ACCT 372 – CHAPTER 12 – CAPITAL BUDGETING DECISION

WHAT IS CAPITAL BUDGETING?

 represents a long-term investment decision

o for example, buy a new computer system 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
o 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
o all cash flows are calculated after-tax

CASH FLOWS – the benefits and costs to the firm as a result of investment decisions

Incremental Cash Flows – inflows, money received on sale of old machine

Decremental Cash Flows – outflows, cost of a replacement machine

5 METHODS FOR EVALUATING INVESTMENT PROPOSALS

1. Average Accounting Return (AAR)

2. Payback Period (PP)
3. Internal Rate of Return (IRR)
4. Net Present Value (NPV)
5. Profitability Index (PI)

AVERAGE ACCOUNTING RETURN

Advantage: Relatively easy to calculate

Disadvantages:

 Uses accounting earnings, not cash flows

 Ignores the timing of the earnings
 Uses book value, not market value of investment
 Does not suggest an evaluation yardstick

PAYBACK PERIOD - computes the amount of time required to recoup the initial investment

Advantages:

 easy to use (“quick and dirty” approach)

 emphasizes liquidity
 one measure of the risk of an investment

Disadvantages:

 ignores inflows after the cut-off period and fails to consider the time value of money
 better measures of risk
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NET PRESENT VALUE

 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)(assuming similar risk)

INTERNAL RATE OF RETURN

 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

Payback Period (PP):

 if PP < cut-off period, accept the project

 if PP > cut-off 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

CAPITAL RATIONING – a limit or constraint on the amount of funds that can be invested.

 The firm must rank investments based on their NPVs

 Those with positive NPVs are accepted until all funds are exhausted

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NET PRESENT VALUE PROFILE – graph of the NPV of a project at different discount rates shows the NPV
at 3 different points (0 discount rate, normal discount rate, the IRR)

NET PRESENT VALUE WITH CROSS OVER

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CAPITAL COST ALLOWANCE

 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;
o ex. Class 8 is Machinery with a rate of 20%
 CCA is calculated on the Undepreciated Capital Cost (UCC) 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

Before CCA Expense After CCA Expense

Income (cash flow) 12,000 Income (cash flow) 12,000
CCA 5,000
Taxable Income 7,000
Tax @ 25% 3,000 Tax @ 25% 1.750
Income (cash flow) after tax $9,000 Income after taxes 5,250
Add back CCA 5,000
Income / cash flow after taxes 10,250
After tax expense (500 (1 – T) 3,750
Tax Savings (5000 (T)) 1,250
Before -tax saving $5,000

Considerations that determine the amount of CCA

 Each capital acquisition is assigned to a particular asset class (asset pool) which determines the rate
of CCA.
 Only half the CCA rate is allowable in the year of acquisition.
 Amortization for the most part is on the declining balance method and it is the asset pool, not the
individual asset that is amortized for the tax purposes. If an asset pool remains open an acquired
asset is effectively amortized to infinity.
 Therefore, tax savings result each year to infinity as a result of a capital acquisition.
 The sale of an acquired asset reduces the amount remaining in an asset pool (its Undepreciated
Capital Cost).

INCOME TAX CREDIT - The Income Tax Act allows for tax credits on certain capital investments deemed
appropriate for economic reasons by the Federal government. Cash flow consequences result.

1. A direct reduction in taxes payable the amount of the investment tax credit.
2. A reduction in tax saving through CCA because the amount of investment tax credit is deducted
from the asset pool ( UCC ) in the year following acquisition.

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SHOULD I BUY THE NEW MACHINE? - 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 (after-tax)
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)

SUMMARY

 A capital budgeting decision involves planning cash flows for a long-term investment
 Several methods are used to analyze investment proposals: average accounting return, payback, net
present value, internal rate of return, and profitability index
 Net present value method, in particular, considers the amount and timing of cash flows
 The analysis is based upon estimates of incremental cash flows after-tax that will result from the
investment

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One of the most significant decisions that the management of a firm will ever have to make concerns
capital investment.

Capital budgeting decisions are important as they usually involve the long-term commitment of a firm`s
resources and because a large amount of capital is usually involved; management is setting the firm into
a strategic direction that is difficult to change.

A decision to build a new plant, develop a new technology, purchase another company, or expand into a
foreign market may influence the performance of the firm over the next decade or more. A bad
decision can lead to great financial stress and even bankruptcy for a firm.

The capital budgeting decision involves the planning of expenditures for a project with a life of at least
one year and usually considerably longer. In general, the capital expenditure decision requires extensive
planning to ensure that engineering and marketing information is available, product design is
completed, necessary patents are acquired, production costs are fully understood, and the capital
markets are tapped for the necessary funds. Throughout this chapter we use the techniques developed
in our discussion of the time value of money to equate future cash flows to present ones. The firm`s
cost of capital is used as the basic discount rate.

One problem that a manager faces is that as the time horizon moves further into the future, uncertainty
becomes a greater hazard. The manager is uncertain about annual costs and inflows, product life,
interest rates, economic conditions, and technological change.

The personal computer industry is a good example of rapid change. In 1976, the Apple 1, with 8K of RAM
and a keyboard, was sold for $666.66. As others entered the personal computing market, it has rapidly
transformed communication and informational technologies. Many technology companies have risen
on great dreams and then failed when their promised cash flows did not materialize. In Canada the
development of the oil sands in Northern Alberta involves the commitment of tens of billions of dollars
to projects dependent on the volatile price of oil.

Capital budgeting analyzes long-run investment decisions (new projects, replacements, diversification
into new areas) while considering the impact of uncertainty. Canadian tax laws and development will
impact capital budgeting decisions significantly and must be considered.