ADMN3121H - CHAPTER 21 LECTURE SLIDES (Blackboard)

Chapter 21: Capital Budgeting - Methods of Investment Analysis

Learning Objectives

  • Time Value of Money: Apply concepts related to the time value of money in capital budgeting decisions.

  • Investment Evaluation: Evaluate both discounted cash flow (DCF) and non-DCF methods to calculate the rate of return (ROR).

  • Tax Impact: Analyze how income taxes affect discounted cash flows and capital budgeting choices.

  • Relevance in DCF: Understand the relevance of cash flows in DCF methods of capital budgeting.

  • Complexities in Capital Budgeting: Assess the complexities arising from interdependent value-chain business functions.

  • Defensive Strategic Investment: Apply defensive strategic investment concepts in capital budgeting processes.

Capital Budgeting Definition

  • Capital Budgeting: A planning process used to determine which long-term investments or projects are worth pursuing. It encompasses:

    • Decision-making across multiple years.

    • Evaluation of all cash flows from initial expenditures to project termination.

    • Selection from various potential projects, often across several periods.

  • Working Capital: Defined as the difference between current assets and current liabilities, essential for day-to-day operations.

Dimensions of Capital Budgeting

  1. Project-by-Project Dimension: Each project can span multiple accounting periods.

  2. Period-by-Period Dimension: Each period accommodates multiple projects, which may affect overall cash flow strategies.

Stages in Capital Budgeting

  1. Identify Projects: Identify potential investments aligned with organizational strategy.

  2. Obtain Information: Gather necessary data from various parts of the organization (e.g., marketing, suppliers).

  3. Make Predictions: Forecast cash flows associated with the projects.

  4. Make Decisions: Choose projects based on which offer the greatest return relative to cost.

  5. Implement, Evaluate, and Learn: Fund selected projects, track performance, and adjust plans as necessary.

Factors Influencing Capital Budgeting Decisions

  • Financial Outcomes: Direct impacts on costs and efficiencies (e.g., lower labor costs, reduced cycle times).

  • Non-Financial/Qualitative Outcomes: Considerations like increased flexibility, market response speed, and competitive positioning.

Relevant Cash Flows in DCF Analysis

  • Categories of Cash Flows:

    1. Net Initial Investment:

      • Equipment investment: Initial cash outflows for procurement, transportation, and installation.

      • Working capital investment: Current asset inflows minus current liabilities outflows.

    2. Cash Flows from Operations:

      • After-tax cash flows from operations that indicate profitability.

      • Tax savings from operations due to capital cost allowances (CCA).

    3. Terminal Disposal of Investment:

      • Cash inflows from the sale of equipment and recovery of working capital at project end.

Four Capital Budgeting Methods

  1. Net Present Value (NPV)

  2. Internal Rate of Return (IRR)

  3. Payback Period

  4. Accrual Accounting Rate of Return (AARR)

Discounted Cash Flows (DCF) Definition

  • DCF methods evaluate future inflows/outflows discounted to present value, emphasizing the time value of money.

    • Derived methods include NPV and IRR.

    • Use of Required Rate of Return (RRR) for minimum acceptable returns.

Net Present Value (NPV) Method

  • Calculates expected net gains/losses by discounting future cash flows to present value and assessing if cash inflows meet or exceed outflows.

  • Acceptable projects have a zero or positive NPV, as this indicates returns exceed capital costs.

Present Value of $1 Table

  • Utilized for discounting future cash flows to present values at various interest rates.

Example of NPV Method

  • Evaluation of a project’s viability with specific cash flows and a required return rate, showcasing steps for determination of NPV including summation of discounted flows.

Internal Rate of Return (IRR) Method

  • Finds discount rates making the present value of inflows equal to outflows, wherein acceptance is based on IRR meeting or exceeding the RRR.

  • Calculated through iterative approaches or using software tools.

Comparison of NPV & IRR

  1. NPV is often preferred for its straightforward dollar return interpretation.

  2. NPV always achievable for any project, whereas IRR may not be applicable under varying conditions.

Income Tax and Capital Budgeting

  • Income taxes impact cash flows, requiring consideration for accurate profitability assessments.

  • Marginal Tax Rate influences tax calculations on additional earnings.

Capital Cost Allowance (CCA)

  • Allows businesses to deduct the cost of depreciable assets over time for tax purposes.

  • Rates differ by asset class, providing a means to calculate tax deductions on investments.

Payback Method

  • Measures the time required to recover the initial investment through cash inflows.

  • Shorter payback preferred; however, it fails to account for the time value of money and does not evaluate cash flows beyond cut-off.

Accrual Accounting Rate of Return (AARR)

  • Accounts for average annual income versus initial investment.

  • AARR evaluates standard accounting records but omits cash flow tracking and time value considerations.