Capital Budgeting

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Question description

As a manager, you may be responsible for proposing or approving significant, long-term investments by a business. An example of such a long-term investment is a business’ acquisition of manufacturing facilities, machinery and equipment, and working capital needed to launch a new product or to establish productive capacity abroad. Topic 1 described expenditures for plant and equipment as committed fixed costs. Of course, businesses commit financial capital to such investments with the expectation of earning a return on them. The expected return must be sufficiently large to justify undertaking the risks that arise from committing significant amounts of capital to activities whose outcomes (payoffs) are uncertain. In order to determine whether the expected return on investment is adequate, managers apply capital budgeting analysis. Capital budgeting analysis requires managers to determine:

  • The business’ required rate of return, referred to as its cost of capital.
  • The amount, timing, and risk (uncertainty) of the incremental future cash flows to the business attributable to the proposed investment.

The key feature of capital budgeting is its use of the present value concepts and models you examined in Topic 5. Because the cost of capital of a business and the prospective, future cash flows from a long-term investment are forward-looking estimates, the capital budgeting process is subject to potential judgmental errors or purposeful manipulation. Furthermore, capital investment decisions may be highly sensitive to changes in those estimates. Considering the significant size and long duration of these investments, inappropriate capital investment decisions may have serious financial consequences for a business. Therefore, it is critical that managers install controls over the capital budgeting process.

By completing this assignment, you will learn how to prepare a capital budgeting analysis for a proposed long-term capital investment by a business. As a manager, you may be responsible for proposing or approving significant, long-term investments. Considering the significant size and long duration of these investments, inappropriate capital investment decisions may have serious financial consequences for a business.

Please use the file entitled Topic6Template for this assignment.

Background Paper: Capital Budgeting and the Cost of Capital College of Business and Economics Master of Business Administration MBA C604 Accounting and Finance Concepts for Managers Contents Topic 6  Introduction and Purpose  The Capital Budgeting Process □ Contrasting Perspectives of Capital Budgeting and Financial Reporting — Capital Budgeting Analysis of a Proposed New Product □ Projected income, investment in working capital, and depreciation tax shield — Riskiness (Uncertainty) of Investment Cash Flows □ Probability-weighted expected cash flows □ Sensitivity (or “what if”) analysis — Sunk Costs, Opportunity Costs, and Sales Erosion □ Relevant cash flows and sunk costs □ Relevance of opportunity costs □ Sales erosion resulting from investments in new products — Investment in Working Capital   — Income Tax Cash Flows □ Combined effective income tax rate □ Income tax cash flows related to income □ Tax effects of assumed end-of-investment disposal of property  Replacement of Machinery and Equipment Used in Making Existing Products  Choosing Between Alternative Machinery and Equipment Having Unequal Lives and Costs  Using Internal Rate of Return (IRR) to Supplement NPV Analysis □ Weaknesses of IRR (or, “Why clever managers use IRR only to supplement their NPV analyses”) □ Growth in business’ value from new investments The Cost of Capital  Investment Risk, Beta, and the Cost of Equity Capital □ Cost of equity capital and beta for unrelated investments  Cost of Capital for a Business with Financial Leverage □ Effect of financial leverage on a business’ weighted average cost of capital □ Targeted capital structure □ Fair value of equity and debt capital Capital Budgeting Controls and Non-financial Factors — Conflict between Cash Flow-based Capital Budgeting and Accrual-based Financial Ratios — Controls Over Capital Budgeting  Effect of Non-financial Factors and Management Incentives on Capital Budgeting 1 Topic 6 Introduction and Purpose As indicated in the Topic 5 background paper, managers are often responsible for identifying, evaluating, and proposing investments made by a business. These investments may include:      Acquiring additional plant and equipment in order to expand productive capacity, Replacing equipment used in production with more efficient or more highly automated equipment, Launching product research and development efforts, Introducing a new product, or Acquiring a business that is a competitor, key supplier, or customer The Topic 1-2 background paper describes expenditures for plant and equipment as committed fixed costs. Businesses commit costly financial capital to such investments with the expectation of earning a return. The expected return must be sufficient to justify undertaking the risks of committing significant amounts of capital to activities whose outcomes (payoffs) are uncertain. In order to determine whether the expected return on investment is adequate, managers apply capital budgeting analysis. Capital budgeting analysis requires managers to estimate:   The amount, timing, and risk (uncertainty) of the incremental cash flows to the business attributable to the proposed investment (the Topic 5 background paper defines these as relevant cash flows), and The business’ cost of capital, which establishes its required rate of return Managers evaluate the acceptability of proposed investments based on their net present value (NPV), introduced in the Topic 5 background paper. Because the prospective, future cash flows from a long-term investment and the cost of capital of a business are forward-looking estimates, capital investment decisions may be highly sensitive to changes in those estimates. These estimates depend on managers’ judgment about the outcome of future events and conditions. Therefore, the capital budgeting process is subject to purposeful manipulation, as well as judgmental errors. Considering the significant size and long duration of these investments, inappropriate capital investment decisions may have serious financial consequences for a business. Therefore, it is critical that managers install controls over the capital budgeting process. 2 Learning Objective 3 The Capital Budgeting Process Capital budgeting is the process used by managers to identify, analyze, accept, and control a business’ longterm investments. As a primarily financial management process, the principal steps of capital budgeting analysis (as indicated above) are (1) projecting the relevant cash flows associated with proposed investments and (2) estimating the business’ cost of capital. The model for analyzing relevant cash flows is NPV analysis.1 As the Topic 5 background paper explains, if managers’ properly prepared analysis shows that the NPV of a proposed investment is positive, its expected rate of return exceeds the company’s required rate of return. In that case, managers should approve the investment because positive-NPV investments increase the value of a business to its owners. In contrast, negative-NPV investments reduce the value of a business. This background paper examines three common applications of NPV analysis to the capital budgeting process:  Introduction of new products,  Replacement of machinery and equipment used in making existing products, and  Choosing between alternative machinery and equipment having unequal lives and costs Contrasting perspectives of capital budgeting and financial reporting. Capital budgeting analysis relies on discounted future cash flows, including opportunity costs. This is a different perspective than financial reporting (examined in the Topic 3-4 background paper) and financial ratio analysis (examined in the Topic 8 background paper). Financial statements, and the ratios computed using them, reflect accrual-basis income that summarizes the results of revenues earned and expenses incurred and ignores most opportunity costs.2 For example, capital budgeting analysis reflects the cash outflows representing the initial investment in PP&E at “time zero.” In contrast, financial statements reflect the cost of PP&E as depreciation expense over several successive periods corresponding to the assets’ estimated economic lives. (Capital budgeting considers depreciation, or amortization, of initial investments only in determining the related income tax cash flows – the so-called “depreciation tax shield,” discussed further below). As examined later in this background paper, the contrasting orientations of capital budgeting and financial reporting may lead to difficulties in evaluating the subsequent performance of investments and the managers responsible them. _____ 1 Other models for performing capital budgeting analysis include internal rate of return (IRR), payback, and accounting rate of return. This background paper considers IRR further below, stressing its limitations as a primary model for capital budgeting and recommending its use as a supplement only to the NPV model. The principles of business finance course you previously completed examined the payback and accounting rate of return models, including their conceptual weaknesses. (For example, both of these inferior models ignore opportunity costs, including the time value of money; in addition, payback ignores investment profitability (return on investment) altogether!) Graduate finance and managerial accounting texts include discussions of these models, as well. There appear to be two reasons why texts continue to discuss these inferior models nearly a half-century after U.S. businesses adopted the conceptually superior discounted cash flow (DCF) models. First, complete texts are easier for publishers to sell to professors who have become comfortable teaching topics their professors drilled into them when they were students. Second, the present-day managers of some business were students of these finance professors and, understandably, they tend to practice what they learned to do in college. Given the ubiquitous presence of compact, powerful computing devices, ease-of-use is no longer a compelling argument favoring the inferior models. It is encouraging, however, that very few firms rely exclusively on the payback, accounting rate of return, or IRR models. The great majority of businesses now use these lesser models only to complement NPV analysis (although, it’s not clear how this complimentary analysis improves capital budgeting decisions). Presumably, some managers simply need additional reassurance. On the other hand, the payback model is probably adequate, on cost-benefit grounds, for analyzing very small investments. 2 In limited, prescribed instances, financial reporting recognizes opportunity costs using discounted cash flow measurements and fair values of certain assets and liabilities. 3 Capital Budgeting Analysis of a Proposed New Product The application of NPV analysis to the proposed introduction of a new product follows these steps: In illustration below, refer to line(s): Steps in NPV / Capital Budgeting Analysis 1. Determine the amount of the business’ required initial investment in machinery and equipment (M&E) or other property (cash outflow) at “time zero” necessary to manufacture the new product (A) 2. Determine the business’ combined effective income tax rate, as explained later in this background paper (used in steps 3 through 6, below) – 3. For each period of the investment, estimate the operating cash flows (OCF) from projected sales of the new product, less the related operating expenses, incremental investment in working capital, and income taxes, as well as the lost contribution margin attributable to any sales erosion of the business’ existing products (D) and (E) 4. For each period of the investment, determine the amount of the depreciation tax shield (cash inflow) attributable to the tax-basis “cost recovery” (i.e., income tax deduction for depreciation) of the initial investment in M&E, as explained later in this background paper (K) 5. Estimate the opportunity costs, net of any related capital gain tax, of existing resources used in the investment, rather than their alternative use, and include those costs as relevant cash flows (C) 6. Estimate the proceeds from the assumed end-of-investment disposal of M&E and other property, net of any related capital gain tax, as explained later in this background paper (B) 7. For each period of the investment, summarize the (a) cash flows other than the depreciation tax shield separately from (b) the depreciation tax shield (F) and (K) 8. Compute the present value of the cash flows other than the depreciation tax shield by discounting them at the business’ cost of capital (using discount factors computed for each period of the investment) (G) through (J) 9. Compute the present value of depreciation tax shield by discounting it at the “risk-free” interest rate (using discount factors computed for each period of the investment) (L) through (O) 10. Compute the NPV of the proposed investment by summarizing the present value of cash flows computed in the two preceding steps (P) 11. Accept the proposed investment if its estimated NPV is zero or positive; or reject it if the proposed NPV is negative – 4 To illustrate, managers of FirstRate Company are considering the introduction of a new product, Product Z. The company recently completed test-marketing of the new product, at a cost of $280,000. The company previously incurred research and development (R&D) costs related to Product Z totaling $4.5 million. Management estimates that the economic life of Product Z is five (5) years, after which changes in consumer taste and technology will make the product obsolete. The company’s production engineers have determined that, in order to begin production of Product Z, the company will need to acquire additional machinery and equipment (M&E) costing $55.0 million. Instead of acquiring a new manufacturing site for Product Z, management proposes that the company convert an unused warehouse, which the company acquired many years ago, to this purpose (the warehouse is in good condition, though fully depreciated for accounting and income tax purposes). Management estimates that the residual (fair) value of the M&E will be $14.0 million after five years, when the company discontinues Product Z. An appraiser reported to management that the current fair value of the existing warehouse is $3.0 million. The appraiser’s report indicated that he did not foresee significant changes in the value of the property over the next five years. Management prepared an analysis of Market Share and Sales Projections (units and revenue) for Product Z (examined below) as the basis for its Projection of Income and Depreciation Tax Shield (also examined below). Management used its projections of unit sales and sales revenue to prepare a Projection of Required Investment in Net Working Capital, (also examined below). Finally, in its projection of income from Product Z, managers included the expected adverse effects on the profitability of an existing company product, Product Y (refer to managers’ Projected Erosion ("Cannibalization") from Existing Product Y (Contribution margin), discussed below). As discussed later in this background paper, managers previously determined: □ The company’s combined (federal and state) effective income tax rate is 40 percent □ The company’s cost of capital (rWACC), used to discount cash flows, other than the “depreciation tax shield,” is 12.0 percent □ The current “risk-free” interest rate (rF), used to discount “depreciation tax shield,” is 4.0 percent Presented below is managers’ Capital Budgeting Analysis of proposed new Product Z. As shown in the analysis, the NPV of the proposed investment is positive (about $930,000). Therefore, based on this analysis, the company should accept the proposal and proceed with the launch of Product Z. 5 FirstRate Company Capital Budgeting Analysis – Proposal for New Product Z Year 0 (A) (B) (C) (D) (E) (F) Year 1 Year 2 Year 3 Year 4 Cash flows other than depreciation tax shield : Machinery and equipment (M&E): Step 1 $ (55,000,000) – Acquisition and installation costs ("original tax basis") $ – Proceeds from disposal, net of capital gain tax (Note 1) Step 6 Step 5 (1,800,000) Opportunity cost of existing warehouse, net of capital gain tax (7,829,000) (511,000) 701,000 520,000 Incremental (investment) or reduction in net working capital (Note 2) Step 3 17,148,000 15,339,000 7,719,000 4,260,000 After-tax income before tax-basis "cost recovery" of M&E (Note 3) Total cash flows other than depreciation tax shield [Total (A) through (E)] $ (56,800,000) $ 9,319,000 $ 14,828,000 $ 8,420,000 $ 4,780,000 $ (G) Discount rate (weighted-average cost of capital, or r WACC) (Note 4) 12.00% n 1.0000 (H) Discount factors [1 / (1 + r WACC) ] (Note 5) (I) Discounted present value (PV) of cash flows [(F) x (H)] Step 8 (J) Total discounted PV [Total of (I) for all years, 1 through 5] $ (56,800,000) $ Year 5 13,310,000 1,800,000 7,119,000 983,400 23,212,400 Step 7 0.8929 0.7972 0.7118 0.6355 0.5674 8,320,536 $ 11,820,791 $ 5,993,190 $ 3,037,776 $ 13,171,339 3,141,600 $ 3,848,000 $ 2,750,000 $ $ (14,456,368) Depreciation tax shield : (K) Depreciation tax shield on M&E (Note 3) Steps 4, 7 $ n (N) Discounted present value (PV) of cash flows [(K) x (M)] Step 9 (Q) Total undiscounted net cash flows (R) Total discounted net cash flows 1,962,400 1.0000 $ - $ 0.9615 0.9246 0.8890 0.8548 3,020,769 $ 4,981,509 $ 3,420,858 $ 2,350,712 $ 0.8219 1,612,950 $ 15,386,797 (O) Total discounted PV [Total of (N) for all years, 1 through 5] (P) Net present value (NPV) of investment [(J) + (O)] 5,388,000 $ 4.00% (L) Discount rate ("risk-free" interest rate, or r F) (Note 4) (M) Discount factors [1 / (1 + r F) ] (Note 5) - $ Step 10 [(F) + (K)] [(I) + (N)] $ 930,429 (56,800,000) 12,460,600 20,216,000 $ (56,800,000) $ 11,341,305 $ 16,802,300 $ (S) Internal rate of return (IRR) [Computed using cashflows at (Q)] (Note 6) 10.8% (T) Profitability index (PI) [Computed using cashflows at (R)] (Note 7) 102% 12,268,000 9,414,048 $ 7,530,000 25,174,800 5,388,488 $ 14,784,289 Note 1 – Refer to the separate computation of the tax effects of assumed end-of-investment disposition of M&E, examined below Note 2 – Refer to the separate Projection of Required Investment in Net Working Capital, examined below Note 3 – Refer to the separate Projection of Income and Depreciation Tax Shield, examined below Note 4 – Later in this background paper is an examination of business' weighted average cost of capital, r WACC and the "risk-free" interest rate r F Note 5 – Recall the Topic 5 background paper discussed the computation of discount factors, including related MS Excel formulas used for this purpose Note 6 – This background paper examines (below) IRR, including its computation, limitations, and proper role in capital budgeting analysis Note 7 – Recall that the Topic 5 background paper defined and discussed the use of the PI (also called the excess present value index) The illustration above adopts three conventions commonly used in preparing NPV analyses:  End-of-period cash flows. Managers generally assume that all cash flows occur at the end of the periods indicated.3 However, in practice, managers often prepare NPV analyses using more frequent cash flow intervals (quarters or months), which may lead to more refined results than assuming annual, end-of-year cash flows. In these cases, managers take care to recast the discount rates used, as described in the Topic 5 background paper. _____ 3 As indicated in the Topic 5 background paper, application of the present value equations requires some minor adjustment in the case where the investment analyzed involves beginning-of-period cash flows. 6  Discounting “depreciation tax shield” at the risk-free interest rate. As indicated above, investment cash flows are generally risky (that is, uncertain). However, managers typically treat the tax benefits from the "cost recovery" of M&E (the so-called “depreciation tax shield”) as riskless. This is because, once a business acquires M&E, the amounts and timing of these tax deductions is certain, assuming that (i) the business is profitable (has taxable income) in the aggregate and (ii) income tax rates do not change during the life of the investment. The appropriate rate to use in discounting riskless cash flows is the “risk-free” interest rate, rF. As described later in this background paper, rF is the interest rate on U.S. Treasury (government) securities because these have virtually no credit default risk (in light of the government’s power to print money).  Nominal versus real cash flows and discount rates. Managers generally prepare capital budgeting analyses using nominal, rather than real, projected cash flows and discount rates. As examined in the Topic 5 background paper, real amounts reflect adjustments for the anticipated effects of price inflation (i.e., deterioration in a currency’s purchasing power). Nominal amounts do not include adjustments for the effects of inflation.4 Projected income, investment in working capital, and depreciation tax shield In the illustrative NPV analysis of the proposed Product Z, above, managers determined the amounts for three elements of operating cash flows (OCF), (D) Incremental investments in, or reductions of, net working capital, (E) After-tax income, and (K) Tax benefits from the tax-basis "cost recovery" of M&E (the “depreciation tax shield”) from additional, supporting analyses. These additional analyses, examined below, include the:  Projection of Income and Depreciation Tax Shield and  Projection of Required Investment in Net Working Capital _____ 4 The economic life of many investments by businesses exceeds the five years assumed in the illustrations typically used in finance and accounting courses – say, 10, 20, or more years. So, the question that naturally comes to the minds of many students is, “What about inflation over such a long period? After all, when I was a kid 20 years ago, a movie ticket cost only $_, and now ticket prices are X times that earlier amount!” Well, managers may prepare NPV analyses using either nominal amounts or real values of currency. Nominal (or stated) amounts are unadjusted for the effects of changes in the currency’s purchasing power (i.e., inflation) over time. In that case, for example, managers deem a $1,000,000 cash flow in 20X1 as being equal to a $1,000,000 cash flow in 20X8, irrespective of changes in the dollar’s purchasing power during the intervening seven years. Alternatively, if managers prefer to prepare their NPV analyses using real currency values, they must recast the amounts of all cash flows in terms of the currency’s purchasing power as of a single, common date (such as, “time zero”). In that case for example, if the average annual rate of inflation between 20X1 and 20X8 is 7 expected to be 3.0 percent, a $1,000,000 projected cash flow in 20X8 is recast as: $1,000,000 / (1 + 0.03) = $813,092 in an NPV analysis prepared as of 20X1 (“time zero”). In general, Real value of a cash flow = Nominal amount of the cash flow / (1 + Compound average annual rate of inflation) n where n is number of years between the occurrence of the projected nominal cash flow and the date of the NPV analysis (“time zero”) When preparing NPV analyses using real cash flows, managers must take care to also use the business’ real (rather than nominal) required rate of return (cost of capital). As defined in the Topic 5 background paper: Required real rate of return = Required rate of return excluding effects of inflation 1 + required nominal rate of return = –1 1 + expected annual rate of inflation Competently prepared, NPV analyses of a particular investment opportunity prepared using either nominal or real cash flows (and the corresponding required rate of return) will result in the same computed NPV amount as of “time zero.” As a practical matter, however, NPV analyses that use nominal amounts of cash flows are generally easier for managers to prepare and interpret. In addition, as examined further below, use of nominal amounts of cash flows facilitates subsequent evaluations of investment performance because recorded results (recognized in a business’ accounting information system) also use primarily nominal amounts of revenues and expenses (i.e., nominal cash flows, adjusted for accruals). 7 Careful study of the Projection of Income and Depreciation Tax Shield, below, reveals that: The amount of the after-tax income before tax-basis "cost recovery" of M&E, Line (K), depends on:  Projected Product Z sales, variable costs, and incremental fixed costs (other than depreciation of M&E),  Projected erosion (or “cannibalization”) of existing Product Y (contribution margin), as discussed further below, and  The company’s combined effective income tax rate, also discussed further below The amount of the tax benefit of tax-basis “cost recovery” of M&E (“depreciation tax shield”), Line (N), depends on the:  Tax-basis “cost recovery” of M&E (an income tax deduction, analogous to depreciation), discussed below, and  Company’s combined effective income tax rate, as discussed further below FirstRate Company Product Z Proposal – Projection of Income and Depreciation Tax Shield Note 1 (A) (B) (C) (D) (E) (F) (G) (H) (I) (J) (K) (L) (M) (N) Projected number of units produced and sold Note 2 Projected sales revenue Note 2 Projected variable cost (VC) per unit Note 3 Projected total VC (A) x (C) Note 4 Projected total fixed costs (FC), other than depreciation of M&E (D) + (E) Total operating expenses, other than depreciation of M&E Erosion of existing Product Y (contribution margin) Note 5 (B) – (F) – (G) Income before tax-basis "cost recovery" of M&E Combined effective income tax rate Note 6 (H) x (I) Taxes on income before tax-basis "cost recovery" of M&E (H) – (J) After-tax income before tax-basis "cost recovery" of M&E Tax-basis "cost recovery" percentage of M&E Note 7 Tax-basis "cost recovery" (L) x Original cost of (investment in) M&E: $55,000,000 Tax benefit of tax-basis "cost recovery" of M&E ("depreciation tax shield") (I) x (M) (O) Cumulative tax-basis cost recovery [Cumulative total to date of (M)] Year 1 Year 2 Year 3 Year 4 Year 5 4,928,000 5,413,400 5,280,100 5,081,600 4,758,800 $ 96,896,000 $101,258,000 $ 90,050,000 $ 81,973,000 $ 72,337,000 $ 8.00 $ 8.40 $ 8.80 $ 9.20 $ 9.70 $ 39,424,000 $ 45,473,000 $ 46,465,000 $ 46,751,000 $ 46,160,000 $ 21,500,000 $ 22,100,000 $ 22,800,000 $ 20,500,000 $ 17,400,000 $ 60,924,000 $ 67,573,000 $ 69,265,000 $ 67,251,000 $ 63,560,000 $ 7,392,000 $ 8,120,000 $ 7,920,000 $ 7,622,000 $ 7,138,000 $ 28,580,000 $ 25,565,000 $ 12,865,000 $ 7,100,000 $ 1,639,000 40% 40% 40% 40% 40% $ 11,432,000 $ 10,226,000 $ 5,146,000 $ 2,840,000 $ 655,600 $ 17,148,000 $ 15,339,000 $ 7,719,000 $ 4,260,000 $ 14.28% 24.49% 17.49% 12.50% 983,400 8.92% $ 7,854,000 $ 13,470,000 $ 9,620,000 $ 6,875,000 $ 4,906,000 $ 3,141,600 $ 5,388,000 $ 3,848,000 $ 2,750,000 $ 1,962,400 Note 8 $ 42,725,000 Note 1 – This capital budgeting analysis uses nominal (rather than real ) cash flows and discount rates. This is the most common practice of managers (as indicated above in this background paper) Note 2 – Refer to the Market Share and Sales Projections, below Note 3 – Recall from the Topic 1 background paper that VC include both variable manufacturing costs and variable selling-and-administrative (S&A) costs. Also recall that variable manufacturing costs include direct materials (DM), direct labor (DL), and variable manufacturing overhead (MOH) costs. Variable S&A costs include such costs as shipping costs and sales commissions Note 4 – The Topic 1 background paper defined and discussed fixed costs (FC). For purposes of NPV analysis, FC include only incremental costs related to the proposed investment and exclude allocations of existing fixed MOH or non-manufacturing FC (such as, corporate office costs) Note 5 – Refer to the Projected Erosion ("Cannibalization") from Existing Product Y (Contribution margin), below Note 6 – Refer to the discussion, below, of a business' combined effective income tax rate Note 7 – Refer to the discussion, below, of the depreciation tax shield (the cost recovery percentages included in this analysis are those set forth by IRS regulations for "7-year Class Life" property) Note 8 – Management used the cumulative tax-basis cost recovery to compute the proceeds, net of capital gain tax, from assumed disposal of M&E in Year 5 8 Learning Objective 2 Riskiness (Uncertainty) of Investment Cash Flows Management’s decision to accept or reject a particular investment proposal depends on the results obtained in the related NPV (capital budgeting) analysis. In turn, the results of an NPV analysis depend critically on whether managers have properly identified and projected all relevant cash flows. Usually, the most challenging cash flows to project accurately are the operating cash flows (OCF) that managers expect the investment to generate. In turn, the element of OCF that is typically the most difficult to project accurately is sales, including both the quantity (units or volume) of sales and average effective selling prices. When preparing capital budgeting analyses, managers may cope with the riskiness (uncertainty) of future cash flows, including OCF, using such devices as:  Probability-weighted expected cash flows, and  Sensitivity analysis Probability-weighted expected cash flows. The methodology illustrated below is a common one. However, managers use a variety of methodologies to project sales or OCF for proposed projects. The precise methodology used should reflect the market and technological characteristics of a business' products (or services), the business’ distribution methods, and other factors. (Marketing and business strategy courses examine methods for projecting sales.) To illustrate, as presented in the table below, FirstRate Company used subjective probability distributions to project sales over the five-year life of proposed new Product Z. Management considered the product’s market potential and growth, the company’s market share over time, and product unit selling prices in developing three sales scenarios – pessimistic case, most likely case, and optimistic case. Then, managers applied their subjective probability distribution to each case in order to develop the probability-weighted expected sales (units and revenue) for each year of proposed Product Z. Managers’ previous experience with other products may provide only limited guidance in projecting sales of proposed new products. In these situations, managers must rely on a subjective analysis based on their current assessment of any market research data obtained, the susceptibility of the product to technological obsolescence, industry competition, and the outlook for the economy. 9 FirstRate Company Product Z Proposal – Market Share and Sales Projections Projected Year 1 Pessimistic case: (A) Projected rate of growth in market size (B) Projected total market size (units) (C) Company's projected market share (D) Company's projected sales (units) (1) (B) x (C) (E) Company's projected average selling price (F) Company's projected sales (dollars) $ (D) x (E) (1) (F) Company's projected sales (dollars) (D) x (E) $ $ (D) x (E) Company's projected sales (units) Pessimistic case Most likely case Probability (2) Optimistic case Probability-weighted expected sales 3.0% 16,000,000 17,120,000 18,490,000 19,230,000 19,810,000 23.0% 3,680,000 23.0% 3,937,600 20.0% 3,698,000 18.0% 3,461,400 16.0% 3,169,600 16.00 $ 5,000,000 20.00 $ 24,000,000 28.0% 6,720,000 (B) x (C) (F) Company's projected sales (dollars) Company's projected sales (dollars) Pessimistic case Most likely case 4.0% (1) (E) Company's projected average selling price Optimistic case Probability-weighted expected sales 8.0% 25% 60% 15% 100% 15.20 $ 12.60 $ 11.90 $ 11.20 10.0% 12.0% 6.0% 4.0% 22,000,000 25.0% 24,640,000 22.0% 26,118,000 20.0% 27,163,000 18.0% 5,500,000 19.00 $ 5,420,800 18.00 $ 5,223,600 17.00 $ 4,889,300 16.00 $ 100,000,000 $ 104,500,000 $ 97,574,000 $ 88,801,000 $ 78,229,000 Optimistic case: (A) Projected rate of growth in market size (B) Projected total market size (units) (C) Company's projected market share (D) Company's projected sales (units) Year 5 7.0% 20,000,000 25.0% (B) x (C) Year 4 - - (D) Company's projected sales (units) (E) Company's projected average selling price Year 3 $ 58,880,000 $ 59,852,000 $ 46,595,000 $ 41,191,000 $ 35,500,000 Most likely case: (A) Projected rate of growth in market size (B) Projected total market size (units) (C) Company's projected market share Year 2 22.00 $ 12.0% 14.0% 7.0% 5.0% 26,880,000 28.0% 7,526,400 30,643,000 24.0% 7,354,300 32,788,000 22.0% 7,213,400 34,427,000 20.0% 6,885,400 20.90 $ 18.00 $ 17.00 $ 16.00 $ 147,840,000 $ 157,302,000 $ 132,377,000 $ 122,628,000 $ 110,166,000 920,000 3,000,000 1,008,000 984,400 3,300,000 1,129,000 924,500 3,252,500 1,103,100 865,400 3,134,200 1,082,000 792,400 2,933,600 1,032,800 4,928,000 5,413,400 5,280,100 5,081,600 4,758,800 Probability (2) 25% $ 14,720,000 $ 14,963,000 $ 11,649,000 $ 10,298,000 $ 8,875,000 60,000,000 62,700,000 58,544,000 53,281,000 46,937,000 60% 22,176,000 23,595,000 19,857,000 18,394,000 16,525,000 15% 100% $ 96,896,000 $ 101,258,000 $ 90,050,000 $ 81,973,000 $ 72,337,000 (1) In years 2 - 5, projected total market size (units) = (B) in preceding year x [ 1 + (A) in current year ] (2) Management assigned subjectively determined probabilities to each case based on a consensus view reached in a meeting of the President, VP-Marketing, VP-Operations, and VP-Finance, as moderated by VP-Human Resources, after consideration of industry conditions, the company's competitive position and business strategy over the next five years, and the overall economic outlook. 10 Sensitivity (or “what if”) analysis. Using computer spreadsheets to perform NPV analysis, managers can quickly “stress test” the sensitivity of their tentative decisions to approve or reject proposed investments by changing one or more key assumptions or estimates used in preparing them. For example, managers may progressively:  Reduce the assumed sales growth rate, unit selling prices, or fair value of equipment at the end of the project’s life  Increase estimated unit variable costs or total fixed operating costs5 in order to determine the extent of such changes necessary to change the results of its NPV analysis from positive (accept) to negative (reject), or vice versa. Sensitivity analysis helps managers to quantify the “maximum tolerable error” in the assumptions or estimates they used in preparing an NPV analysis. Sunk Costs, Opportunity Costs, and Sales Erosion Relevant cash flows and sunk costs. The Topic 5 background paper defines and discusses relevant cash flows in the context of NPV analysis, explaining that managers properly exclude sunk costs from their analysis because these costs do not represent relevant cash flows. For example, in the illustration above, at the time that FirstRate’s managers performed their capital budgeting analysis of the proposed launch of new Product Z, they had already completed R&D and test-marketing activities related to the new product. Therefore, the company’s costs of those activities are sunk costs and not relevant to the decision about whether to launch the new product. Relevance of opportunity costs. In contrast, managers properly include certain opportunity costs with cash flows in performing NPV analysis. In the context of capital budgeting, opportunity cost is the fair value of economic benefits a business forgoes when it decides to use a resource as part of an accepted investment proposal, rather than exploit its alternative use.6 For example, in the illustration above, FirstRate Company owned a large, unused warehouse and the land it sits on. Instead of selling (or renting out) the property, managers have proposed using it as the site of a manufacturing plant for new Product Z. The fair value of the property (net of any capital gain tax on its sales proceeds) represents an opportunity cost managers should include in their NPV analysis for the proposed new product. This is because, if the company did not use the property for the proposed manufacturing plant, it could sell the building and land for its fair value (or possibly lease it to another business at a market rent). Viewed differently, if the company sold (or leased) the unused property, it would need to incur the costs of acquiring another site to manufacture the new product – costs that would certainly represent relevant cash flows in the corresponding NPV analysis. As the Topic 5 background paper explains, opportunity costs also include the time-value of money. Of course, an NPV analysis includes the time-value of money by discounting an investment’s cash flows to determine their net present value. _____ 5 The Topic 1-2 background paper examines cost behavior, including variable costs, fixed costs, and contribution margin. 6 The Topic 5 background paper provides the example of opportunity cost in which you supposedly quit your high-paying job to form a new business and, to help finance your cash-starved start-up, you pay yourself a salary well below the salary you gave up when you made the career change. In that example, the “resource” is your service potential and the “fair value of economic benefits forgone” is the salary you earned in your old job in excess of the much lower salary your new business pays you. The question is, did you properly include this opportunity cost in the NPV analysis you prepared in anticipation of starting the new venture? 11 Sales erosion resulting from investments in new products. Sales erosion (or, product “cannibalization”) is the decreased cash flows from a business’ existing product(s) that results from the business’ introduction of new products that have functions or benefits similar to the existing product(s).7 For example, when a consumer technology business introduces a mobile personal device that has functions its existing similar product does not have, some prospective customers of the existing product will decide to purchase the new product, instead. The lost contribution margin8 from diverted sales of an existing product represents a cost that the NPV analysis for a proposed new product should consider as a relevant cash outflow. However, a manager may find it especially challenging to estimate with reasonable accuracy the value of sales erosion. This is because the contribution margin attributable to lost sales effectively represents the difference between two estimates:  The estimated contribution margin from projected future periods’ sales of the existing product assuming the business launches the new product, and  The estimated contribution margin from projected future periods’ sales of the existing product assuming the business does not launch the new product; because this is a hypothetical amount if the business launches the new product, a manager will not be able to subsequently evaluate its forecasting accuracy Managers’ estimates of the contribution margin attributable to sales erosion from a business’ existing product may take the form illustrated below: FirstRate’s proposed new Product Z – the subject of managers’ capital budgeting analysis – is a potential substitute for Product Y, already marketed by the business. Managers estimate that 10 percent of the unit sales of new Product Z in each year will represent erosion (or "cannibalization") of sales from the existing Product Y. The relevant cash outflow for purposes of the Product Z NPV analysis is the contribution margin (CM) from the lost of sales of existing Product Y, which managers estimated as follows: FirstRate Company Product Z Proposal – Projected Erosion ("Cannibalization") from Existing Product Y (Contribution margin) (A) Probability-weighted expected unit sales of new Product Z Note 1 Year 1 Year 2 Year 3 Year 4 Year 5 4,928,000 5,413,400 5,280,100 5,081,600 4,758,800 10.0% 10.0% 10.0% 10.0% 10.0% (B) Percent of new Product Z sales representing erosion of existing Product Y 492,800 541,340 528,010 508,160 475,880 (C) Units of new Product Z sales representing erosion of existing Product Y (A) x (B) Note 2 $ 15.00 $ 15.00 $ 15.00 $ 15.00 $ 15.00 (D) Unit CM of existing Product Y (2) (C) x (D) $7,392,000 $8,120,000 $7,920,000 $7,622,000 $7,138,000 (E) Total CM lost from erosion of existing Product Y Note 1 – Refer to Product Z Proposal – Market Share and Sales Projections, above Note 2 – Assume that the existing Product Y's unit selling price (SP) and unit variable cost (VC) remain stable over life of proposed new Product Z _____ 7 8 Courses in marketing and business strategy examine the nature and implications of sales erosion (or “cannibalization”). The Topic 1-2 background paper defines product contribution margin, including unit CM and total CM, as: Unit CM = Selling price (SP) – unit variable costs (VC) where VC include direct material (DM), direct labor (DL), variable manufacturing overhead (MOH) costs, and certain selling-andadministrative (S&A) costs, such as sales commissions and shipping costs. 12 Investment in Working Capital In general, increases in working capital9 necessarily accompany increases in a business' operating activities, including product expansion. Components of a business’ working capital typically include: Working capital assets:  Cash and short-term, liquid investments (such as holdings of U.S. Treasury bills)  Accounts receivable (AR) from customers  Inventory (raw material, work-in-process, and finished goods) Working capital liabilities:  Accounts payable (AP) to suppliers  Accrued salaries, wages, and payroll taxes  Accrued taxes (sales-and-use, income, and property taxes)  Accrued costs of customer product warranty claims and other items The capital budgeting analysis of a proposed new product assumes the working capital assets not financed with accounts payable (AP) and accrued liabilities represent cash outflows. That is, the business must finance net working capital assets with cash from another source, for which there is an accompanying opportunity cost, as discussed in the Topic 5 background paper. Managers often make the following assumptions when projecting the required investment in working capital related to a proposed new product:  In a manner similar to the CVP analysis examined in the Topic 1-2 background paper, managers assume the business sells all units in the same period in which it manufactures them. As a result, the business holds no end-of-period finished goods (or work-in-process) inventory.  Managers assume the business fully recovers its investment in working capital by end of the investment because, once a business winds down a production activity, it no longer requires working capital to support it. _____ 9 The Topic 3-4 background paper defines and discusses working capital within the context of the balance sheet and statement of cash flows. By including working capital requirements in their capital budgeting analyses, managers effectively convert the accrual-basis revenues and operating expenses (included in these analyses) into cash-basis amounts. The Topic 7 background paper examines working capital management. 13 To illustrate, FirstRate’s managers used the projected sales and operating expenses, included in the Projection of Income and Depreciation Tax Shield examined above, to prepare the following projection of the company’s required incremental investment in net working capital: FirstRate Company Product Z Proposal – Projection of Required Investment in Net Working Capital Year 1 $ (A) Cash and short-term, liquid investments (B) x [(C) + (E) + (F)] (B) Projected cash-and-investments as percent of total AR and inventory [Projected unit sales / 365 x (G) x (H)] (G) Projected number days' raw (direct) material on hand required for production Note 3 (H) Projected raw (direct) material cost per unit (Prior-year (H) x [ 1 + (I) ]) Note 4 (I) Note 5 Projected annual increase in per-unit cost of raw material (J) Accounts payable (AP) and accrued liabilities [ (K) x [ (A) + (C) + (E) + (F) ] (K) Projected AP and accrued liabilities as percent of working capital assets (L) Required investment in net working capital 40 2,780,000 $ 20% Note 7 40 Year 4 2,546,000 $ 2,373,000 $ 20% 9,868,000 $ Year 5 - 20% 8,983,000 $ 40 - 40 $ - $ - $ - $ - $ - $ 2,430,000 $ 2,803,000 $ 2,864,000 $ 2,882,000 $ - 30 $ 6.00 $ 5% 30 6.30 $ 5% 30 6.60 $ 6.90 5% $ 7,829,000 $ 8,340,000 $ 7,639,000 $ 7,119,000 $ - $ (7,829,000) $ (511,000) $ 701,000 $ 520,000 $ 7,119,000 50% 7,639,000 $ 5% 7,830,000 $ 50% 8,340,000 $ 30 $ Note 6 (A) + (C) + (E) + (F) – (J) (M) Incremental (investment) or reduction in net working capital Year 3 $ 10,619,000 $ 11,097,000 $ Note 2 (E) Finished goods inventory (assume all units sold in period manufactured) (F) Raw material inventory 2,610,000 $ 20% Note 1 (C) Accounts receivable (AR) [Projected sales for year / 365 x (D)] (D) Projected number of days' sales in accounts receivable Year 2 7,119,000 $ 50% - 50% Note 1 – The company’s finance manager estimates that the amount of cash-and-investments necessary to maintain a proper level of liquidity will change with the level of accounts receivable and inventory. The percentage relationship assumed here represents the business' historical ratio of cash-and-investments-to -total accounts receivable and inventory. Note 2 – The company’s customer credit terms are "net 30" (i.e., sales invoices state that payments are due within 30 days). The company's historical experience is that, on average, customers actually pay within 40 days. That is, some customers pay late. To simplify the capital budgeting analysis here, management assumes that all customers eventually pay (that is, the company experiences no bad debts). Note 3 – The company’s vice president of operations estimates that, to ensure uninterrupted production and customer order fulfillment, the company must maintain raw (direct) material inventory on hand sufficient to meet 30 days' projected unit production-and-sales. (Courses in operations management examine production and material resource planning methods.) Note 4 – The company's purchasing manager obtained the Year 1 material costs per unit from a preliminary bill-of-materials (BoM) he prepared in collaboration with the company's product engineer and R&D personnel Note 5 – The company’s vice president of operations and its purchasing manager examined forecasts prepared by industry economists to help them estimate the long-run rate of increases in raw (direct) material prices. Note 6 – The company’s finance manager estimates that the portion of working capital assets (cash-and-investments, AR, and inventory) financed by AP and accrued liabilities will follow the company’s historical average ratio of total AP-and-accrued liabilities-to -total working capital assets Note 7 – An increase in net working capital in any year (from the preceding year) represents an incremental investment cash outflow. A decrease in net working capital in a particular year (from the preceding year) represents a cash inflow. Recall the related discussion of the statement of cash flows and operating cash flows in the Topic 3-4 background paper The net working capital balance at the end of year 4 represents an end-of-project cash inflow because the company no longer needs it at that point and the cash used to finance the investment in net working capital becomes available for alternative investments at that time. Managers treat the partial recovery of net working capital in years 3 and 4 in a similar manner. 14 Income Tax Cash Flows Most students are familiar with Benjamin Franklin’s quip that, “nothing in life is certain, but death and taxes.”10 While the sometimes arduous task of preparing an NPV analysis probably will not be a manager’s death knell, taxes are an unavoidable element of capital budgeting. Mercifully, this background paper considers only the basic aspects of income taxation as they relate to NPV analysis. Managers should not ignore the effects of income taxes on capital budgeting analysis because taxes are unavoidable, relevant cash flows that significantly affect the profitability and NPV of investments. At a minimum, managers must:   Estimate the combined effective income tax rate of the business, Determine the income tax cash flows related to (i) income before the tax-basis "cost recovery" of M&E (the depreciation tax shield) and (ii) the depreciation tax shield, Estimate the tax effects of the assumed end-of-project disposal of M&E and other property acquired in connection with an investment, and As discussed later in this background paper, apply the proper discount rate (i.e., the so-called “risk-free rate”) to compute the present value of the depreciation tax shield11   Combined effective income tax rate. In the U.S., “large” corporations12 pay federal income taxes at the top rate of 35 percent of taxable income. Businesses incorporated or doing business in a state that subjects corporations to income (or franchise) taxes13 may deduct these taxes in determining their federal taxable income.14 As a result, managers may estimate the combined effective income tax rate of a U.S. corporation as: Combined effective income tax rate = State income tax rate 15 + Federal income tax rate x ( 1 – State income tax rate ) To illustrate, assume FirstRate Company, a U.S.-based corporation, expects to report taxable income large enough to subject it to the top federal tax rate of 35 percent and its weighted-average state income tax rate is 7.7 percent. The corporation’s combined effective income tax rate is 40.0 percent, computed as follows: Combined effective income tax rate = State income tax rate + Federal income tax rate x ( 1 – State income tax rate ) = 0.077 + 0.35 x (1 – 0.077) = 0.400 _____ 10 This background paper examined the uncertainty of projected cash flows in preparing NPV analyses, above, in connection with the use of subjective probability distributions. 11 Because the “risk-free” interest rate is less than a business’ cost of capital, the present value of the depreciation tax shield is higher than a similar amount of non-tax cash flows. 12 Most U.S. businesses organized as corporations in their state of domicile are so-called “C” corporations (under Subchapter C of the Internal Revenue Code). The top marginal “C” corporation income tax rate is currently 35 percent and applies to taxable income of about $18.3 million, or more. 13 45 of the 50 U.S. states impose taxes on corporations at “top” rates ranging from less than 1 percent to about 12 percent. 14 This discussion does not consider the possibility of additional taxes imposed by foreign countries on foreign-source income of U.S.based corporations. However, note that the U.S. imposes federal income taxes on “worldwide” income of U.S.-based corporations, subject to credits for taxes paid to foreign countries on such income. 15 For a corporation having income subject to tax in more than one state, the state income tax rate, here, is the income-weighted average state income tax rate for all such states. 15 Income tax cash flows related to income. In preparing an NPV analysis, managers project the periodic operating cash flows (OCF) that they expect the investment to generate. As examined in the Topic 3-4 background paper, operating cash inflows include collections of selling prices from customers. Operating cash outflows include payments to employees, suppliers, and governments’ tax-collection agencies. When determining the amount of income tax cash flows, managers must use care to compute these amounts using income tax accounting methods prescribed (in the U.S.) by the Internal Revenue Code (IRC) and Internal Revenue Service (IRS) regulations. Under the IRC and IRS regulations, most businesses determine their taxable income using accounting methods that generally resemble accrual basis (rather than cash basis) accounting. However, there remain numerous differences between the accounting methods prescribed by federal income tax regulations and U.S. GAAP (used to prepare financial statements, as examined in the Topic 3-4 background paper).16 One significant “tax-vs.-GAAP” difference is in the depreciation methods used to prepare financial statements and the “cost recovery” system prescribed by federal income tax regulations. As discussed in the Topic 3-4 background paper, businesses allocate the cost of long-lived assets (including PP&E) over their economic lives, which span multiple accounting periods benefitting from their services. Managers apply their judgment and specific knowledge about the nature and planned use of particular depreciable assets in estimating service lives and in selecting depreciation methods used (for example, straight-line, declining balance, unitsof-production methods). However, in determining U.S. taxable income, businesses usually apply the rigid “modified accelerated cost recovery system” to listed assets. This system predetermines the cost recovery (depreciation) method and the recovery period (depreciable life) for each category of eligible assets. As a result, the amount of depreciation expense reported in a business’ income statement for a given year typically differs from the amount of the “cost recovery” deduction claimed in the business’ income tax return for the corresponding taxable year.17 Consequently, a business’ accounting income before income taxes and its taxable income will be different amounts. Of course, managers compute a business’ income tax cash outflow based its taxable income, rather than its accounting income before income taxes. _____ 16 Financial statements, prepared in accordance with U.S. GAAP, recognize many of these differences (so-called “temporary differences”) as deferred income tax assets and liabilities in the balance sheet and as deferred income tax provisions or benefits within the income statement. 17 Underlying the differences between accounting methods used to prepare financial statements and income tax returns is the essentially different purposes of these two reporting systems. The purpose of financial statements, as examined in the Topic 3-4 background paper, is to provide information useful for making investment, credit, and similar decisions, including information about a business’ economic resources, changes in those resources, and claims to those resources. In contrast, the purpose of the income tax reporting system is to provide for the raising of revenue to fund the operations of the U.S. government according to laws and regulations that reflect politically determined fiscal priorities. 16 As illustrated in the new product proposal, above, in preparing an NPV analysis, managers compute projected OCF18 for a given period as: OCF Revenue (sales) = – Operating expenses, other than depreciation – Increase in net working capital or + Decrease in net working capital – Operating expenses, other than depreciation – – Income taxes where, Income = taxes ( Revenue ) Tax-basis “cost recovery” x Combined effective income tax rate Financial analysts refer to the shaded portion of the income taxes cash outflow equation, above – Tax-basis cost recovery (i.e., depreciation-like income tax deduction) x Combined effective income tax rate – as the depreciation tax shield because it reduces the income taxes a business would otherwise pay on the excess of its revenues less other operating expenses. Tax effects of assumed end-of-investment disposal of property. Recall that, in preparing an NPV analysis, managers include the cost of the initial investment in M&E as a cash outflow, which typically occurs at “time zero.” The NPV analysis assumes that the business disposes of the M&E in the final period of the analysis and includes the related cash inflows as a return of investment in that period. The use of M&E during the investment period may substantially exhaust its service potential. Consequently, the end-of-investment cash inflow from the assumed disposal is likely to be substantially less than its original cost. The projected net proceeds from the disposal of M&E is the assets’ projected fair value at the disposal date less any “capital gains tax,” as follows: Projected fair value of M&E Projected net proceeds (net cash inflow) from assumed end-ofinvestment sale of M&E = Income tax on "capital gain"19 – Projected fair value of M&E – Projected fair value of M&E – Projected fair value of M&E – – Projected fair value of M&E (1) Original cost – (taxable basis) of M&E Projected fair value of M&E (1) Taxable capital gain Adjusted taxable basis of PP&E – Cumulative allowable “cost recovery” through final period of NPV analysis x Combined effective income tax rate x Combined effective income tax rate x Combined effective income tax rate (1) This amount is the projected fair value of M&E in the final period of the NPV analysis – i.e., the assumed gross proceeds on disposal of M&E. _____ 18 The Topic 3-4 background paper examines the statement of cash flows (SCF). For purposes of preparing its SCF, a business reports OCF net of any interest expense on its borrowings. However, in preparing an NPV analysis, managers ignore cash outflows representing the interest costs of debt used to finance the investment. Instead, managers incorporate the cost of debt financing in their NPV analysis via the cost of capital (discount rate) used to compute the investment’s NPV. See the discussion of cost of capital, below. 19 The definition of capital asset under U.S. federal income tax law includes “almost everything owned and used for personal or investment purposes.” Examples include PP&E, real estate, intangible assets (such as intellectual property rights), and securities (e.g., stocks and bonds). Corporations pay taxes on capital gains at the regular income tax rates in effect. 17 If a business disposes of M&E after it has fully recovered the cost of the M&E via deductions in successive income tax returns, the adjusted taxable basis of the M&E will be zero at the date of its disposal. In that case, the entire proceeds represent a taxable capital gain. However, if the life of an investment is less than the socalled “recovery period” prescribed by income tax regulations, the M&E will have a remaining adjusted taxable basis at the date of its assumed disposal. In that case, the taxable capital gain is only the excess of the gross proceeds over the adjusted taxable basis of the M&E. To illustrate the income tax effect of the assumed disposal of project-specific M&E at the end of an investment’s life, recall that FirstRate Company will acquire M&E for use in making new Product Z costing $55.0 million. Management’s NPV analysis assumes a five-year investment period (corresponding to the expected economic life of the new product). However, managers determined from income tax rules published by the IRS that the equipment is “7-year class property.” As a result, the company will not fully recover the cost (i.e., original taxable basis) of the equipment through annual income tax deductions before the end of the five-year investment period. Management’s best estimate of the equipment’s fair value at the end of the five-year investment (the assumed gross proceeds upon the equipment’s disposal) is $14.0 million. The table below presents managers’ computation of the projected proceeds from the assumed sale of the equipment at the end of the investment’s five-year life, net of the related capital gain tax (cash inflow): FirstRate Company (A) (B) (C) (D) (E) (F) (G) (H) Computation of Projected Proceeds and Capital Gain Tax from Assumed End-of-Investment Sale of M&E Projected fair value of M&E in final period of NPV analysis (assumed gross proceeds) $ 14,000,000 $ 14,000,000 Original cost (taxable basis) of M&E $ 55,000,000 Cumulative allowable “cost recovery” through final period of NPV analysis Note 1 42,725,000 12,275,000 Adjusted taxable basis of M&E (B) – (C) Taxable "capital gain" (A) – (D) 1,725,000 0.40 Combined effective income tax rate 690,000 Income tax on "capital gain" (E) x (F) Projected net proceeds from assumed end-of-investment sale of M&E (A) – (G) $ 13,310,000 Note 1 - Management determined from IRS Publication 946 (obtained at www.IRS.gov) that the equipment to be acquired for this proposed project is "7-year class property," for which the cumulative cost recovery amount through year 5 is 77.69 percent of the equipment's original cost (taxable basis) In most NPV analyses, managers find it challenging to project the net proceeds from the assumed disposal of PP&E. This is because of the difficulty of estimating the fair value of:  Unique or specialized assets,  Particular kinds of used machinery or equipment for which an active dealer market does not exist, and  Assets that a business will use over a long investment period (say, more than five years) for which the factors affecting fair values are very difficult to foresee Fortunately, however, the NPV analyses for many investments may not be highly sensitive to errors in estimating these fair values because:  The service potential of PP&E may be substantially consumed during the life of an investment, reducing the assets’ end-of-life value to a small percentage of its original cost, and  The more distant the assumed net proceeds from the disposal of PP&E, the lower its present value and, therefore, its significance to the NPV of the investment. (To illustrate, the PV of $100,000 net proceeds, discounted at 10 percent, received in 5 years is about $62,000, but if received in 10 years, its PV is only about $38,500 – about 38 percent less!) 18 PP&E replacement analysis. An investment may involve principally the replacement of existing PP&E at the beginning of the investment period, with newly acquired PP&E. For such projects, managers’ NPV analysis should include, at “time zero,” the net (after-tax) cash inflow from the disposal of the existing PP&E, as well as the cash outflow representing the purchase of the new PP&E. Managers compute the net (after-tax) cash flow from the disposal of existing PP&E in the same way they project the net cash inflows from the assumed end-ofinvestment disposal of PP&E, examined above. 20 PP&E disposals resulting in capital losses. Of course, the disposal of PP&E may result in a loss for income tax purposes, rather than a taxable gain. This may occur, for example, if a business disposes of machinery before it fully recovers its cost via tax deductions on its income tax returns when the market demand for that particular kind of machinery is weak. In such cases, managers compute the net cash inflows from the disposal of PP&E in the same way that they compute the net cash inflows from disposals resulting in capital gains, explained above. However, instead of deducting a capital gain tax, the managers add the tax benefit of the capital loss to the gross proceeds. The rationale for this treatment is that the business will realize the tax benefit of the capital loss by offsetting it against its other taxable income in its income tax return for the year of the disposal. To illustrate, consider Best Products Co.’s assumed end-of-investment disposal of project-specific M&E, acquired for an original cost of $250,000 and having a “7-year Class Life” under IRS regulations. Management’s best estimate of the equipment’s fair value at the end of the five-year investment (the assumed gross proceeds upon the equipment’s disposal) is $40,000. The table below presents managers’ computation of the projected proceeds (cash inflow) from the assumed sale of the equipment at the end of the investment’s five-year life including the related income tax benefit of a projected capital loss: (A) (B) (C) (D) (E) (F) (G) (H) Computation of Projected Proceeds and Capital Loss Tax Benefit from Assumed End-of-Investment Sale of M&E Projected fair value of M&E in final period of NPV analysis (assumed gross proceeds) $ 40,000 $ Original cost (taxable basis) of M&E $ 250,000 194,200 Cumulative allowable “cost recovery” through final period of NPV analysis Note 1 55,800 Adjusted taxable basis of M&E (B) – (C) Taxable "capital loss" Combined effective income tax rate Income tax benefit from "capital loss" Projected net proceeds from assumed end-of-investment sale of M&E (A) – (D) (E) x (F) (A) – (G) 40,000 (15,800) 0.40 (6,300) $ 46,300 Note 1 - Management determined from IRS Publication 946 (obtained at www.IRS.gov) that the equipment to be acquired for this proposed project is "7-year class property," for which the cumulative cost recovery amount through year 5 is 77.69 percent of the equipment's original cost (taxable basis) _____ 20 Cases involving the trade-in of existing equipment for similar replacement equipment may be subject to IRC § 1031 (so-called “likekind exchanges”). In such cases, a taxpayer-business does not recognize a capital gain (or loss) in its tax return immediately. Instead, the business effectively reduces the original cost basis of the replacement equipment by the amount of the deferred capital gain (or increases it by the amount of any deferred capital loss). As a result, the business recognizes the gain (or loss) in succeeding years’ income tax returns in the form of lower (or higher) cost recovery deductions related to the replacement equipment. 19 Replacement of Machinery and Equipment Used in Making Existing Products Many business investment decisions do not involve the proposed introduction of new products (or services), but only the replacement of machinery and equipment (M&E) used in making existing products. M&E replacement decisions do not affect product revenues and affect only those operating costs directly related to the ownership of M&E. Therefore, managers properly ignore the unaffected revenues and costs when preparing NPV analyses for proposed replacement of M&E. Of course, equipment replacement does affect income tax cash flows, which are a component of OCF (defined above).21 Managers’ “replace versus repair” capital budgeting analysis takes the form illustrated below: Management of Company LMN is considering replacing M&E it uses to make one of its existing products. Based on their most recent review of the product’s market and technology, managers plan to continue manufacturing it for an additional 5 years.  The cost of replacement M&E is $200,000. While managers estimate the economic life of the replacement M&E is 10 years, they plan to dispose of it in 5 years (when the company winds down production of the existing product) for its projected fair value of $80,000 at that date. Managers estimate that on-going ownership costs of the replacement M&E (comprised of maintenance, insurance, and property taxes) will total $5,000 annually.  The existing M&E is 10 years old and requires major refurbishment, costing $110,000, immediately. Management estimates that ownership costs of the existing M&E (primarily maintenance) will be $12,000 annually during next 5 years and it will have no further salvage value. The company has fully recovered the cost of the existing M&E in past income tax returns filed. The company’s required rate of return (weighted average cost of capital, rWACC, discussed in the next section of this background paper) is 0.095 (or, 9.5 percent). The current “risk-free” rate, rF (also discussed in the next section) is 0.05 (or, 5.0 percent). The company’s combined effective income tax rate is 0.40 (or, 40.0 percent). Management first estimated the NPV of the replacement M&E, as follows: _____ 21 Refer to the discussion of the depreciation tax shield, above. 20 Risky cash flows (initial investment, ownership costs, and net disposal proceeds) (a) Year (n) (b) (a) - (b) Relevant Combined Tax benefit After-tax Discount before-tax effective of ownership cash factor cash flows tax rate, t costs – flows 1 / (1 + r WACC) of cost Discount after-tax recovery factor (4) cash flows (below) (2) 1 / (1 + r F ) cost cash flows recovery – (NPV) 1 (5,000) x 0.40 2,000 (3,000) 0.91324 (2,740) $ 11,424 10,880 8,140 2 (5,000) 0.40 2,000 (3,000) 0.83401 (2,502) 19,592 0.90703 17,771 15,268 20X3 3 (5,000) 0.40 2,000 (3,000) 0.76165 (2,285) 13,992 0.86384 12,087 9,802 20X4 4 (5,000) 0.40 2,000 (3,000) 0.69557 (2,087) 10,000 0.82270 8,227 6,140 20X5 (1) 5 (5,000) 0.40 2,000 (3,000) 0.63523 (1,906) 7,136 0.78353 5,591 3,686 20X5 (1) (5) 5 80,000 – – 65,856 0.63523 – 0.78353 – 41,834 10,000 $ (149,144) $ (200,000) (c) + (d) Total PV of 20X2 $ = n (d) PV of 20X1 = $ 1.00000 Tax benefit 0 $ (145,000) – $ (200,000) x (c) PV of "Time zero" Net cash flows $ (200,000) n Non-risky cash flows ("depreciation tax shield") 41,834 $ (169,686) $ x 0.95238 62,144 – $ (200,000) = $ $ 54,556 $ (115,130) (1) Analyzed in separate rows are the Year 5 (a) cash outflow for ownership costs and (b) net cash inflow from disposal of the M&E, each discounted at r WACC (2) Management determined from IRS Publication 946 (obtained at www.IRS.gov) that the replacement M&E is "7-year Class Property" and used annual cost recovery percentages set forth in the 7-year Property Class schedule to compute the annual cost recovery (income tax deduction) in each year, below. The company plans to dispose of the M&E at the end of year 5, when it winds down production and sales of the product that it uses this M&E to manufacture. (e) Cost Cost Cumulative (f) (e) x (f) Combined Tax benefit recovery recovery (3) cost effective of cost percentage (tax deduction) recovery tax rate, t recovery $ $ MS Excel formulas for discount factors Period Risky Non-risky cash flows cash flows 0 =1/(1+0.095)^0 - 20X1 1 14.28% $ 28,560 28,560 0.40 11,424 1 =1/(1+0.095)^1 =1/(1+0.05)^1 20X2 2 24.49% 48,980 77,540 0.40 19,592 2 =1/(1+0.095)^2 =1/(1+0.05)^2 20X3 3 17.49% 34,980 112,520 0.40 13,992 3 =1/(1+0.095)^3 =1/(1+0.05)^3 20X4 4 12.50% 25,000 137,520 0.40 10,000 4 =1/(1+0.095)^4 =1/(1+0.05)^4 20X5 5 8.92% 17,840 155,360 0.40 7,136 5 =1/(1+0.095)^5 =1/(1+0.05)^5 6 8.92% 17,840 173,200 – 7 8.92% 17,840 191,040 – 8 4.48% 8,960 $ 200,000 – 100.00% $ 200,000 $ 62,144 (3) Cost recovery (i.e., income tax deduction) for a given year equals the original cost (taxable basis) of M&E times the cost recovery percentage for the corresponding year (4) The tax benefit of the annual cost recovery (or, "depreciation tax shield") is discounted at the "risk-free" interest rate, rF , 0.05 (or, 5.0 percent) at the date of this analysis. (5) Computation of Projected Net Proceeds from End-of-Investment Sale of M&E (A) Projected fair value of M&E in Year 5 (assumed gross proceeds) $ (B) Original cost (taxable basis) of M&E $ (C) Cumulative “cost recovery” (tax deductions) through Year 5 [see (2) above] 80,000 $ 200,000 155,360 (D) Adjusted taxable basis of M&E upon disposal (B) – (C) 44,640 (E) Taxable "capital gain" (A) – (D) 35,360 0.40 (F) Combined effective income tax rate, t (G) Income tax on "capital gain" (E) x (F) (H) Projected net proceeds from sale of M&E at end of Year 5 (A) – (G) 80,000 14,144 $ 65,856 Management’s NPV analysis of the existing M&E, below, indicates that refurbishing and maintaining the existing M&E is less costly than replacing it. The NPV of the net costs of the existing M&E, $(93,646) is less than the NPV of the net cash outflows of the replacement M&E, ($115,130). 21 (a) Year (n) "Time zero" 20X1 20X2 20X3 20X4 20X5 5 Net cash flows (a) - (b) Relevant Combined Tax benefit After-tax Discount before-tax effective of ownership cash factor cash flows 0 1 2 3 4 (b) tax rate, t $ (110,000) x (12,000) (12,000) (12,000) (12,000) 0.40 0.40 0.40 0.40 0.40 (12,000) $ (170,000) 0.40 costs = $ $ flows 44,000 $ (66,000) x 4,800 (7,200) 4,800 (7,200) 4,800 (7,200) 4,800 (7,200) 4,800 (7,200) 68,000 $ (102,000) PV of aftertax cash n 1 / (1 + r WACC) flows (NPV) 1.00000 $ (66,000) 0.91324 (6,575) 0.83401 (6,005) 0.76165 (5,484) 0.69557 (5,008) 0.63523 (4,574) $ (93,646) Based on the comparative results of these NPV analyses, the company should retain and refurbish the existing M&E, rather than replace it. 22 Choosing Between Alternative Machinery and Equipment Having Unequal Lives and Costs Some M&E acquisition decisions involve mutually exclusive choices between different M&E that provide essentially the same functions, but have unequal economic lives and costs that may arise from differences in quality, recurring ownership costs, or market factors. Of course, nonfinancial factors may properly affect a manager’s choice. However, in order to make a financial comparison of M&E having unequal lives and cash flows, managers compare the equivalent annual costs (EAC) of the alternative M&E. In order to determine the EAC of M&E, managers begin by computing the NPV of the relevant cash flows. The relevant cash flows include:  The required initial investment (cost of M&E),  Periodic ownership costs (including maintenance, property taxes, and insurance) during the economic life of the M&E, net of related income tax benefits resulting from the deductibility of these costs,  The tax benefits of annual cost recovery (the “depreciation tax shield”), and  The projected end-of-life salvage (disposal) value of the M&E (if any), net of related capital gains tax 22 Then, using the PVannuity equation examined in the Topic 5 background paper (with slight algebraic rearrangement), managers compute the periodic cash outflow of an annuity whose PV, number of periods (n), and discount rate, rWACC (the required rate of return) are identical to those parameters in the preceding NPV computation: Periodic cash outflow (EAC of replacement M&E) = PVannuity ÷ 1– 1 (1 + rWACC)n rWACC where, rWACC is the business’ required periodic rate of return (weighted average cost of capital, examined further below) and n is the number of periods corresponding to the economic life of the M&E Managers compute the EAC of each M&E alternative and select the alternative having the lowest EAC. To illustrate, consider a manager’s analysis of two alternative machines she is considering for a particular product assembly plant of Company PQR. Machine A and Machine B provide similar functions. However, the machines have different acquisition costs, economic lives, regular maintenance and other ownership costs, and end-of-life salvage values, as summarized in the table, below. The company’s required rate of return (weighted average cost of capital), rWACC, is 0.105 (or, 10.5 percent). Functionally similar alternatives Machine A Acquisition cost (initial investment) Economic life (years) Annual costs of maintenance, insurance, and property taxes Projected end-of-life salvage value $ $ $ 175,000 10 4,000 30,000 Machine B $ 125,000 7 $ 7,500 $ 10,000 For ease of demonstration, this illustration ignores income taxes (including cost recovery deductions, the tax deductibility of regular ownership costs, and capital gains taxes upon the machine’s disposal). _____ 22 In preparing such analyses, managers use real, rather than nominal, cash outflows corresponding to the existing and proposed replacement equipment. 23 Machine A Relevant Year (n) 0 1 Machine B Discount Relevant cash factor (1) Discounted flows (1) 1 / (1 + r WACC)n cash flows $ (175,000) x (4,000) Year (n) 1.00000 = $ (175,000) 0.90498 (3,620) 0 1 Discount cash factor (1) Discounted flows (1) 1 / (1 + r WACC)n cash flows $ (125,000) x (7,500) 1.00000 = $ (125,000) 0.90498 (6,787) 2 (4,000) 0.81898 (3,276) 2 (7,500) 0.81898 (6,142) 3 4 5 (4,000) (4,000) (4,000) 0.74116 0.67073 0.60700 (2,965) (2,683) (2,428) 3 4 5 (7,500) (7,500) (7,500) 0.74116 0.67073 0.60700 (5,559) (5,031) (4,552) 6 7 8 (4,000) (4,000) (4,000) 0.54932 0.49712 0.44989 (2,197) (1,988) (1,800) 6 7 7 (7,500) (7,500) 10,000 0.54932 0.49712 0.49712 (4,120) (3,728) 4,971 9 10 10 (4,000) (4,000) 30,000 0.40714 0.36845 0.36845 (1,629) (1,474) 11,053 Net cash flows $ (185,000) NPV $ (188,006) Net cash flows $ (167,500) NPV $ (155,949) (1) The discount rate is company's required rate of return, r WACC: 0.105 (or, 10.5%). See MS Excel formulas for periodic discount factors, below Equivalent annual cost (EAC) = NPV Annuity discount factor = NPV Equivalent annual cost (EAC) = = n $ 188,006 = 10 $ 188,006 $ (1 – 1 / (1+.105) ) / .105 = $ 6.014773 = $ 31,257 155,949 7 (1 – 1 / (1+.105) ) / .105 = NPV (1 – 1 / (1 + r WACC)n) / r WACC (1 – 1 / (1 + r WACC) ) / r WACC = NPV Annuity discount factor 155,949 4.789303 = $ 32,562 MS Excel formula for annuity discount factor =(1-1/(1+.105)^10)/.105 =(1-1/(1+.105)^7)/.105 MS Excel formulas for discount factors =1/(1+0.105)^0 =1/(1+0.105)^1 =1/(1+0.105)^2 =1/(1+0.105)^3 =1/(1+0.105)^4 =1/(1+0.105)^5 =1/(1+0.105)^6 =1/(1+0.105)^7 etc. Because the EAC of Machine A, $31,257, is less than that of Machine B, $32,562, the manager should select Machine A, unless she concludes nonfinancial considerations out-weigh the $1,305 EAC “advantage” of Machine A. 24 Using Internal Rate of Return (IRR) to Supplement NPV Analysis The internal rate of return (IRR) from an investment is that discount rate which results in an NPV of zero. To clarify IRR, reconsider the illustration in the Topic 5 background paper in which managers of Company XYZ proposed that the company acquire an additional drill press, making it possible for the company to increase its production and sales and resulting in projected additional operating cash flows (OCF) in each of the next five years, at right: The equipment will cost $640,000 to purchase and install. Management estimates that its economic life will be five years, after which it will have no residual value. Year Projected increase in OCF 20X1 $150,000 20X2 180,000 20X3 200,000 20X4 170,000 20X5 140,000 Total $840,000 The analysis assumes that the projected increases in OCF occur at the end of years indicated. Recall that this analysis includes the initial investment (the cost of the drill press) as a negative cash flow at “time zero” and managers do not discount cash flows occurring at the outset of an investment (i.e., the discount factor is 1.0). Year (n) Relevant Discount cash factor flows n = formulas for cash flows discount factors (640,000) =1/(1+0.0990326)^0 0 20X1 1 150,000 0.90989 136,484 =1/(1+0.0990326)^1 20X2 2 180,000 0.82790 149,022 =1/(1+0.0990326)^2 20X3 3 200,000 0.75330 150,660 =1/(1+0.0990326)^3 20X4 4 170,000 0.68542 116,522 =1/(1+0.0990326)^4 20X5 5 140,000 0.62366 87,312 =1/(1+0.0990326)^5 200,000 1.00000 Discounted 20X0 Net cash flows (640,000) x 1 / (1 + r ) MS Excel 9.90326% IRR 0 NPV The function (formula) in the MS Excel spreadsheet cell that displays the IRR of the relevant cash flows, .0990326 (or, 9.90326 percent) above is: =IRR(values,guess) where “values” is usually a range of cells within a spreadsheet column or row that contain the net cash flows for “time zero” and each of years 1 through n (where, in the case of a five-year investment, n = 5)23, and “guess” is the manager’s initial guess at the actual IRR that the spreadsheet function computes using a trial-and-error (iterative) process24 The related illustration in the Topic 5 background paper indicates Company XYZ’s required rate of return is 9.5 percent. Because the IRR of the proposed investment (9.90 percent) is equal to or greater than the required rate of return (cost of capital), managers should accept the investment proposal. This conclusion is the same as that reached in the original NPV analysis (refer to the Topic 5 background paper) in which the computed NPV is $6,619 – i.e., greater than or equal to zero. _____ 23 In the illustration above, the range of cells used in the IRR function are those in the “relevant cash flows” column, beginning with $(640,000) and continuing through $140,000. 24 Before financial calculators and computer spreadsheets made it possible to compute the IRR of an investment quickly and easily, managers performed these computations “by hand” using a time-consuming trial-and-error (iterative) approach. Financial calculators and spreadsheets compute IRR using trial and error, as well, but much faster. 25 The general decision rules in capital budgeting analysis using IRR are:  If the IRR of a proposed investment equals or exceeds the business’ required rate of return (cost of capital), accept the proposal because its NPV is greater than or equal to zero (recall that positive-NPV investments increase the value of a business to its owners)  If the IRR of a proposed investment is less than the business’ required rate of return (cost of capital), reject the proposal because its NPV is negative (and negative-NPV investments destroy business value) Weaknesses of IRR (or, “Why clever managers use IRR only to supplement their NPV analyses”). While the IRR model for capital budgeting acknowledges opportunity costs, including the time-value of money, it suffers from conceptual weaknesses that do not impair the NPV model. Comparing alternative investments and implied rate of return on reinvested cash flows. If managers compare alternative investment opportunities of unequal lives (say 5 years and 10 years, respectively), the IRR model implicitly assumes that a business is able to reinvest the cash flows generated by the shorter-lived investment at the IRR of that project.25 In contrast, the NPV model implicitly assumes that the business is able to reinvest these cash flows at the company’s required rate of return (cost of capital). As a result, when managers compare investments that each promise an IRR greater than the business’ required rate of return, the IRR model portrays the shorter-lived investment more favorably than the longer-lived alternative, even though the NPV of the longer-lived project may exceed the NPV of shorter-lived project. A similar problem with using IRR to compare alternative investments may occur when the investments have similar lives, initial investment cash outflows, and total undiscounted cash inflows, but significantly different cash inflow patterns. For example, one investment may produce a significant portion of its cash inflows early in the life of the investment, while the alternative investment may produce a significant portion of its cash inflows late in the life of the investment. In this situation, the IRR of the investment having significant early cash inflows will exceed the IRR of the investment having significant late cash inflows. However, depending on the business’ required rate of return (cost of capital), the NPV of lower-IRR investment may exceed the NPV of the higher-IRR investment. These situations may lead managers to make improper choices among alternative investments when those opportunities are mutually exclusive26 or when capital rationing is necessary.27 _____ 25 The assumption that a business can reinvest cash flows generated by “high-IRR” investments at this same “high” rate of return may be unrealistic, as well. Consider a five-year investment proposal promising an IRR of 30 percent (wow!) to a business whose required rate of return (cost of capital) is 12 percent. Now, contemplate this question: As the manager responsible for proposing this “home run” opportunity, are you prepared to stake your bonus or next promotion on the promise of finding another “30 percent IRR” project into which your company can reinvest the cash flows from the first such “winner”? Most finance and many managerial accounting texts also describe the use of incremental NPV and incremental IRR, as an alternative to comparing the NPV individual investments, to compare mutually exclusive investments. 26 Mutually exclusive projects include, for example, a “large” manufacturing facility designed to make Product X and a “small” manufacturing facility built to make the same product – that is, if managers invest in the small facility, they will not build the large one, and vice versa. As another example of mutually exclusive projects, if a business owns a vacant building, it may use it as a warehouse, assembly plant, or administrative offices (each of a size adequate to use the entire building), but may use it for only one of these purposes. 27 The Topic 5 background paper examines the need for managers to rank investment opportunities when a business must ration a fixed amount of available financial capital during a normal operating cycle (such as, one year). 26 Investments requiring significant cash outflows after period(s) of net cash inflows. An investment opportunity may have more than one IRR if it requires significant cash outflows in a period subsequent to the first period that follows “time zero.” Examples of these investments include projects involving significant end-of-life asset retirement obligations (ARO), such as waste landfill sites, surface mines, or nuclear power plants. Federal or state laws or regulations are usually the source of an ARO. In such situations, none of the investment’s multiple IRRs is meaningful. Growth in business’ value from new investments. In spite of its weaknesses, many managers find the IRR model appealing. The popularity of the IRR model may derive from the fact that it summarizes the results of capital budgeting analysis in a single rate, say 12.5 percent, that managers may readily compare to other rates of return – say, the current yield on five-year U.S. Treasury securities, or the total rate of return on largecompany stocks. In contrast, the NPV model yields a currency (e.g., U.S. dollar) amount – say, $10,000 or $10,000,000 – that managers cannot immediately compare to a market index or an industry norm. Recall that NPV measures the increase in a business’ value resulting from an investment’s promised profits (return) in excess of the business’ cost of financing the project. This realization suggests that managers may meaningfully relate the NPV of investment opportunities to the business’ value without them: Percent growth in business’ value attributable to new investment = NPV of accepted project Value of business before the decision to accept the project 28 To illustrate, the managers of a business whose current fair value is $100 million may increase that value by 5 percent by accepting an investment opportunity having a positive NPV of $5 million. _____ 28 For publicly traded companies (i.e., companies who common stock is listed and traded on a nationally recognized exchange) the price of the company’s stock on a given date times the number of such shares then outstanding indicates the company’s fair market value on the given date. 27 Learning Objective 1 The Cost of Capital As stated in the Topic 5 background paper, businesses make investments in PP&E, product research, manufacturing technology and processes, and other firms. Of course, businesses expect to earn a profitable return on these investments. They finance the acquisition of these investments with the cash flows they generate from their daily operations and a variety of equity and debt financial instruments. Equity instruments include principally common stock and preferred stock. Examples of debt instruments include corporate bonds and notes issued to financial institutions in connection with loans. Bonds and notes may be either collateralized or unsecured. Financial capital – in the form of equity or debt – comes to businesses at a cost (after all, the providers of financial capital expect a return, too). Profitable investments increase the value of a business to its owners. In order for its investments to be profitable29, a business must earn a return on its investments that exceeds its cost of capital. The cost of capital takes the form of:    Interest that businesses pay on borrowings, such as notes issued to financial institutions, Dividends or other distributions that businesses pay to their common and preferred stockholders, and Appreciation in the value of (or, capital gain from) shares held by common stockholders As examined earlier in this background paper and in the Topic 5 background paper, managers quantify investment returns in terms of rates or percentages – say, an IRR of 12 percent – and measure the profitability of proposed investments by computing their net present value (NPV) – say, $2.5 million. Recall that managers compute the NPV of an investment opportunity by discounting its expected incremental cash flows at the business’ required rate of return. In turn, the business’ required rate of return equals its cost of capital. Just as with investment returns, managers express a business’ cost of capital in terms of rates or percentages – say 10 percent.30 So that you’re less likely to get confused by the various symbols referring to rate of return examined in this section, the table below lists them in one place with their definitions: rE Owners’ expected (required) rate of return on a business’ equity capital (corporate common stock) and the business’ cost of equity capital rD A business’ current interest rate (cost) on its borrowings, such as bonds and notes rF The “risk-free interest rate” on U.S. government securities, used to estimate rE, as explained below rM The expected rate of return on a “market portfolio” of all “risky assets” available in the economy, used to estimate rE, as explained below (a commonly used proxy for the “market portfolio” is the Standard & Poor’s’ 500 index of the stocks of the 500 largest corporations, in terms of market valuation, listed on U.S. stock exchanges) rWACC A business’ weighted-average cost of capital, computed using rE and rD, as explained below _____ 29 Courses in business strategy and marketing examine the devices managers use to develop profitable businesses. These include (for example) product differentiation (by pursuing appealing product features, product placement, customer service, and advertising); reducing product costs in order to “compete on price” (for example, by achieving a production scale large enough to gain bargaining power with suppliers or to “leverage” fixed operating costs, as discussed in the Topic 1-2 background paper); and obtaining product technology leadership by emphasizing research and development. 30 A useful analogy to the cost of financial capital is the rent a business pays a building owner for the use of office space during the term of a lease. In a similar manner, managers regard the interest a business pays to its bondholders as “rent” for the use of that capital. 28 Investment Risk, Beta, and the Cost of Equity Capital Most students in this course immediately accept the notion that, the higher the level of risk inherent in an investment, the greater is the rate of return (discount rate) an investor will demand for making the investment and undertaking its risk. Managers assess the riskiness of investments made by a business by evaluating the uncertainty of the investments’ expected cash flows. In a similar manner, investor’s in the business’ common stock assess the riskiness of the stock by measuring the volatility of the stock’s price31 relative to that of the overall market for all “risky assets” in an economy, including stocks. The covariance (a common statistical measurement) of changes in the return on a stock with changes in the return on all market assets, called beta (β), measures the individual stock’s relative volatility and its contribution to the riskiness of a diversified portfolio of risky assets. Because investors can construct diversified investment portfolios with relative ease, the market will not reward investors in a particular stock with a higher return in exchange for taking on that portion of a stock’s risk that investors can eliminate by diversifying, called diversifiable (or “nonsystematic”) risk. Beta (β) is a measurement of the remaining, nondiversifiable (or, “systematic”) risk, for which the market will reward an investor with a return.32 Investors’ expected rate of return on a company’s stock provides its managers with the required rate of return on the business’ investments of equity capital in new projects. Using the widely accepted Capital Asset Pricing Model (CAPM)33, managers may estimate the required (expected) rate of return on their company’s equity (common stock), rE, as follows: Expected rate of return on a stock, rE = Risk-free interest rate, rF + β x ( Expected rate of return on the “market portfolio,” rM – Risk-free interest rate, rF ) where,  rF is the credit risk-free interest rate, generally regarded as the expected long-run average rate of return on U.S. government (Treasury) notes or bonds with medium-to-long-term maturities  β measures the riskiness of a particular stock – that is, the volatility of the stock’s price relative to that of the overall market for all “risky assets,” including stocks. As indicated above, managers calculate β as the covariance of changes in a stock’s market price with changes in the value of a market index, usually the S&P 500 index) 34, and  rM is the expected rate of return on the “market portfolio,” which managers generally interpret as the long-run expected total rate of return from a portfolio comprised of all or most publicly traded common stocks. A commonly used proxy for the “market portfolio” is the Standard & Poor’s 500 index of the stocks of the 500 largest corporations (in terms of market valuation) listed on U.S. stock exchanges. _____ 31 Technically, investors assess the riskiness of the stock of a publicly traded company by measuring the volatility of its total return, comprised of capital gains or losses (i.e., stock price changes) and dividends. However, because the dividends of most companies do not exhibit significant volatility, the discussion of volatility (risk) usually focuses on stock prices changes, alone. 32 Courses in investments and portfolio management examine in detail systematic and nonsystematic risk, beta, and the Capital Asset Pricing Model. Historically, the standard deviation of returns for individual common stocks has averaged “around” 50 percent, while the standard deviation of returns for the S&P 500 stock index (a useful proxy for a portfolio comprised of all risky assets) has historically been less than 25 percent. So, diversification substantially reduces, but by no means eliminates, investment risk. The residual risk in a well-diversified portfolio is the systematic kind. According to capital market theory, the required (expected) return on stocks compensates investors for taking on this residual risk. Examples of systematic risk include inflation and recession, which effect most businesses to some extent. Examples of nonsystematic risk include the sudden death of a business’ highly regarded and successful president-and-CEO, and an unexpected negative decision from the U.S. FDA regarding a new drug about which a pharmaceutical business previously announced it was “highly optimistic” based on the results of clinical trials. 33 Other courses in finance, investments, and portfolio management examine another well-known model for estimating the required (expected) rate of return, called Arbitrage Pricing Theory. 34 Courses in investments and portfolio management examine the computation of historical beta for the stock of publicly traded companies. However, most managers simply look up these betas on one of several financial Web search engines (such as, http://finance.yahoo.com/). While historical betas are easy to obtain, the CAPM actually calls for the expected future beta that is presently unknown, simply because investors cannot know future changes in stock price in advance (unless they happen to be coconspirators of Gordon Gekko). Therefore, historical betas are proxies for (estimates of) future betas. Fundamentally, the beta of a company’s stock depends on the riskiness of the underlying business itself. For example, a business whose sales and net income are highly susceptible to changes in overall economic conditions or technology will have a higher beta than a business that is “noncyclical” or not technology-dependent. 29 In the CAPM, above, managers refer to the term, ( Expected rate of return on the market portfolio, rM – Risk-free interest rate, rF ) as the market risk premium. A stock for which β is:  Equal to 1.0 has systematic (nondiversifiable) risk identical to that of the market as a whole; as a result, rE for this stock equals rM  Less than 1.0 has less systematic risk than the overall market; as a result, its expected return will reflect a risk premium, β x (rM – rF), less than the market risk premium and rE for this stock is less than rM  Greater than 1.0 has more systematic risk than the overall market; as a result, its expected return will reflect a risk premium, β x (rM – rF), exceeding the market risk premium and rE for this stock exceeds rM To illustrate, the expected rate of return on the stock of FirstRate Company, rE, whose β is 1.5 at a time when managers estimate rF is 0.04 (or, 4.0 percent) and rM is 0.125 (or, 12.5 percent) is: 0.04 + 1.5 x (0.125 – 0.04) = 0.1675 (or 16.75 percent) A business that has no debt finances its investments entirely with equity capital. For those relatively few businesses that have no debt, the required (expected) rate of return on their equity capital, rE, provides their cost of capital, and the discount rate for evaluating proposed investments).35 Cost of equity capital and beta for unrelated investments. The current beta, β, of a business reflects the relative riskiness of the industry in which the business already operates and its relative susceptibility to other generalized risks, such as possible changes in technology, regulation, government fiscal policy, interest rates, purchasing power of currencies in which it conducts its business, and other economic factors. If a business that has operated in a particular industry is contemplating an investment in a different industry, managers should estimate the cost of equity for the proposed investment using the beta of a business already operating in the new industry. For example, for the past 20 years, Company STR has operated solely in the health care services industry. However, managers are contemplating a new division that will develop and manufacture medical equipment. Managers should estimate the cost of equity capital for the proposed division using the beta (β) of a publicly traded company already operating in the medical equipment manufacturing industry, rather than use the company’s current beta for this purpose. _____ 35 Some students who know a bit about stocks when they begin their first finance or accounting course are a bit circumspect about the proposition that an investor’s required rate of a return on a company’s common stock represents a cost of equity capital to the company. After all, no law requires corporations to pay dividends on their common stock (and, in fact, many companies do not pay dividends), nor is there a requirement that corporations repurchase the stock from stockholders. In that case, stockholders get their return from market appreciation in the stock’s price – that is, the market, rather the corporation issuing the stock, provides the return to stockholders, right?” Well, not exactly. The reason is opportunity cost, examined in the Topic 5 background paper. If a corporation does not make positive-NPV investments – the source of growth in the business’ value – disillusioned investors in the business’ stock will sell it, driving its price down, and seek out the stocks of more promising businesses. And, just ask the CEO of any company whose stock price has been falling despite managers’ attempts to reverse that trend – and who hoped to issue additional shares in the near future to finance new projects – whether she thinks equity has a real cost. You’ll get an “ear full.” 30 Cost of Capital for a Business with Financial Leverage Only a small minority of businesses finance their investments with equity capital only. The great majority of businesses have some amount of debt, in the form of bank borrowings, bonds, “revolving” commercial paper, equipment leases, and so forth). Businesses’ that finance their investments with debt, in addition to owners’ equity, use financial leverage. For businesses that finance their investments with a combination of equity and debt, the weighted average cost of capital, rWACC, provides the appropriate discount rate for evaluating investment opportunities:36. Business’ weighted average cost of capital = Business’ cost of equity capital, rE x Portion of business’ total capital that is equity, E + Business’ current cost of debt, rD, after-tax x Portion of business’ total capital that is debt, D rWACC = rE x E / (D + E) + rD x (1 – t) x D / (D + E) where, E is the fair value of the business’ common equity capital, D is the fair value of the business’ debt capital (such as bonds and notes), rD x (1 – t) is the current market rate of interest on the business’ debt, net of the related income tax benefit, t is the business’ combined effective income tax rate (as discussed earlier in this background paper), and The sum of the weights, E / (D + E) and D / (D + E), equals 1.0 To illustrate, the capital of FirstRate Company includes common equity having a current fair value of $30,000,000 and debt (bank notes and bonded debt) with an estimated current fair value of $20,000,000. Using the CAPM, managers’ current estimate of the company’s cost of equity capital, rE, is 0.1675 (or, 16.75 percent) (see previous illustration). Management’s estimate of the company’s current cost of debt rD is 0.08 (or 8.0 percent). The company’s combined effective income tax rate, t, is 0.40 (or, 40.0 percent). Management estimated the company’s weighted-average cost of capital, rWACC, as approximately 12 percent, as follows: 0.1675 x $30 million / ($20 mill. + $30 mill.) + 0.08 x (1 – 0.40) x $20 million / ($20 mill. + $30 mill.) = 0.12 (rounded) Corresponding MS Excel formula is =0.1675*30/(20+30)+0.08*(1-0.4)*20/(20+30) Effect of financial leverage on a business’ weighted average cost of capital. In the equation for rWACC, above, the term, D / (D + E), quantifies the extent of a business’ financial leverage. Holding constant a business’ total capital, as the portion of this total represented by debt, D, increases, so does the business’ financial leverage. _____ 36 For a firm whose capital structure includes preferred stock, in addition to common stock and debt, rWACC becomes: rWACC = rE x E / (D + E + P) + rD x (1 – t) x D / (D + E + P) + rP x P / (D + E + P) where, P is the fair value of the business’ preferred stock, rP is the dividend rate specified on the business’ preferred stock The sum of the weights, E / (D + E + P), D / (D + E + P), and P / (D + E +P), equals 1.0 31 In the illustration above, note that FirstRate Company’s weighted average cost of capital, rWACC, 12.0 percent, is less than its cost of equity capital, rE, alone, 0.1675 (or 16.75 percent). Indeed, rWACC is less than rE for nearly all businesses that use debt. This is because the cost of debt is usually less than the cost of equity, for two primary reasons:  Interest tax shield. Unlike dividends37 paid on common stock, businesses may deduct the cost of interest on debt in determining their taxable income under U.S. federal and state income tax laws. As a result, a borrower’s effective borrowing cost, rD x (1 – t), is less than the nominal or stated interest rate in a note agreement or bond indenture.  Priority claim in bankruptcy. Debt is generally less risky for the lenders (including banks and bondholders) than common stock is for equity investors because (unlike common equity) debt is often secured (or, collateralized) by assets of the borrowing business, the personal guarantees of parties affiliated with the borrower, or both. Even unsecured debt is generally less risky than common stock because, in the event, of bankruptcy by the borrowing business, unsecured creditors (lenders) have a higher-priority claim against the assets of the business under the terms of borrowing agreements and U.S. federal bankruptcy law. When projecting the cash flows used in capital budgeting analysis, managers ignore the financing cash flows, including the interest costs of debt (that is, managers use “after-tax, unlevered cash flows”). Instead:  Managers incorporate the cost of debt financing into their NPV analysis via rWACC, the discount rate used to compute the NPV of investment opportunities, and  When estimating a business’ rWACC, managers use a business’ after-tax cost of debt financing, rD x (1 – t) because this is consistent with the use of after-tax cash flows in an NPV analysis, as examined earlier in this background paper To illustrate, suppose that managers recently approved a plan to “recapitalize” FirstRate Company by issuing $10 million in bonds and use the bond proceeds to repurchase an equivalent amount of the business’ common stock. In that case, the company’s rWACC declines from 12 percent) to about 9.6 percent, while its financial leverage increases by one-half from 0.40 [$20 million / ($20 million + $30 million)] to 0.60 [$30 million / ($30 million + $20 million)]: 0.1675 x $20 million / ($30 mill. + $20 mill.) + 0.08 x (1 – 0.40) x $30 million / ($30 mill. + $20 mill.) = 0.096 (rounded) Corresponding MS Excel formula is =0.1675*20/(30+20)+0.08*(1-0.4)*30/(30+20) FirstRate Company’s recapitalization will achieve a (roughly) 20 percent decrease in the company’s weighted average cost of capital, rWACC (0.024 reduction / 0.12). However, it will also increase its financial leverage by 50 percent. The relative cost advantage of debt explains the attractiveness of financial leverage. The Topic 8 background paper further examines the benefits and risks of financial leverage, in terms of its effects on accounting-based measurements of investment returns and capital structure. _____ 37 U.S. tax law provides for the exclusion from taxable income of a corporation certain dividends received from other corporations. Courses in income taxation examine these provisions of the U.S. IRC. 32 Targeted capital structure. The time frame for which managers estimate a business’ cost of capital must be consistent with the duration of its portfolio of investments. For example, it would be inappropriate for managers to prepare an NPV analysis for a proposed 15-year investment in a new business unit using a discount rate (required rate of return) that does not correspond with managers’ expected long-term capital structure. Suppose managers discounted the expected cash flows from this 15-year investment using a business’ current rWACC and the computed NPV of the proposed new business unit is positive. Based on that analysis, managers accepted the investment proposal. However, suppose managers separately adopted a plan to reduce the business’ financial leverage to a level in line with industry norms and responsive to a somewhat pessimistic economic forecast. As part of its recapitalization plan, the business issued new common stock and used the proceeds from the stock to pay off some of its bank loans and complete a tender offer for some of its outstanding bonds. As a result, the business’ rWACC rose and, in retrospect, the NPV of the new business unit is negative, rather than positive. The financial consequences of its long-term commitment to an unprofitable (valuedestroying) investment may be severe for the business. Therefore, it is important that the values for the weights, E / (D + E) and D / (D + E), reflect managers’ targeted capital structure for the business. If necessary, when estimating a business’ rWACC, managers should adjust these weights based on their expectations or plans for the company’s capital structure.38 Fair value of equity and debt capital. Subject to possible adjustment to the weights as explained above, the equation for computing a business’ rWACC, above, uses the current fair value of its equity and debt capital, rather than the stated (contractual or par) value of these instruments or their “carrying amounts,” as reported in the business’ balance sheet. This is because fair values are:   Relevant for financial analysis (including capital budgeting analysis), as examined in the Topic 3-4 background paper, and Consistent with the definitions of the cost of equity capital, rE, and cost of debt capital, rD, used in the equation, which represent the current market costs of capital to the business _____ 38 As stated above, the capital structure of most businesses includes both equity and debt capital. Except in special circumstances, it is not appropriate for these businesses to discount the cash flows from an investment proposal using only the cost of its equity, debt, or certain components of its debt capital. There are at least two reasons for this.  First, a business represents a portfolio of investments (projects) entered into at various dates, requiring differing amounts of initial cash outflows, and having varying durations. Similarly, a business’ capital financing represents a portfolio of equity and debt instruments issued on varying dates, at varying amounts, and with varying maturity dates. Due to mismatches in dates, amounts, and durations between investments and financing components, it is not practical to match particular investments with particular financing components. While managers take into account the riskiness and duration of current and prospective investments when establishing a business’ capital structure, it is impractical for them to complete new financings in anticipation of every accepted investment. As a result, businesses raise long-term financial capital before they have a clear view of the precise nature, timing, size, and duration of most future investments.  Second, imagine the “knock-down, drag-out” arguments that would erupt between managers if a business attempted to pick from its business’ balance sheet the source of financing for each projects. Of course, every manager would claim priority on the business’ lower-cost debt, and the business’ relatively costly equity capital would immediately become the “ugly stepsister” that no manager would want because, discounted at rE (rather than rWACC or rD) the NPV of many proposed investments would quickly become negative. However, when businesses finance their acquisitions of PP&E with mortgage notes or equipment leases, it is appropriate to assign this financing (and its cost) entirely to the investments to which the acquired PP&E belongs. This is because this financing is directly linked (by contractual instrument) to identifiable assets serving as collateral (security) for the money borrowed under the financing arrangement. 33  Fair value of common equity. Determining the fair value of the equity capital of a company whose common stock is not publicly traded on a national securities exchange is problematic. This is because there is no readily observable market price for a share of stock that managers can use to compute quickly the fair value of all shares of common stock held by stockholders. Managers can retain valuation experts to determine the fair value of business’ equity; however, this is costly and time-consuming.39 And, common stockholders’ equity, as reported in the business’ balance sheet is usually a very poor indicator of its fair value because of the limitations on the usefulness of financial statements examined in the Topic 3-4 background paper)40. Students may learn the methodologies that managers use to estimate the fair value of a business’ common equity in MBA A602, Interpreting Accounting Information, and MBA F602, Financial Decision-making, in additional to other graduate finance courses.41  Fair value of debt. The fair value of publicly traded corporate bonds is usually observable from published bid-and-ask prices on exchanges or from large investment firms that “make a market” as dealers in these securities. However, bank debt and bonds issued by some corporations are not actively traded and, consequently, managers are not able to determine the fair value of these instruments from observable prices. Fortunately, the Topic 5 background paper examines the methodology that managers use to estimate the fair value of a business’ debt in the form of bonds and bank notes. _____ 39 Some of the reasons that businesses retain professional valuation experts relate to planned sales or acquisitions of businesses, litigation (including disputes with income tax authorities), and estate planning by owners of closely held businesses. 40 Note, too, that the capital structure (relative amounts of total capital financing comprised of debt and common equity) indicated by a business’ latest balance sheet is not necessarily an indicator of managers’ targeted capital structure for the business. 41 Not surprisingly, several of these methods rely on the discounted present value of payoffs in the form of dividends to stockholders, levered or unlevered cash flows to the business, or “residual income” to the business. 34 Learning Objective 4 Capital Budgeting Controls and Non-financial Factors Conflict between Cash Flow-based Capital Budgeting and Accrual-based Financial Ratios The Topic 8 background paper examines financial ratio analysis. One category of these ratios examines return on investment, focusing on two such ratios:   Return on assets (ROA) ratio, and Return on common stockholders’ equity (ROCE) ratio42 Return on assets (ROA) ratio = [Net income + Net interest expense x (1 – Effective income tax rate)] Average total assets Return on total common equity (ROCE) ratio = (Net income – Dividends on any preferred stock) Average total common stockholders’ equity The Topic 8 background paper examines the computation and interpretation of these ratios using the accrual basis financial statements examined in the Topic 3-4 background paper. In the meantime, note that:  The owners and board members of a business will rate the performance of managers who are responsible for business units (investments) more highly, the higher are the ROA and ROCE ratios of those business units (holding all other performance assessment factors constant).  The numerator of these ratios uses the business’ reported net income. Even for positive-NPV investments, in the early years of a new product or business unit, depreciation of investments in PP&E may be significant compared to operating cash flows (OCF), thereby reducing business unit net income, along with the ROA and ROCE ratios. Immediate expensing of R&D project costs (as described in the Topic 3-4 background paper) has a similar effect on reported net income.  The denominators of these ratios include total assets and total common stockholders’ equity, respectively. Additional investments increase the amount of total assets for which managers are responsible and the amount of common equity allocated to the business units holding those investments. This has the effect of reducing the ROA and ROCE ratios of affected business units. _____ 42 The Topic 3-4 background paper examines the elements of financial statements, including assets and stockholders’ equity. Within the context of an incorporated business, the owners’ residual claim on assets takes the form of common stockholders’ equity. 35 These observations highlight an apparent contradiction between the orientations of: □ Discounted cash flow-based NPV analyses used to approve proposed individual long-term projects for which the analyses demonstrate that the return on investment exceeds the business’ cost of capital – that is, the investment will increase the value of the business to its owners (assuming competently prepared NPV analyses), and □ Accrual accounting-based financial ratio analyses (in particular, ROA and ROCE ratios) used to evaluate actual aggregate short-term business unit performance results of managers responsible for these investments and the business units holding those investments Capital budgeting analysis Financial ratio analysis Information used  Discounted cash flows  Accrual accounting Primary purpose  Approval of proposed investments  Evaluation of actual financial performance Unit of analysis  Individual investments  Aggregate business unit Time frame  Long-term (several to many years)  Short-term (one year or less) These conflicting orientations may lead managers to avoid making significant investments promising positive NPV (increase in the business’ value) if, as is common, businesses base the evaluation of managers’ performance and annual incentive-based compensation on accrual accounting-based measurements. Managers’ avoidance of profitable investments represents real earnings management, examined in the Topic 3-4 background paper. One way to reduce this practice is to base managers’ performance evaluations on the actual performance of investments for which they are responsible, in addition to accounting-based measurements. Evaluations of an investment’s actual performance requires that a business periodically compare actual cash flows related to the investment with the projected cash flows set forth in the NPV analysis prepared prior to its acceptance. In order to ensure that such comparisons are effective, businesses must implement controls over both the capital budgeting and subsequent accounting processes.43 Controls Over Capital Budgeting A business’ cost of capital and the projected relevant cash flows from a long-term investment are forwardlooking estimates. Consequently, the capital budgeting process is subject to purposeful manipulation by managers. The motivations for such manipulation include “empire building,” promotions, and incentive-based compensation. Investment decisions may be highly sensitive to changes in estimates of the cost of capital and projected cash flows. Given the significant size and long duration of many of these investments, inappropriate investment decisions may have serious financial consequences for a business. Therefore, it is critical that managers install controls over the capital budgeting process. Controls over the capital budgeting process include formal processes for preparing, reviewing, and approving investment proposals. As with their operating budgets, businesses typically prepare their capital budgets annually in advance of the fiscal year to which they relate. Businesses usually require their board of directors, president, and chief executive officer to approve annual operating budgets and capital budgets. Of course, the projections of OCF, depreciation of investments in PP&E, and investments in net working capital directly affect the operating budget. Therefore, businesses must carefully coordinate their preparation. As indicated above, periodic comparison of actual and budgeted amounts, including related investigation and reporting of reasons for the differences, is a critical control procedure. _____ 43 Courses in auditing and managerial control examine internal accounting controls in detail. 36 Effect of Non-financial Factors and Management Incentives on Capital Budgeting As stated above, capital budgeting is primarily a financial management process. However, strategic, operating, or other non-financial factors may affect managers’ capital budgeting decisions. Establishing objective criteria for weighing the affects of non-financial factors on capital budgeting decisions is problematic. When a business’ capital budgeting process includes factors for which objective criteria are not determinable, influential managers may be able to sway investment decisions to obtain approval of particular proposals. This influence may derive, for example, from a manager’s record of significant accomplishments or role as the leader of a relatively large business unit or a new business unit that promises significant growth and profitability. ***** Course developer’s note on content of and sources used in preparing course background papers: In selecting the content and determining the organization of material for this course, the developer considered a number of factors, including the university’s MBA program outcomes, material examined in the program’s accounting and finance foundation courses, and material examined in subsequent MBA accounting and finance courses, in particular MBA A602 (Interpreting Accounting Information) and MBA F602 (Financial Decision-making), which, in turn, are prerequisites for other MBA accounting and finance courses. The course developer reviewed several accounting and finance texts, listed below, to ensure that the examination of models, concepts, methods, and terminology in the background papers is generally consistent with a variety of such texts over time. The course developer noticed that, on the one hand, there is substantial similarity among texts in the material (models, concepts, methods, and terminology) examined. The developer also noticed that, on the other hand, in spite of this similarity, none of these texts appears to include references to other texts (just original research articles, authoritative accounting literature, and the occasional federal statute, internal revenue code section, or IRS regulation). In addition, much of the material examined in the texts and the background papers is the subject of articles on several unrestricted Websites, such as Wikipedia.com. As such, the material contained in the background papers represents both essential and common knowledge for business managers. Atkinson, A. A., Banker, R. D., Kaplan, R. S. & Young, S. M. (1995). Management accounting. Englewood Cliffs, New Jersey: Simon & Schuster Co./Prentice-Hall. Horngren, Charles T. (1977). Cost accounting: A managerial emphasis. (4th ed.). Englewood Cliffs, NJ: Prentice-Hall. Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2004). Intermediate accounting. (11th ed.). New York: Wiley & Sons. Ross, S. A., Westerfield, R. W. & Jaffe, J. E. (1993). Corporate finance. (3rd ed.). Burr Ridge, IL: Richard D. Irwin. Wild, J. J., Subramanyam, K. R. & Halsey, R. F. (2004). Financial statement analysis. (10th ed.). New York: McGraw-Hill/Irwin. Wolk, H. I., Dodd, J. L. & Tearney, M. G. (2004). Accounting theory: Conceptual issues in a political and economic environment. (6th ed.). Mason, OH: Thomson Learning/South-Western. 37
Instructions: Using the company information provided below, complete the following two tabs in this MS Excel Workbook: – Computation of the company's estimated cost of equity capital, r E, and weighted average cost of capital, r WACC – NPV (capital budgeting) analysis of the company's proposed investment in a new Product B 17S8W2 The background paper, Capital Budgeting and the Cost of Capital , provides useful guidance for completing this assignment. Based on the results of your NVP Analysis, summarize your recommendations to management regarding its contemplated introduction of the new product. Limit the length of your response to 75 words. Replace the text in this cell with your response. Company information: North American Manufacturing Company is a U.S.-based publicly traded company, whose stock is listed on a national securities exchange. Management looked up the stock's historical β (beta) at a popular financial Web search engine and obtained this additional information: 1,20 0,095 (9.5 percent) 0,400 (40.0 percent) Historical β (beta) of the company's common stock Current market interest rate on the company's new borrowings, r D Company's combined effective income tax rate, t 0,125 (12.5 percent) 0,040 (4.0 percent) Management's estimate of the expected rate of return on the “market portfolio,” r M Management's estimate of the risk-free interest rate, r F The balance sheet of the company as of its most recent fiscal year end reflects management's targeted capital structure for the company. That balance sheet reports the following liability and shareholders' equity balances: Notes payable to banks - current portion $ 10.000.000 65.000.000 Bonds payable - current portion Notes payable to banks - noncurrent portion 375.000.000 Bonds payable - noncurrent portion 150.000.000 30.000.000 Common stock, at par Additional paid-in capital 285.000.000 Treasury stock (45.000.000) Retained earnings $ 130.000.000 Product-investment information: Cost of recently completed test-marketing of Product B $ 220.000 Costs of previously incurred Product B research and development (R&D) costs $ 3.000.000 5,0 years Management's estimate of the economic life of Product B Cost of additional machinery and equipment (M&E) needed to manufacture Product B $ Fair value of vacant building owned, to be used as Product B manufacturing facility $ Estimated residual (fair) value of M&E at end of investment (Product B's economic life) $ 50.000.000 2.000.000 (Note 1) 12.560.000 Note 1 – The vacant building is fully depreciated; no significant changes in the value of building over Product B investment period expected As such, the projected net proceeds from the assumed end-of-investment disposal of the building is $1,200,000 [i.e., $2.0 million x (1 – 0.40)] Management's projections: Year 1 Probability-weighted expected sales of Product B: 3.300.000 Units Revenue $64.600.000 $ 7,00 $ Year 2 3.600.000 Year 3 Year 4 Year 5 3.500.000 3.400.000 3.200.000 67.500.000 $60.000.000 $54.600.000 $48.200.000 Variable cost (VC) per unit $ Incremental fixed costs (FC), other than depreciation of M&E $15.400.000 $ 15.720.000 $16.150.000 $14.800.000 $12.940.000 7,30 $ 7,70 $ 8,00 $ Erosion of existing Product A (contribution margin) (Note 2) $ 5.600.000 $ 5.500.000 $ 5.400.000 $ 5.100.000 $ 4.200.000 Required end-of-year balance of net working capital $ 5.600.000 $ 6.000.000 $ 5.400.000 $ 4.800.000 $ Note 2 – Projected adverse effects on the profitability of the company's existing Product A, resulting from introduction of new Product B The facilitator will grade this assignment, assigning up to 100 points for it as follows: Maximum Earned Accuracy, completeness, and clear presentation of: – Business’ cost of capital, including related information input and computations 25 points – Incremental cash flows attributable to proposed investment and capital budgeting analysis, including related information input and computations, and investment decision reached Total points 75 100 - 8,30 - 17S8W2 B4 Instructions: Use the information in the first worksheet tab (Instructions and company/product information) to complete this tab. For each of a. through c., below, show all computations in good form and label properly all amounts presented, anywhere within the boxes. However, you a. Compute American Manufacuring Company's estimated cost of equity capital, r E Re = a. Compute American Manufacuring Company's estimated cost of equity capital, r E 17F8W2 b. Compute the company's targeted capital structure (relative proportions of debt and common equity capital). Targeted Capital Structure % Rwacc = Error 17F8W2 Targeted Capital Structure % Debt = Equity = c. Compute the company's estimated weighted average cost of capital, r WACC Re = b. Compute the company's targeted capital structure (relative proportions of debt and common equity capital). 17F8W2 Debt = Error Equity = Error c. Compute the company's estimated weighted average cost of capital, r WACC Rwacc = Error 17F8W2 B1 - 1 2 3 4 5 North American Manufacturing Company Use the information in the first worksheet tab (Instructions and company/product information) to complete the analysis in this and the preceding tab. Capital Budgeting Analysis – Pr oposal for New Pr oduct B Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cash flows other than depreciation tax shield: 17M8W1 Machinery and equipment (M&E): (A) – Acquisition and installation costs ("original tax basis") (B) – Proceeds from disposal, net of capital gain tax (Note 1) (C) Opportunity cost of existing facility, net of capital gain tax (D) Incremental (investment) or reduction in net working capital (E) After-tax income before tax-basis "cost recovery" of M&E (Note 2) (F) Total cash flows other than depreciation tax shield Enter numbers, formulas, or labels, as appropriate, in shaded worksheet cells only, leaving the remainder of this worksheet tab unchanged. (G) Discount rate 1,0000 (H) Discount factors (I) Discounted present value (PV) of cash flows (J) Total discounted PV Depreciation tax shield : (K) Depreciation tax shield on M&E $ - (L) Discount rate (M) Discount factors (N) Discounted present value (PV) of cash flows (O) Total discounted PV (P) Net present value (NPV) of investment (Q) Total undiscounted net cash flows (R) Total discounted net cash flows (S) Internal rate of return (IRR) (T) Profitability index (PI) $ - #NUM! #DIV/0! Note 1 – Complete the Computation of Projected Proceeds and Capital Gain Tax from Assumed End-of-Investment Sale of M&E, below To ensure maximum credit for your work, use formulas whenever possible. This will help enable the faciliator 's understanding of your reasoning, which may justify "partial credit" for inaccurate results. Use care not to overwrite any formulas in worksheet cells, provided to assist with preparing this worksheet tab. North American Manufacturing Company Capital Budgeting Analysis – Pr oposal for New Pr oduct B Year 0 Year 1 Year 3 Year 4 17F8W2 Projected total VC Income before tax-basis "cost recovery" of M&E Combined effective income tax rate Taxes on income before tax-basis "cost recovery" of M&E Note 2 14,28% $ - 24,49% $ - 17,49% $ - 12,50% $ - 8,92% $ - Tax benefit of tax-basis "cost recovery" (i.e., depreciation tax shield) (O) Cumulative tax -basis cost recovery of M&E Error Error Error Error Error Error Error Error Error Error Error Total cash flows other than depreciation tax shield Error Error Error (G) Discount rate Error (H) (I) (J) Discount factors Discounted present value (PV) of cash flows Error Error Error Error Error 1,0000 Error Error Error Error Error Total discounted PV Error Error Error Error Error Error Depreciation tax shield : (K) (L) (M) (N) Depreciation tax shield on M&E $ - Error Discount rate Discount factors Error Discounted present value (PV) of cash flows Error Error Error Error Error Error Error Error Error Error Error (O) Total discounted PV (P) (Q) (R) (S) (T) Net present value (NPV) of investment $ Total undiscounted net cash flows Total discounted net cash flows Error Error Error Error Error Error Error Error Error Error Error Error #NUM! Internal rate of return (IRR) Profitability index (PI) #VALUE! Year 5 Total operating expenses, other than depreciation of M&E Erosion of existing Product A (contribution margin) (L) x Original cost of (investment in) M&E: Year 5 Error Error Error Pr oduct B Pr oposal – Projection of Income and Depreciation Tax Shield Year 2 Projected incremental fixed costs, other than depreciation of M&E Tax-basis "cost recovery" Year 4 Error (Note 2) Note 2 – Complete the Projection of Income and Depreciation Tax Shield, below Note 1 After-tax income before tax-basis "cost recovery" of M&E Tax-basis "cost recovery" percentage of M&E Year 3 Error Incremental (investment) or reduction in net working capital After-tax income before tax-basis "cost recovery" of M&E Pr oduct B Pr oposal – Projection of Income and Depreciation Tax Shield Projected number of units produced and sold Projected sales revenue Projected variable cost (VC) per unit Year 2 Error – Acquisition and installation costs ("original tax basis") – Proceeds from disposal, net of capital gain tax (Note 1) Opportunity cost of existing facility, net of capital gain tax Note 1 – Complete the Computation of Projected Proceeds and Capital Gain Tax from Assumed End-of-Investment Sale of M&E, below Note 2 – Complete the Projection of Income and Depreciation Tax Shield, below (A) (B) (C) (D) (E) (F) (G) (H) (I) (J) (K) (L) (M) (N) Year 1 Cash flows other than depreciation tax shield: 17M8W1 Machinery and equipment (M&E): (A) (B) (C) (D) (E) (F) $ Note 3 Note 1 – This capital budgeting analysis uses nominal (rather than real ) cash flows and discount rates, as is common practice - Note 1 (A) (B) (C) (D) (E) (F) (G) (H) (I) (J) (K) (L) (M) (N) Year 1 Projected number of units produced and sold Projected sales revenue Projected variable cost (VC) per unit Year 2 Year 3 Year 4 Error Error Error Error Error Error Error Error Error Error Error Error Error Error Error Error Error Error Error Total operating expenses, other than depreciation of M&E Erosion of existing Product A (contribution margin) Error Error Error Error Error Error Error Error Error Error Error Error Error Error Error Error Error Error Error Tax-basis "cost recovery" Error Note 2 (L) x Original cost of (investment in) M&E: 14,28% $ (O) Cumulative tax -basis cost recovery of M&E Error Tax benefit of tax-basis "cost recovery" (i.e., depreciation tax shield) Error Error Error Error Error Error Income before tax-basis "cost recovery" of M&E Combined effective income tax rate Taxes on income before tax-basis "cost recovery" of M&E After-tax income before tax-basis "cost recovery" of M&E Tax-basis "cost recovery" percentage of M&E Year 5 Error Error Error 17F8W2 Projected total VC Projected incremental fixed costs, other than depreciation of M&E Error Error Error Error Error Error Error 24,49% 17,49% 12,50% 8,92% $ $ $ Error Error - $ Error Error $ Note 3 - Note 1 – This capital budgeting analysis uses nominal (rather than real ) cash flows and discount rates, as is common practice Note 2 – The cost recovery percentages included in this analysis are those set forth by IRS regulations for "7-year Class Life" property) Note 2 – The cost recovery percentages included in this analysis are those set forth by IRS regulations for "7-year Class Life" property) Note 3 – Use the cumulative tax-basis cost recovery amount to compute the proceeds, net of capital gain tax, from assumed disposal of M&E in Year 5 (below) Note 3 – Use the cumulative tax-basis cost recovery amount to compute the proceeds, net of capital gain tax, from assumed disposal of M&E in Year 5 (below) Pr oposal for New Pr oduct B – Computation of Pr ojected Pr oceeds and Capital Gain Tax fr om Assumed End-of-Investment Sale of M&E (A) (B) (C) (D) (E) (F) (G) (H) Projected fair value of M&E in final period of NPV analysis (assumed gross proceeds) Original cost (taxable basis) of M&E $ - Cumulative allowable “cost recovery” through final period of NPV analysis Adjusted taxable basis of M&E Taxable "capital gain" Combined effective income tax rate Income tax on "capital gain" Projected net proceeds from assumed end-of-investment sale of M&E $ - Pr oposal for New Pr oduct B – Computation of Pr ojected Pr oceeds and Capital Gain Tax fr om Assumed End-of-Investment Sale of M&E (A) (B) (C) (D) (E) (F) (G) (H) Projected fair value of M&E in final period of NPV analysis (assumed gross proceeds) Original cost (taxable basis) of M&E Cumulative allowable “cost recovery” through final period of NPV analysis Adjusted taxable basis of M&E Error Error Error Error Error Taxable "capital gain" Error Combined effective income tax rate Error Income tax on "capital gain" Projected net proceeds from assumed end-of-investment sale of M&E Error $ - B6

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Instructions:
Using the company information provided below, complete the following two tabs in this MS Excel Workbook:
– Computation of the company's estimated cost of equity capital, r E, and weighted average cost of capital, r WACC
– NPV (capital budgeting) analysis of the company's proposed investment in a new Product B 17S8W2
The background paper, Capital Budgeting and the Cost of Capital , provides useful guidance for completing this assignment.
Based on the results of your NVP Analysis, summarize your recommendations to management regarding its contemplated introduction of the
new product. Limit the length of your response to 75 words.

NPV (Net Present Value) capital investment appraisal technique incorporates the time value of money
concept. As a general rule, a project having positive NPV is preferred.
In this case, the calculated NPV of the new product is $2,524,179, which means that the introduction of the
product B (i.e. new product) is feasible as because it is expected to generate higher returns than the require
rate of return (i.e. because of the positive Net Present Value).
Company information:
North American Manufacturing Company is a U.S.-based publicly traded company, whose stock is listed on a national securities exchange.
Management looked up the stock's historical β (beta) at a popular financial Web search engine and obtained this additional information:

1.20

Historical β (beta) of the company's common stock

0.095 (9.5 percent)
0.400 (40.0 percent)

Current market interest rate on the company's new borrowings, r D
Company's combined effective income tax rate, t

0.125 (12.5 percent)
0.040 (4.0 percent)

Management's estimate of the expected rate of return on the “market portfolio,” r M
Management's estimate of the risk-free interest rate, r F

The balance sheet of the company as of its most recent fiscal year end reflects management's targeted capital structure for the company.
That balance sheet reports the following liability and shareholders' equity balances:
Notes payable to banks - current portion

$

10,000,000
65,000,000

Bonds payable - current portion
Notes payable to banks - noncurrent portion

375,000,000

Bonds payable - noncurrent portion

150,000,000
30,000,000

Common stock, at par

285,000,000

Additional paid-in capital

(45,000,000)

Treasury stock
Retained earnings

$ 130,000,000

Product-investment information:
Cost of recently completed test-marketing of Product B

$

220,000

Costs of previously incurred Product B research and development (R&D) costs

$

3,000,000
5.0 years

Management's estimate of the economic life of Product B
Cost of additional machinery and equipment (M&E) needed to manufacture Product B

$

Fair value of vacant building owned, to be used as Product B manufacturing facility

$

Estimated residual (fair) value of M&E at end of invest...

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