Chapter 17 - Capital Budgeting - The Investment Decision PDF

# Chapter 17: Capital Budgeting - The Investment Decision ## Chapter 17: Capital Budgeting - The Investment Decision Once the relevant cash flows related to a capital budget have been determined, the next step is to determine if the project should be accepted or not. A variety of methods may be u...

# Chapter 17: Capital Budgeting - The Investment Decision ## Chapter 17: Capital Budgeting - The Investment Decision Once the relevant cash flows related to a capital budget have been determined, the next step is to determine if the project should be accepted or not. A variety of methods may be used for quantitative analysis to evaluate whether the project is viable from a financial perspective. Three commonly used methods are demonstrated in this chapter: * Net present value * Payback period * Internal rate of return The advantages and disadvantages of each method are discussed. The last step in the quantitative analysis is to evaluate the impact of variations in the underlying assumptions on future cash flow projections, which is shown at the end of this chapter. ### Lessons * **Lesson 1:** The Net Present Value Method * **Lesson 2:** The Internal Rate of Return and Payback Methods * **Lesson 3:** Capital Budgeting - The Investment Decision - Summary Problem ## Capital Budgeting **Once relevant cash flows are identified, several quantitative methods and tools can be used for analysis. Common methods for capital budgeting include:** * Net present value * Internal rate of return * Payback period (undiscounted or discounted) ### NPV * **Definition and approach**: PV of all relevant cash flows for the project. * **Decision criteria**: Accept projects with positive NPV. * **Advantages**: Determines the increase in firm value from accepting the project. * **Disadvantages**: Assumptions are difficult to predict further into the future (for example, tax rates, CCA rates, inflation, operating cash flows). ### Payback Period (PBP) * **Definition and approach**: Time required to recover the initial investment (undiscounted cash flows) * **Decision criteria**: Shorter PBP preferred (must be less than the prescribed period for the project). * **Advantages**: Easy to calculate and explain. A good indicator of liquidity risk. * **Disadvantages**: No standard benchmark against which to judge when a project's PBP is acceptable. Ignores post-PBP cash flows. Typically ignores the time value of money. Gives no indication of impact on firm value. ### IRR * **Definition and approach**: Discount rate at which NPV = 0. Uses undiscounted relevant cash flows. * **Decision criteria**: Accept if project's IRR exceeds the appropriate discount rate. * **Advantages**: Intuitive interpretation. Leads to the same accept/reject decision as NPV for independent projects. * **Disadvantages**: Assumes intermediate cash flows are reinvested at a rate equal to the IRR. Not reliable when future cash flows have multiple signs changes. Comparing mutually exclusive projects. ## Sensitivity (or "what-if") analysis The systematic testing of results by identifying and varying the values of key assumptions.Key assumptions are those that can have a significant effect on the analysis or conclusions. Sensitivity analysis is used to more fully understand the range of possible results. It is a future-focused projection tool used by managers to anticipate the impact of uncertainties, or financial risks, that are inherent in capital budgeting. ## Lesson 1: The Net Present Value Method **Technical competency: 5.3.1 Develops or evaluates capital budgeting processes and decisions** **Learning outcomes:** * Calculate the net present value for a capital project and conclude if the project should be accepted or not. * Perform sensitivity analysis on future cash flow estimates and assess the impact on the net present value. **17.1 Net present value** The most common quantitative method for capital budgeting is net present value (NPV), which adjusts each cash flow for the time value of money using the appropriate discount rate, given the level of risk. The Time Value of Money chapter provides further discussion on this topic. **17.1.1 Method** The NPV method requires that the relevant cash flows be allocated to each period of the project's life. Using the appropriate discount rate, the NPV of all the relevant cash flows for the project is calculated. The Net Present Value chapter demonstrates how these calculations are performed using a spreadsheet approach and the formulas used in the NPV analysis. **17.1.2 Rule for acceptance (based only on quantitative analysis)** The general rule when using the NPV method is to accept projects with a positive NPV and reject projects with a negative NPV. Projects with a positive NPV are expected to increase value for the entity, while projects with a negative NPV are expected to reduce value. Projects with a $0 NPV are expected to provide a return equal to the discount rate used in the analysis and to have no impact on entity value. **17.1.3 Example: NPV using tax shield approach** A company is considering an investment in new equipment that will cost $20,000,000. The equipment qualifies for CCA at the rate of 30% declining balance, and 1.5 times the CCA can be claimed in the first year of use. The project will last three years, and the incremental operating cash flows before tax related to this project are indexed to inflation at 2% and estimated as follows: | (in 000s) | Year 1 | Year 2 | Year 3 | |------------------------------------|----------|---------|---------| | Incremental contribution margin | $8,310 | $8,476 | $8,646 | | Incremental fixed costs | $600 | $612 | $624 | An initial investment in working capital of $650,000 is required. There will be an additional investment in operating working capital of $20,000 in each of Year 1 and Year 2. In Year 3, the equipment will be sold for proceeds of $10,000,000. The company has an income tax rate of 25%, and the appropriate discount rate for this project is 15%. The table below uses the tax shield approach introduced in the Capital Budgeting - Overview and Relevant Cash Flows chapter. The table provides details on the assumptions and calculations used. | (in '000s) | Inception | Year 1 | Year 2 | Year 3 | |------------------------------------|----------|---------|---------|---------| | Initial investment | $(20,000) | | | | | Capital expenditures - equipment | | | | | | PV of the tax shield on CCA | | | | | | - equipment | $1,551 | | | | | Annual operating after-tax cash flows | | | | | | Increment contribution margin | | $8,310 | $8.476 | $8,646 | | Incremental fixed costs | | $(600) | $(612) | $(624) | | Income tax thereon | 25% | | $(1,928) | $(2,006) | | After-tax annual operating cash flows | | $5,782 | $6,016 | | | Investment in working capital | | $(650) | $(20) | $690 | | Salvage value | | | | $10,000 | | PV of the lost tax shield | | | | $(1,667) | | - equipment | | | | | | Net incremental cash flow | | $(17,099) | $5,011 | $4,445 | $15,039 | | PV factor - Discount rate | 15% | 1.0000 | 0.8696 | 0.7562 | 0.6576 | | Net present value | | | | | $2,247 | **Conclusion:** The proposal generates a positive net present value and is expected to increase organizational value. **Notes:** * **Note 1:** Per proposal for the new equipment, $20,000. The equipment qualifies for a 30% CCA rate and 1.5 times the CCA can be claimed in the first year of use. * **Note 2:** PV of the tax shield on CCA formula * **Note 3:** Based on the information provided, the company is taxed at a rate of 25%. * **Note 4:** Working capital is expected to change with an initial increase of $650,000 and increase by $20,000 each year. In Year 3, working capital levels would return to pre-investment levels at the end of the analysis time frame. * **Note 5:** The equipment will be sold at the end of the project's life for cash proceeds of $10,000,000. It is assumed that there are no other assets in the class and a recapture of CCA that is included in business income is therefore required. * **Note 6:** PV of the lost tax shield on CCA on salvage: * **Example: NPV using annual CCA deduction (rather than the tax shield)** Using the annual CCA calculation (Section 17.1.3), the tax expense each year shows CCA using a CCA deduction each year as incorporated in a lower operating cash flow. The tax savings due to the same information is above the income tax on the NPV calculation. The CCA is reported for tax purposes. The recapture of $2,300,000 has been deducted in calculating the after-tax operating cash flows for Year 3. ## 17.2: Sensitivity anaylsis Once a quantitative method has been applied, the underlying assumptions need to be tested. Sensitivity analysis is the systematic testing of results by identifying and varying the values of key assumptions to more fully understand the range of possible results. Key assumptions are those assumptions that can have a significant effect on the analysis or conclusions. Sensitivity analysis should be used to analyze the potential impact of changing key assumptions. Sensitivity analysis is a future-focused projection tool used by managers to actively anticipate the impact of uncertainties, or financial risks, that are inherent in capital budgeting. When conducting sensitivity analysis, the key assumptions used in the initial expected forecast are varied to accommodate the possibility of different outcomes. Sensitivity analysis is also referred to as "what-if" analysis. ## 17.3: Internal Rate of Return Another common quantitive method for capital budgeting is internal rate of return (IRR), which calculates the discount rate for the project that would cause the project's NPV to be $0. **17.3.1: Method** In the IRR method, the relevant cash flows are allocated to each period of the project's life.A formula is then used to calculate the rate of return that results in a $0 NPV for the project. Note that the cash flows for the IRR analysis below use the CCA annual deduction approach. It would be complex to calculate an IRR using the tax shield formula because the tax shield formula already includes a discount rate. Note also that the IRR method and NPV analysis normally lead to similar outcomes (that is, project acceptance) If the cash flows are consistent. **17.3.2: Rule for Acceptance (based only on quantitive analysis)** If the IRR is greater than the discount rate appropriate for the project, then the project should be accepted. If the IRR is less than the appropriate discount rate, then the project should be rejected. **17.3.3 Example: IRR** This example involves an initial investment in equipment of $21,000,000 and a time horizon of three years. The equipment qualifies for straight-line CCA. The incremental operating cash flows before tax related to this project and the CCA deductions are estimated as follows: | (in '000s) | Year 1 | Year 2 | Year 3 | |------------------------------------|----------|---------|---------| | Incremental contribution margin | $8,500 | $8,670 | $8,843 | | Incremental fixed costs | $900 | $918 | $936 | | Annual CCA deduction | $3,150 | $5,355 | $3,749 | An initial investment in working capital of $80,000 is required. There will be an additional investment in operating working capital of $20,000 in each of Year 1 and Year 2. At the end of the project's life, the equipment can be sold for after-tax proceeds of $9,100,000. The corporate tax rate for the company is 25%. | | A | B | C | D | E | F | G | |---|---|---|---|---|---|---|---| | 1 | | | | | | | | | 2 | | | | | | | | | 3 | | | | | | | | | 4 | | | | | | | | | 5 | | | | | | | | | 6 | (in thousands of dollars) | | | | | | | | 7 | | | | | | | | | 8 | Initial investment | | | | $(21,000) | | | | 9 | Capital expenditures - equipment | | | | | | | | 10 | | | | | | | | | 11 | Annual operating after-tax cash flows | | | | | | | | 12 | | | | | | | | | 13 | Incremental contribution margin | | | | $8,500 | $8,670 | $8,843 | | 14 | Incremental fixed costs | | | | $(900) | $(918) | $(936) | | 15 | CCA deduction | | | | $(3,150) | $(5,355) | $(3,749) | | 16 | | | | | | | | | 17 | Income tax thereon | 25% | | | $(1,113) | $(599) | $(1,040) | | 18 | Add back CCA | | | | $3,150 | $5,355 | $3,749 | | 19 | After-tax annual operating cash flows | | | | $6,487 | $7,153 | $6,867 | | 20 | Investment in working capital | | | | $(80) | $(20) | $(20) | | 21 | | | | | | | | | 22 | Salvage value net of taxes | | | | | | $9,100 | | 23 | | | | | | | | | 24 | Net incremental cash flow | | | | $(21,080) | $6,467 | $7,133 | $16,087 | | 25 | | | | | | | | | 26 | IRR | | | | | | 16.25% | | 27 | | | | | | | | | 28 | | | | | | | | The IRR for this project is calculated in the worksheet below. **Notice the IRR formula used for the IRR calculation that is shown. The IRR for this project is 16.25%. Assume the hurdle rate (the appropriate discount rate to use for this project) is 15%. Since the IRR is 16.25%, which is higher than the hurdle rate of 15%, this project would be accepted (ignoring possible relevant qualitative factors). If the IRR had been lower than the hurdle rate of 15%, the project would be rejected.** **17.3.4 Merits and limitations of IRR** **Merits of the IRR method include the following:** * It considers the time value of money. * It is easily understood. **Limitations of the IRR method include the following:** * The IRR method can have more than one result. If the periodic cash flows are positive and negative throughout the life of the project, there can be multiple IRRs. For example, this could happen if a major renovation requiring large cash outflows occurs later in a project's life, the project would have two IRRs, making it difficult to conclude what the true return actually is. * It cannot be used to rank mutually exclusive projects because IRR assumes that project cash flows are reinvested at the project's IRR, rather than the cost of capital rate. This problem arises when comparing two projects that differ in scale or timing. * The IRR does not indicate the impact of the project on firm value in absolute dollars. * The IRRs are not additive like NPVs and therefore cannot be combined. ## 17.4: Payback Period Payback period is a quantitive capital budgeting tool for determining the number of time periods (usually measured in years) required for an initial investment to be recovered from the cash inflows generated from that investment. In other words, payback measures how long an investment takes to pay for itself, or to break even. Payback period is one of the simplest capital budgeting analysis techniques. **All else being equal, shorter payback periods are prefferable to longer payback periods because the investment costs are recovered sooner and the cash inflows from the project are available earlier for futher use. A shorter payback period is also viewed as less risky, because it is usually assumed that the longer the payback period, the more uncertain the expected cash inflow estimate. For this reason, payback period is often used as a measure of risk, or as a risk-related criterion that must be met before funds are spent. For example, to reduce risk, a company may require a specific payback period before an investment can be undertaken.** **17.4.1. Rule of Acceptance (based only on quantitative analysis)** The general decision-making rule is to accept the project only if its payback period is less than the company's target payback period. Companies set a prescribed period of time and accept projects with payback periods of less than this amount of time. For instance, a company may decide not to undertake investments that have a payback period of more than three years. In practice, companies have different prescribed period for different projects. For example, one department may accept projects with a payback period of six months or less, while another department may set its target time limit to two years. The method for payback calculation depends on whether future cash flows are even or uneven across time periods. Below are examples for each situation. Note that cash flows are on an after-tax basis , using the annual CCA deduction approach. **17.4.2 Even Cash Flows** When future cash flows are the same amount for each future period, the formula to calculate payback period is: Payback period = Initial investment / cash flow per period **17.4.3 Uneven Cash Flows** When cash inflows for a project are uneven over the project time frame, the cumulative net after-tax cash flow is calculated for each period. Assuming the cash flows occur evenly throughout the period, the following formula is used: Payback period = A + (B-C)/C Where: * A = the last period with a negative cumulative cash flow (for example, Year 3) * B = the absolute value of cumulative cash flow at the end of period A (how much total cash was spent and has since been recouped to period A) * C = the total cash flow during the period right after period A (cash generated in the year the project breaks even) Typically, you can scan the cash flows and come up with a reasonable proxy, but if you have two competing projects that break even in the same year, then you might use the formula to compare and contrast each project. **17.4.4 Discounted Payback Method** The discounted payback period formula is used to calculate the length of time to recover an investment based on its discounted cash flows. By applying an appropriate discount rate to cash flows, the discounted payback period formula takes into consideration the time value of money. **17.4.5 Merits and Limitations of Payback Period** **Merits of the payback period method include the following: ** * It is very simple to calculate, and its results are intuitive and easy to understand. * It can be a measure of risk inherent in a project, assuming the longer payback period is an indicator of greater risk. * It can be used to rank projects for companies focused on pursuing projects that have the quickest cash returns. * It highlights liquidity. **Limitations of the payback period method include the following: ** * It does not take into account the time value of money, which can lead to wrong decisions. However, this limitation can be overcome by using the discounted payback period approach. * It does not take into account the cash flows that occur after the payback period. For example, one investment may have a shorter payback period than another, but the other may achieve greater cumulative cash flow over time and have a greater NPV * It does not give any indication of value that will be added to the company if the project is accepted. * It assumes an arbitrary cut-off period for project acceptance. ## 17.5: Merits and limitations of the NPV method **Merits of the NPV method include the following:** * It considers the time value of money. * It considers all cash flows over the investment's lifespan - regardless of the decision maker can sum the NPV of various investment opportunities to determine the total impact of any combination of projects. * It is possible to use varying discount rates which allows for differing levels of risk, the longer the project, the greater the risk that the cash flows will not materialize. **Limitations of the NPV method include the following:** * Long-term cash flow forecasting may be difficult because assumptions are difficult to predict further into the future (for example, tax rates, CCA rates, inflation, or operating cash flows). * It assumes that cash flows occur at the end of every period (although the discounting can be changed to assume that the cash flows occur evenly throughout the year). ## 17.1a: Let's look at an example HR Software Inc is looking to invest in a new product. The initial investment will cost $1,500,000 and qualify for a 50% declining balance CCA for income tax purposes and be eligible for full (100%) expensing in the first year of use. Incremental sales related to this new product are forecasted as follows: | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |--------|--------|--------|--------|--------| | Sales | $350,000 | $860,000 | $1,250,000 | $910,000 | $475,000 | **Note that the sales forecasts already include the effect of inflation.** Variable operating costs will be 30% of sales. Incremental fixed operating costs will be $90,000 in Year 1 and then increase annually with inflation. The inflation rate is expected to be 1.5%. The initial investment in accounts receivable will be $10,000, and days sales in receivables is expected to be 30 days at the end of each year. The increase in the balance for the receivables from one year to the next will represent the additional investment required. Supplier payables will have an initial balance of $7,000 and then be equal to 10% of variable operating costs. The product is expected to have a life cycle of five years. At the end of the five years, there will be no more sales made and the equipment will be sold for proceeds estimated to be $300,000. Assume that at this time, there are remaining assets in the undepreciated capital cost pool, which has a positive balance. For this project, a discount rate of 12% is appropriate. The company's income tax rate is 15%. **Required:** Using the NPV with tax shield approach, determine whether this investment in the new product should be accepted or rejected. **Solution:** **HR Software Inc** **Discounted cash flow analysis using the tax shield approach** | Initial investment | Inception | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | |---------------------------------|-----------|---------------|---------------|--------------|---------------|---------------|-------| | Capital expenditures - equipment | $(1,500,000) | | | | | | | | PV of tax shield on CCA | | $200,893 | | | | | | | - equipment | | | | | | | | | Annual operating after-tax cash flows | | | | | | | | | Sales | | $350,000 | $860,000 | $1,250,000 | $910,000 | $475,000 | | | Variable operating costs | | $(105,000) | $(258,000) | $(375,000) | $(273,000) | $(142,500) | | **Note 3:** Variable costs are 30% of sales, as given. | | | | | | | | | |---|---|---|---|---|---|---|---| | | Fixed operating costs | $(90,000) | $(91,350) | $(92,720) | $(94,111) | $(95,523) | | | | Income tax thereon | 15% | | $(76,598) | $(117,342) | $(81,433) | $(35,547) | | | After-tax annual operating cash flows | | $131,750 | $434,052 | $664,938 | $461,456 | $201,430 | | | | Investment in working capital | | $(3,000) | $(15,267) | $(26,618) | $(20,355) | $17,745 | | | | Salvage value | | | | | | $300,000 | | | | PV of lost tax shield | | | | | | $(36,290) | | | | - equipment | | | | | | | | | Net incremental cash flow | | $(1,302,307) | $104,003 | $324,804 | $458,801 | $304,541 | $290,883 | | | PV factor - discount rate | 12% | 1.0000 | 0.8929 | 0.7972 | 0.7118 | 0.6355 | 0.5674 | | | Net present value | | | | | | | $180,925 | **Note 2:** PV of the tax shield on CCA formula: **Note 4:** Fixed costs increase with inflation of 1.5% each year. **Note 5:** 15% tax rate is provided. **Note 6:** Calculation of changes in net working capital: Balances at inception are given. | | Inception | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | |---|---|---|---|---|---|---|---| | Accounts receivable | $10,000 | $28,767 | $70,685 | $102,740 | $74,795 | | | | Supplier payables | $(7,000) | $(10,500) | $(25,800) | $(37,500) | $(27,300) | | | | Net Balance | $3,000 | $18,267 | $44,885 | $65,240 | $47,495 | | | | Opening balance | $3,000 | | | | | | | | Change in working capital balance | | $(18.267) | $(44,885) | $(65,240) | $(47,495) | | | **Note 7:** The equipment will be sold at the end of the project's life for cash proceeds of $300,000. Given the assumption that this is the only asset in the class, there is a zero balance in the CCA class when the asset is sold. This results in recaptured CCA, which is taxed as income. **Note 8:** 15% tax rate is provided and assuming that negative taxable income will lead to a cash recovery in taxes. **Conclusion:** Accept the investment because the NPV is positive $180,925. ## 17.1b: Let's look at an example Refer to the information provided in Example 17.1a for all the required assumptions related to this project. However, in this case, the equipment costing $1,500,000 is eligible for straight-line CCA as follows: 25% in Year 1, 50% in Year 2, and 25% in Year 3. Assume this is the only asset in the class. **Required:** Using the NPV with the annual CCA deduction approach, determine whether this investment in the new product should be accepted or rejected. **Solution:** **HR Software Inc.** **Discounted cash flow analysis using the annual deduction of CCA approach** | | Inception | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | |---|---|---|---|---|---|---|---| | Initial Investment | $(1,500,000) | | | | | | | | Capital expenditure - Equipment | | | | | | | | | Annual operating after-tax cash flows | | | | | | | | | Sales | | $350,000 | $860,000 | $1,250,000 | $910,000 | $475,000 | | **Note 2:** Related CCA schedule (in '000s) (CCA is 30% declining balance): | Annual CCA on new equipment: | Year 1 | Year 2 | Year 3 | |---|---|---|---| | Opening | $20,000 | $11,000 | $7,700 | | Additions | | | $(10,000) | | Disposals | | $(9,000) | | | CCA | $3,000 | $3,300 | $2,300 | | Recapture of CCA | | | $(3,300) | | Closing balance | $11,000 | $7,700 | $2,300 | **Note 3:** Based on the information provided, the company is taxed at a rate of 25%. **Note 4:** Working capital is expected to change with an initial increase of $650,000 and increase by $20,000 each year. In Year 3, working capital levels would return to pre-investment levels at the end of the analysis time frame. **Note 5:** The equipment will be sold at the end of the project's life for cash proceeds of $10,000,000. It is assumed that there are no other assets in the class and a recapture of CCA that is included in business income is therefore required. **Note 6:** PV of the lost tax shield on CCA on salvage: * **Example: NPV using annual CCA deduction (rather than the tax shield)** Using the annual CCA calculation (Section 17.1.3), the tax expense each year shows CCA using a CCA deduction each year as incorporated in a lower operating cash flow. The tax savings due to the same information is above the income tax on the NPV calculation. The CCA is reported for tax purposes. **Conclusion:** The proposal generates a positive net present value and is expected to increase organizational value. ## 17.2: Sensitivity Analysis Once a quantitative method has been applied, the underlying assumptions need to be tested. Sensitivity analysis is the systematic testing of results by identifying and varying the values of key assumptions to more fully understand the range of possible results. Key assumptions are those assumptions that can have a significant effect on the analysis or conclusions. Sensitivity analysis should be used to analyze the potential impact of key assumptions. Sensitivity analysis is a future-focused projection tool used by managers to actively anticipate the impact of uncertainties, or financial risks, that are inherent in capital budgeting. When conducting sensitivity analysis, the key assumptions used in the initial expected forecast are varied to accommodate the possibility of different outcomes. Sensitivity analysis is also referred to as "what-if" analysis. ## 17.3: Internal Rate of Return (IRR) Another common quantitive method for capital budgeting is internal rate of return (IRR), which calculates the discount rate for the project that would cause the project's NPV to be $0. **17.3.1: Method** In the IRR method, the relevant cash flows are allocated to each period of the project's life. A formula is then used to calculate the rate of return that results in a $0 NPV for the project. Note that the cash flows for the IRR analysis below use the CCA annual deduction approach. **17.3.2: Rule for Acceptance (based only on quantitive analysis)** If your IRR is greater than the discount rate appropriate for the project, then the project should be accepted. If your IRR is less than the appropriate discount rate, then the project should be rejected. **17.3.3: Example: IRR** This example involves an initial investment in equipment of $21,000,000 and a time horizon of three years. The equipment qualifies for straight-line CCA. The incremental operating cash flows before tax related to this project and the CCA deductions are estimated as follows: | (in '000s) | Year 1 | Year 2 | Year 3 | |------------------------------------|----------|---------|---------| | Incremental contribution margin | $8,500 | $8,670 | $8,843 |