CHAPTER 12 Planning for Capital Investments ASSIGNMENT CLASSIFICATION TABLE Exercises A Problems B Problems 1, 2, 7, 1A, 2A 1B, 2B 4, 5, 6, 2, 3, 4, 1, 2, 3, 1A, 2A, 3A, 4A, 5A 1B, 2B, 3B, 4B, 5B Identify the challenges presented by intangible benefits in capital budgeting 8, 4A 4B Describe the profitability index 10 3A 3B Indicate the benefits of performing a post-audit 11 Explain the internal rate of return method 12, 13, 16 7, 4, 3A, 5A 3B, 5B Describe the annual rate of return method 3, 14, 15 6, 7, 1A, 2A 1B, 2B Brief Exercises 2, Explain the net present value method Study Objectives Questions Discuss capital budgeting evaluation, and explain inputs used in capital budgeting Describe the cash payback technique 12-1 ASSIGNMENT CHARACTERISTICS TABLE Problem Number Description Difficulty Level Time Allotted (min.) 1A Compute annual rate of return, cash payback, and net present value Moderate 30–40 2A Compute annual rate of return, cash payback, and net present value Complex 30–40 3A Compute net present value, profitability index, and internal rate of return Moderate 20–30 4A Compute net present value considering intangible benefits Moderate 20–30 5A Compute net present value and internal rate of return with sensitivity analysis Moderate 30–40 1B Compute annual rate of return, cash payback, and net present value Moderate 30–40 2B Compute annual rate of return, cash payback, and net present value Complex 30–40 3B Compute net present value, profitability index, and internal rate of return Moderate 20–30 4B Compute net present value considering intangible benefits Moderate 30–40 5B Compute net present value and internal rate of return with sensitivity analysis Moderate 30–40 12-2 12-3 Describe the cash payback technique Explain the net present value method Identify the challenges presented by intangible benefits in capital budgeting Describe the profitability index Indicate the benefits of performing a post-audit Explain the internal rate of return method Describe the annual rate of return method Broadening Your Perspective Discuss capital budgeting evaluation, and explain inputs used in capital budgeting Study Objective Q12-14 Q12-15 Q12-12 Q12-13 Q12-11 Q12-8 Q12-9 BE12-9 E12-6 Q12-3 E12-7 E12-8 Real-World Focus Exploring the Web Decision Making Across the Organization BE12-7 BE12-3 E12-8 BE12-1 E12-7 E12-8 Application Q12-16 Q12-10 Q12-4 Q12-7 Q12-5 Q12-6 Q12-2 Q12-3 Q12-1 Knowledge Comprehension P12-5A P12-5B BE12-4 BE12-4 P12-5A P12-5B P12-1A P12-1B BE12-8 E12-4 E12-5 BE12-6 BE12-5 E12-3 P12-4A P12-4B BE12-2 BE12-5 E12-1 E12-2 E12-3 P12-1A P12-2A E12-1 E12-2 P12-1A P12-2A P12-2B P12-3A P12-3B P12-3A P12-3B P12-3A P12-4A P12-1B P12-2B P12-3B P12-4B P12-2A P12-1B P12-2B Evaluation All About Managerial Analysis Decision Making You Across the Organization Ethics Case Communication Analysis Synthesis Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems BLOOM’S TAXONOMY TABLE STUDY OBJECTIVES DISCUSS CAPITAL BUDGETING EVALUATION, AND EXPLAIN INPUTS USED IN CAPITAL BUDGETING DESCRIBE THE CASH PAYBACK TECHNIQUE EXPLAIN THE NET PRESENT VALUE METHOD IDENTIFY THE CHALLENGES PRESENTED BY INTANGIBLE BENEFITS IN CAPITAL BUDGETING DESCRIBE THE PROFITABILITY INDEX INDICATE THE BENEFITS OF PERFORMING A POSTAUDIT EXPLAIN THE INTERNAL RATE OF RETURN METHOD DESCRIBE THE ANNUAL RATE OF RETURN METHOD 12-4 CHAPTER REVIEW The Capital Budgeting Evaluation Process (S.O 1) The capital budgeting evaluation process generally has the following steps: a Project proposals are requested from departments, plants, and authorized personnel b Proposals are screened by a capital budget committee c Officers determine which projects are worthy of funding; and d Board of directors approves capital budget Cash Flow Information While accrual accounting has advantages over cash accounting in many contexts, for purposes of capital budgeting, estimated cash inflows and outflows are preferred for inputs into the capital budgeting decision tools Sometimes cash flow information is not available, in which case adjustments can be made to accrual accounting numbers to estimate cash flows The capital budgeting decision, under any technique, depends in part on a variety of considerations: a The availability of funds; b Relationships among proposed projects; c The company’s basic decision-making approach; and d The risk associated with a particular project Cash Payback (S.O 2) The cash payback technique identifies the time period required to recover the cost of the capital investment from the net annual cash inflow produced by the investment The formula for computing the cash payback period is: Cost of Capital Investment ÷ Net Annual Cash Flow = Cash Payback Period Net annual cash flow can be approximated by adding depreciation expense to net income The evaluation of the payback period is often related to the expected useful life of the asset a With this technique, the shorter the payback period, the more attractive the investment b This technique is useful as an initial screening tool c This technique ignores both the expected profitability of the investment and the time value of money Net Present Value Method (S.O 3) Under the net present value (NPV) method, cash flows are discounted to their present value and then compared with the capital outlay required by the investment The difference between these two amounts is the net present value (NPV) a The interest rate used in discounting the future net cash flows is the required minimum rate of return b A proposal is acceptable when NPV is zero or positive c The higher the positive NPV, the more attractive the investment 12-5 When there are equal annual cash inflows, the table showing the present value of an annuity of can be used in determining present value When there are unequal annual cash inflows, the table showing the present value of a single future amount must be used in determining present value The discount rate used by most companies is its cost of capital—that is, the rate that the company must pay to obtain funds from creditors and stockholders 10 The net present value method demonstrated in the text requires the following assumptions: a All cash flows come at the end of each year; b All cash flows are immediately reinvested in another project that has a similar return; and c All cash flows can be predicted with certainty Intangible Benefits 11 (S.O 4) By ignoring intangible benefits, such as increased quality or improved safety, capital budgeting techniques might incorrectly eliminate projects that could be financially beneficial to the company To avoid rejecting projects that actually should be accepted, two possible approaches are suggested; a Calculate net present value ignoring intangible benefits, and then, if the NPV is negative, ask whether the intangible benefits are worth at least the amount of the negative NPV b Project rough, conservative estimates of the value of the intangible benefits, and incorporate these values into the NPV calculation Mutually Exclusive Projects 12 (S.O 5) In theory, all projects with positive NPVs should be accepted However, companies rarely are able to adopt all positive-NPV proposals because (1) the proposals are mutually exclusive (if the company adopts one proposal, it would be impossible to also adopt the other proposal), and (2) companies have limited resources 13 In choosing between two projects, one method that takes into account both the size of the original investment and the discounted cash flows is the profitability index The profitability index formula is as follows: Present Value of Initial ÷ Investment Future Cash Flows = Profitability Index The project with the greater profitability index should be the one chosen 14 Another consideration made by financial analysts is uncertainty or risk One approach for dealing with uncertainty is sensitivity analysis Sensitivity analysis uses a number of outcome estimates to get a sense of the variability among potential returns In general, a higher risk project should be evaluated using a higher discount rate Post-Audit of Investment Projects 15 (S.O 6) A post-audit is a thorough evaluation of how well a project’s actual performance matches the projections made when the project was proposed Performing a post-audit is beneficial for the following reasons: a Management will be encouraged to submit reasonable and accurate data when they make investment proposals; b A formal mechanism is used for determining whether existing projects should be supported or terminated; c Management improves their estimation techniques by evaluating their past successes and failures 12-6 16 A post-audit involves the same evaluation techniques that were used in making the original capital budgeting decision—for example, use of the net present value method The difference is that, in the post-audit, actual figures are inserted where known, and estimation of future amounts is revised based on new information Internal Rate of Return Method 17 (S.O 7) The internal rate of return method results in finding the interest yield of the potential investment This is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows Determining the internal rate of return can be done with a financial (business) calculator, computerized spreadsheet, or by employing a trial-and-error procedure 18 The decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return, and reject the project when the internal rate of return is less than the required rate Annual Rate of Return Method 19 (S.O 8) The annual rate of return method indicates the profitability of a capital expenditure and its formula is: Expected Annual Net Income ÷ Average Investment = Annual Rate of Return Average investment is based on the following: Original investment + Value at end of usefull life = Average Investment 20 The annual rate of return is compared with management’s required minimum rate of return for investments of similar risk The minimum rate of return (the hurdle rate or cutoff rate) is generally based on the company’s cost of capital The decision rule is: A project is acceptable if its rate of return is greater than management’s minimum rate of return; it is unacceptable when the reverse is true 21 When the rate of return technique is used in deciding among several acceptable projects, the higher the rate of return for a given risk, the more attractive the investment 12-7 LECTURE OUTLINE A Capital Budgeting Evaluation Process The process of making capital expenditure decisions in business is referred to as capital budgeting Capital budgeting involves choosing among various projects to find the one(s) that will maximize a company’s return on its financial investment TEACHING TIP ILLUSTRATION 12-1 presents the steps involved in the capital budgeting evaluation process Top management requests proposals for projects from each department and a capital budgeting committee screens the proposals and recommends worthy projects to company officers Company officers decide which projects to fund and submit this list of projects to the board of directors for approval For purposes of capital budgeting, estimated cash inflows and outflows are the preferred inputs B Cash Payback The cash payback technique identifies the time period required to recover the cost of the capital investment from the net annual cash flow produced by the investment Net annual cash flow is computed by adding back depreciation expense to net income Depreciation expense is added back because it is an expense that does not require an outflow of cash 12-8 TEACHING TIP ILLUSTRATION 12-2 provides an example of calculating the cash payback period on an investment project Point out that cash payback is easy to compute and is often used to screen projects for risk, but it does not consider the profitability of the project Also available as teaching transparency a The formula when net annual cash flows are equal is: Cost of Capital Investment ÷ Net Annual Cash FIow = Cash Payback Period b The shorter the payback period, the more attractive the investment c The cash payback technique recognizes that: (1) The earlier the investment is recovered, the sooner the company can use the cash funds for other purposes (2) The risk of loss from obsolescence and changed economic conditions is less in a shorter payback period C d In the case of uneven net annual cash flows, the company determines the cash payback period when the cumulative net cash flows from the investment equal the cost of the investment e The cash payback technique is relatively easy to compute and understand f It should not ordinarily be the only basis for the capital budgeting decision because it ignores the expected profitability of the project Net Present Value Method Discounted cash flow techniques are generally recognized as the most informative and best conceptual approaches to making capital budgeting decisions 12-9 These techniques consider both the time value of money and the estimated net cash flow from the investment The primary discounted cash flow technique is the net present value method The net present value method in values discounting net cash flows to their present value and then comparing that present value with the capital outlay required by the investment The difference between these two amounts is referred to as net present value (NPV) TEACHING TIP ILLUSTRATION 12-3 presents a diagram of the decision criteria for the net present value method a Company management determines what interest rate to use in discounting the future net cash flows This rate is often referred to as the discount rate or required rate of return b A proposal is acceptable when net present value is zero or positive, because this means the rate of return on the investment equals or exceeds the discount rate (required rate of return) c The higher the positive net present value, the more attractive the investment TEACHING TIP ILLUSTRATION 12-4 provides a short example of applying the net present value method Also available as teaching transparency 12-10 F Post-Audit of Investment Projects A post-audit is a thorough evaluation of how well a project’s actual performance matches the original projections Performing a post-audit is important for several reasons a Since managers know that their results will be evaluated, there is an incentive for them to make accurate estimates rather than presenting overly optimistic estimates in an effort to get projects approved b A post-audit provides a formal mechanism for determining whether existing projects should be continued, expanded, or terminated c Post-audits improve future investment proposals because managers improve their estimation techniques by evaluating past successes and failures A post-audit involves the same evaluation techniques used in making the original capital budgeting decision In the post-audit, managers use actual figures where known, and they revise estimates of future amounts based on new information G Internal Rate of Return The internal rate of return method differs from the net present value method in that it finds the interest yield of the potential investment a The internal rate of return is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected net annual cash flows TEACHING TIP Use ILLUSTRATION 12-4 to calculate the internal rate of return on an investment project Compare the net present value method and the internal rate of return method for the same investment proposal Also available as teaching transparency 12-12 b The determination of the internal rate of return involves the use of a financial calculator or computerized spreadsheet to solve for the rate (if the cash flows are uneven) c If the net annual cash flows are equal, an easier approach to solving for the internal rate of return can be used This approach involves two steps: (1) Compute the internal rate of return factor (2) Use the factor and the present value of an annuity of table to find the internal rate of return d The formula for determining the internal rate of return factor is: Capital Investment ÷ Net Annual Cash Flows = Internal Rate of Return Factor e Once managers know the internal rate, of return, they compare it to the company’s required rate of return (the discount rate) f The decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return Reject the project when the internal rate of return is less than the required rate TEACHING TIP ILLUSTRATION 12-6 provides a diagram of the decision criteria for the internal rate of return method The two discounted cash flow methods differ as follows: a Objective: (1) Net present value: compute net present value (a dollar amount) (2) Internal rate of return: compute internal rate of return (a percentage) 12-13 b Decision rule: (1) Net present value (NPV): If NPV is zero or positive, accept the proposal If NPV is negative, reject the proposal (2) Internal rate of return (IRR): If IRR is equal to or greater than the required rate of return, accept the proposal If IRR is less than the required rate of return, reject the proposal H Annual Rate of Return Method The annual rate of return method is based directly on accounting data rather than on cash flows TEACHING TIP ILLUSTRATION 12-7 provides an example of calculating the annual rate of return on an investment project Point out that this is the only approach that uses accrual accounting data, and it ignores the time value of money Also available as teaching transparency a Annual rate of return is obtained from the following formula: Expected Annual Net Income ÷ Average Investment b Management compares the annual rate of return with its required rate of return for investments of similar risk c The required rate of return is generally based on the company’s cost of capital d The decision rule is: A project is acceptable if its rate of return is greater than management’s required rate of return It is unacceptable when the reverse is true 12-14 e The higher the rate of return for a given risk, the more attractive the investment f The principal advantages of this method are the simplicity of its calculation and management’s familiarity with the accounting terms used in the computation g A major limitation of this method is that it does not consider the time value of money 12-15 20 MINUTE QUIZ Circle the correct answer True/False For purposes of capital budgeting, estimated cash inflows and outflows are the preferred inputs True The cash payback technique is relatively easy to compute and considers the expected profitability of the project True False The internal rate of return method does not recognize the time value of money True False Performing a post-audit is important because if managers know their estimates will be compared to actual results they will be more likely to submit reasonable and accurate data when they make investment proposals True False The profitability index takes into account both the size of the original investment and the discounted cash flows True False Intangible benefits, such as increased quality or improved safety, should be ignored in capital budgeting decisions True False A company’s cost of capital is the rate that it must pay to obtain funds from creditors and stockholders True False The primary discounted cash flow technique is the net present value method True False False The internal rate of return is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected net annual cash flows True False 12-16 10 The annual rate of return is computed by dividing net annual cash flow by the average investment True False Multiple Choice All of the capital budgeting methods use cash flow except the a cash payback method b annual rate of return method c internal rate of return method d profitability index method The cash payback period is computed by dividing the a cost of the capital investment by the annual net income b cost of the capital investment by the present value of the cash flows c cost of the capital investment by the net annual cash flow d present value of the cash flows by the cost of the capital investment The primary discounted cash flow technique is the a Annual rate of return method b Cash payback method c Net present value method d None of the above A company is considering investing in a project that costs $780,000 and is expected to generate net annual cash flows of $315,000 each year for years The company has a required rate of return of 9% The present value of an annuity of for periods at 9% is 2.531 The net present value of this project is a $797,265 b $465,000 c $797,725 d $17,265 If capital investment is $800,000 and equal annual cash inflows are $200,000, the internal rate of return factor is a 25.0 b 4.0 c 5.0 d .25 12-17 ANSWERS TO QUIZ True/False True False True True False 10 True True False True False Multiple Choice b c c d b 12-18 ILLUSTRATION 12-1 CAPITAL BUDGET AUTHORIZATION PROCESS Project proposals are requested from departments, plants, and authorized personnel Proposals are screened by a capital budget committee Officers determine which projects are worthy of funding Board of directors approves capital budget 12-19 ILLUSTRATION 12-2 CASH PAYBACK PERIOD Cash Payback Period* = Cost of Capital Investment Net Annual Cash Flow * Assuming net annual cash flows are equal A company wishes to invest $200,000 in a project that has a 10-year life, expected annual net income of $35,000, and annual net cash flow of $50,000 Compute the cash payback period Cash Payback Period = $200,000 $50,000 12-20 = years ILLUSTRATION 12-3 NET PRESENT VALUE METHOD DECISION CRITERIA Present Value of Net Cash Flows Less Capital Investment Equals Net Present Value If Zero or Positive If Negative Accept Proposal Reject Proposal 12-21 ILLUSTRATION 12-4 DISCOUNTED CASH FLOWS A company is considering an investment of $83,750 for equipment that is expected to provide a net cash flow of $25,000 each year for the five years of the equipment's life The equipment will have no salvage value at the end of five years Compute the net present value of this investment if the company requires a 10% rate of return on its investments Present Value of an Annuity of I (n) 8% 93 1.78 2.58 3.31 3.99 10% 91 1.74 2.49 3.17 3.79 Cash Flow $83,750 25,000 15% 87 1.63 2.28 2.85 3.35 10% Factor 1.00 3.79 Present Value $(83,750) 94,750 $11,000 Event Period Investment Annual net cash inflow – Net present value The project is acceptable because it has a positive net present value and therefore earns more than the 10% required rate of return Compute the internal rate of return on the project if management has a required rate of 10% on investment projects Compute the internal rate of return factor $83,750 $25,000 = 3.35 Use the factor and the present value of an annuity of I table to find the internal rate of return n = 5; IRR = 15% 12-22 ILLUSTRATION 12-5 PROFITABILITY INDEX Profitability Index = Present Value of Net Cash Flows Initial Investment A company wishes to invest $80,000 in a project that has a present value of net cash flows of $100,000 Compute the profitability index Profitability Index = $100,000 12-23 $80,000 = 1.25 ILLUSTRATION 12-6 INTERNAL RATE OF RETURN METHOD DECISION CRITERIA Internal Rate of Return Compared to Required Rate of Return (the Discount Rate) If equal to or greater than: If less than: Accept Proposal Reject Proposal 12-24 ILLUSTRATION 12-7 ANNUAL RATE OF RETURN A company wishes to invest $160,000 and provides the following projected cost data: $250,000 Sales Manufacturing costs (150,000) (exclusive of depreciation) (16,000) Depreciation expense ($160,000 ÷ 10 years) (56,000) Selling and administrative expenses (8,000) Income tax expense $ 20,000 Net income Provide the formula and computation for the (a) average investment, and (b) annual rate of return Compute average investment (assume no salvage value) Average Investment = Investment at End of Useful Life Original Investment + $160,000 + = $80,000 Compute annual rate of return Expected Annual Net Income $20,000 ÷ ÷ Average Investment $80,000 = = Annual Rate of Return 25% If the project's rate of return exceeds the required rate of return, then the project may be accepted 12-25 ... computed by dividing the a cost of the capital investment by the annual net income b cost of the capital investment by the present value of the cash flows c cost of the capital investment by the... produced by the investment The formula for computing the cash payback period is: Cost of Capital Investment ÷ Net Annual Cash Flow = Cash Payback Period Net annual cash flow can be approximated by. .. cost of the capital investment from the net annual cash flow produced by the investment Net annual cash flow is computed by adding back depreciation expense to net income Depreciation expense