Textbook Behavior in Organizations, 8ed A' B' Shani

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Chapter Three

• Opportunity Cost of Capital and Capital Budgeting

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Outline of Chapter 3 Opportunity Cost of Capital
and Capital Budgeting

• Opportunity Cost of Capital
• Interest Rate Fundamentals
• Capital Budgeting The Basics
• Capital Budgeting Some Complexities
• Alternative Investment Criteria

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Opportunity Cost of Capital

• Opportunity cost of capital benefits of
  investing capital in a bank account that is
  forgone when that capital is invested in some
  other alternative.
• Importance for decision making when expected
  cash flows occur in different time periods.
• Capital budgeting analysis of investment
  alternatives involving cash flows received or
  paid over time.
• Capital budgeting is used for decisions about
  replacing equipment, lease or buy, and plant
  acquisitions.

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Time Value of Money

• A dollar today is worth more than a dollar
  tomorrow, because you could invest the dollar
  today and have your dollar plus interest
  tomorrow.
• Value at end
• Alternative of one year
• A. Invest 1,000 in bank account earning
• 5 percent per year 1,050
• B. Invest 1,000 in project returning 1,000 in
  one year 1,000
• Alternative B forgoes the 50 of interest that
  could have been earned from the bank account.
  The opportunity cost of selecting alternative B
  is 1,050.

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Present Value Concept

• Since investment decisions are being made now at
  beginning of the investment period, all future
  cash flows must be converted to their equivalent
  dollars now.
• Beginning-of-year dollars ? (1 ?? Interest rate)
  End-of-year dollars
• Beginning-of-year dollars End-of-year
  dollars????(1 ?? Interest rate)

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Interest Rate Fundamentals

• FV Future Value
• PV Present Value
• r Interest rate per period (usually per year)
• n Periods from now (usually years)
• Future Value of a single flow FV PV (1
  r)n
• Present Value of a single flow PV FV???(1
  r)n
• Discount factor 1 ??(1 r)n

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Interest Rate Fundamentals

• Present value of a perpetuity (a stream of equal
  periodic payments for infinite periods)
• PV FV?? r
• Present value of an annuity (a stream of equal
  periodic payments for a fixed number of years)
• PV (FV?? r ) ?? 1 1? (1 r)n
• Multiple cash flows per year - see text.

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NPV Basics

• 1. Identify after-tax cash flows for each period
• 2. Determine discount rate
• 3. Multiply by appropriate present-value factor
  (single or annuity) for each cash flow. PV factor
  is 1.0 for cash invested now
• 4. Sum of the present values of all cash flows
  net present value (NPV)
• 5. If NPV ??0, then accept project
• 6. If NPV lt 0, then reject project
• NPV is also known as discounted cash flow (DCF).
• See examples.

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Some Factors are Difficult to Quantify, but
Important to Consider

• Consider the example of Sue Koerners considering
  returning to school to get an MBA degree.
• How would you account for the additional utility
  Sue would receive from the prestige of earning an
  advanced degree?
• Could you apply the concept of an indifference
  point?
• What other approaches might be helpful?

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Capital Budgeting - Warnings

• 1. Discount after-tax cash flows, not accounting
  earnings
• Cash can be invested and earn interest.
  Accounting earnings include accruals that
  estimate future cash flows.
• 2. Include working capital requirements
• Consider cash needed for additional inventory
  and accounts receivable.
• 3. Include opportunity costs but not sunk costs
• Sunk costs are not relevant to decisions about
  future alternatives.
• 4. Exclude financing costs
• The firms opportunity cost of capital is
  included in the discount rate.

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Adjustment for Risk

• Discount risky projects at a higher discount rate
  than safe projects
• Risk-free rate of interest on government bonds
• Risk premium associated with project i
• Risk-adjusted discount rate for project i
• (Determining the appropriate discount rate is
  covered in a corporate finance course. In most
  problems in the managerial accounting course, the
  discount rate is given.)
• Use expected cash flows rather than highest or
  lowest cash flow that could occur
• Example If cash flow could be 100 or 200 with
  equal probability, then expected cash flow is
  150.

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Adjustment for Inflation

• If inflation exists in the economy, then the
  discount rate should be adjusted for inflation.
• rnominal nominal interest rate with inflation
• i inflation rate
• rreal real interest rate if no inflation
  riskless rate risk premium
• (1 rnominal ) (1 rreal
  ) (1 i)
• Solving rnominal rreal i
  (rreal ? i )
• 1. Restate future cash flows into nominal dollars
  (after inflation)
• 2. Discount cash flows with nominal interest rate

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After-Tax Cash Flow(ATCF) - Concept

• Determine cash flows after taxes
• On the firms income tax return, they cannot
  fully deduct the cost of a capital investment in
  the year purchased. Instead firms depreciate the
  investment over several years at the rate allowed
  by the tax law.
• Time Cash flow
• Beginning of project Cash to acquire assets
• Future years Depreciation deduction on tax
  return reduces future tax payments
• (depreciation tax shield)

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ATCF - Definitions

• t Tax rate (tax refund rate if negative income)
• R Revenue in one year (assume all cash)
• E All cash expenses in one year (excludes
  depreciation)
• D Depreciation allowed in one year on income
  tax return
• Tax expense for one year
• TAX (R - E - D) ? t
• After-tax cash flow for year
• ATCF R - E - Tax
• R - E - (R - E - D) ? t (R - E)(1 - t)
  Dt

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ATCF - Equivalent Methods

• 1. Separate tax computation
• ATCF (Cash flow before tax) - TAX
• ( R - E ) - (R -
  E - D) ? t
• 2. Depreciation tax shield
• ATCF (After-tax cash flow without
  depreciation) Depreciation tax
  shield
• ( R - E ) (1 - t)
  D ?? t
• 3. Financial accounting income after tax and add
  back non-cash expenses
• ATCF (Accounting income after tax)
  (Non-cash expenses)
• (R - E - D) (1 - t)
  D

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Alternative Capital Budgeting Methods

• Methods that consider time value of money
• 1. Discounted cash flow (DCF), also known as net
  present value (NPV) method
• 2. Internal rate of return (IRR)
• Methods that do not consider time value of money
• 3. Payback method
• 4. Accounting rate of return on investment (ROI)

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Alternative Payback Method

• Payback the time required until cash inflows
  from a project equal the initial cash investment.
• Rank projects by payback and accept those with
  shortest payback period
• Advantages of payback method
• Simple to explain and compute
• Disadvantages of payback method
• Ignores time value of money (when is cash
  received within payback period)
• Ignores cash flows beyond end of payback period

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Alternative Accounting Return (ROI)

• Average annual accounting income from project
• ? Average annual investment in the project
• Return on investment (ROI)
• Average annual investment (Initial investment
  Salvage value at end) ??2
• Advantages of ROI method
• Simple to explain and compute using financial
  statements
• Disadvantages of payback method
• Ignores time value of money (when is cash
  received within payback period)
• Accounting income is often not equal to cash flow

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Alternative Internal Return (IRR)

• Internal rate of return (IRR) is the interest
  rate that equates the present value of future
  cash flows to the cash outflows.
• By definition PV FV ??(1 irr)
• Solution for a single cash flow irr (FV ??PV)
  - 1
• Comparison of IRR and DCF/NPV methods
• Both consider time value of cash flows
• IRR indicates relative return on investment
• DCF/NPV indicates magnitude of investments
  return
• IRR can yield multiple rates of return
• IRR assumes all cash flows reinvested at
  projects constant IRR
• DCF/NPV discounts all cash flows with specified
  discount rate

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Capital Budgeting in Practice

• See Table 3-11 .
• DCF/NPV has become the most commonly used capital
  budgeting method for evaluating new and
  replacement projects in large US corporations.
• Urgency, such as governmental mandates, is
  still a significant cause for approving
  replacement projects.