Capital budgeting describes the long-term longplanning for making and financing major long-term projects. long-

CAPITAL BUDGETING

1. Identify potential investments. 2. Choose an investment.

3. Follow-up or “post audit.” Follow“post audit.”

Net present value model

Net present value model

The net-present-value (NPV) method net-presentcomputes the present value of all expected future cash flows using a minimum desired rate of return.

The minimum desired rate of return depends on the risk of a proposed project – the higher the risk, the higher the rate.

The required rate of return (also called hurdle rate or discount rate) is the minimum desired rate of return based on the firm’s cost of capital.

Applying the NPV method

NPV example

Original investment (cash outflow): $5,827

Prepare a diagram of relevant expected cash inflows and outflows.

Useful life: four years

Find the present value of each expected cash inflow or outflow.

Annual income generated from investment (cash inflow): $2,000

Sum the individual present values.

Minimum desired rate of return: 10%

1

NPV example

Present Value of $1 Total Discounted Present At 10% Value Discounting Cash Flows .9091 .8264 .7513 .6830 $1,818 1,653 1,503 1,366

NPV example

0

Sketch of Cash Flows at End of Year 1 2 3

4

Approach 2: Using an Annuity Table Sketch of Cash Flows at End of Year 0 1 2 3 4 3.1699 $6,340 $2,000 $2,000 $2,000 $2,000 1.0000 (5,827) $(5,827) $ 513

Approach 1: Cash flows Annual savings

2,000 2,000 2,000 2,000

Annual Savings Initial Outlay Net present value

Present value of Future inflows Initial Outlay 1.0000 Net present value

$6,340 (5,827) $(5,827) $ 513

Assumptions of the NPV model

Decision rules

Managers determine the sum of the present values of all expected cash flows from the project.

There is a world of certainty.

Predicted cash flows occur timely.

If the sum of the present values is positive, the project is desirable. There are perfect capital markets. Money can be borrowed or loaned at the same interest rate.

If the sum of the present values is negative, the project is undesirable.

Sensitivity analysis

Sensitivity analysis shows the financial consequences that would occur if actual cash inflows and outflows differ from those expected.

Sensitivity analysis example

Suppose that a manager knows that the actual cash inflows in the previous example could fall below the predicted level of $2,000.

How far below $2,000 must the annual cash inflow drop before the NPV becomes negative?

2

Sensitivity analysis example

Relevant cash flows for NPV

(3.1699

Cash flow) – $5,827 = 0

The four types of inflows and outflows should be considered when the relevant cash flows are arrayed:

Cash flow = $5,827

3.1699 = $1,838

If the annual cash flow is less than $1,838, the NPV is negative, and the project should be rejected.

1) Initial cash inflows and outflows at time zero 2) Investments in receivables and inventories 3) Future disposal values 4) Operating cash flows

Annual cash inflows can drop only $2,000 – $1,838 = $162 or 8.1%

Operating cash flows

Income taxes and capital budgeting

Another type of cash flow (outflow) that must be considered when making capital-budgeting decisions: capital-

The only relevant cash flows are those that will differ among alternatives.

Income taxes Depreciation and book values should be ignored.

A reduction in cash outflow is treated the same as a cash inflow.

In capital budgeting, the relevant tax rate is the marginal income tax rate.

This is the tax rate paid on additional amounts of pretax income.

Effects of depreciation deductions

Tax deductions, cash effects and timing

Depreciation expense is a noncash expense and so is ignored for capital budgeting, except that it is an expense for tax purposes and so will provide a cash inflow from income tax savings....