The Capital Budgeting Decision C H A P T E R T W E L V E

The Capital Budgeting Decision C H A P T E R T W E L V E

Figure 12-1 Capital budgeting procedures PPT 12-1 Accounting, finance, engineering Idea development Collection of data Decision making Results Assign probabilities Reassign probabilities Reevaluation

Table 12-1 Cash flow for Alston Corporation PPT 12-2 Earnings before amortization and taxes (cash inflow)... $20,000 Amortization (noncash expense)......... 5,000 Earnings before taxes............ 15,000 Taxes (cash outflow)............ 7,500 Earnings aftertaxes............ 7,500 Amortization.............. + 5,000 Cash flow............... $12,500 Alternative method of cash flow calculation Cash inflow (EBAT)............ $20,000 Cash outflow (taxes)............ - 7,500 Cash flow............... $12,500

Table 12-2 Revised cash flow for Alston Corporation PPT 12-2 Earnings before amortization and taxes..... $20,000 Amortization............. 20,000 Earnings before taxes.......... 0 Taxes............... 0 Earnings aftertaxes........... 0 Amortization............. + 20,000 Cash flow............. $20,000

Table 12-3 Investment alternatives PPT 12-3 Net Cash Inflows (of a $10,000 investment) Year Investment A Investment B 1....... $5,000 $1,500 2....... 5,000 2,000 3....... 2,000 2,500 4....... 5,000 5....... 5,000

Table 12-4 Capital budgeting results PPT 12-4 Investment A Investment B Selection Payback period.... 2 years 3.8 years Quickest payback: Investment A Net present value... $180 $1,414 Highest net present value: Investment B Internal rate of return 11.16% 14.33% Highest yield: Investment B Profitability Index.. 1.0180 1.1414 Highest relative profitability: Investment B

Table 12-5 Internal rate of return and net present value ($10,000 investment) PPT 12-5 Investment A (11.16% IRR) Investment A Year Cash Flow Year Cash Flow 1... $5,000 1... $5,000 10% 2... 5,000 2... 5,000 11% 3... 2,000 3... 2,000 12% discounted at discounted 11.16% at various rates if desired NPV = 0 NPV = 27

Table 12-6 Multiple IRRs PPT 12-5 Cash Flow @20% @500% 0............. -1,528-1,528-1,528 1............. 11,000 9,167 1,833 2............. -11,000-7,639-305 NPV 0 0

Table 12-7 Capital rationing PPT 12-6 Net Total Present Project Investment Investment Value Capital A $2,000,000 $400,000 rationing B 2,000,000 380,000 solution C 1,000,000 $5,000,000 150,000 D 1,000,000 100,000 Best E 800,000 6,800,000 40,000 solution F 800,000 (30,000.)

Figure 12-2 Net present value profile Net present value ($) 6,000 4,000 Investment B Investm ent A Discount Rate NPV Investm ent B PPT 12-7 Discount Rate NPV 0 % $ 2,0 00 0 % $6,0 00 5 1, 023 5 3,4 33 10 180 10 1,414 11.16 0 14.33 0 15-556 15-195 2,000 Investment A IRR B = 14.33% 0 5% 10% 15% 20% 25% IRR A = 11.16% Discount rate (percent)

Figure 12-3 Net present value profile with crossover Net present value ($) 6,000 4,000 Investment B D In vestm i s c o u n t R a te PPT 12-8 en t C N P V 0 % $ 3,2 0 0 5 2, 3 8 1 10 1, 5 6 3 15 1,002 20 417 22.49 0 25-112 2,000 Investment C Investment C IRR C = 22.49% 0 Investment B 5% 10% 15% 20% 25% IRR B = 14.33% Crossover point Discount rate (percent)

Capital Cost Allowance: tax savings PPT 12-9 Before CCA Expense After CCA Expense Income (cash flow).. $12,000 Income (cash flow).. $12,000 CCA.............. 5,000 Taxable income..... 7,000 Tax @ 40%........ 4,800 Tax @ 40%........ 2,800 Income (cash flow) Income aftertaxes $4,200 aftertaxes....... 7,200 Add back CCA 5,000 Income/cash flow aftertax 9,200 Aftertax expense $5,000 (1 - T) = 3,000 Tax savings $5,000 (T) = $2,000 Before-tax expense $5,000

Table 12-8 Some declining balance CCA classes Rate Class Assets PPT 12-10 Class 1 4% Bridges, buildings, dams Class 3 5 Windmills, telegraph poles Class 6 10 Greenhouses, hangars, wood jetties Class 7 15 Boats, ships Class 8 20 Most machinery, radio, communications equipment Class 9 25 Aircraft Class 10 30 Automobile equipment, computer hardware, feature films Class 12 100 Cutlery, television commercials, computer software Class 16 40 Taxicabs, autos for short-term rental, video games (coin) Class 17 8 Roads, storage areas Class 30 40 Telecommunications spacecraft Class 32 15 Timber resource property Class 42 12 Fibre optic cable

Table 12-9 Capital Cost Allowance for investment A or B PPT 12-11 Year 1: Net original cost............................................................. $10,000 Less: capital cost allowance 1/2($10,000 x.20).................................... 1,000 Undepreciated capital cost*.................................................... $ 9,000 Year 2: Less: capital cost allowance ($9,000 x.20)........................................ 1,800 Undepreciated capital cost................................................... 7,200 Year 3: Less: capital cost allowance ($7,200 x.20)......................................... 1,440 Undepreciated capital cost...................................................... $ 5,760 Year 4: Less capital cost allowance $(5,760 x.20).......................................... 1,152 Undepreciated capital cost...................................................... $ 4,608 Year n: Undepreciated capital cost (for year n - 1) Less capital cost allowance (UCC in year n - 1 x.20) Equals: undepreciated capital cost (for year n) *UCC for short UCC n = (1-d/2)(1 - d) n-1

Table 12-10 Liquidation of asset pool Year3: Outcome 1 Outcome 2 Outcome 3 Outcome 4 UCC.......... $12,960 $12,960 $12,960 $12,960 PPT 12-12 Year 4: Sale price A... 5,000 7,000 7,500 12,000 Sale price B... 5,000 5,960 7,500 7,200 Balance in pool.. $ 2,960 $ 0 $ (2,040) $ (4,240) Capital gain.... $ 0 $ 0 $ 0 $ 2,000 Tax consequences (40%): Positive values are tax savings: From CCA pool $ 1,184 $ 0 $ (816) $ (1,696) From capital gain $ 0 $ 0 $ 0 $ (600) $ 1,184 $ 0 $ (816) $ (2,296)

Table 12-15 Net price of the new computer PPT 12-13 Price of the new computer........................ $150,000 - Investment tax credit (15%) or $22,500............ 19,737* Net price of new computer........................ 130,263 - Cash inflow from sale of old computer............. 40,000 Net cost of new computer......................... $ 90,263 *Our assumption about cash flows (revenues, expenses) and tax-initiated cash flows is that they occur at the end of the year. Therefore, the tax credit of $22,500 is discounted one year. The CCA pool is affected in the year after acquisition. The CCA tax shield formula is constructed assuming tax savings effects occur at the end of the year.

Table 12-16 Differential analysis of new computer PPT 12-14 Present Aftertax Value Year Cash Flow Amount (1-tax rate) Cash Flow (@14%) 0... New computer $90,623 $90,623 0... Working capital investment 5,000 5,000 1... Cost savings 20,000.61 12,200 10,702 2... Cost savings 38,000.61 23,180 17,836 3... Cost savings 40,000.61 24,400 16,469 4... Cost savings 45,000.61 27,450 16,253 5... Cost savings 45,000.61 27,450 14,257* 5... Salvage 30,000 15,581 5... Working capital recovery 5,000 2,597 Present value of CCA tax shield benefits... (from calculation) 18,317 Net present value $16,749 *The present value of all the cost savings may be handled in one output from the calculator, particularly if it is an annuity

Chapter 12 - Outline LT 12-1 What is Capital Budgeting? 5 Methods of Evaluating Investment Proposals Average Accounting Return Payback Period Net Present Value Internal Rate of Return Accept/Reject Decision Net Present Value Profile Capital Cost allowance Determining Whether to Purchase a Machine

What is Capital Budgeting? LT 12-2 Capital Budgeting: represents a long-term investment decision for example, buy a new computer or build a new plant involves the planning of expenditures for a project with a life of 1 or more years emphasizes amounts and timing of cash flows and opportunity costs and benefits investment usually requires a large initial cash outflow with the expectation of future cash inflows considers only those cash flows that will change as a result of the investment all cash flows are calculated aftertax

5 Methods of Evaluating Investment Proposals LT 12-3 Average Accounting Return (AAR) Payback Period (PP) Internal Rate of Return (IRR) Net Present Value (NPV) Profitability Index (PI)

Average Accounting Return LT 12-4 Equals Average Earnings Aftertax /Average Book Value of Investment Relatively easy to calculate Uses accounting earnings, not cash flows Ignores the timing of the earnings Uses book value, not market value of investment Does not suggest an an evaluation yardstick

Payback Period LT 12-5 Payback Period (PP): computes the amount of time required to recoup the initial investment a cutoff period is established Advantages: easy to use ( quick and dirty approach) emphasizes liquidity one measure of the risk of an investment Disadvantages: ignores inflows after the cutoff period and fails to consider the time value of money an inferior method

Net Present Value LT 12-6 Net Present Value (NPV): the present value of the cash inflows minus the present value of the cash outflows the future cash flows are discounted back over the life of the investment the basic discount rate is usually the firm s cost of capital (WACC)

Internal Rate of Return LT 12-7 Internal Rate of Return (IRR): represents a yield on an investment or an interest rate requires calculating the discount rate that equates the initial cash outflow (cost) with the future cash inflows (benefits) is the discount rate where the cash outflows equal the cash inflows (or NPV = 0)

Accept/Reject Decision LT 12-8 Payback Period (PP): if PP < cutoff period, accept the project if PP > cutoff period, reject the project Internal Rate of Return (IRR): if IRR > cost of capital, accept the project if IRR < cost of capital, reject the project Net Present Value (NPV): if NPV > 0, accept the project if NPV < 0, reject the project

Net Present Value Profile LT 12-9 Net Present Value Profile: a graph of the NPV of a project at different discount rates shows the NPV at 3 different points: a zero discount rate the normal discount rate (or cost of capital) the IRR allows an easy way to visualize whether or not an investment should be undertaken

Capital Cost Allowance LT 12-10 Amortization for income tax purposes Capital Cost Allowance (CCA) is the maximum amount of amortization allowable under the tax act Capital assets are divided among a number of classes (pools) Each Class is assigned a CCA rate; ex. Class 8 is Machinery with a rate of 20% CCA is calculated on the Undepreciated Capital Cost in the pool (declining balance) CCA provides a tax shield over the life of the investment A formula provides the present value of the CCA tax shield

Determining Whether to Purchase a Machine LT 12-11 To make the actual investment decision: (1) determine the net cash outflow arising from the initial investment (2) estimate the amounts and timing of net future cash inflows (aftertax) (3) discount the future cash flows back to the present (4) add the present value of the Capital Cost Allowance shield, using the formula and appropriate CCA rate (5) determine whether the machine should be purchased (if NPV > 0)