Capital Budgeting Long Term Decision Making Short-term decisions (routine decisions) are ones are which have

e little or no impact beyond the immediate future. It is the long-term programs and projects that identify and define specifically the strategic markets the firms will pursue. Building a new facility, funding research or creating a new organisation all are long term decisions requiring investments aimed specifically at the markets in which the firm will operate. Capital budgeting is a systematic approach to deciding among long term investment opportunities that further an organisations strategies. Therefore capital budgeting plays a prominent role in decision making. By acquiring or disposing of capital assets managers determine the long-tem resources available to implement the organisations strategies. Capital budgeting decisions not only affect the balance sheet but also the income statement. Thats because capital budgeting decisions determine and organisations cost structure particular mix of fixed and variable costs. For instance companies who compete based on low cost will sometimes have cost structures that are predominately fixed. This allows them to achieve lower unit costs through companys economies of scale. In contrast companies who differentiate their products might want cost structures with relatively high proportions of variable costs. Capital budgeting decisions are based on expected future cash flows. Capital budgeting focuses on how managers decide which opportunities they will take advantage (i.e. invest in) & which they will forego. Capital Budgeting goal is to achieve as follows: Identify investment opportunities Establish selection criteria Gathering data Performing a capital budgeting evaluation Evaluating project costs and benefits Performing a post audit evaluation

Performing a capital budget evaluation All investments in capital assets have 3 kinds of cash flows in common: 1. An outlay of cash at the outset of the project 2. Cash flow derived from the assets over the projects planning horizon

3. Cash flow when assets are sold a process called disinvestment at the end of the projects planning horizon There is a five step framework to organize data for each of the 3 types of cash flows: 1. Incremental cash inflow and outflow (net benefit) from operations 2. Incremental cash flow from depreciation 3. Incremental cash flow from disinvestment 4. Incremental cash flow for the initial investment outlay 5. Summary of incremental cash flow using net present value These above categories are based on incremental cash flows. Since new projects replace existing projects, it is the change in cash flow that we are interested in. E.g. if the cash flow expected from operating a new piece of equipment is $100,000 each year, it replaces an existing piece of equipment having an operating cash flow of $25,000, then the incremental cash flow is $75,000 per year. Even if the project is entirely new and there is no existing project to compare it against, its cash flow is still considered incremental. The new project is simply against zero. By concentrating on changes in cash flows, only those cash flows that differ are considered relevant to the decision. Capital Budgeting problems tend to focus on specific projects o programs. E.g. Which cost reduction programs will provide the city with the greatest benefits? Over time as managers make decisions about a variety of specific programs & projects, the organisation as a whole will become the sum total of its individual investments, activities, programs and projects. The organisations performance in any particular year is the combined result of all the projects under way during that one year. The proper approach is to use the discounted cash flow analysis which takes into account the timing of the cash flows. There are 2 widely used methods of discounted cash flow analysis: The net present value method and the internal rate of return method. NET PRESENT VALUE METHOD 1. Prepare a table showing the cash flows during each year of the proposed investment 2. Compute the present value of each cash flow using the discounting rate that reflects the cost of acquiring investment capital. This discount rate is often called the hurdle rate or minimum desired rate of return

3. Compute the net present value which is the sum value of the cash flows 4. If the net present value (NPV) is equal to or greater than zero accept the investment proposal

For example: Step 1 Time 4 Time 0 Time 5 ($50,470) $14,000 $14,000 $14,000 Time 1 Time 2 Time 3

Acquisition Cost Annual Cost Savings $14,000 $14,000 Step 2 (3.791)

Present Value of Annuity = $14,000 i.e. Annuity discount factor r =10 n=5

Present Value

($50,470) $2,604

$53,074

Step 3 Net Present Value

Step 4 Accept proposal since net present value is positive The above example shows the 4 steps in the decision making process for the purchase of a new street cleaner. In step 2 the controller uses a discount rate of 10%. Notice that the cost savings are $14,000 each in each of the years from 1 to 5 expected with the new machinery. The controller uses the annuity discount factor to compute the present value of the five years of cost savings. The net present value analysis indicates that the city should purchase the new street cleaner. The present value of the cost savings exceeds the new machines acquisition cost. Internal Rate of Return Method An alternative discounted cash flow method for analyzing investment proposals is the Internal rate of return method. This is the discount rate that would be required in a net present value analysis in order for the assets net present value

to be zero. In the above example the discount rate chosen was 10%. What would you expect IRRs discount to be. Think about it carefully, the higher the discount rate used in net present value analysis, the lower the present value of future cash flows will be. A higher discount rate means it is even more important to have the money earlier. How can we find this rate? We already know the discount rate yields a positive NPV at 10%. If we increase the discount rate to 12%: (3.605) ($14,000) - $50,470 = 0 Annuity discount rate factor for r=12 & n=5 (Table will be provided in the exam). With a 12% discount rate the investment proposals net present value is zero, since the acquisition cost is equal to the present value of the cost savings. An alternative way of finding the discount rate here would be $50,470/$14,000 = 3.605 (Annuity Discount Factor)

Assumptions Underlying Discounted Cash Flow Analysis 1. In the present value calculations used in the NPV & IRR methods, all cash flows are treated as they occur at year end. 2. Discounted cash flow analysis, treat the cash flows associated with an investment project as though they were known with certainty. 3. Both the NPV & IRR methods assume that each cash flow is immediately re-invested in another project that earns a return for the organisation. 4. A discounted cash flow analysis assumes a perfect capital market. This means that the money can be borrowed or lent at an interest rate equal to the hurdle rate used in the analysis. Choosing the hurdle rate The hurdle rate is determined by management based on an investment opportunity rate. This is the rate of return the organization can earn on its best alternative investments of equivalent risk. IN general, the great a projects risk is, the higher the hurdle rate should be. Managerial Accountants Role To use discounted cash flow analysis in deciding about investment projects, managers need accurate cash flow projections. The accountant is often asked to predict cash flows related to operating cost savings, additional working capital requirements, or incremental costs & revenues. The management accountant draws upon historical accounting data to help in making cost predictions.

Knowledge of market conditions, economic trends and the likely reaction of competitors also can be important in projecting cash flows. Alternative Methods for Making Investment Decisions Payback Method The payback method of an investment proposal is the amount of time it will take for the after tax cash inflows from the project to accumulate to an amount that covers the original investment. Payback method = Initial Investment / Annual after tax cash inflow

There is no adjustment in the payback method for the time value for money. A cash flow in year 5 is treated in the same way a cash flow in year 1. A department store manager is considering purchasing a new conveyor system for its warehouse. The two alternative machines under consideration have the following projected cash flows.

Conveyor System Initial Investment Flow when system sold 1 0 2 $14,000 $20,000/4,000 = ($20,000) ($27,000) 5 years payback period Cash Flow Year1 through 7 Cash $4,000 $4,500

$27,000/4,500 = 6 years payback period Payback one is more desirable than payback 2 method. The conclusion however is too simplistic as it ignores the large salvage value associated with system 2. Indeed the NPV system of 1 is negative, while the NPV of system 2 is positive as shown below: System 1 Initial Investment $20,000 x 1 = $20,000 = $19,472

Years 1 7 4,000 x 4.868

Cash flow from sale Net Present Value System 2 Initial Investment $27,000 x 1

= $0 = ($528)

= $27,000 = $21,906 = $ 7,182 = $2,088

Years 1 7 4,500 x 4.868 Cash flow from sale 14,000 x 0.513 Net Present Value

The NPV demonstrates that only system 2 can generate cash flows sufficient to cover the companys cost of capital. The payback method makes it appear as though system 1 pays back its initial investment more quickly, but the method fails to consider the time value for money. Another short coming of the payback method is that it fails to consider an investment projects profitability beyond the payback period.

Q. Washington Countys Board of Representatives is considering the construction of a long runway at the county airport. Currently the airport can handle only private aircraft and small computer jets. Currently the airport can handle only private aircraft and small computer jets. A long runway would enable the airport to handle the midsize jets used on domestic flights. Data pertinent to the boards decision appear below: Cost of acquiring additional land for runway Cost of runway construction Cost of extended perimeter fence Cost of runway flights Annual cost of maintaining new runway Annual incremental revenue from landing fees $70,000 200,000 29,840 39,600 28,000 40,000

In addition to the preceding data, 2 other facts are relevant to the decision. First a long runway will require a new snowplow which will cost $100,000. The old

snowplow could now be sold for $10,000. The new, larger snowplow will cost $12,000 more in annual costs. Second the board of representatives believes that the proposed long runway and the major jet service it will bring to the county, will increase economic activity in the community. The board projects that the increase in economic activity will result in $64,000 per year in additional tax revenue for the county. In analyzing the runway proposal the board has decided to use a 10 year time horizon. The countrys hurdle rate for capital projects is 12%. Q.1. Compute the initial cost of the investment in the long runway. Q.2. Compute the annual net cost or benefit from the runway. Q.3. Determine the IRR on the proposed long runway. Should it be built? Q.4. Prepare a net present value analysis of the proposed long runway? Q.5. Should the County Board of Representatives approve the runway?