Topic 4

Capital Budgeting
Part 2






The NPV Investment Evaluation Process

Step 1 - Calculate depreciation

Step 2 - Calculate any gain/loss on disposal

Step 3 - Calculate taxable income, i.e. profit or loss

Step 4 Calculate the tax item, i.e tax bill or rebate

Step 5 - Calculate net cash flows

Step 6 - Discount the net cash flows

Step 7 Conclusion NPV: + accept, - reject

Example

Purchase price $42 000
Salvage value $1 000 at end Year 3
Operating net cash-inflows Year 1 $31 000
Year 2 $29 000
Year 3 $27 000
Feasibility study cost $4 000 yet to be paid
Warehouse previously rented out for $8,000 p.a. will be used for
project
New technician will replace existing technician.
Existing technicians salary = $65 000 p.a.
New technicians salary = $70 000 p.a.
Old machine can be sold for $2500, book value is $3 000
Tax rate is 30%
Depreciation is straight line
Required rate of return is 12% p.a.
Solution
depreciation and gain/loss on disposal
Depreciation = cost price/no. of years
= $42,000/3 = $14,000 p.a.


Gain/loss on sale:
Old Machine New Machine
Book value yr 0 3000 Book value yr 3 0
Salvage value yr 0 2500 Salvage value yr 3 1000
Loss on sale 500 Gain on sale 1000
Note: book value =cost price less accumulated depreciation
Solution - taxable income
Profit & Loss
Statement
0 1 2 3
Operating
cash flows
31 000 29 000 27 000
- Depreciation
(14 000) (14 000) (14 000)
- Rent foregone
(8 000) (8 000) (8 000)
+ Gain/loss on sale
(500) 1 000
- Additional salary
(5 000) (5 000) (5 000)
= Taxable income
(profit/loss)
(500) 4 000 2 000 1000
Tax Paid (30%)
(150) 1 200 600 300




Cash Flow
Statement
0 1 2 3
Tax (30%)
150 (1 200) (600) (300)
Oper. cash flows
31 000 29 000 27 000
Rent foregone
(8 000) (8 000) (8 000)
Salvage value
2 500 1 000
Additional salary
(5 000) (5 000) (5 000)
Initial outlay
(42 000)
Net Cash Flows
(39 350) 16 800 15 400 14 700


Solution Cash flows

Solution Discount The Net Cash Flows
NPV = -$39,350 + $16,800(1.12)
-1
+ $15,400(1.12)
-2
+
$14,700(1.12)
-3

= ($1,610)
Conclusion: NPV < 0 therefore, reject the project.
Finance costs

Finance costs should not be included as an explicit
cash flow in the analysis.

Finance costs:
cost of debt (interest expense),
cost of equity (dividends)

Finance costs are included in the required rate of
return (discount rate) used to evaluate the project.
Incremental Cash-Flow Example
In NPV analysis we are only interested in incremental cash-
flows.
Example: A firm is currently considering replacing a
machine purchased 2 years ago with an original estimated
useful life of 5 years. The replacement machine has an
economic life of 3 years.
Old Machine New Machine
Initial cost $240 000 $360 000
Annual revenues $100 000 $150 000
Annual costs $60 000 $70 000
Annual depreciation $48 000 $120 000
Salvage value $80 000 (now) $100 000 (End year 3)
Tax rate 30%
Required rate of return 10%

Solution depreciation and gain/loss on disposal

Depreciation: old machine = $48,000 p.a.,
new machine = $120,000 p.a.
Gain/loss on sale:
Old Machine New Machine
Book value yr 0 144,000* Book value yr 0
Salvage value yr 0 80,000 Salvage value yr 3 100,000
Loss on sale 64,000 Gain on sale 100,000
Book value = cost price less accumulated depreciation

*Book value of old machine =240,000 96,000
=144,000
Solution - taxable income
Profit & Loss
Statement
0 1 2 3
Incremental
cash revenues
50 000 50 000 50 000
- Incremental
cash expenses
(10 000) (10 000) (10 000)
- Incremental depn
(72 000) (72 000) (72 000)
- Loss on sale (old)
(64 000)
+ Gain on sale (new)
100 000
= Taxable income
(64 000) (32 000) (32 000) 68 000
Tax Paid (30%)
(19 200) (9 600) (9 600) 20 400
Solution cash flows

Cash Flow
Statement
0 1 2 3
Tax Paid (30%)
19 200 9 600 9 600 (20 400)
Incremental
cash revenues
50 000 50 000 50 000
Incremental
cash expenses
(10 000) (10 000) (10 000)
Salvage values
80 000 100 000
Initial outlay
(360 000)
Net Cash Flows
(260 800) 49 600 49 600 119 600
Solution discount net cash-flows
Conclusion: NPV < 0, therefore reject the project.
NPV = ($260,800) + $49,600(1.1)
-1
+ $49,600(1.1)
-2
+
$119,600(1.1)
-3

= ($84,860)
Summary: Which items appear in P/L Statement and
which appear in Cash-Flow Statement?
When In P/L

In CF
Initial investment or cost Yr 0 No Yes
Depreciation Yr 1 to Yr n Yes No
Salvage value Yr 0 and/or Yr n No Yes
Gain on disposal Yr 0 and/or Yr n Yes No
Loss on disposal Yr 0 and/or Yr n Yes No
Cash revenues Yr 1 to Yr n Yes Yes
Cash expenses Yr 1 to Yr n Yes Yes
Working capital Yr 0 and Yr n No Yes
Rent rev. foregone Yr 1 to Yr n Yes Yes
One Step Process

Rather than adopt a two step process to Project Evaluation
(i.e. P & L Statement and Cash-Flow Statement) a one step process
can be undertaken (Cash-Flow Statement only).

Rather than work out taxable income (profit or loss) and tax in step
1 (P & L Statement) and cash flows in step 2 (Cash-Flow Statement)
one can directly work out after tax cash flows for each item (in the
Cash-Flow Statement).

We will go on to illustrate by doing the second worked example just
undertaken in one step

Relevant Cash Flows
One-Step Process
Revenue:
cash inflow due to sale of goods and services
revenue is taxable, therefore net cash-inflow after-tax equals:
REV - (REV * (t
c
)) or REV (1 - t
c
)
where t
c
= corporate tax-rate
Expenses:
cash outflow due to expenditures of production, etc
expenses represent a tax saving (they are tax deductible,
therefore they reduce tax payable (they provide a tax-shield))
net cash-outflow after-tax equals:
EXP (EXP * t
c
) or EXP * ( 1 - t
c
)



Non-Cash Flow Items

Depreciation Tax Shield

Depreciation is a non-cash expense that is an allowable tax
deduction (it provides a tax-shield). Thus it reduces the tax
payable by:

Depreciation * (tc)

This represents a cash inflow (a tax rebate).


Book Gain/Loss on Disposal
salvage value (SV) = sale price (market value) received on disposal of asset
asset has a book value (BV) = purchase price less accumulated depreciation

if SV > BV we have a book gain
a taxable profit arises
Tax on profit = book gain * t
c

This leads to a tax liability (a cash-outflow)
The net after-tax cash-inflow from disposal will be:
SV less (book gain * tc)

if SV < BV we have a book loss
- a deductible loss arises
Tax saving on loss = book loss * t
c

This leads to a tax rebate (a cash-inflow)


The net after-tax cash-inflow from disposal will be:
SV plus (book loss * tc)
One-Step Process: Cash-Flow Statement

After tax cash
flows
0 1 2 3
Depreciation tax
saving
21,600
i.e. 72,000 x 0.30
21,600 21,600
Incremental after
tax cash revenues
35, 000
i.e. 50,000 x
(1 - 0.30)
35, 000 35, 000
Incremental after
tax cash expenses
(7, 000)
i.e.
10,000 x (1 0.30)
(7, 000) (7, 000)
Initial outlay
(360 000)
Net after tax cash
flow asset disposal
99,200
i.e. 80,000 +
(64,000 x 0.30)
70 000
i.e. 100,000
(100,000 x 0.30)
After tax net cash
flows
(260 800) 49 600 49 600 119 600
NPV
(84,860)
Evaluating Projects with Different Lives

If two projects are mutually exclusive they are competing projects

A choice between the projects must be made

Evaluation of the projects is complicated if they differ in life span
i.e. are each over a different number of years

A common base is required for comparison
Evaluating Projects with Different Lives
Two methods of evaluating projects with different
livespans:
Equivalent
Annual Annuity
Approach
(EAA)
2.
Lowest Common
Life Approach
(LCL)
1.
Lowest Common Life Approach
Involves choosing the lowest common multiple of lives

NPV of each project is calculated assuming each is replaced with itself
until the lowest common multiple life is reached:
e.g. Project A has a life of 9 years
Project B has a life of 11 years
Therefore LCL = 9 x 11 years = 99 years

Replace Project A 11 times with another project of an identical
cash flow pattern
Replace Project B 9 times with another project of an identical
cash flow pattern.

Computations can become tedious (in this example over 99 years!!!)
Lowest Common Life Approach
Project A 2 year life
Cash flows; yr 0 ($100), yr 1 $80, yr 2 $70
Project B 3 year life
Cash flows; yr 0 ($175), yr 1 $43, yr 2 $50, yr 3 $55
Lowest Common Life = 2 x 3 = 6 yrs
Threfore, undertake Project A three times & Project B two times
Project A
0 1 2 3 4 5 6
(100) 80 70
(100) 80 70
(100) 80 70
Project B
0 1 2 3 4 5 6
(175) 43 50 55
(175) 43 50 55
LCL Approach Constant Chain of Replacement Assumption
Implicit assumption with LCL approach is that asset will be
replaced continually by itself, and that technology,
operating efficiency, sales and costs do not change.

This is supported by:
The importance of cash flows further into the future
decreases (time value of money concept), and
Cash flows forecasted for the life of an asset are as good as
any other forecast of cash flows (i.e. managements forecast
of cash-flows will be more accurate than any others)
Equivalent Annual Annuities (EAA)

When comparing two mutually exclusive projects with different
lifespans it is necessary to make comparisons over the same time
period.

EAA compares each projects cash-flows calculated on an
annual basis.

We select the project with the highest EAA if the cash-flows are
positive

We select the project with the lowest Equivalent Annual Cost
(EAC) if the cash-flows are based on costs (i.e. cash-outflows)
Equivalent annual annuity

To calculate the equivalent annual annuity (EAA):

1. Calculate NPV of each project over one life - as if it were
"one-off"

2. Convert the NPV into an equivalent annuity for the life of
each project - convert into a series of annual payments or
annuity payments
(i.e find the unknown PMT for the project using the PV of an
ordinary annuity formula)

Suppose our firm has to choose between 2 machines
that differ in terms of economic life and capacity.
Our required return is 14% p.a. The after-tax net
cash-flows are:
Year
0
1
2
3
4
5
6
Machine 1
(45,000)
20,000
20,000
20,000
Machine 2
(45,000)
12,000
12,000
12,000
12,000
12,000
12,000
How do we
decide
which
machine to
choose?
The unequal life-span problem
NPV
1
= $1,432.64




NPV
2
= $1,664.01



Does this mean machine 2 is better?

No, the NPVs cant be compared.
Step 1: Calculate NPVs
| | 64 . 432 , 1 $ 64 . 432 , 46 $ 000 , 45 $ 322 . 2 000 , 20 $ 000 , 45 $
14 . 0
) 14 . 0 1 ( 1
000 , 20 $ 000 , 45 $
3
= + = + =
(

+
+

| | 01 . 664 , 1 $ 01 . 664 , 46 $ 000 , 45 $ 888 . 3 000 , 12 $ 000 , 45 $
14 . 0
) 14 . 0 1 ( 1
000 , 12 $ 000 , 45 $
6
= + = + =
(

+
+

We assume each project can be replaced an infinite number of
times in the future, and then convert each NPV to its equivalent
annuity

The projects EAAs can be compared to determine which is the
best project

The EAA is the annuity amount (PMT) from the present value
formula of an ordinary annuity

Step 2: Calculate The Equivalent Annual Annuities
( )
(

+
=

r
r
PMT PV
n
1 1
EAA
EAA Decision
EAA
1
= $617.08



EAA
2
= $427.91



Weve reduced a problem with different time horizons to a choice
between two annuities

Decision rule:
Choose the project with the highest EAA

Choose Machine 1
| | 00 . 617 $
322 . 2
64 . 432 , 1 $
322 . 2 64 . 432 , 1 $
14 . 0
) 14 . 0 1 ( 1
64 . 432 , 1 $
3
= = = = =
(

+
=

PMT PMT PMT
| | 76 . 427 $
888 . 3
01 . 664 , 1 $
888 . 3 01 . 664 , 1 $
14 . 0
) 14 . 0 1 ( 1
01 . 664 , 1 $
6
= = = = =
(

+
=

PMT PMT PMT
Example timeline equivalents
Machine 1
Each of these cash flow streams are exactly equivalent (because all
three timelines have the same PV or NPV ($1,432.64)

0 1 2 3
(45 000) 20 000 20 000 20 000

0 1 2 3
1432.64

0 1 2 3
617.08 617.08 617.08
Example timeline equivalents
Machine 2
Each of these cash flow streams are exactly equivalent
(because all three timelines have the same PV or NPV
($1,664.01)

0 1 2 3 4 5 6
(45 000) 12 000 12 000 12 000 12 000 12 000 12 000


0 1 2 3 4 5 6
1664.01


0 1 2 3 4 5 6
427.91 427.91 427.91 427.91 427.91 427.91
Capital Budgeting And Inflation

In project evaluation not adjusting for inflation may result in
material errors in capital budgeting decisions.

Inflation is included implicitly in the discount rate

Nominal interest rate = [(1+ real interest rate)(1+Inflation rate)] 1
This is known as the Fisher Equation
Example:
expected inflation rate = 4.72%, real interest rate = 6%
nominal interest rate = [(1+0.06)(1+0.0472)] 1 = 0.1100
= 11.00%
Depreciation And Inflation

Inflation erodes the real value of any depreciation tax deduction and therefore
discourages capital investment in an inflationary period.

The further into the future is the depreciation claim the lower is its real present value
(time value of money concept).

If we assume no real rate of interest we can work out at varying inflation rates the
present value of the depreciation deductions and divide this by the cost of the asset to
get an estimate of the effective write-off of the asset (use the formula:

depreciation p.a.(1+r)
-n

cost of asset
(where r = inflation rate)

Example:
Plant and equipment which could be written off over 5 years if the inflation rate is
11%. effectively, only 74% of the assets cost will be written off.



Example: Depreciation - Real Analysis

Acme Ltd., a scrap metal dealer, is considering the acquisition of a
"Crushit" metal compactor at a cost of $25,000.
The compactor is estimated to have a five-year life.
Tax allowable depreciation is 20% prime cost per annum
The company tax rate is 40%
Expected inflation rate of 8% per annum for the next 5 years

Depreciation Tax-Shield (nominal):
$25,000 x 0.20 = $5,000 x 0.40 = $2,000 p.a.

Real Depreciation Tax-Shield

Under this approach it is necessary to deflate the depreciation tax
shields by the expected inflation rate to take account of the loss of
real value (i.e. loss of purchasing power) of the tax shields in an
inflationary environment:

Year 1 = $2,000(1.08)
-1
= $1,851.85

Year 2 = $2,000(1.08)
-2
= $1,714.67

Year 3 = $2,000(1.08)
-3
= $1,587.66

Year 4 = $2,000(1.08)
-4
= $1,470.05

Year 5 = $2,000(1.08)
-5
= $1,361.16








Capital Rationing
Capital rationing where a firm limits the total amount of
funds to be invested in projects.
Therefore, even though certain projects may have a postive
NPV, they could be rejected due to capital (financing)
constraints

Hard Capital Rationing
Imposed by Capital Markets - markets will not provide
sufficient finance for a project at an acceptable cost.
Does this mean capital markets are not efficient as they are
not providing funding to positive NPV projects?

Soft Capital Rationing
Imposed by upper management to ensure subsidiaries
prioritise investments.
Ensures discipline by lower level management subsidiaries
to only invest in highest NPV projects.

Profitability Index (Benefit-Cost Ratio)
A projects Profitability Index (PI) measures
the return of a project relative to cost

PI = Present Value/Cost
or
(NPV+Cost)/Cost

If PI > 1 = Accept the project
(NPV must be positive)

If PI < 1 = Reject the project
(NPV must be negative)

Capital Rationing


Assume capital constraint = 15 m
Project 0 1 2 NPV PI
A -15 30 15 23.7 2.583
B -8 4 25 15.5 2.938
C -7 6 22 15.9 3.271
Note. PI = (NPV+Cost)/Cost
Cost of Capital = 12%
Combined NPV = 31.4
As compared to A alone 23.7
Capital Rationing

Both Projects B and C have a higher PI than Project A
Total cost of Projects B and C = $15million
Total cost of Project A = $15million

Rules:
Maximise total NPV subject to the capital constraint (i.e. subject to
financing limits).

Use Profitability Index to rank projects as PI measures return relative to
cost.

In the above example we would choose Projects B and C as they both have a
higher PI than Project A and together B and C meet the capital constraint
of $15million.

Optimal Economic Lives

Abandonment Value
Compare a projects economic value (PV of future net cash-
flows) to its abandonment value (market/selling price at
timeperiod T)
If abandonment value is greater than the PV of the future net
cash-flows we should abandon the project

Replacement timing
Use Equivalent Annual Costs (EAC) to determine the optimal
time to replace assets
EACs are used when a project is evaluated only on its costs
and revenues are ignored

Replacement timing
By comparing EACs over time, the firm can determine the
optimal time to replace the asset.
In the following example, the firm should replace the asset at the
end of 4 years (because EAC are lowest in Year 4).
Equivalent Annual Costs - Replacement Timing
7,500
7,419
7,372
7,355
7,367
7,404
7,463
7,543
7,642
7,758
7,100
7,200
7,300
7,400
7,500
7,600
7,700
7,800
1 2 3 4 5 6 7 8 9 10