Topic 4

Capital Budgeting
Part 2
 Net Present Value
The NPV Investment Evaluation Process
 Step 1 - Calculate depreciation
 Step 2 - Calculate any gain or loss on sale
 Step 3 - Calculate taxable income, i.e. profit or loss
 Step 4 – Calculate the tax item, i.e. tax bill or tax rebate
 Step 5 - Calculate net cash-flows
 Step 6 - Discount net cash-flows
 Step 7 – Conclusion: NPV positive accept,
negative reject
 Net Present Value
Example
 Purchase price of asset $42 000.
 Salvage value $1,000 at end of Year 3.
 Operating net cash-inflows: Year 1 $31 000
Year 2 $29 000
Year 3 $27 000.
 Feasibility study cost $4,000 – yet to be paid.
 Warehouse previously rented out for $8,000 p.a. will be used for the
project.
 New technician will replace existing technician.
 Existing technician’s salary = $65 000 p.a.
 New technician’s salary = $70 000 p.a.
 Old machine can be sold for $2,500; it’s book value is $3,000.
 Tax rate is 30%.
 Depreciation is straight-line.
 Required rate of return is 12% p.a.
 Net Present Value
Step 1: Depreciation p.a.
 Depreciation p.a. = cost of asset/n (no. of years)
 Depreciation = $42,000/3 = $14,000 p.a.
Step 2: Gain or Loss on Sale
 Gain/loss on sale = sale price (salvage value of asset) less book value of
assett

 Book Value of Assett = purchase price of asset less accumulated

depreciationt
Old Machine: loss on sale = salvage value0 less book value0
= $2,500 less $3,000 = -$500
New Machine: gain on sale = salvage value3 less book value3*
= $1,000 less $0 = $1,000
* Book value3 = $42,000 less (3 x $14,000)
= $42,000 less $42,000 = $0
 Net Present Value
Step 3: Tax Item p.a.
Profit & Loss 0 1 2 3
Statement
Operating 31 000 29 000 27 000
cash flows
Depreciation (14 000) (14 000) (14 000)

Rent foregone (8 000) (8 000) (8 000)

Gain/loss on sale (500) 1 000

Incremental salary (5 000) (5 000) (5 000)

Taxable income (500) 4 000 2 000 1000

(profit/loss)
Tax Paid (30%) 150 (1 200) (600) (300)
 Net Present Value
Step 4: Net Cash-Flows
Cash Flow 0 1 2 3
Statement
Tax (30%) 150 (1 200) (600) (300)

Oper. cash flows 31 000 29 000 27 000

Rent foregone (8 000) (8 000) (8 000)

Salvage value 2 500 1 000

Additional salary (5 000) (5 000) (5 000)

Initial outlay (42 000)

Net Cash Flows (39 350) 16 800 15 400 14 700

 Net Present Value
Step 5: Net Present Value
NPV = -$39,350 + $16,800(1.12)-1 + $15,400(1.12)-2 + $14,700(1.12)-3
NPV = -$39,350 + $16,800(0.8929) + $15,400(0.7972) + $14,700(0.7118)
NPV = -$39,350 + $15,000.72 + $12,276.88 + $10,463.46
NPV = -$39,350 + $37,741.06
NPV = -$1,608.94
Conclusion: NPV is negative, therefore, reject the project.
 Net Present Value
Incremental Cash-Flows
 Remember, in NPV project evaluation analysis we are only interested in
incremental cash-flows i.e. the additional cash-flows that occur as a result of
taking on a project.
 Incremental cash-flow example: A firm is considering replacing a machine
purchased two years ago with a useful life of five years with a new machine that
has a useful life of three years.
 Relevant Information
 Net Present Value
Step 1: Depreciation p.a.
 Depreciation p.a. on old machine = $48,000
 Depreciation p.a. on new machine = $120,000
 Therefore, incremental depreciation p.a. = $120,000 less $48,000 = $72,000

Step 2: Gain or Loss on Sale

 Old Machine: Book value0 = $144,000*1, salvage value0 = $80,000
Loss on sale0= $80,000 less $144,000 = -$64,000
*1Book value = purchase price less accumulated depreciation
= $240,000 less (2 x $48,000)
= $240,000 less $96,000 = $144,000
 New Machine: Book value3 = $0*2, salvage value3 = $100,000
Gain on sale3 = $100,000 less $0 = $100,000
*2 Book value = purchase price less accumulated depreciation
= $360,000 less (3 x $120,000)
= $360,000 less $360,000 = $0
 Net Present Value
Step 3: Tax Item p.a.
Profit & Loss 0 1 2 3
Statement

Incremental 50 000 50 000 50 000

cash revenues
Incremental (10 000) (10 000) (10 000)
cash expenses
Incremental dep’n (72 000) (72 000) (72 000)

Loss on sale (old) (64 000)

Gain on sale (new) 100 000

Taxable income (64 000) (32 000) (32 000) 68 000

(profit/loss)
Tax Paid (30%) 19 200 9 600 9 600 (20 400)
 Net Present Value
Step 4: Net Cash-Flows
Cash Flow Statement 0 1 2 3

Tax Paid (30%) 19 200 9 600 9 600 (20 400)

Incremental 50 000 50 000 50 000

cash revenues
Incremental (10 000) (10 000) (10 000)
cash expenses
Salvage values 80 000 100 000

Initial outlay (360 000)

Net Cash Flows (260 800) 49 600 49 600 119 600

 Net Present Value
Step 5: Net Present Value
NPV = -$260,800 + $49,600(1.10)-1 + $49,600(1.10)-2 +
$119,600(1.10)-3
NPV = -$260,800 + $49,600(0.9091) + $49,600(0.8264) +
$119,600(0.7513)
NPV = -$260,800 + $45,091.36 + $40,989.44 + $89,855.48
NPV = -$260,800 + $175,936.28
NPV = -$84,863.72
 Conclusion: NPV is negative, therefore, reject the project.
 Net Present Value
 Which items appear in P/L Statement and which appear
in Cash-Flow Statement?
When In P/L In CF

Initial investment or cost Yr 0 No Yes

Depreciation Yr 1 to Yr n Yes No
Salvage value Yr 0 and/or Yr n No Yes
Gain on disposal Yr 0 and/or Yr n Yes No
Loss on disposal Yr 0 and/or Yr n Yes No
Cash revenues Yr 1 to Yr n Yes Yes
Cash expenses Yr 1 to Yr n Yes Yes
Working capital Yr 0 and Yr n No Yes
Opportunity costs & side Yr 1 to Yr n Yes Yes
effects
 Net Present Value
One-Step Process

 Rather than adopt a two-step process to Project Evaluation (i.e. P & L

Statement and Cash-Flow Statement) a one-step process can be undertaken
(Cash-Flow Statement only).
 When a one-step process is adopted it is necessary to account for all tax items
in the cash-flow statement.
 Rather than work out taxable income (profit or loss) and tax in Step 1 (P & L
Statement) and net cash-flows in Step 2 (Cash-Flow Statement), one can
directly work out after-tax net cash-flows for each item (in the Cash-Flow
Statement).
 We will go on to illustrate by doing the example just undertaken in one step
 Net Present Value
One-Step Process
 Revenue
 cash-inflow due to sale of goods and services
 revenue is taxable, therefore net cash-inflow after-tax equals:
Rev. - (Rev. * (tc)) or Rev. (1 - tc) where tc = corporate tax-rate

 Expenses
 cash-outflow due to expenditures of production, etc.
 expenses represent a tax saving (they are tax deductible, therefore they
reduce tax payable (they provide a tax-shield))
 net cash-outflow after-tax equals: Exp. – (Exp. * tc ) or Exp.* ( 1 - tc)
 Net Present Value
One-Step Process
 Depreciation Tax-Shield
 Depreciation is a non-cash expense that is an allowable tax deduction (it
provides a tax-shield). Thus it reduces the tax payable by: Depreciation * (tc)
 This represents a cash-inflow (a tax-rebate).
 Net Present Value
One-Step Process
 Book Gain or Loss on Disposal
 salvage value (SV) is the sale price (market value) received on disposal of
an asset
 assets have a book value (BV), which is the purchase price less
accumulated depreciation
 if SV > BV we have a book gain on disposal of the asset and a taxable
profit arises
 Tax on profit = book gain * tc
 This leads to a tax-liability (a cash-outflow)
 The net after-tax cash-inflow from disposal will be SV less (book gain * tc)

 if SV < BV we have a book loss on disposal of the asset and a deductible

loss arises
 Tax saving on loss = book loss * tc
 This leads to a tax-rebate (a cash-inflow)
 The net after-tax cash-inflow from disposal will be SV plus (book loss * tc)
 Net Present Value
One-Step Process
Cash-Flow Statement 0 1 2 3
After tax cash- flows
Depreciation tax saving 21,600 21,600 21,600
i.e. 72,000 x 0.30
Incremental after-tax 35, 000 35, 000 35, 000
cash revenues i.e. 50,000 x
(1 - 0.30)
Incremental after-tax (7, 000) (7, 000) (7, 000)
cash expenses i.e.
10,000 x (1 – 0.30)
Initial outlay (360 000)

Net after tax cash-flows 99,200 70 000

from asset disposal i.e. 80,000 + i.e. 100,000 –
(64,000 x 0.30) (100,000 x 0.30)
After tax net cash-flows (260 800) 49 600 49 600 119 600
NPV (-$84,863.72)
 Equivalent Annual Annuities
Evaluating Projects With Different Lifespans

 If two projects are mutually exclusive they are competing projects and a
choice between the two projects must be made.
 Evaluation of the projects is complicated if they differ in life span i.e. they are
each over a different number of years.
 If two projects have different lifespans we cannot base a NPV analysis of the
two projects simply on which project has the higher NPV.
 A common base is required for comparison.
 Equivalent Annual Annuities
Evaluating Projects With Different Lifespans

 When comparing two mutually exclusive projects with different lifespans it is

necessary to make comparisons over the same time period.
 To make such a comparison we must calculate each project’s Equivalent
Annual Annuity (EAA), which compares each project’s net cash-flows
calculated on an annual basis.
 We select the project with the highest EAA if the net cash-flows are positive
(i.e. if the net cash-flows are net cash-inflows (apart from at T 0))

 We select the project with the lowest Equivalent Annual Cost (EAC) if the
cash-flows are based on costs (i.e. net cash-outflows)
 Equivalent Annual Annuities
Evaluating Projects With Different Lifespans
 To calculate the equivalent annual annuity (EAA) of a project, asset, or
investment:
1. Calculate the NPV of each project over one life - as if it were "one-off“; then
2. Convert the NPV of each project into an equivalent annuity for the life of each
project, i.e. convert the NPV into a series of annual payments or annuity
payments. To do this we must find the unknown PMT for the project using the
PV of an ordinary annuity formula.
 Equivalent Annual Annuities
Evaluating Projects With Different Lifespans
 Suppose our firm has to choose between two machines that differ in terms of
economic life and capacity. Our required return is 14% p.a. The after-tax net
cash-flows for each machine are as follows:

Machine 1 Machine 2 How do we decide

Year which machine to
(45,000) (45,000)
0 choose?
20,000 12,000
1
20,000 12,000
2
20,000 12,000
3
12,000
4
12,000
5
12,000
6
 Equivalent Annual Annuities
Evaluating Projects With Different Lifespans
Step 1: Calculate each project’s NPV
 NPV1 = $1,432.64
1  (1  0.14) 3 
 $45,000  $20,000    $45,000  $20,0002.322  $45,000  $46,432.64  $1,432.64
 0.14 

 NPV2 = $1,664.01
1  (1  0.14) 6 
 $45,000  $12,000   $45,000  $12,0003.888  $45,000  $46,664.01  $1,664.01
 0.14 

 Does this mean Machine 2 is better? No, the NPVs can’t be compared.
 We must take the analysis one step further and calculate each project’s EAA.
 Equivalent Annual Annuities
Evaluating Projects With Different Lifespans
Step 2: We assume each project can be replaced an infinite number of times
in the future, and then convert each NPV to its equivalent annuity.
 The projects’ EAAs can be compared to determine which is the best project.
 The EAA is the annuity amount (PMT) from the present value of an ordinary
annuity formula:

1  1  r  n 
PV  PMT  
 r 

EAA
 Equivalent Annual Annuities
Evaluating Projects With Different Lifespans
 EAA1 = $617.08

1  (1  0.14) 3  $1,432.64
$1,432.64  PMT    $1,432.64  PMT 2.322  PMT   $617.00
 0.14  2.322

 EAA2 = $427.91
1  (1  0.14) 6  $1,664.01
$1,664.01  PMT    $1,664.01  PMT 3.888  PMT   $427.76
 0.14  3.888

 We’ve reduced a problem with different time horizons to a choice between two
annuities

 Decision rule: Choose the project with the highest EAA

 Choose Machine 1
 Capital Budgeting And Inflation
 In project evaluation not adjusting for inflation may result in errors in
capital budgeting decisions.

 In our analyses inflation is included implicitly in the discount rate r.

 Capital Budgeting And Inflation
Depreciation And Inflation

 Depreciation p.a. on a productive asset is calculated based on historical cost, i.e. based
on the cost of the asset at the time it was bought, and not on replacement cost, i.e. not
on the cost of the asset when it has to be replaced in the future.
 As depreciation is based on historical cost inflation erodes the real value of any
depreciation tax deduction and therefore discourages capital investment in an
inflationary period.
 If we have inflation then the further into the future is the depreciation claim the lower is
its real present value (time value of money concept).

 To get the effective write-off of an asset we work out at the inflation rate the sum of the
present value of the depreciation deductions and divide this by the cost of the asset. To
do this we use the formula:
Σ depreciation p.a.(1+r)-n

cost of asset

Note: here r is the inflation rate (and not the required rate of return/discount rate)
 Capital Budgeting And Inflation
Depreciation And Inflation

Example: Project Evaluation & Depreciation - A Real Analysis

 Acme Ltd., a scrap metal dealer, is considering the acquisition of a "Crusher"
metal compactor at a cost of $25,000.
 The compactor is estimated to have a five-year lifespan.
 Tax allowable depreciation is 20% prime cost (purchase price) p.a.
 The company tax rate is 40% p.a.
 Expected inflation rate of 8% p.a. for the next 5 years
 Capital Budgeting And Inflation
Depreciation And Inflation

Example: Project Evaluation & Depreciation – A Real Analysis

 Real value at T0 of annual depreciation expense:
Yr Dep’n p.a. PVIF PV0
1 $5,000 (1.08)-1 = (0.9259) $4,629.50
2 $5,000 (1.08)-2 = (0.8573) $4,286.50
3 $5,000 (1.08)-3 = (0.7938) $3,969.00
4 $5,000 (1.08)-4 = (0.7350) $3,675.00
5 $5,000 (1.08)-5 = (0.6806) $3,403.00

Σ PV0 = $19,963.00*1

 Effective Depreciation Write-Off :

= $19,963.00 = 0.7985 = 79.85%

$25,000.00
 Therefore, only 79.85% of the replacement cost of the asset is covered by the annual
depreciation expense, and 20.15% (i.e. 1 – 0.7985 = 0.2015) of the purchasing power
of the sum of the annual depreciation expense is lost through inflation.

*1 See note on next page.

 Capital Budgeting And Inflation
Depreciation And Inflation
Example: Project Evaluation & Depreciation - A Real Analysis
 Note: As in this example the depreciation expense each year is of the same value,
$5000, we could have calculated the sum of the PV 0 of the annual depreciation
expenses as an ordinary annuity using the PV of an ordinary annuity formula:

1  1  r  n 
PV  PMT  
 r 

 So, the PV0 of the sum of the annual depreciation expenses is:

1  1.085 
PV0  $5,000 
 0 .8 
PV0  $5,0003.9927
PV0  $19,963.00
 Capital Rationing
 Capital Rationing – where a firm limits the total amount of funds to be
invested in projects.
 Therefore, even though certain projects may have a positive NPV they could
be rejected due to capital (financing) constraints.
Hard Capital Rationing
 Imposed by Capital Markets - markets will not provide sufficient finance for a
project at an acceptable cost, i.e. markets will not provide financing for the
project at a rate of interest that will give the project a positive NPV. For
example, management may base its project evaluation on a required rate of
return of 7% p.a., and using this rate the project has a positive NPV.
However, the market (e.g. banks, shareholders) believe the project is of
higher risk and will require a rate of return of, say, 10% p.a., and using 10%
p.a. as the discount rate for the project may lead to the project having a
negative NPV.
Soft Capital Rationing
 Imposed by upper management to ensure subsidiaries prioritise investments.
 Ensures discipline by lower level management – subsidiaries to only invest in
highest NPV projects.
 Capital Rationing
Profitability Index (PI) (Benefit-Cost Ratio)
 A project’s Profitability Index (PI) measures the return of the project relative
to its cost.
 Profitability Index (PI) = Present Value/Cost
or
(NPV+Cost)/Cost
PI Decision Criteria
 If PI > 1 = Accept the project (NPV must be positive).
 If PI < 1 = Reject the project (NPV must be negative).
 Capital Rationing
Profitability Index (PI) (Benefit-Cost Ratio)

Assume capital constraint = $15m

Project 0 1 2 NPV PI

A -15 30 15 23.7 2.583

B -8 4 25 15.5 2.938
C -7 6 22 15.9 3.271

Note. PI = (NPV+Cost)/Cost
Cost of Capital = 12%
Combined NPV B & C = $31.4
As compared to A alone = $23.7
 Capital Rationing
Profitability Index (PI) (Benefit-Cost Ratio)
 PIA = ($23.7m + $15m)/$15m = 2.583

 PIB = ($15.5m + $8m)/$8m = 2.938

 PIC = ($15.9m + $7m)/$7m = 3.271

 Both Projects B and C have a higher PI than Project A.

 Total cost of Projects B and C combined = $15million.
 Total cost of Project A alone = $15million.

PI Decision Rule
 Maximise the total NPV subject to the capital constraint (i.e. subject to the
financing limit).
 Use PI to rank projects as PI measures return relative to cost.
 In the above example, we would choose both Projects B and C as they both
have a higher PI than Project A and together B and C meet the capital
constraint of $15million.