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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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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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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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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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organizations chosen strategy (planning) and to

the Balanced Scorecard (control):

Strategic control systems

Multi-criteria decision models

Analytic hierarchy process (AHP)

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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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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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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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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Dharma

Sanata Dharma Mendoza Co.:

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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Dharma

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Mendoza Co.: Projected After-Tax

Cash Flow Summary (Exhibit 12.2)

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present-dollar equivalents

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 =

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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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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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 +

Integrating

0.10) -1 academic excellence and humanistic v

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Estimating NPV Using Built-In

Function: Mendoza Company

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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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General Solution:

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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

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

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Sanata Dharma Mendoza Co.: Estimating the

Projects IRR Using Built-In

Function

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Dharma

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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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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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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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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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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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Dharma

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Easy to compute

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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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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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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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income Average

investment

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Accounting $58,000

= = 13.14%

Rate of Return $441,500

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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Advantages:

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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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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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