Capital Budgeting

Chapters 9-10

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Financial Management, FINC 450
Capital Budgeting
 Process of evaluating and selecting long-term investments
that are consistent with the firm’s goal of owner wealth
maximization
 Motivations for Making Capital Expenditures
 Expansion: most common during growth phase
 Replacement: most common during maturity phase
 Renewal: rebuilding, overhauling existing fixed assets
 Other purposes: e.g., government mandated devices
 Project types
 Independent: acceptance does not eliminate others
 Mutually exclusive: acceptance eliminates others

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Financial Management, FINC 450
Steps in the Capital Budgeting
Process

1. Proposal Generation

2. Review and Analysis

3. Decision Making

4. Implementation

5. Follow-up
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Financial Management, FINC 450
Relevant Cash Flows
 After-tax cost of initial investment
= Investment needed - After-tax inflows from liquidation of old asset

 After-tax operating cash flows

=OCF from new asset - OCF from old asset

 After-tax terminal cash flows

= After-tax cash flows from termination - After-tax termination of old asset

 Other issues
 Sunk Costs (previous outlays) are irrelevant
 Opportunity Costs of alternative uses are relevant

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Financial Management, FINC 450
Finding the Initial Investment

Installed cost of new asset =

Capital expenditure on new asset
+ Installation costs
- After-tax proceeds from sale of old asset =
Proceeds from sale of old asset
+/- Tax on sale of old asset
+/- Change in NWC
Initial Investment

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Financial Management, FINC 450
Basic Tax Rules
 Book Value = Installed Cost - Accumulated Depreciation
 Accounting for Deprecation
 Straight-line depreciation: Depr. = Installed Cost ÷ Project Life
 MACRS: IRS-standardized accelerated depreciation
 3 years - Research equipment and certain equipment
 5 years - computers and office equipment, light-duty trucks
 7 years - Office furniture, fixtures, most mfg. equipment
 10 years - Equipment in petroleum refining, tobacco products, certain foods
 Example: Initial Cost = $100,000 2 years (depreciated using 5 year
MACRS) was sold for $80,000. Tax rate is 40%.

Taxable Income = $80,000 - [1 - (0.20 + 0.32)]$100,000 = $32,000

After-tax Proceeds = $80,000 - 0.40($32,000) = $67,2000

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Financial Management, FINC 450
Rounded Depreciation % by Recovery Year
Using MACRS for Different Property Classes

Recovery year 3 years 5 years 7 years 10 years

1 33% 20% 14% 10%
2 45% 32% 25% 18%
3 15% 19% 18% 14%
4 7% 12% 12% 12%
5 12% 9% 9%
6 5% 9% 8%
7 9% 7%
8 4% 6%
9 6%
10 6%
11 4%

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Financial Management, FINC 450
Finding Operating Cash Flows

Revenue
- Expenses (excluding depreciation)
- Depreciation
Taxable Cash Flows
- Taxes
Net Cash Flows After-tax
+ Depreciation
Operating Cash Flows

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Financial Management, FINC 450
Evaluating Projects
 Net Present Value: The present value of future after-tax cash
flows minus the initial investment
 Profitability Index: PV of future CF’s/Initial Cost
 Internal Rate of Return: The discount rate that sets future CF’s
equal to the Initial Cost
 Payback Method: How long does it take to recoup the initial cost
 Average Accounting Return: Average After-Tax
Income/Average Book Value

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Financial Management, FINC 450
Expansion Example
 A firm is evaluating whether to expand operations. To do so would
require the investment in new plant and equipment of $1,000,000
with installation cost of $200,000, with an expected life of 5 years.
Revenue would increase by $800,000 each year, with operating
expenses (not including depreciation) of $400,000 per year. The
expansion will also require an investment in Net Working Capital of
$300,000. Using MACRS 5 year cost recovery, a tax rate of 35%, a
zero salvage value, and a WACC of 9%, is expansion worth while?

NPV $39,078
PI 102.61%
IRR 9.92%
Payback 4.2 years
AAR 14.4%

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Financial Management, FINC 450
 Cash Flows
Year 0 1 2 3 4 5 6
Depreciation Rate 20% 32% 19% 12% 12% 5%
Depreciation $240,000 $384,000 $228,000 $144,000 $144,000 $60,000
Book Value $1,200,000 $960,000 $576,000 $348,000 $204,000 $60,000 $0

Revenues $800,000 $800,000 $800,000 $800,000 $800,000

Operating Costs ($400,000) ($400,000) ($400,000) ($400,000) ($400,000)
Depreciation ($240,000) ($384,000) ($228,000) ($144,000) ($144,000) ($60,000)
Taxable Income $160,000 $16,000 $172,000 $256,000 $256,000 ($60,000)
Taxes @ 35% ($56,000) ($5,600) ($60,200) ($89,600) ($89,600) $21,000
Net Operating Profit $104,000 $10,400 $111,800 $166,400 $166,400 ($39,000)
Depreciation $240,000 $384,000 $228,000 $144,000 $144,000 $60,000
Operating Cash Flows $344,000 $394,400 $339,800 $310,400 $310,400 $21,000

Installed Cost of New Asset ($1,200,000)

Increase in NWC ($300,000) $300,000
Operating Cash Flows $344,000 $394,400 $339,800 $310,400 $310,400 $21,000
Salvage Value $0
Free Cash Flows ($1,500,000) $344,000 $394,400 $339,800 $310,400 $610,400 $21,000
Cumulative FCF ($1,500,000) ($1,156,000) ($761,600) ($421,800) ($111,400) $499,000 $520,000

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Financial Management, FINC 450
Renewal
 A firm is considering renewing its equipment to meet increased demand for
its product. The cost of equipment modifications is $1.9 million plus
$100,000 in installation costs. The firm will depreciate using MACRS with a
5-year recovery period. Additional revenue should amount to $1.2 million
per year, and additional costs (excluding depreciation) will amount to 40%
of the additional sales, and new working capital requirements will amount
to 10% of the additional sales. The firm has a tax rate of 40%. WACC =
10%. Should the renewal project be undertaken?

NPV $272,205
PI 112.84%
IRR 13.81%
Payback 3.5 years
AAR 16.0%

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Financial Management, FINC 450
Cash Flows
Year 0 1 2 3 4 5 6
Depreciation Rate 20% 32% 19% 12% 12% 5%
Depreciation $400,000 $640,000 $380,000 $240,000 $240,000 $100,000
Book Value $2,000,000 $1,600,000 $960,000 $580,000 $340,000 $100,000 $0

Revenues $1,200,000 $1,200,000 $1,200,000 $1,200,000 $1,200,000

Operating Costs ($480,000) ($480,000) ($480,000) ($480,000) ($480,000)
Depreciation ($400,000) ($640,000) ($380,000) ($240,000) ($240,000) ($100,000)
Taxable Income $320,000 $80,000 $340,000 $480,000 $480,000 ($100,000)
Taxes @ 40% ($128,000) ($32,000) ($136,000) ($192,000) ($192,000) $40,000
Net Operating Profit $192,000 $48,000 $204,000 $288,000 $288,000 ($60,000)
Depreciation $400,000 $640,000 $380,000 $240,000 $240,000 $100,000
Operating Cash Flows $592,000 $688,000 $584,000 $528,000 $528,000 $40,000

Installed Cost of New Asset ($2,000,000)

Increase in NWC ($120,000) $120,000
Operating Cash Flows $592,000 $688,000 $584,000 $528,000 $528,000 $40,000
Salvage Value $0
Free Cash Flows ($2,120,000) $592,000 $688,000 $584,000 $528,000 $648,000 $40,000
Cumulative FCF ($2,120,000) ($1,528,000) ($840,000) ($256,000) $272,000 $920,000 $960,000

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Financial Management, FINC 450
Replacement
 Miller Corp. is considering replacing a machine. The replacement will
reduce operating expenses(that is, increase net operating income) by
$16,000 per year for each of the 5 years the new machine is expected to
last. The replacement machine will also require $2,000 less inventory than
the older machine. Although the old machine has zero book value, it can
be used for five more years, and it has a market value of $15,000. The
depreciable value of the new machine is $48,000, and is expected to have
a sale value of $20,000 in five years. The firm will depreciate the machine
under MACRS using a 5-year recovery period, and is subject to a 40% tax
rate on ordinary income. WACC is 9%.
NPV $22,105
PI 159.74%
IRR 28.67%
Payback 2.6 years
AAR 16.4%
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Financial Management, FINC 450
Cash Flows
Year 0 1 2 3 4 5 6
Depreciation Rate 20% 32% 19% 12% 12% 5%
Depreciation $9,600 $15,360 $9,120 $5,760 $5,760 $2,400
Book Value $48,000 $38,400 $23,040 $13,920 $8,160 $2,400 $0

Increase in Op Income $16,000 $16,000 $16,000 $16,000 $16,000

Depreciation ($9,600) ($15,360) ($9,120) ($5,760) ($5,760)
Taxable Income $6,400 $640 $6,880 $10,240 $10,240
Taxes @ 40% ($2,560) ($256) ($2,752) ($4,096) ($4,096)
Net Operating Profit $3,840 $384 $4,128 $6,144 $6,144
Depreciation $9,600 $15,360 $9,120 $5,760 $5,760
Operating Cash Flows $13,440 $15,744 $13,248 $11,904 $11,904

Installed Cost of New Asset ($39,000)

Increase in NWC $2,000 ($2,000)
Operating Cash Flows $13,440 $15,744 $13,248 $11,904 $11,904
Salvage Proceeds $12,960
Free Cash Flows ($37,000) $13,440 $15,744 $13,248 $11,904 $22,864
Cumulative FCF ($37,000) ($23,560) ($7,816) $5,432 $17,336 $40,200

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Financial Management, FINC 450
Relevant Cash Flows for a Marketing
Campaign

 Maltin Tube, a manufacturer of high-quality aluminum tubing, has

maintained stable sales and profits over the last ten years. Now Maltin
wants to increase its sales and is considering an aggressive marketing
campaign that centers on regularly running ads in all relevant trade journals
and exhibiting products at all major regional and national trade shows.
 The campaign will have a pre-tax cost of $150,000 over the next five years.
Sales revenue is expected to grow from its present $20,000,000 up to
23,500,000 by the year 2005.
 There is excess capacity so no new capital expenditures are required.
 Depreciation stays at $500,000
 COGS stays at 80% of Sales
 SG&A stays at 10% of Sales
 Tax rate is 40%

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Financial Management, FINC 450
Maltin Tube Forecasts and
Income Statement

Income Statement Sales Forecast

Maltin Tube Year Sales
for year ended December 31, 2000
Sales revenue $20,000,000
2001 $20,500,000
Less: Cost of goods sold (80%) (16,000,000) 2002 21,000,000
Gross profits $4,000,000 2003 21,500,000
Less: Operating expenses 2004 22,500,000
General & Administrative (10%) $2,000,000 2005 23,500,000
Depreciation 500,000
Total Operating Expenses (2,500,000)
Net profits before tax 1,500,000
Less: Taxes @40% (600,000)
Net profits after taxes 900,000

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Financial Management, FINC 450
Yes! The Ad Campaign
Pays Off

Year 0 1 2 3 4 5
Increase in Sales $500,000 $1,000,000 $1,500,000 $2,500,000 $3,500,000
Incremental Cost (90%) ($450,000) ($900,000) ($1,350,000) ($2,250,000) ($3,150,000)
Advertising Cost ($150,000) ($150,000) ($150,000) ($150,000) ($150,000)
Incremental Depreciation $0 $0 $0 $0 $0
Taxable Income ($100,000) ($50,000) $0 $100,000 $200,000
Taxes @ 40% $40,000 $20,000 $0 ($40,000) ($80,000)
Incremental Net Operating Profit ($60,000) ($30,000) $0 $60,000 $120,000
Incremental Depreciation $0 $0 $0 $0 $0
Incremental Operating Cash Flows ($60,000) ($30,000) $0 $60,000 $120,000

NPV $40,201
IRR 23.12%

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Financial Management, FINC 450
Problems with Value
Measures
 Payback Method
 no time value of money factored in
 ignores payment information after payback period
 IRR
 assumes firm can reinvest cash flows at IRR rate
 NPV
 biased toward longer-lived projects

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Financial Management, FINC 450
Comparing Projects with Unequal
Lives

 The NPV of a five-year project is $150

 The NPV of a ten-year project is $200
 Which is the better project?
 Depends: Is this a one-shot investment? If yes, then the 10-year
project rules.

If the 5-year project is renewable it is better.

 Equivalent Annuities: Hypothetical Annual Cash
Flow that sets future CF equal to NPV
 At a discount rate of 10%
 EA5-year = $39.57
 EA10-year = $32.55

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Financial Management, FINC 450
Capital Rationing
 Firms with limited sources of capital must pick the best
projects with a given sum of funds (budget constraint)
 IRR Approach: Sequentially pick the highest IRR
projects down to lowest until funds are used up
 NPV Approach: Maximize NPV subject to budget
constraint (an operations research problem)

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Financial Management, FINC 450
Which Machine Do You Pick?
Evans Industries wishes to select the best of three possible machines, each expected to fulfill the
firm’s ongoing need for additional aluminum-extrusion capacity. The three machines-A, B, and C-are
equally risky. The firm plans to use a 12% WACC to evaluate each of them. The initial investment
and annual free cash flows to the firm over the life of each machine are shown in the following table.

Machine A Machine B Machine C

Year
0 -$92,000 -$65,000 -$100,500
1 12,000 10,000 30,000
2 12,000 20,000 30,000
3 12,000 30,000 30,000
4 12,000 40,000 30,000
5 12,000 30,000
6 12,000

a. Calculate the NPV for each machine over its life. Rank the machines in descending order based
on NPV.
b. Use the equivalent annuity approach to evaluate and rank the machines in descending order.
c. Compare and contrast your findings in a and b. Which machine would you recommend the firm
acquire? Why?
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Financial Management, FINC 450
B or C, depending on your
assumptions
Year Machine A Machine B Machine C
0 ($92,000) ($65,000) ($100,500)
1 12,000 10,000 30,000
2 12,000 20,000 30,000
3 12,000 30,000 30,000
4 12,000 40,000 30,000
5 12,000 30,000
6 12,000

NPV ($42,663) $6,647 $7,643

IRR -6.58% 15.87% 15.03%
EA ($10,376.77) $1,616.62 $1,859.04

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Financial Management, FINC 450
Accounting for Project Risk

 Using firm-level WACC is not appropriate for

 higher/lower risk divisions
 higher/lower risk projects
 Using firm-WACC as the discount rate
 biases against low risk projects
 biases for high risk projects
 Companies typically have Risk Classes for projects
 Lowest Risk => WACC - 2%
 Below-Average Risk=> WACC - 1%
 Average Risk => WACC
 Above-Average Risk => WACC +2%
 Highest Risk => WACC + 5%

Loyola University Chicago Graduate School of Business

Financial Management, FINC 450