CHAPTER 27 LONGER-RUN DECISIONS: CAPITAL BUDGETING
Changes from Eleventh Edition
All changes to chapter 27 were minor. Approach
Capital investment decisions are a special kind of alternative choice problem. They are analyzed in the same way as that used for the problems described in Chapter 26 with the e!ception that the timing of cash inflows and outflows must be taken into account. This one difference is an important one however. "n order to incorporate its effect in the analysis one must have a thorough understanding of the concept of present value. #ecause of the difficulty difficulty that students students seem to have with with the topic the discussion discussion of present value in the first part of this chapter proceeds $uite slowly unless the Appendi! to Chapter % was previously assigned and discussed. &nce students understand the nature and use of this concept they should have relatively little difficulty with most other topics discussed in the chapter. 'uite early in the chapter the steps in analyzing a capital investment problem are set forth. As various aspects of the analysis are discussed it is a good idea to relate each of them to these steps and to keep the students continually aware of the purpose of the analysis namely to reach a decision on the acceptability of a proposed capital investment. The reason for the omission of depreciation is often difficult to understand. (tudents must appreciate that the procedure takes into account the recovery of the investment and that to include depreciation as a separate item of cost would be double counting. "n addition to the te!t discussion of this point it may be desira desirable ble to introd introduce uce additi additiona onall illust illustrat ration ions. s. "t may also also be desira desirable ble to relate relate this this topic topic to the corresponding discussion in Chapter 26. (tudents have difficulty in understanding the depreciation ta! shield. They learned in Chapter 26 that
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Problems
Problem 27-1 Land Donated
Land Sold
Calculation of /et "ncome0 1reta! income before disposal..................................................................................................................................................... 3333333 3333333 Addition to +deduction from- ta!able income.............................................................................................................................. +33333333 1reta! income after disposal........................................................................................................................................................ 4%43333 33333 "ncome ta! 5 .3........................................................................................................................................................................ 486333 3333 Accounting income before disposal............................................................................................................................................. 3333333 3333333 9ess book value of land............................................................................................................................................................... 3333 1lus gain on sale of land.............................................................................................................................................................. : 33333 1reta! accounting income............................................................................................................................................................ 4443333 333333 9ess income ta! +above-.............................................................................................................................................................. 486333 3333 /et "ncome................................................................................................................................................................................ 63333 6386333 Calculation of cash flow (aving in ta! .3 ! 3333.................................................................................................................................................... 333 Cash from sale............................................................................................................................................................................. 3333 9ess additional ta!....................................................................................................................................................................... : %%333 Additional cash............................................................................................................................................................................ 333 22333 (trangely enough the company is better off to donate the land rather than to sell it. /otes0 +- "t would also be correct to calculate the additional ta! at a capital gains rate of say 28 percent. +2- The cost of the land is disregarded in the ta! calculation. Actually the ta!able gain would probably be 3333 * 3333 ; 33333. +-
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Problem 27-#: Corrine Compan!
a.
(99 &> >/T "f sell Cost.............................................................................................................................................................................. 273333 Accumulated depreciation............................................................................................................................................ %3333 +2733338 years- ! 3 years #ook value................................................................................................................................................................... 43333 (elling price................................................................................................................................................................. 228333 9ong*term gain............................................................................................................................................................ 8333 Ta! 5 .3..................................................................................................................................................................... 3833 /et gain after ta!.......................................................................................................................................................... 4833 /et cash inflow ; 228333 * 3833......................................................................................................................... %833 "f rent >ent proceeds per year................................................................................................................................................ 72333 =aintenance etc........................................................................................................................................................ 27333 ?epreciation................................................................................................................................................................ %333 8333 /et rent income before ta!.......................................................................................................................................... 27333 Ta! 5 .3.................................................................................................................................................................... 3%33 /et rent after ta!......................................................................................................................................................... 6233
b. The cash flow of 8333 * 3%33 or 233 after ta! for five years is 7333 which is less than the after*ta! profit from a sale now. +The present value of 233 for 8 years at say 3D is 24682 even less than the 7333 and more accurate making the sale even more attractive.- #ut the value of the warehouse 8 years hence is not mentioned. "t might be sold at a large enough gain to offset the difference between rent proceeds and a sale now. >ent might increase or e!penses increase. vidence is weighted in favor of a sale now for after*ta! benefits.
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Problem 27-%: 'ellington Corporation
Calculation of 1ro,ect >eturns
Pro(ect 2 8 +a33333 33333 3333 23333 83.333
)sef*l Life 6 years 8 2 28333 ÷ 3333 ÷ 8333 ÷ 3333 ÷ 2833 ÷
+nvestment, +nflo .a/ .3 . %.3 2.3 .3 ; .3 ; . ; %.3 ; 2.3 ; .3
et*rn .b/ D %D 4D 3D negative
an0 st rd 2nd th 8th
+b- >eturns for 1ro,ects * are from Table #. 1ro,ect Es return is zero since the nondiscounted inflows +3333 ! 2- e!actly e$ual the initial investment. 1ro,ect 8 over its entire life returns only 7833 of the initial 83333 investment so its return must be negative. Problem 27-: a3ton Compan!
a. ?ifferential after*ta! cash flows +333 omitted-0 1445 1441 1442 (ales.............................................................................................................................................................................................. 333 633 %33 =aterial labor direct overhead..................................................................................................................................................... 33 783 83 Added rent +2833 ! -.............................................................................................................................................................. 83 83 83 ?epreciation.................................................................................................................................................................................. 83 33 83
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443 /et income............................................................................................................................ 833 44 /et income............................................................................................................................ 22833 442 /et income............................................................................................................................ 36833 82833 Average income............................................................................................................................. 7833 +Average investmentF...................................................................................................................... 83333 +2Accounting rate of return............................................................................................................... 22D +÷2Average "nvestment /et ?epreciation 433 +.6- ; 83 Cash outlay for e$uipment ; 3%3 623 ; 83
d. The pro,ect should be adopted if a 23D after*ta! rate of return is re$uired0 Present val*e of cash flos at 256: 4430 83333 ! 3.% ; 2%3 440 633333 ! 3.64 ; 633 4420 %3333 ! 3.874 ; 277423 483
The present value of 483 is greater than the initial outlay of 3%3333) therefore the pro,ect more than satisfies the 23D re$uirement. e. "f the student does not have access to a calculator or computer programmed to make ">> calculations the ">> must be estimated using a trial*and*error approach. The ">> is slightly in e!cess of 22D as shown by these calculations0 "ear 4430 440 442
Cash lo 83333 633333 %3 333
226 actor 3.%23 3.672 3 88
226 P898 %233 3233 26 %3
2$6 actor 3.%36 3.683 3 82
2$6 P898 363 43333 28 823
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There are several valid ways in which the figures may be put together. There are also several ways of arriving at the basic figures for investment and earnings. This may lead to confusion when students come to class with solutions prepared in accordance with different methods. &ne way of avoiding this is to specify a method when assigning the case. Ge prefer to let the students use whatever method they wish and e!pect them to be able to follow someone elseEs method as it unfolds in class. &ften after someone has started the class discussion with a valid method we ask everyone to continue to develop the data in accordance with that method and although they do not like to make the adaptation they usually can do it. The commentaries to several of the cases are more detailed than students reasonably can be e!pected to develop in class. Case 27-1: Sinclair Company ote: $hi cae i unchange% from the Ele!enth E%ition . Approach
These problems are constructed so that each one builds on the preceding one and brings out a new point. "t often happens that in connection with the very first problem students raise $uestions that range all over the chapter. " ask them not to do this as the $uestions usually can be handled better later on in connection with the specific problems to which they apply. Also " prefer to get right to the problems rather than spending very much time on the te!t. " do go over the idea of present value and answer some $uestions but " think troublesome points are best handled in the conte!t of specific problems. "n introducing 1art A " may ask0 H"f you were going to buy a machine and had your choice of paying 8 now or a year for the ne!t five years which would you takeIJ /e!t H"f you had your choice of paying 8 now or per year for si! yearsIJ H
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"nvestment.............................................................................................................................................................. 283333 Annual earnings..................................................................................................................................................... 7833 1resent value 3 years 8D0 7833 F 8.34........................................................................................................ %%2 ?ecision0 /et present value ; *67%7) therefore................................................................................................... ?o not purchase
Moral 0 Although total earnings are appro!imately the same as in $uestion +78333 versus 63333- the present value is considerably different. "t is the pattern of earnings through time that counts not the total Hamount.J PA& . "nvestment.............................................................................................................................................................. 833333 Annual earnings..................................................................................................................................................... 63333 1resent value0 63333 F .82.............................................................................................................................. 8623 ?ecision0 /et present value ; 623) therefore.................................................................................................... 1urchase +"f =odel A has resale value the return would be even higher.2. The error arose when =odel A was purchased. Assuming the situation in A+- =odel A has an acceptable return if its economic life is 8 years. "t turns out that its economic life was only two years) conse$uently =odel A should not have been bought +although this is known only from hindsight-.
Moral 0 ?onEt let past mistakes prevent you from making wise decisions now +i.e. sunk costs are irrelevant-. PA& C
The 4% Ta! Act +and subse$uent acts- with AC>( provisions usually makes this kind of a computational nightmare for students because of the erratic HdepreciationJ +officially Hcost recoveryJamounts in years *8 and the absence of such amounts in later years. Ge have assumed that the AC>( allowances stay at 8D 26D 8D 2D 2D for 8*year assets. The cash flow pattern including a 8D +assumed to be time zero- "TC is0 1K of cash savings of 63333year for 8 years ; 63333 F .63 F .44............................................................. %2%
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PA& D "nvestment............................................................................................................................................................................. 283333 1resent value of earnings Lears *0 74833 F 2.2% +Table #-............................................................................................................................... %44 Lears *80 63783 F .364F............................................................................................................................................. 642 Total 1K of earnings..................................................................................................................................................... 26
?ecision0 ?o not purchase since /1K ; * 884. FThis is the difference between .82 and 2.2%
2. Although the total earnings for the 8*year period are the same in 1art ? as in A+- shifting more of the earnings to the early years and less to the later years increases the present value from 2 to 26. Moral 0 The time pattern of earnings makes a difference.
.
"nvestment net of "TC.......................................................................................................................................................... 27833 1resent value of cash savings0 Lears *0 74833 F .63 + * ta! rate- F 2.877................................................................................................................. 2242 Lears *80 63783 F .63 F l.6...................................................................................................................................... 86 1resent value of AC>( depredation ta! shield0 23%4%8 F .3................................................................................................................................................................. %84 Total present value................................................................................................................................................................ 28%3 F.44 +8 yrs.- N 2.877 + yrs.-
Moral 0 The combination of ta!*shield benefits and a shift in earnings now makes the decision to purchase a good one +even without the 2833 "TC-. Case 27-2: Rock Creek Golf Club* ote: $hi cae i unchange% from the Ele!enth E%ition .
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?epreciation ta! shield....................................................................................................................................... 7372 n.a. ?epreciation ta! shield....................................................................................................................................... 2 n.a. ?epreciation ta! shield....................................................................................................................................... %2 n.a. ?epreciation ta! shield....................................................................................................................................... %2 n.a. 1roceeds from disposal....................................................................................................................................... 4633 n.a. Time Pero flow.................................................................................................................................................... %23 82%3 /1K of net streams.............................................................................................................................................. 82F 82F .44 ; 7734% .44; 243
ate...................................................................................................................................... 7788 4 >&ES &> E<=++& A:
F"tems so marked can be eliminated from the analysis because they are the same for either alternative and because not ac$uiring the new carts has been e!cluded by the case as an alternative. . 233 F 3 carts F . ta! rate 2. %333 F + * .. 23 F 3 carts F + * .. 833 F 3 carts F + * .-
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ote0 $hi cae i unchange% from the Ele!enth E%ition0 S!nopsis 1huket #each Rotel has an opportunity to lease its under*utilised space to a karaoke pub and earn a rental income. Alternatively the hotel could develop the unused space and create its own pub. The general manager of the hotel must decide which of the two capital pro,ects to recommend to the hotel owners. The case presents sufficient information to build cashflow forecasts for each pro,ect and to rank the mutually e!clusive pro,ects using various evaluation criteria. &eaching >b(ectives
This case may be used to e!pose students to a range of capital*budgeting i ssues0 •
The principle of incremental analysis for identifying relevant cashflows for a pro,ect.
•
The treatment of sunk costs corporate overhead allocations opportunity costs e!ternalities and social costs in the identification of relevant cashflows.
•
The use of ?C< versus non*?C< techni$ues i n evaluating capital budgeting pro,ects.
•
1ossible conflict in pro,ect rankings on the basis of /1K and ">>.
•
The use of the e$uivalent*annuity criterion to solve the problem in ranking pro,ects of une$ual life.
•
"dentification of Hkey value driversJ for performing sensitivity analysis.
S*ggested ;*estions
.
1lease assess the economic benefits associated with each of the capital pro,ects. Ghat is the initial outlayI Ghat are the incremental cashflows over the life of the pro,ectI Ghat is an appropriate discount rate to use for discounting the cashflows of the pro,ectsI
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occurs as a direct result of accepting t he pro,ects. They include changes in e!isting revenues e!penses and ta!es caused by a pro,ectEs acceptance. The financial controller in this case stresses the importance of identifying future profits instead of cashflows. (tudents should note that accounting profits are not the relevant measure of benefits. )gnore unk cot
A sunk cost is an outlay that has already been committed or that has already occurred hence is not affected by the decision under consideration. "n this case t he overhead e!penses and salary e!penses of the e!cess labour can be considered as sunk costs. /ote that repairs and maintenance e!penses will increase if the karaoke pro,ects are accepted. "n this situation it is appropriate to include such incremental e!penses in the cashflow estimates for both pro,ects. Coni%er externalitie
!ternalities represent the effects of a pro,ect on other parts of the firm. "n this case the possible reduction in room sales should be considered in the analysis for both pro,ects. The social effects of the pro,ects are difficult to $uantify) yet they should be taken into account if the detrimental effect on the hotel will affect the pro,ectsE future cashflows. Coni%er opportunity cot
&pportunity costs are cashflows that could be generated from an asset the firm already owns provided it is not used for the pro,ect in $uestion. #ecause the two pro,ects in this case are mutually e!clusive the opportunity costs of one pro,ect are the cashflows that are forgone due to the re,ection of the other pro,ect. Pro(ect Eval*ation &echni?*es
"n this case since it is technically impossible for the hotel to undertake both pro,ects on the same site the acceptance of one pro,ect implies the re,ection of the other. Thus the two pro,ects are mutually e!clusive and a ranking of the two pro,ects in terms of their economic attractiveness becomes necessary. The present capital budgeting system in 1huket #each Rotel ranks pro,ects according to payback period and average return on investment. Although these methods are simple to use they have a number of weaknesses that dis$ualify them as effective methods for ranking pro,ects. "n fact there are other pro,ect evaluation techni$ues that are more effective. The following table summarises the advantages and disadvantages of each of the pro,ect evaluation techni$ues.
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/ote0 The discounted payback method is similar to the regular payback method e!cept that it discounts cashflows at the pro,ectsE cost of capital. "t considers the time value of money but it ignores cashflows occurring after the payback period. ))
iscounte, Cashflo .echni/ues 0c )nternal rate of return 0)RR Advantages
Disadvantages
−
Takes into account the time value of money
−
1ossible e!istence of multiple ">>s
−
"s in general consistent with the firm goal of shareholder wealth ma!imisation
−
>e$uires more complicated calculations
−
>e$uires detailed long*term forecast of incremental costs and benefits
−
"mplicitly assumes that the intermediate cashflows from the pro,ect are reinvested at the ">> rather than at the opportunity cost of capital
0, Profitability )n,e& 0P) Advantages −
"s consistent with the firm goal of shareholder wealth ma!imisation
−
Takes into account the time value of money and the scale of investment
Disadvantages −
>e$uires detailed long*term forecast of incremental costs and benefits
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S*mmar! of es*lts
ption Planet @arao0e P*b
*ild >ption each @arao0e P*b
Pa!bac0
2.6 years
.% years
Disco*nted pa!bac0
.3 years
.48 years
Average ret*rn on investment
4D
3D
+
2D
7D
P+
.2
.22
P9
6837 baht
73 baht
E?*ivalent ann*it! .EA/
82436 baht
%788 baht
The above summary shows that ranking conflicts have arisen. The first four measures favour the lease option while the 1" and /1K measures favour the build option. The last measure e$uivalent annuity which solves the une$ual life problem also favours the buil d option. +1lease refer to the earlier e!hibit on the pros and cons of using each measure.The graph below illustrates the classic Hcross*overJ problem in which conflict in pro,ect rankings arises on the basis of the /1K and ">> criteria. The standard approach to this problem is to rely on the ranking by /1K because the implicit reinvestment*rate assumption in the /1K method is more reasonable than that in the ">> method. +P" Profiles of the 4ease an, uil, 5ption
The graph shows that the /1K profiles of the two pro,ects cross over when the discount rate used is 6D. The ranking conflict between /1K and ">> disappears at discount rates above 6D. /ote that the build optionEs net present value profile has the steeper slope indicating that a given change in discount rate has a larger effect on its net present value. The build option has a greater sensitivity because it offers rising cashflows in the later years. "ts
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58% .base/
9'7-;
<.79=9
Buil%
587%
+88266-
+843-
>e,ect both
1
+8%%-
+877-
>e,ect both
Sensiti'ity nalysis: upfront in'estment 6 increase in *pfront investment
Lease >ption EA .baht/
*ild >ption EA .baht/
Decision
56 .base/
9'7-;
<.79=9
Buil%
%6
83
876%3
#uild
156
44
27%6
9ease
256
83%2
+42-
9ease
#56
+%3-
+46-
>e,ect both
Sensiti'ity nalysis: cost of capital Cost of capital
Lease >ption EA .baht/
*ild >ption EA .baht/
Decision
6
66676
22887
#uild
1587%6 .base/
9'7-;
<.79=9
Buil%
126
686
72
#uild
1$6
6237
8322
#uild
16
2872
%27
9ease
16
8387
+%%%4-
9ease
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.he 4ease 5ption Cost of capital Patronage actor
6
1587%6
126
1$6
16
16
5
274224
26483
2864
288
23
22286
582%
672482
68%2%
6872
63%64
624%62
6%736
58%
66676
82436
686
6237
2872
8387
587%
+8463-
+88266-
+88%68-
+86%88-
+87%7-
+8%%842-
1
+8%77-
+8%%-
+6%%-
+77-
+%28%7-
+422-
ifference in %/ui'alent nnuity 0in baht uil, - 4ease8 Cost of capital Patronage actor
6
1587%6
126
1$6
16
16
5
437
6%%6
8742
3%63
28
8474
582%
784
8862
6%
2%7
%3%
+%4%-
58%
88%%
64
2746
%%8
+7%-
+246-
587%
%6%
778
%22
+723%-
+2242-
+%434-
1
2388
74
+%8-
+22-
+%34-
+8%7-
E<=++& &-1 &=E LEASE >P&+>: PLAE& @AA>@E P) AAL"S+S > >PEA&+ CAS=L>'
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+
5
1
2
#
$
/et room revenueF
233333
6333
7333
%333
>eduction in net room revenue
683333
6%333
76728
%88833
1
2
#
$
>ental income
233333
233333
22333
22333
9ess0 ?epreciation e!pense
+42833-
+42833-
+42833-
+42833-
"ncrease in repairs U maintenance
+3333-
+3333-
+3333-
+3333-
>eduction in net room revenue
+683333-
+6%333-
+76728-
+%88833-
Additional operating income
%7833
8833
7278
%333
9ess0 ta!es
+86283-
+683-
+87-
+28233-
/&1AT
283
3%83
2366
8%%33
Add0 ?epreciation
42833
42833
42833
42833
"ear
5
9ess0 Capital e!penditure
+773333-
&perating cashflow
+773333-
2783
33683
6
2833
?iscounted operating cashflow
+773333-
24228
287
2386
6734
1ote: &0 #!
n on in!etment i calculate% a the a!erage of the cahflo, o!er the life of the pro"ect
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E<=++& &-2 &=E )+LD >P&+>: EAC= @AA>@E P) AAL"S+S > >PEA&+ CAS=L>'
1ro,ect life
6 years
Qpfront investment * renovation
%33333 baht
* e$uipment
433333 baht
Ta! rate
3D
cost of capital
3.78D
(ales growth rate
8D
28D of sales
(alary
6D of sales
&ther operating e!pense
22D of sales
"ncrease in repairs and maintenance
3333 baht
Annual capital e!penditure
e$uals depreciation
1atronage factor
3.8
1atronage factor
?ecrease in net room revenue
3
3D
3.28
6.28D
38
2 83D
+
"ear
5
1
2
#
$
%
/et room revenue
233333
6333
7333
%333
83333
8333
>eduction in net room revenue
683333
6%333
76728
%88833
%42833
4378
"ear
5
1
2
#
$
%
(ales
672333
438633
883%%3
83%2
867%%8
84627%7
9ess0
+6%333-
+22633-
+2%7723-
+8236-
+47-
+43647-
&ther operating e!penses
+327%3-
+37422-
+4-
+%4%8-
+246-
+%-
"ncrease in repairs and maintenance
+3333-
+3333-
+3333-
+3333-
+3333-
+3333-
?epreciation
+2%-
+2%-
+2%-
+2%-
+2%-
+2%-
>eduction in net room revenue
+683333-
+6%333-
+76728-
+%88833-
+%42833-
+4378-
Additional operating income
82%27
6268
66483%
776
%2488
46864
9ess0 ta!es
+84%%-
+%7343-
+233%82-
+282%4-
+27%6-
+2%347-
/&1AT
72474
68
6%686
8322
87676%
68884%
Add0 ?epreciation
9ess0 Capital e!penditure
2%
2%
2%
2%
2%
2%
6862
74%7%
784%4
7%8678
%6332
4%42
+2%-
+2%-
+2%-
+2%-
+2%-
+2%-
Qpfront investment
+733333-
*
*
*
*
*
*
&perating cashflow
+733333-
72474
68
6%686
8322
87676%
68884%
?iscounted operating cashflow
+733333-
6778
884
833
436
668
882%
Pa!bac0
.% Lears
Disco*nted pa!bac0
.48 Lears
Average ret*rn on investment
3D
+
7D
Profitabilit! +nde3
.22
P9
73 #aht
EA
%788 #aht
