Dharma

Sanata Dharma
STRATEGY AND THE ANALYSIS
OF CAPITAL INVESTMENTS

Sanata
niversitas
Dhina/162222105 Olivina/162222113 Rani/162222117
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Learning Objectives
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Explain the strategic role of capital-investment analysis

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Describe how accountants can add value to the capital-

budgeting process
Provide a general model for determining relevant cash
flows associated with capital-expenditure projects
Apply discounted cash flow (DCF) decision models for
capital-budgeting purposes
Deal with uncertainty in the capital-budgeting process
Discuss and apply other capital-budgeting decision
models
Identify behavioral issues associated with the capital-
budgeting process
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Introductory Definitions
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Capital budgeting:
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Procedures used to identify, select, monitor, and

control capital (i.e., long-term) investments
Capital investments:
Long-term projects involving substantial initial
cash outlays followed by a series of future cash
returns
Capital budget:
Part of the organizations master budget (Chap.
10) that deals with the current periods planned
capital investment outlays
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Discounted cash-flow (DCF) decision models:

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Decision models (e. g., NPV and IRR) for capital budgeting
that explicitly incorporate the time-value-of-money
Weighted-average cost of capital (WACC):
Under normal circumstances, the discount factor used in
DCF capital-budgeting decision models
Estimated as a weighted average of the cost of obtaining
capital from various sources (e.g., equity and debt)
Non-discounted cash flow decision models:
Capital budgeting decision models that do not incorporate
the time-value-of-money into the analysis of capital
investment projects

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Role of Accounting in the Capital-
Budgeting Process
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Linkage to the Master Budget (planning)

Linkage of capital investment decisions to the

organizations chosen strategy (planning) and to
the Balanced Scorecard (control):
Strategic control systems
Multi-criteria decision models
Analytic hierarchy process (AHP)

Generation of relevant financial data for investment

analysis purposes (decision-making)
Conducting post-audits of capital investment projects
(control)
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Identifying Relevant After-tax Cash
Flows for Capital-Expenditure Analysis
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Project initiation:
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Required investment outlays, including installation costs

Includes incremental net working capital commitments
Cash inflow associated with investment tax credits
Project operation:
Cash operating expenses, net of tax
Additional net working capital requirements, if any
Operating cash inflows (or reductions in expenses), net of
tax
Project disposal:
Net of tax proceeds from disposal of the investment
Recapture of investment in net working capital

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Example: New Investment
Decision (Exhibit 12.1)
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Mendoza Co. manufactures high-pressure pipe

for deep-sea oil drilling. The firm is considering
the purchase of a drilling machine with a base
cost of $465,000. Incremental cash revenues
per year = $1,000,000; incremental cash
operating expenses per year = $733,333. The
combined income tax rate for Mendoza is
expected to be 40.00%.

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Additional Assumptions: Mendoza Co.
(Exhibit 12.1)
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Machine installation cost = $5,000

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Testing/Adjustment cost, installation = $10,000

Expected useful life = 4.0 years
Expected salvage value = $100,000 (ignore for tax
purposes)
End-of-life disposal-related costs = $95,000
Depreciation method: straight-line (SL)
Year 4 employee relocating expenses = $150,000
1st year employee training costs = $50,000
Incremental net working capital investment, year 0, equals
$200,000 (completely recovered at end of year 4)

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Mendoza Co.: Net After-Tax Cash
Outflow, Year 0
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SL Depreciation Calculation, Years 1
through 4
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Project Operation: After-tax Cash Flows (Inflows
and Outflows) During Life of the New Machine
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Transaction
Transaction Calc.
Calc. of
of After-tax
After-tax Cash
Cash Flow
Flow
Cash
Cash receipts
receipts Taxable
Taxable cash
cash receipt
receipt
(1
(1 t)
t)
Cash
Cash expenditures
expenditures Pretax
Pretax cash
cash expense
expense (1
(1

t)
t)
Depreciated
Depreciated Tax
Tax shield
shield Depreciation
Depreciation
expense
expense tt
Allocated
Allocated costs
costs No
No effect
effect

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Project Operation: After-tax Cash Flows
(Exhibit 12.2)
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Mendoza Co.: Project Disposal
(Exhibit 12.2)
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Mendoza Co.: Projected After-Tax
Cash Flow Summary (Exhibit 12.2)
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Calculating the Discount Rate (WACC)

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The weighted average cost of capital (WACC) is used in capital

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budgeting to discount future after-tax cash flows back to

present-dollar equivalents

Weights used to calculate the WACC can be determined based

on the target capital structure for the firm or they can be
based on the current market values of the various sources of
funds
The after-tax cost of debt =

Effective interest rate on debt (1 t)

Cost of common equity is equal to the expected/required market rate

of return on the companys stock (for listed companies, this can be
estimated using the CAPM)

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Example: Calculating the Discount
Rate (WACC)Exhibit 12.9
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A firm (not the Mendoza Co.) has a $100,000 bank

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loan with an effective interest rate of 12%; $500,000,

10%, 20-year mortgage bonds selling at 90% of face
value; $200,000 of 15%, $20 noncumulative, non-
callable preferred stock with a total market value of
$300,000; and, 50,000 shares of $1 par common
stock, with a total current market value of $750,000.
The estimated required rate of return on the common
stock, based on application of the CAPM, is 20%. The
firm is subject to a 40% income tax rate.
Lets calculate the weighted average cost of capital...

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Note: the cost of using preferred stock is equal to the current dividend
yield on the stock (i.e., current dividend per share of preferred stock
current market price per share)

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Making the Decision: The NPV Model

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Discount all future net-of-tax cash inflows to

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present value using the WACC as the discount rate

Discount all future net-of-tax cash outflows to
present value using the WACC as the discount rate
If NPV > 0, accept the project (that is, the project
adds to the value of the company)
If NPV < 0, reject the project (that is, the project
does not add value to the company)

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Estimating NPV: Mendoza Company
Assumed WACC = 10.0%
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(1 +
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Estimating NPV Using Built-In
Function: Mendoza Company
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Internal Rate of Return (IRR) Model

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IRR represents an estimate of the true (i.e.,

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economic) rate of return on a proposed

investment project
IRR is calculated as the rate of return that
results in a NPV of zero
If IRR > WACC, then the proposed project should
be accepted (i.e., its anticipated rate of return >
the cost of invested capital for the firm)
If IRR < WACC, the proposed project should be
rejected (i.e., its NPV will be < 0)

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Estimating the IRR of a Project

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General Solution:
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Use built-in function in Excel

When Future Cash Inflows are Uniform:

Use annuity table to identify, in the row
corresponding to the life of the project, an
amount equal to the ratio of the initial investment
outlay to the equal annual net-of- tax cash inflow

When Future Cash Inflows are Uneven:

Use a trial-and-error approach (with interpolation)

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Projects IRR Using Built-In
Function
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Mendoza Co.: Estimating the Projects
MIRR Using Built-In Function
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Uncertainty and the Capital-
Budgeting Process
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NPV, IRR, and MIRR models provide an

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investment recommendationthat is, to accept

or to reject a given project
Sensitivity analysis refers to the sensitivity of
the recommendation to estimated values for
the variables in the decision model: examples
of sensitivity analysis include:
What-if analysis

Scenario analysis
Monte Carlo simulation analysis
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What-if Analysis
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Involves changing one variable (e.g., the

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discount rate/WACC) at a time; as part of

this form of sensitivity analysis we might
consider the:
Most optimistic case
Most pessimistic case
Break-even after-tax cash flow amount
(use Goal Seek option in Excel)

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Additional Methods for Handling
Uncertainty
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Scenario Analysis:
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Disaster Scenario
Disappointing Scenario
Optimistic Scenario
Monte Carlo Simulation Analysis:
Decision inputs subjected to probability
distribution
Use of simulation (e.g., @ RISK Excel add-on)

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Analysis of Real Options

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Definition of Real Options

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Contrast with Financial Options

Examples of Real Options:
Option to Delay Investment Project (i.e., an Investment-
Timing Option)
Option to Expand a Profitable Investment Project
Option to Abandon and Investment Project
Option to Curtail or Scale Back an Investment Project
Real Options Analysis Complements, Not
Replaces, DCF Analysis
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Other Capital Budgeting Decision
Models: Payback Period
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Payback period = length of time (in years)

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required for the cumulative after-tax cash

inflows from an investment to recover the
initial (net) investment outlay
When after-tax cash inflows are expected
to be equal, the payback period is
determined as:
(Net) initial investment Annual after-
tax cash inflows

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Mendoza Co. : Use of the Payback
Method (Exhibit 12.11)
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Strengths of the Payback Decision Model

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Easy to compute
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Businesspeople have an intuitive

understanding of payback periods
Payback period can serve as a rough
measure of riskthe longer the payback
period, the higher the perceived risk

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Weaknesses of the Payback
Decision Model
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The model fails to consider returns over

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the entire life of the investment

In its unadjusted state, the model ignores
the time value of money
The decision rule for accepting/rejecting
projects is ill-defined (ambiguous or
subjective)
Use of this model may encourage
excessive investment in short-lived projects

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Present Value (or, Discounted)
Payback Model
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Present value payback = the length of time (in years) required

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for the cumulative present value of after-tax cash inflows to

recover the initial investment outlay

Note: if the discounted payback period is less that the life of the
project, then the project must have a positive NPV
Strength:
Takes into consideration the time value of money
Weaknesses:
Can motivate excessive short-term investments
Returns beyond the payback period are ignored
Decision rule for project acceptance is ambiguous/
subjective

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Mendoza Co.: Discounted Payback
Calculation (Exhibit 12.12)
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Accounting (Book) Rate of Return (ARR)

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ARR = Average annual net operating

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income Average
investment

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Accounting $58,000
= = 13.14%
Rate of Return $441,500

Note, however, that some companies define the

denominator of the ARR as the net
original investment. Again, there are different
ways to define this number. If the ARR is
calculated based on this measure ($680,000), the
calculated ARR for the proposed project
would be 8.53%.
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Evaluation of ARR Decision Model

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Advantages:
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Readily available data

Consistency between data for capital budgeting
purposes and data for subsequent performance
evaluation
Disadvantages:
No adjustment for the time value of money
(undiscounted data are used)
Decision rule for project acceptance is not well defined
The ARR measure relies on accounting numbers, not
cash flows (which is what the market values)

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Behavioral Issues in Capital Budgeting

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Cost escalation (escalating commitment)decision makers

may consider past costs or losses as relevant
Incrementalism (the practice of choosing multiple, small
investments)
Uncertainty Intolerance (risk-averse managers may require
excessively short payback periods)
Goal congruence (i.e., the need to align DCF decision models
with models used to subsequent financial performance)
Addressing the goal-congruency problem:
Use of Economic Value Added (EVA)
Separating Incentive Compensation from Budgeted Performance
Use of Post-Audits

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TERIMA KASIH

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