CAPITAL INVESTMENT Capital Investment (Capital Budgeting) involves the allocation of large amounts of resources in long-term investments.

Examples: => Replacement of Equipment => Expansion of Existing Product Lines => Development of New Product Lines => Intangibles: => Research & Development => Patents => Advertising campaigns Success: Texas Instruments - semiconductor in 1950s and 1960s; microchip in 1970s Microsoft - Bought Quick and Dirty Operating System for $20,000 Failure: Ford Edsel (Loss of $250 million in 1957-59, or approximately $1.6 billion today) Once the Investment is made, it is almost impossible to back out. Unlike a surplus of inventory which can be quickly corrected, an unutilized refinery just sits vacant. The firm's existence is a series of capital investment decisions that are necessary for the company to grow, remain competitive, etc. Basic Concept: Accept all projects that yield a return that exceeds the cost of financing the project. Thus, if we are maximizing stockholder wealth, we would accept Projects A D and reject the remainder:

% A B C D E F G Cost of Capital

Numerous investment alternatives exist. We need a means of ranking the projects from best to worst in order to select those that are most valuable to the firm; i.e., a means of evaluating and ranking proposals. The primary concern in the investment decision regards cash flows: => => => => => => Incremental Revenues Incremental Costs Taxes Depreciation considerations Investment in Working Capital Cost Savings

Any cash inflow or outflow.

EVALUATION TECHNIQUES A. Payback Period Proj. A --------(3,000) 1,000 2,000 3,000 Proj. B --------(3,000) 2,000 1,000 4,000 Payback = 2 years

Year 0 Year 1 Year 2 Year 3

Payback = 2 years

Both projects have a payback of two years, so the payback method indicates that the two projects are equally desirable. Problems: 1) 2) Ignores the Time Value of Money Ignores cash flows beyond the payback period

Project B returns $1,000 a year earlier than Project A and also returns an additional $1,000 in the last year. Present Value Payback, which utilizes the present value of each year's cash flow, overcomes the first problem, but not the second. B) Net Present Value (NPV)

We need a methodology that takes into account all of the cash flows as well as the time value of money. Net Present Value is one such technique: NPV = PV of Cash Inflows - PV of Cash Outflows

Required Rate of Return = 10% 0 (4,000) 0.9091 909 0.8264 1,653 0.7513 2,254 NPV @ 10% = 816 1 1,000 2 2,000 3 3,000

NPV represents the increase in the value of the firm that occurs by accepting the project. In other words, it represents the amount by which the value of the project exceeds its cost. Proof: Year 0 Investment Return of Investment Year 1 Investment Return of Investment Year 2 Investment Return of Investment Surplus Return PVIF10%,3 Present Value 4,000 (600) -------3,400 (1,660) -------1,740 (2,826) -------(1,086) 0.7513 --------816 Cash Flow - Year 1 Less: Interest Return of Investment Cash Flow - Year 2 Less: Interest Return of Investment Cash Flow - Year 3 Less: Interest Return of Investment 1,000 (400) (10%*$4,000) -------600 2,000 (340) (10%*$3,400) -------1,660 3,000 (174) (10%*$1,740) -------2,826

The problem with NPV is that there is no consideration of cost, or what is referred to as size disparity. Proj. A Proj. B -------------Present Value of Inflows 1,050 125 Cost (1,000) (100) -------------Net Present Value 50 25 If these are mutually exclusive projects (i.e., choose one or the other, but not both), the NPV criterion says to choose Project A. While Project A increases the value of the firm by twice the

amount of Project B, it costs ten times as much. The NPV does not indicate how efficiently money has been invested. Capital Rationing - the allocation of a scarce resource, in this case money. C) Profitability Index (PI) (or Benefit-Cost Ratio) - a measure of efficiency of investment

Profitabil ity Index =

PV of Inflows PV of Outflows
PIB = 1.25

PIA = 1.05

The interpretation of PI is that of the amount of money in today's dollar terms that you get per dollar of investment. This indicates how efficiently you have invested money. D) Internal Rate of Return (IRR)

Another measure of the efficiency of investment is the Internal Rate of Return. When someone asks what rate of return an investment is earning, they mean the Internal Rate of Return. The IRR can be defined as PV of Inflows @ IRR = PV of Outflows @ IRR or NPV @ IRR = 0 This is the actual rate of interest that is being earned on the investment. While the present value and annuity tables can be used in certain cases, the more general situation of uneven cash flows requires that the IRR be found by trial and error. From the previous example, it is clear that more than 10% is being earned, since the NPV is $816. Try 20% NPV @ 20% = 1,000*(.8333) + 2,000*(.6944) + 3,000*(.5787) - 4,000 = 3,958 - 4,000 = (42) Interpolating provides an estimate: 10% Z 10% IRR 20% 816 0 (42) 858 816

Z 816 = 10% 858

Z= IRR =

9.51% +10.00 19.51%

Year 0 Investment Return of Investment Year 1 Investment Return of Investment Year 2 Investment Return of Investment Surplus Return PVIF10%,3 Present Value

4,000 (220) 3,780 (1,262) 2,518 2,509 9 0.7513 (7)

Cash Flow -- Year 1 Less: Interest Return of Investment Cash Flow -- Year 2 Less: Interest Return of Investment Cash Flow -- Year 3 Less: Interest Return of Investment

1,000 (780) (19.5% * $4,000) 220 2,000 (738) (19.5% * $3,780) 1,262 3,000 (491) (19.5% * $2,518) 2,509

Hence, it is the rate of interest earned on the funds that remain invested within the project. This is the economic interpretation of the mathematical solution. Note that the "true" IRR is 19.44%. The error occurs because interpolation assumes linearity of a non-linear function. Year 0 Project A Project B (15,000) (48,000) Year 1 10,000 30,000 Year 2 10,000 30,000 Year 3 0 0 NPV @ 10% 2,355 4,066 PI @ 10% 1.16 1.08 IRR 21.5% 16.3%

Which project is better? The major difference is the costs of the projects. Year 0 Project C Project D (10,000) (10,000) Year 1 8,000 0 Year 2 5,600 0 Year 3 0 17,000 NPV @ 10% 1,901 2,772 PI @ 10% 1.19 1.28 IRR 24.9% 19.3%

Which project is better? The major difference is the timing of the cash flows. Note that all three measures agree as to whether a project is acceptable or not. The conflict is in the ranking of the investment proposals. Note also that the Profitability Index, a measure of efficiency of investment, does not always agree with IRR in terms of which is the most efficient use of funds. III) THE REINVESTMENT ASSUMPTION Consider the following two projects, their NPVs, PIs, and IRRs.

Project X Year 0 Cash Flows NPV @ 10% = 114 PI @ 10% = 1.13 IRR = 15.0% Project Y Year 0 Cash Flows NPV @ 10% = 97 PI @ 10% = 1.11 IRR = 20.0% Most academicians claim that the conflict is a consequence of the reinvestment assumption. Net Present Value and Profitability Index assume reinvestment at the discount rate. Internal Rate of Return can be thought of as a special case of NPV (when it equals zero). Hence, it assumes reinvestment at the IRR. Realistically, investments are made to maximize future wealth. Present value (discounted cash flow techniques) are used since we know the value of a dollar today. The reinvestment assumption is invoked in order to make the future value (terminal value) rankings consistent with the present value rankings. To see this, let's reinvest the cash flows of Projects X and Y at the discount rate of 10%. Project X Year 0 Cash Flows (886) Year 1 100 1.21 121 1.10 110 Terminal Value = 1,331 Year 2 100 Year 3 1,100 (886) Year 1 900 Year 2 150 Year 3 55 (886) Year 1 100 Year 2 100 Year 3 1,100

Project Y Year 0 Cash Flows (886) Year 1 900 1.21 1,089 1.10 Year 2 150 Year 3 55

165 Terminal Value = 1,309

Since the costs are the same, the terminal values are both relative to the same size of investment. The $1,331 terminal value of Project X represents a 14.53% rate of return on an investment of $886 over three years while the $1,309 terminal value of Project Y is a 13.89% return on the initial investment. The difference in the terminal values of $22 has a present value of $17 which is the same as the difference in NPVs of the two projects (114 - 97 = 17). Thus, the terminal value rankings are consistent with the NPV and PI rankings that indicate Project X is superior to Project Y. Similarly, if the cash flows of each project are reinvested at their respective IRRs, the following is obtained: Project X Year 0 Cash Flows (886) Year 1 100 1.3223 132 1.1499 115 Terminal Value = Project Y Year 0 Cash Flows (886) Year 1 900 1.4400 1,296 1.2000 180 Terminal Value = 1,531 Year 2 150 Year 3 55 1,347 Year 2 100 Year 3 1,100

Since the costs are identical, it is clear that Project Y is better since it maximizes future wealth, and agrees with the rankings of the IRRs. Moreover, the terminal value of $1,347 of Project X represents a 15% return on the cost of the project, while the $1,531 terminal value of Project Y is a 20% return on the investment in Project Y.

IV. A.

RELEVANT CASH FLOWS Incremental Cash Flows

The relevant cash flows for investment analysis is the change in the cash flows that would occur by accepting a proposal, or what is referred to by the term incremental cash flows. An opportunity cost is a cash flow given up as a consequence of a decision, and is

generally defined as the next-best-alternative. Since an opportunity cost is a change in cash flow, it is relevant to the investment decision. A sunk cost refers to past expenditures. Sunk costs are not relevant since they occurred in the past and the decision of whether or not to undertake a project does not change the past. A general (simplified) format for analyzing a capital expenditure that considers all incremental cash flows is on the following page. Note that the relevant cash flows include those found on the income statement as well as those that are not on the income statement (such as working capital). Also, some cash flows are only reflected on the income statement in part (such as the gain or loss on the sale of an asset).

CASH FLOW ANALYSIS PURCHASE/REPLACEMENT DECISION Today A. <Cash outlay for new asset> B. Cash proceeds from sale of old asset C. Tax effect of gain or loss on disposal of old asset1 D. <Additional working capital needed to support new asset> Intervening Years E. Incremental Revenues from new asset F. Less: Incremental Costs from new asset G. Less: Incremental Depreciation ------------------------------------------Change in Taxable Income Less: Taxes on Tax. Inc. (t) ------------------------------------------Change in Net Income Plus: Incremental Depreciation ------------------------------------------Incremental Operating Cash Flow H. <Additional working capital> In a Purchase Decision, the relevant occurrences are A, D, E, F, H, I, J, and M In a Replacement Decision, the relevant occurrences are A through M 1 If the asset is sold for less than the book value, the company incurs a loss which is tax-deductible. This loss reduces taxable income and thereby creates a tax savings equal to the difference between the market value of the asset and its book value multiplied by the tax rate: Loss * t If the asset is sold for more than the book value, the company must report the difference as a profit to be taxed as ordinary income to the extent that the profit is less than the accumulated depreciation for the asset: Gain * t In the event that the asset is sold for more than the original purchase price, the gain above the original purchase price is subject to the capital gains tax rate while the accumulated depreciation is taxed as ordinary income. < > indicates that the cash flow is an outflow. t = applicable tax rate Last Year I. Salvage of new asset J. Tax effect of gain or loss on disposal of new asset1 K. <Salvage value lost on old asset> L. Tax effect of gain or loss on disposal of old asset1 M. Recovery of working capital

B.

The Replacement Decision

The classic capital investment decision is that of whether or not to replace a large piece of equipment. Example Kinky's Copying Service is considering expanding operations to include color copying service. The new service is expected to result in additional sales of $60,000 in the first year, increasing by 12% per year as word of the color copies spreads. Labor and material costs are predicted to rise by $48,000 in the first year, increasing at a 6% annual rate due primarily to inflation. To accommodate the service, a new color copier will have to be purchased at a cost of $28,000. The new machine will be depreciated using the MACRS rates for 5-year assets (20%, 32%, 19.2%, 11.52%, 11.52%, 5.76%), even though you expect that after three years of 24-hour per day operation, it will have a resale value of only $10,000 and will have to be replaced. Since the color copier can also copy black and white, one of the small existing copy machines can be sold to a local university for $4,000 rather than keeping it for the remaining three years of its useful life and scrapping it for $800. The existing copy machine was purchased for $9,000 two years ago and is also being depreciated using the same MACRS rates for 5-year assets. The expanded service would use existing floor space which would result in an allocation of depreciation totalling $5,000 per year. Also, $6,000 in administrative expenses would be allocated to the project each year; however, only $3,000 of the amount represents an actual increase in expenses not otherwise incurred by the firm. The existing floor space could be leased annually for $2,500 if the project is not accepted. An investment in working capital of $15,000 will initially be required, with additional increments of 8% per year due to both inflation and increasing sales, all of which will be recovered in the third year. Kinky's is in the 40% tax bracket. Calculate the net cash flows for each year of the project's life. Solution Year 1 Incremental Revenues Increased sales Lost lease payments Total Incremental Revenues Incremental Costs Labor & materials Administrative expense Total Incremental Costs Year 2 Year 3

60,000 x 1.12 = 67,200 x 1.12 = 75,264 (2,500) (2,500) (2,500) 57,500 64,700 72,764

48,000 x 1.06 = 50,880 x 1.06 = 53,933 3,000 3,000 3,000 51,000 53,880 56,933

Year 1 Incremental Depreciation New Machine MACRS rate New Depreciation Old Machine MACRS rate New Depreciation Incremental Depreciation Sale of Equipment Old machine - Yr. 0 Market Value Book Value Gain (loss) Tax rate Tax due (refund) Old machine - Yr. 3 Market Value Book Value Gain (loss) Tax rate Tax due (refund) New machine - Yr. 3 Market Value Book Value Gain (loss) Tax rate Tax due (refund) Working Capital 28,000 20.00% 5,600 9,000 19.20% 1,728 3,872

Year 2 28,000 32.00% 8,960 9,000 11.52% 1,037 7,923

Year 3 28,000 19.20% 5,376 9,000 11.52% 1,037 4,339

4,000 4,320 (320) 40% (128)

(9,000*48%)

800 518 282 40% 113

(9,000*5.76%)

10,000 8,064 1,936 40% 774 Year 0 1 2 3

(28,000*28.8%)

Required 15,000 16,200 17,496 18,896

Change 15,000 1,200 1,296 1,400

Putting it all together Year 0 Operating Cash Flows Revenues Less: Costs Less: Depreciation Change in Taxable Income Less: Taxes (40%) Change in Net Income Add-back depreciation Change in Operating Cash Flow Working Capital Requirements Additional Working Capital Working Capital Recovery New Machine Purchase Sale - Yr. 3 Tax on Sale Old Machine Sale - Yr. 0 Tax on Sale Lost Sale - Yr. 3 Tax on Sale TOTAL INCREMENTAL CASH FLOW (38,872) 4,249 8,365 (15,000) Year 1 57,500 (51,000) (3,872) 2,628 (1,051) 1,577 3,872 5,449 (1,200) Year 2 64,700 (53,880) (7,923) 2,897 (1,159) 1,738 7,923 9,661 (1,296) Year 3 72,764 (56,933) (4,339) 11,492 (4,597) 6,895 4,339 11,234 (1,400) 18,896

(28,000) 10,000 (774) 4,000 128 (800) 113 37,269