES OF INTANGIBLES
 Competitive advantage
– Producing a product or providing a service
that competitors cannot
 Quality
– Improving the quality of a product by
reducing the potential to make mistakes
 Process simplification
– Enhanced production capabilities
 Reduced time to produce
– Reducing the cycle time needed to make a
product or provide a service
Cap Budgeting - 21
Capital investment decisions have
potential pitfalls
Cap Budgeting - 22
WHAT TO DO?
 Consider the opportunity cost of not
making an investment
 Give full consideration to costs that may
be hidden
 Don’t set the barriers to strategic
investment too high
Cap Budgeting - 23
Find the hidden costs
warranty
costs
Training
costs
Cost of
faulty
assumptions
Cap Budgeting - 24
POST-IMPLEMENTATION AUDITS
 An opportunity to re-evaluate a
past decision to purchase a longterm asset by comparing expected
and actual inflows and outflows
Cap Budgeting - 25
POST-IMPLEMENTATION AUDITS
Benefits
 By comparing estimates with results,
planners can determine why their
estimates were incorrect and can avoid
making the same mistakes in the future
 Rewards can be given to those who
make good capital budgeting decisions
 If the audit is not done, there are no
controls on planners who might be
tempted to inflate the benefits in order
to get their projects approved
Cap Budgeting - 26
Don’t throw good money after bad