CAPITAL BUDGETING AND

LEASING

Chapter 4

Investment

• The addition of durable assets to a business• Disinvestment is the withdrawal of durable assets from the business

Investment Opportunities

• Maintenance and replacement of depreciable capital items• Adoption of cost-reducing investments• Adoption of income-increasing investments• A combination of the above

Investment Analysis

• STEPS IN INVESTMENT ANALYSIS:• 1. IDENTIFY POTENTIALLY PROFITABLE INVESTMENT

ALTERNATIVES• 2. COLLECT RELEVANT DATA ON:

• CAPITAL OUTLAYS• COSTS• RETURNS

• 3. USE AN APPROPRIATE METHOD TO ANALYZE THE DATA.• 4. DECIDE WHETHER TO ACCEPT OR REJECT THE INVESTMENT

OR SELECT THE TOP RANKING AMONG MUTUALLY EXCLUSIVE PROJECTS.

Capital Budgeting

• The process of planning expenditures on assets whose returns will extend beyond one year.

Weighted Average Cost of Capital

There are two types of capital invested in a business:• Debt Capital• Equity Capital

• What is the cost of debt?• What is the cost of equity?

Weighted Average Cost of Capital

• Kc = wd Kd + we Ke • Where:

• Kc is the weighted average cost of capital

• wd is the proportion of assets financed with debt• Kd is the cost of debt capital• we is the proportion of assets financed with equity• Ke is the cost of equity capital

Payback Method

• The payback method gives the number of years necessary to recover the initial investment.

• Does not account for the timing of cash flows.

Payback Method

P = I / EWHERE:P = PAYBACK PERIOD IN YEARSI= INITIAL INVESTMENT OUTLAYE = ANNUAL NET CASH RETURN

Simple Rate of Return

• Expresses the average annual net income as a percentage of the amount invested.

• This may be in terms of the initial capital outlay or the average amount invested over the useful life of the investment.

SRR = Y/IWhere:SRR = SIMPLE RATE OF RETURN

Y = AVERAGE ANNUAL NET CASH RECEIPTS (DEPRECIATION TAKEN INTO ACCOUNT)

I = INITIAL INVESTMENT OUTLAY

Simple Rate of Return

Calculation of Annual Cash Receipts

Y =(E – D)WHERE:Y = AVERAGE ANNUAL NET INCOMEE = TOTAL EXPECTED ANNUAL CASH RECEIPTSD= TOTAL ANNUAL DEPRECIATION

Net Present Value (NPV)

• With the NPV, the cash flows of the investment are discounted by a minimum acceptable compound annual rate of return.

• The investment is judged to be acceptable if the present value of the cash inflows exceeds the investment’s present value of the cash outflows.

Net Present Value (NPV)

NPV = ΣPVCash Inflows – ΣPVCash Outflows

Benefit Cost Ratio

• A ratio that utilizes the same two elements of the Net Present Value.

B/C = ΣPV cash inflows / ΣPV cash outflows

Internal Rate of Return (IRR)

• The IRR is the compound interest rate that equates the present value of the future net cash inflows with the cash outflows.

• Or in other words the discount rate that gives a NPV = Zero. • Both the NPV and IRR take into account the time value of

money.• The purpose of these investment analysis techniques is to

evaluate the acceptability of investments relative to an acceptable rate of return.

What goes into the Discount Rate?

• The discount rate should reflect the cost of capital or the cost of funds used to finance the business.

• An investment is not acceptable unless it generates a return sufficient to cover the cost of funds.

What goes into the Discount Rate?

The discount rate contains three components:

• Real Risk-Free Rate• Risk Premium• Inflation Expectations

Other Considerations Regarding Capital Budgeting

• Profitability Index• Used to allocate limited capital among several independent projects.• Present value of the cash inflows divided by the cash outflows.

Other Considerations Regarding Capital Budgeting

• Annuity Equivalent• Used to compare NPVs with unequal lives.

Other Considerations Regarding Capital Budgeting

•Financial Feasibility• Once you have evaluated an investment, the financing of the project should

be determined.• After-tax cash flows may not be sufficient to meet debt repayment

requirements.

Comparing Four Methods Among Three

Investments

Cash Flows for Three Investments

YEAR INV A INV B INV C

0 -20,000 - 20,000 - 20,000

1 2,000 5,800 10,000

2 4,000 5,800 8,000

3 6,000 5,800 6,000

4 8,000 5,800 3,000

5 10,000 5,800 1,000

AVG 6,000 5,800 5,600

Payback Method

• A 20000/6000 = 3.33 YEARS

• B 20000/5800 = 3.45 YEARS

• C 20000/5600 = 3.57 YEARS

Simple Rate of Return

• A (30000-20000)/5 = 2000• 2000/20000 = 0.10 10%

• B (29000-20000)/5 = 1800• 1800/20000 = 0.09 9%

• C (28000-20000)/5 = 1600• 1600/20000 = 0.08 8%

Net Present Value

• A NPV = -20000 + 2000/(1.08)+ 4000/(1.08)2 + 6000/(1.08)3 + 8000/(1.08)4 + 10000/(1.08)5 + 0/(1.08)5

• NPV = -20000 + 1852 + 3429+ 4763 + 5880 + 6806 + 0

• NPV = 2730

Net Present Value and Internal Rate of Return

• A NPV = 2730 IRR = 12.01

• B NPV = 3158 IRR = 13.82

• C NPV = 3766 IRR = 17.57

Leasing Versus Owning

Leasing Versus Owning

• A lease represents an agreement that gives control over an asset owned by the lessor to the lessee for a specific period of time upon the payment of an agreed upon amount, known as rent.

Types of Leases

• IN NON-REAL ESTATE LEASING THERE ARE SEVERAL TYPES OF LEASES:

• OPERATING LEASE

• CAPITAL (OR FINANCIAL) LEASE

• CUSTOM HIRE

Operating Lease

• USUALLY A SHORT-TERM RENTAL ARRANGEMENT IN WHICH THE RENTALCHARGE IS CALCULATED ON A TIME BASIS.

• SUCH AS THE HOUR OR THE DAY, ETC.• THE LESSEE PAYS THE DIRECT COST SUCH AS FUEL AND

LABOR.

Capital or Financial Lease

• A LONG - TERM CONTRACTUAL ARRANGEMENT IN WHICH THE LESSEE ACQUIRES CONTROL OF AN ASSET IN RETURN FOR RENTAL PAYMENTS.

• USUALLY RUNS FOR SEVEAL YEARS AND CANNOT BE CANCELLED WITHOUT PENALTY.

• IS FULLY AMORTIZED, MEANING THAT THE PRESENT VALUE OF THE LEASE PAYMENTS EQUALS THE FULL PRICE OF THE LEASED EQUIPMENT.

• MAY HAVE A PRUCHASE OPTION AT THE END OF THE LEASE.

Capital Vs. Operating Lease

• Capital lease transfers some of the risks of ownership to the lessee.

Issues in Capital Leasing

• Advantages:• CONSERVATION OF WORKING CAPITAL• NEARLY 100% FINANCING • THE USE OF MODERN EQUIPMENT • POSSIBLE TAX BENEFITS

Evaluation of a lease vs. Purchase

• May be evaluated by looking at the present value of cash flows for each option.

Sample Problem

• $ 30,000 TRUCK• 35% TAX BRACKET• 12% COST OF CAPITAL• PURCHASE

• 30% DOWN PAYMENT• LEVEL PAYMENTS• 10% INTEREST• 5 YEARS

• LEASE• 5 YEAR LEASE• ANNUAL PAYMENTS OF $7,000