Long-Term Investment Decisions

1. Capital Budgeting Cash Flows 2. Capital Budgeting Techniques 3. Risk and Refinements in Capital Budgeting

 Gitman & Zutter (2012:390): Capital Budgeting is the process of evaluating and selecting long-term investments that are consistent with the firms goal of maximazing owners wealth. Brigham & Houston (2007: 358): Capital budgeting is process of planning capital expenditures on assets whose cash flows are expected to extend beyond one year.

Capital expenditure vs Operating expenditure

Capital Expenditure is an outlay of funds by the firm that is expected to produce benefits over a period of time greater than 1 year. Operating Expenditure is an outlay of funds by the firm resulting in benefits received within 1 year. Not all capital expenditures are made for fixed assets. An expenditure made for an advertising campaign may have long-term benefits.

The primary motives for making capital expenditures include: Gitman.

Expansionincreasing the productive capacity of the firm, usually through the acquisition of fixed assets. Replacementreplacing existing assets with new or more advanced assets that provide the same function. Renewalrebuilding or overhauling existing assets to improve efficiency. Other motives include expenditures for nontangible projects that improve a firms profitability, such as advertising, research and development, and product development. A firm may also be required by law to undertake pollution control and similar projects.

Brigham & Houston (2007: 359)

Project classifications: 1. Replacement : needed to continue current operations 2. Replacement: cost reduction 3. Expansion of existing products or markets 4. Expansion into new products or markets 5. Safety and/or enviromental projects 6. Other

Capital Budgeting Cash Flows

Management need to understand which cash flows are relevant in making decisions about proposals ..

The Capital Budgeting Process

Gitman & Zutter (2012:390) 1. Proposal generation 2. Review and analysis 3. Decision making 4. Implementation 5. Follow-up

Basic Terminology:
1. Independent vs Mutually exclusive projects 2. Unlimited funds vs Capital rationing 3. Accept-Reject vs Ranking Approaches

Independent versus Mutually Exclusive Investments

Mutually Exclusive Projects are investments that compete in some way for a companys resources. A firm can select one or another but not both. Independent Projects, on the other hand, do not compete with the firms resources. A company can select one, or the other, or both -- so long as they meet minimum profitability thresholds.

Unlimited Funds Versus Capital Rationing

Firms under capital rationing have only a fixed amount of dollars available for the capital budget, whereas a firm with unlimited funds may accept all projects with a specified rate of return. If the firm has unlimited funds for making investments, then all independent projects that provide returns greater than some specified level can be accepted and implemented.

Accept-reject versus ranking approaches:

The accept-reject approach involves evaluating capital expenditure proposals to determine whether they meet the firms minimum acceptance criterion. The ranking approach, involves ranking projects on the basis of some predetermined measure, such as rate of return.

The Pattern of Cash Flows

Most projects have a conventional pattern of cash flows (-,+,+,+,+,+,+). Some may have unconventional cash flows (-,-,+,+,,+,-,+). For projects with unconventional cash flows, we may have the problem of multiple IRRs.

Categories of Cash Flows:

Initial Cash Flows are cash flows resulting initially from the project. These are typically net negative outflows. Operating/Operational Cash Flows are the cash flows generated by the project during its operation. These cash flows typically net positive cash flows. Terminal Cash Flows result from the disposition of the project. These are typically positive net cash flows.

Initial cashflow: aliran kas yang berhubungan dengan pengeluaran-pengeluaran kas untuk keperluan investasi. Termasuk dalam initial cashflow adalah kebutuhan dana yang digunakan untuk modal kerja. Operational cashflow: aliran kas yang akan digunakan untuk menutup investasi, yang diterima setiap tahun selama umur investasi, dan berupa aliran kas bersih. Terminal cashflow : aliran kas yang diterima pada akhir umur investasi. Dapat berupa nilai residu (taksiran nilai jual aktiva tetap pada akhir umur investasi) dan modal kerja.

Data & Information Requirements

External Economic & Political Data Business Cycle Stages Inflation Trends Interest Rate Trends Exchange Rate Trends Freedom of Cross-Border Currency Flows Political Stability Regulations Taxation

Internal Financial Data Initial Outlay & Working Capital Estimated Cash Flows Financing Costs Transportation, Shipping and Installation Costs Competitor Information

Non-Financial Data Non Distribution Channels Labor Force Information Labor-Management Relations Status of Technological Change in the Industry Competitive Analysis of the Industry Potential Competitive Reactions

Irrelevant Cash Flows

Sunk Costs are not relevant to the analysis because these costs are not dependent on whether or not the project is undertaken. One example would be to include the cost of land already purchased as part of the decision as to how to develop it. Financing costs are not relevant to the determination of cash flows only because they are already accounted for through the discounting process.

Finding the Initial Investment:

a. The cost of the new asset is the purchase price. (Outflow) b. Installation costs are any added costs necessary to get an asset into operation. (Outflow) c. Proceeds from sale of old asset are cash inflows resulting from the sale of an existing asset, reduced by any removal costs. (Inflow) d. Tax on sale of old asset is incurred when the replaced asset is sold due to recaptured depreciation, capital gain, or capital loss. (May be an inflow or an outflow) e. The change in net working capital is the difference between the change in current assets and the change in current liabilities. (May be an inflow or an outflow)

Change in Net Working Capital:

Net working capital is the amount by which a firms current assets exceed its current liabilities. Change in net working capital is the difference between the change in current assets and the change in current liabilities.

Cash Flow from Operations:

Profit After-tax + Depreciation + Interest ( 1- tax rate)

Exp 8.6:
A project generates revenues of $ 1,000, cash expenses of $ 600, and depreciation charges of $ 200 in particular year. Tax rate 35%.

Income Statement
Revenues Cash expenses Depreciation expenses Profit before tax Tax at 35% Net profit $ 1,000 600 200 200 70 130

Penentuan Operational cashflow dengan berbagai sumber pendanaan Suatu investasi membutuhkan dana sebesar Rp 100.000.000,00 yang akan didanai oleh modal sendiri, dengan umur investasi 4 tahun, beban tunai Rp 30.000.000,00 per tahun dan pajak 25%. Depresiasi dengan metode garis lurus dan pendapatan per tahun Rp 75.000.000,00.

Laporan Rugi Laba

Pendapatan Beban tunai Depresiasi Laba sebelum pajak Pajak Laba setelah pajak Rp 75.000.000,00 Rp 30.000.000,00 Rp 25.000.000,00 Rp 20.000.000,00 Rp 5.000.000,00 Rp 15.000.000,00

Jika investasi tersebut akan didanai oleh modal pinjaman dengan tingkat bunga 15% per tahun. Laporan Rugi Laba sbb:
Pendapatan Beban tunai Depresiasi Laba sebelum bunga dan pajak Bunga Laba sebelum pajak Pajak Laba setelah pajak Rp 75.000.000,00 Rp 30.000.000,00 Rp 25.000.000,00 Rp 20.000.000,00 Rp 15.000.000,00 Rp 5.000.000,00 Rp 1.250.000,00 Rp 3.750.000,00

Depreciation

Some Complexities
Inflation is typically adjusted for in the cash flow component of the calculation Taxes are typically adjusted for in the cash flow calculation, yielding net after-tax cash flows Risk is typically adjusted for in the discount rate portion of the calculation

Penentuan Arus Kas

PT ABC menerima tawaran dari PT X yang ingin membeli produknya dan dituangkan dalam kontrak selama 4 tahun, yaitu mulai 2009 2012. Jumlah produk yang akan dibeli sebanyak 20.000 unit per tahun dengan harga jual Rp 30.000,00 per unit. Perusahaan harus menambah kapasitas produksinya, karena itu perusahaan akan menambah bangunan dan peralatan.

Perusahaan memperkirakan bangunan memerlukan biaya Rp 120.000.000,00 dan peralatan Rp 80.000.000,00. Selain itu perusahaan juga memerlukan tambahan modal kerja sebesar Rp 60.000.000,00. Biaya variabel per unit Rp 21.000,00 dan jumlah biaya tetap per tahun Rp 80.000.000,00.

 Tarif pajak 40%. Depresiasi dengan metode garis lurus. Pada akhir tahun 2012 diharapkan bangunan dapat terjual dengan harga Rp 20.000.000,00 dan peralatan Rp 10.000.000,00. Depresiasi per tahun: Bangunan Rp 30.000.000,00 Peralatan Rp 20.000.000,00

Bangunan (Rp) Nilai jual Nilai buku Gain on sales of Assets Pajak Arus kas 20.000.000 0 20.000.000 8.000.000 12.000.000

Peralatan (Rp) 10.000.000 0 10.000.000 4.000.000 6.000.000

Laporan Rugi Laba

Hasil penjualan Biaya variabel Biaya tetap Depresiasi bangunan Depresiasi peralatan Laba sebelum pajak Pajak , 40% Laba setelah pajak Rp 600.000.000,00 420.000.000,00 80.000.000,00 30.000.000,00 20.000.000,00 550.000.000,00 50.000.000,00 20.000.000,00 30.000.000,00

Arus Kas terdiri dari:

Investasi awal Rp 260.000.000,00 Arus kas operasi Rp 80.000.000,00 per tahun selama 4 tahun Arus kas terminal pada akhir tahun ke 4 sebesar Rp 78.000.000,00.

Bloopers Industries chapter 8: Brealey, Myers & Marcus Investment of $ 10,000,000 in mining machinery, at the end of 5 years the ore deposit is exhaused The company applies straight line depreciation Tax 35% A/R turn over 6 kali per tahun Inventory = 15% dari expenses tahun berikutnya

 In year 1 revenue $ 15,000,000 and increase by 5% per year. In year 1 expenses $ 10,000,000 and increase at 5% a year. Equipment can be sold at the end of the project $ 2,000,000

Revenues & A/R (in 000 )

Year 0 1 2 3 4 5 $ 15,000 $ 15,750 $ 16,538 $ 17,364 $ 18,233 $ 2,500 2,625 2,756 2,894 3,039 Revenues A/R

Expenses & Inventory ( in 000 )

Year 0 1 2 3 4 5 $ 10,000 $ 10,500 $ 11,025 $ 11,576 $ 12,155 Expenses Inventory $ 1,500 $ 1,575 $ 1,654 $ 1,736 $ 1,823

A/R,Inventory & WC
Year 0 1 2 3 4 5 $ 2,500 2,625 2,756 2,894 3,039 A/R Inventory $ 1,500 $ 1,575 $ 1,654 $ 1,736 $ 1,823 WC $ 1,500 $ 4,075 $ 4,279 $ 4,493 $ 4,717 $ 3,039

 An increase in working capital is an investment, and therefore implies a negative cash flow; a decrease in working capital implies a positive cash flow. In years 1-4 the change is positive; in these years the project requires a continuing investment in working capital. In year 5 the change is negative; there is a disinvestment as working capital is recovered.

Income Statement
1 Revenues Expenses Depr Profit before tax Tax Profit after tax $ 15,000 10,000 2,000 3,000 1,050 1,950 2 $ 15,750 $ 10,500 2,000 3,250 1,138 2,113 3 $ 16,538 $ 11,025 2,000 3,513 1,229 2,284 4 $ 17,364 $ 11,576 2,000 3,788 1,326 2,462 5 18,233 12,155 2,000 4,078 1,427 2,651

Cash Flow ( in 000 )

0
Initial Cash flow Salvage value Investm ent in Working capital Operatio nal Cash flow Total -$11,500 - $ 1,500 - $ 2,575 - $ 204 - $214 - $ 224 $ 1,678 -$10,000

$ 1,300

$ 3,039

$ 3,950

$ 4,113

$ 4,284

$ 4,462

$ 4,651

1,375

3,909

4,070

4,238

6,329

4,339

Powell corporation Chapter 11: Gitman & Zutter

New Machine: Purchase price $ 380,000 , installation costs $ 20,000, to be depreciated under MACRS using a 5year recovery period The replacement increase in current assets $ 35,000 and increase in current liabilities $ 18,000 increase in working capital $ 17,000 Tax rate 40% Revenue and expenses (excl. Depr & interest) as follow:

Year 1 2 3 4 5

Revenue $ 2,520,000 $ 2,520,000 $ 2,520,000 $ 2,520,000 $ 2,520,000

Expenses $ 2,300,000 $ 2,300,000 $ 2,300,000 $ 2,300,000 $ 2,300,000

Old Machine: Was purchase 3 years ago at a cost $ 240,000 and was being depreciation under MACRS using a 5-year recovery period Buyer willing to pay $ 280,000 Revenue and expenses (excl. Depr & interest) as follow:

Year 1 2 3 4 5

Revenues $ 2,200,000 $ 2,300,000 $ 2,400,000 $ 2,400,000 $ 2,250,000

Expenses $ 1,990,000 $ 2,110,000 $ 2,230,000 $ 2,250,000 $ 2,120,000

After tax proceeds from sale of old machine:

Nilai jual $ 280,000 Nilai buku 69,600 Gain on sales 210,400 Pajak 40% 84,160 $ 195,840

Initial Investment
Cost of new machine: - Cost of machine $ 380,000 - Cost of installation 20,000 + $ 400,000 After tax proceeds from sale of old machine : - proceeds from sale of old machine $ 280,000 - Tax on sale of old machine 84,160 $ 195,840 Change in working capital $ 17,000 + $ 221,160

Depreciation Expenses- New Machine

Year Depreciation Depreciation percentage expenses 1 20% $ 80,000 2 3 4 5 6 32% 19% 12% 12% 5% 128,000 76,000 48,000 48,000 20,000

Depreciation Expenses- Old Machine

Year 1 2 3 4 5 6 Depreciation percentage 12% 12% 5% Depreciation Expenses 28,800 28,800 12,000

Operating cash flow-New Machine

1 Revenue Expenses Earning before Depr, Interest and Taxes Depreciation Earning before Interest and Taxes Taxes Net operating profit after taxes Depreciation Cash flow $ 2,520,000 2,300,000 220,000 2 $ 2,520,000 2,300,000 220,000 3 $ 2,520,000 2,300,000 220,000 4 $ 2,520,000 2,300,000 220,000 5 $ 2,520,000 2,300,000 220,000 6

80,000 140,000

128,000 92,000

76,000 144,000

48,000 172,000

48,000 172,000

20,000 - 20,000

56,000 84,000

36,800 55,200

57,600 86,400

68,800 103,200

68,800 103,200

-8,000 - 12,000

80,000 164,000

128,000 183,200

76,000 162,400

48,000 151,200

48,000 151,200

20,000 8,000

Operating cash flow-Old Machine

1 2 3 4 5 6 Revenue Expenses Earning before Depr, Interest and Taxes Depreciation Earning before Interest and Taxes Taxes Net operating profit after taxes Depreciation Cash flow $ 2,200,000 1,990,000 210,000 $ 2,300,000 2,110,000 190,000 $ 2,400,000 2,230,000 170,000 $ 2,400,000 2,250,000 150,000 $ 2,250,000 2,120,000 130,000

28,800 181,200

28,800 161,200

12,000 158,000 150,000 130,000

72,480 108,720

64,480 96,720

63,200 94,800

60,000 90,000

52,000 78,000

28,800 137,520

28,800 125,520

12,000 106,800 90,000 78,000

Incremental operating cash flow

1 2 3 4 5 6

New Machine Old Machine Cash Flow

$164,000 $183,200 $162,400 $151,200 $151,200

$ 8,000

137,520

125,520

106,800

90,000

78,000

26,480

57,680

55,600

61,200

73,200

8,000

Incremental operating cash flow: EBDIT x ( 1 t ) + ( D x t )

Terminal cash flow

After tax proceeds from sale of new machine : - proceeds from sale of new machine $ 50,000 - Tax on sale of new machine 12,000 $ 38,000 After tax proceeds from sale of old machine : - proceeds from sale of old machine $ 10,000 - Tax on sale of old machine 4,000 $ 6,000 Change in working capital $ 17,000 + $ 49,000

Replacement Project
Intial cash flow $ 221,160 Operating cash flow: 1 $ 26,480 2 57,680 3 55,600 4 61,200 5 73,200 Terminal cash flow $ 49,000