Module 6: Capital BudgetingA factory manager believes some of their plant’s equipment is outdated so they schedule an appointment with a major supplier. The salesperson confirms the equipment should be replaced and proceeds to describe what their company has to offer. Does the factory manager make the purchase immediately? Of course not—in addition to getting a number of competing bids, the manager must carefully compute whether the expected future benefits from the new equipment exceed its initial and ongoing costs on a present value basis. If they do not, then the company is failing to earn its required rate or return (RRR) and the project should not proceed. Show
Capital budgeting is a critical activity at any business. It helps senior management establish a long-term strategic direction for the company by evaluating different growth opportunities such as introducing new products, expanding into new markets or acquiring competing firms. At the lower levels of the firm, it is invaluable in assessing product improvements ideas, cost-saving plans, or proposed capacity additions. Maintaining a constant flow of new investments is essential to a company’s long-term profitability and survival. Although accountants typically take the lead in calculating a project’s net present value (NPV), specialists from the other business areas play a critical role in estimating a project’s future benefits and costs; determining an RRR that accurately reflects a project’s risk level; and ensuring a company’s strategic goals are met. This team approach results in a very thorough project evaluation that helps companies cope with the risk of high initial costs and uncertain future benefits. The capital budgeting process allocates a company’s investment funds to major projects. The process becomes more elaborate as organizations become larger and the value and complexity of projects increase. Many large companies have formal capital expenditure planning committees with detailed operating procedures that approve all major capital expenditures. These committees generally consist of a team of experts from across the company and its different disciplines including accounting, finance, marketing, operations, and human resources. They critically review all projects from their varying perspectives to ensure that they are financially and operationally sound and consistent with the company’s strategic plans. As the size of capital expenditures decrease and become more routine, investment decision making is pushed down into a company’s divisions and departments and the processes used to assess projects become simpler. Most organizations establish cost limits that determine which level of management has authority to approve a project. The five steps in the capital budgeting process include:
Project Evaluation MethodsThere are six different methods companies commonly use to evaluate capital projects. Most are based on cash flow estimates instead of accounting estimates which are heavily influenced by the accounting policies adopted.
NPV is the preferred method for evaluating capital projects especially for large companies who better understand the limitations of the other approaches. Payback and IRR are used to supplement NPV, but are typically not the primary methods partially because of the mathematical problems with the IRR. The remainder of this module will focus on the NPV method after carefully considering these problems. Mathematical Problems with IRRThe IRR method’s mathematical problems relate to the re-investment rate used for the cash flows generated by the project, the potential for multiple IRRs, and faulty decisions when choosing between mutually exclusive projects.
Types of Capital Budgeting DecisionsThere are two general types of capital budgeting decisions.
Data must be collected for both alternatives in a replacement decision. No information is needed for the do nothing alternative in a standalone decision. NPV in each case will measure how much better or worse off a company will be if they undertake the project. Projects can also be classified as independent, mutually exclusive, or contingent. Independent means they can be accepted along with any other project. Mutually exclusive means two or more projects cannot be done together as they are likely options to accomplish the same task. Contingent means one project has to be completed before another product can begin. NPV ChecklistWhen using the NPV method, the following checklist helps ensure that all relevant cash outflows and inflows are considered:
Initial cash flows occur at the start of a project and include the cost of any fixed assets and the tax savings that are realized from claiming depreciation on these assets. Most new projects also require additional net working capital (NWC) although sometimes NWC will fall if more efficient equipment is purchased that operates faster or is less prone to break down. Recurring cash flows include the after-tax net cash flows expected on an ongoing basis over a project’s life. These can come from selling new products, selling additional units of existing products, price increases or cost reductions. Terminal cash flows occur at the end of a project. They include the proceeds from any asset disposals and the lost tax savings from no longer being able to claim depreciation on these amounts. NWC will also return to previous levels. In some industries, companies have to incur considerable decommissioning costs closing down a factory or mine and potentially rehabilitating the site to prevent future environmental problems. Estimating Cash FlowsWhen estimating and discounting cash flows using the NPV method, there are a number of important principles to remember.
Capital Cost AllowanceUnder the Income Tax Act (ITC), businesses must adopt capital cost allowance (CCA) as their depreciation method for tax purposes. CCA is a declining-balance depreciation method which categorizes assets into one of 18 different classes. The cost of individual assets in each class are pooled together to calculate CCA. Each class has its own depreciation or CCA rate that is applied to the declining balance or undepreciated capital cost (UCC). This rate generally reflects the expected life of the assets in that class (i.e. longer lasting assets have lower rates) but other considerations such as stimulating investment may result in higher rates (sometimes 100%) and a faster tax write-off. Most asset classes are subject to the half-year rule which only allows half of the net acquisitions to be included in the class each fiscal year with the remainder added in the subsequent year. Net acquisitions are the net of all asset purchases and sales. The half-year rule was introduced because companies regularly bought assets at yearend but still claimed a full year’s CCA. For convenience, instead of requiring companies to prorate CCA based on the date of purchase, the half-year rule assumes all assets are bought half way through the year. A typical asset class might look like in Exhibit 6: Exhibit 6: Mechanics or a CCA Pool
Although CCA is a non-cash expense and should not be deducted in calculating NPV, being able to deduct CCA for tax purposes does reduce taxes payable which is a cash item. This benefit is referred to as the CCA tax shield and its present value over an asset’s life can be calculated using the formula: [latex]\text{Present value of CCA tax shield}=\text{(Investment)}\text{(Marginal tax rate)}(\frac{{\text{CCA rate}}}{{\text{CCA rate + RRR}}})(\frac{{2+\text{RRR}}}{{2(1+\text{RRR})}})[/latex] There are a few asset classes that do not use the declining balance method and the half-year rule to calculate CCA. For example, Class 14 assets (franchises, concessions, patents, and licences) are amortized on a straight-line basis over the life of the property with a full-year’s CCA in the year of acquisition. The present value of the CCA tax shield has to be calculated separately for these classes. In developed economies, central banks typically have general inflation targets of 2.0% per year but in developing markets inflation can be much higher. It is unreasonable to assume that inflation is negligible. Inflation is incorporated into NPV analysis using either the nominal or real approaches. With the nominal approach, recurring and terminal cash flows are expressed in future dollars which includes an allowance for inflation. To be consistent, the RRR must be expressed in nominal terms as well meaning it has an inflation component. With the real approach, future cash flows are expressed in today’s dollars so no adjustment is made for inflation. Since inflation is not included in future cash flows, it must be taken out of the discount rate resulting in a real RRR. Companies must be careful not to mix up the two methods by expressing all cash flows in today’s dollars while using a nominal RRR. Rates of return are normally expressed nominally in the financial markets, so the inflation component must be removed from the RRR if the real approach is adopted. If the nominal RRR was 8.0% and inflation was 2.0%, then the real RRR would be 6.0%. This real RRR is only an approximation. An exact rate can be calculated using a formula referred to as the Fischer Effect: [latex]\text{Nominal rate}=(1+\text{Real rate})\times(1+\text{Inflation rate})-1[/latex] [latex]0.08=(1.0+\text{Real rate})\times(1.0+0.02)-1.0[/latex] [latex]\text{Real rate}=0.0588\text{ or }5.88%[/latex] This formula recognizes that investors must be compensated for inflation on both the original investment (as represented by 1.0 in the formula) as well as the real rate earned during the year. The difference between the Fischer Effect formula and just subtracting the real rate and inflation rate is small, so the Fischer Effect is often ignored. When incorporating inflation, do not assume the same inflation rate applies to all cash inflows and outflows. Even though the general inflation rate of the economy might be 2.0%, the inflation rate for individual cash flows can vary. For example, commodity price can change dramatically due to shifts in supply and demand and geopolitical forces. Accurate inflation or price forecasts relating to all key inputs and outputs are essential. Inflation is also problematic for businesses because once any capital costs are added to a CCA pool, they are not subsequently indexed for inflation. This reduces the value of the tax benefits companies receive from deducting CCA. The federal government has considered indexing the value of CCA pools to counter this effect, but has decided against it due to the magnitude of lost tax revenues. The general rule in capital budgeting is a company should accept all projects with a positive NPV, but this is not always possible. At the divisional level, managers normally receive a limited budget to spend on capital items. If this budget is insufficient to finance all profitable projects, then the division will have to decide how to best allocate or ration these limited funds to maximize NPV. When capital rationing is done at the divisional level, it is referred to as soft rationing. If divisions are underfunded, it would be logical for a company to simply raise more capital for them. As a company’s assets grow, they are financed with a combination of debt and equity based on the company’s optimal capital structure so not to overleverage the firm. Raising new capital, especially equity, is not always easy. Stock markets can be undervalued for extended periods of time making it ill-advised to issue new equity. Even if stock markets are fairly valued, companies have an aversion to issuing new equity due to high issuance costs and potential control problems. Retained earnings may be insufficient to fund maximum growth given a desired level of dividends, so a company may have no choice but to reduce its growth and ration its limited capital to maximize NPV. A company could also have difficulty raising new funds if it is experiencing financial distress or its loan conditions prevent any additional borrowing. Sometimes, the limitation on the size of the capital is not due to a lack of financing, but a shortage of other non-financial resources such human resources including qualified executives, engineers or marketing specialists. When capital rationing is done at the corporate level, it is referred to as hard rationing. Capital Rationing Using SolverIf a company has a large number of positive NPV projects to choose from, it would be very difficult to determine which combination maximizes NPV manually. For this, the Solver feature in Excel is an excellent tool. To demonstrate capital rationing using Solver, enter the spreadsheet in Exhibit 7 containing the initial investment and NPV for five different projects along with the formulas. The total amount available to spend on all capital projects is CAD 2,500,000 and Projects A and B are mutually exclusive meaning they cannot both be done. All other projects are independent of each other. Exhibit 7: Capital Rationing Using Solver
Open Solver under the Data tab in Excel. In the drop box, complete the following: Maximize F7. Done by setting F7 as the objective function and instructing Excel to maximize that value. F7 is the total NPV of all projects selected. By changing variable cells D2:D6. Excel will select all possible combinations of D2:D6 subject to any constraints. Constraints.
Solve. Excel maximizes F7 subject to the constraints and selects Projects B and C with a maximum NPV of CAD 1,100,000. Instead of using Solver, some companies rank projects based on either their PI or IRR and simply go down the list accepting projects until the capital budget is completely spent. This approach should not be used as it can generate a group of projects that do not maximize NPV. Exhibit 8 contains the same example using a PI ranking. Exhibit 8: Capital Rationing by Ranking PIs
Based on the PI ranking, Projects A, C, D, and E should be chosen. The entire capital budget of CAD 2,500,000 is spent and projects A and B, which are mutually exclusive, are not both selected. As can be seen in Alternative 1 and 2 below, the selection of A, C, D, and E does not maximize NPV though. Alterative 2 maximizes NPV because even though Project B has a slightly lower PI than Project A, the lower PI is earned on a larger investment (CAD 2,000,000 versus CAD 1,000,000) leading to a higher overall NPV. Exhibit 9: Incorrect Ranking Using PIs
Much of the equipment a company buys such as water pumps or metal lathes is needed on an ongoing basis and must be replaced a number of times in succession as assets wear out. A difficulty in analyzing these types of capital projects is that the equipment options being considered likely have different economic lives making a comparison of their NPVs difficult. Two similar methods for dealing with this problem are chaining and equal annual annuity (EAA). To demonstrate these methods, consider the example in Exhibit 10 of two mutually exclusive equipment options with an RRR of 10.0% and varying lives of three and six years. Exhibit 10: Chaining and EAA
ChainingThe lowest common multiple for the lives of the two equipment options is six years. To meet its needs during this six-year period, the company has to purchase Equipment A twice or Equipment B once. For Equipment A, NPV for the first three-year period is added to NPV for the second three-year period. NPV for the second three-year period is discounted for three year since its implementation is deferred. For Equipment B, NPV is calculated for the six-year period. The option with the highest total NPV is selected. Equipment A [latex]\text{First 3-year period: }11,640\frac{{1-(1+1.10)^{-3}}}{{.10}}-25,000=3,946.96[/latex] [latex]\text{Second 3-year period: }\frac{{3,946.96}}{{(1+.10)^{3}}}=2,965.41[/latex] [latex]\text{Total NPV: }3,946.96+2,965.41=6,912.37[/latex] Equipment B [latex]\text{Total NPV: }7,325\frac{{1-(1+.10)^{.6}}}{{.10}}-21,000=10,902.28[/latex] Equipment Option B is preferred. EAACalculate an annual annuity that is equivalent to the NPV of Equipment A and B. The equipment option with the highest annual annuity is preferred as this annuity will be earned each year regardless how many times the project is undertaken. Equipment A [latex]\text{NPV: }11,640\frac{{1-(1+.10)^{-3}}}{{.10}}-25,000=3,946.96[/latex] [latex]\text{EAA: }3,946.96=P\frac{{1-(1+.10)^{-3}}}{{.10}}P=\text{CAD}1,587.13[/latex] Equipment B [latex]\text{NPV: }7,325\frac{{1-(1+.10)^{-6}}}{{.10}}-21,000=10,902.28[/latex] [latex]\text{EAA: }10,902.28=P\frac{{1-(1+.10)^{-6}}}{{.10}}P=\text{CAD}2,503.24[/latex] Equipment Option B is preferred. The chaining and EAA methods can be used to choose between mutually exclusive projects that repeat themselves in the future. The method should not be used to compare one-time projects with different lives. Also, for the project that will be repeated most often, analysts may want to include in the analysis changes in asset replacement costs caused by inflation or changes in technology that make the newer asset more efficient or profitable. In practice, the materially principle and the ability to make accurate estimates should be considered before going to this level of detail. Previously, any additional NWC relating to a proposed capital project was classified as an initial cash outflow. When the NWC was liquidated at the end of the project, it was classified as a terminal cash inflow. This treatment is an over-simplification as NWC actually changes continuously as sales change over a project’s life and not just at the beginning and end of the project. Sales typically rise quickly but then level out and eventually fall based on a product’s or business’s life cycle. Changes in NWC each period can be estimated using the financial ratio: This ratio is equivalent to: [latex]\text{NWC Turnover}=\frac{{\text{Sales}}}{{\text{NWC}}}[/latex] [latex]\text{NWC}=\frac{{\text{Sales}}}{{\text{NWC Turnover}}}[/latex] Sales estimates for the proposed project are available. The relationship between sales and NWC as measured by NWC turnover may be assumed to remain constant or can be adjusted to reflect the project’s varying NWC requirements. Knowing sales and NWC turnover, a project’s NWC needs can be calculated each period and the change can be included as either a cash inflow or outflow. With large capital projects involving land, building, equipment and government assistance, determining the relevant cash flows including the tax effects can be complex.
More on Terminal Losses and RecapturesA terminal loss occurs when an asset class’s UCC is positive and there are no assets remaining in the class. The positive UCC indicates that a company has not taken enough depreciation in the past and can now recognized a tax benefit equal to the class’s UCC times the company’s marginal tax rate. Terminal losses can occur with buildings because each building is held in its own class which must be close out when that building is sold. They are far less likely with equipment as the classes generally contain a number of different pieces of equipment meaning the class is rarely empty. Recaptures occur whenever an asset class’s UCC is negative regardless of whether the class is empty or not. The negative UCC indicates that a company has taken too much depreciation in the past and now must pay taxes equal to the class’s UCC times the company’s marginal tax rate. Recaptures occur can with buildings because, even though they are depreciable assets, they frequently appreciate in value leading to a negative UCC when the asset is sold. Recaptures are far less likely to occur with equipment because of the positive UCC in the class relating to other assets in the pool and equipment generally does not appreciate in value. If the company is growing at a reasonable rate, this UCC should be sufficient to absorb any asset sales. Even if it is not, good tax planners will arrange to buy needed assets that year so the UCC remains positive thus preventing any recaptures. As discussed, the tax effect of any capital gains, terminal losses or recaptures relating to equipment must be included in NPV but they are rare. What must be included is the present value of future CCA tax savings relating to the difference between the UCC of the piece of equipment being sold and the amount received from its sale. If this difference is positive, the company will continue to benefit from future CCA tax savings, but if negative, they will lose future CCA tax savings. Capital budgeting is an uncertain process. Companies may be able to estimate a project’s initial cash flows with a high degree of certainty, but recurring and terminal cash flows that are five, ten, or fifteen years away are obviously much more difficult to forecast. Because of this uncertainty, projects that were initially thought to be profitable may actually lose money for the company. This risk cannot be avoided, but it can be reduced. Common methods for managing risk include:
Exhibit 11: Adjusting RRR for Project Risk
Advantages of Using SpreadsheetsSpreadsheets are invaluable in capital budgeting as they help to organize and automate a very complex process. By using an input page that defines all of a project’s variables in one place, estimates can be easily changed and sensitivity and scenario analysis employed to test various alternatives. Need for More Frequent Cash Flow EstimatesFor simplicity, when first learning about capital budgeting, students assume that cash inflows and outflows all occur at year end. As shown in Exhibit 12, this yearend assumption can lead to erroneous results when using NPV. Exhibit 12: Erroneous Resulting Using the Yearend Cash Flow Assumption
Projects A and B are very similar except for their annual cash inflows and outflows. For both projects, the net cash flows are CAD 3,000 per year over each project’s 10-year life, but the individual cash inflows and outflows are much larger in Project B. If the year-end assumption is used, Project A and B will have the same NPV. But what if the company receives its revenue at year-end and incurs its costs uniformly thorough the year? For Project A, the NPV falls slightly because the costs are being paid sooner, so they are higher on a present value basis thus lowering the NPV. For Project B, the NPV falls by much more and actually becomes negative. This is explained by the size of the individual cash outflows. Because the cash outflows are so large, paying them monthly instead of annually will lead to a much bigger increase in costs thus lowering the NPV. This example demonstrates that adopting the year-end assumption without reference to the actual timing of cash flows can greatly distort the NPV. It this case, the company would have accepted a project that should have been refused. The year-end assumption will lead to erroneous results when: 1) cash inflows and outflows are large in relation to their net values, and 2) cash inflows and outflows have different frequencies (i.e. monthly or yearly). Both these are true in the case of Project B and are very common in practice. To avoid this problem, cash flows should be measured on a monthly or quarterly basis so they are more accurately timed. Capital Budgeting Using SpreadsheetWhen using spreadsheets to analyze capital budgeting projects as om Exhibit 13, relevant cash flows are still classified as initial, recurring, and terminal, but with some changes. Instead of classifying the present value of the tax savings relating to CCA on the building and equipment as initial cash flows, they are classified as recurring cash flows each month resulting in lower income tax and higher net operating cash flows. The changes to NWC occur over the life of the project and are classified as initial, recurring and terminal cash flows. The tax effects of any capital gains, terminal losses and recaptures on the disposal of land, building and equipment are included in terminal cash flows. Once the net cash flows are determined for each period, the initial and monthly NPV are calculated by applying the RRR and these amounts are summed to yield the total NPV for the project. The IRR is calculated using Excel’s IRR function with the net cash flows as the data range. This is the monthly IRR since the net cash flows are monthly, so the result must be multiplied by 12 months to yield the annual IRR. Cumulative initial and monthly NPV is an aggregate total of all initial and monthly NPVs. The discounted payback period occurs when this amount becomes positive and remains positive. Exhibit 13: Format of a Capital Budgeting Spreadsheet
Capital Budgeting in PracticeThe capital budgeting techniques described in this module are all used in industry to varying degrees. Which practices are preferred by companies is an area of considerable research. Academics are trying to determine how closely practice follows current corporate finance theory which is what was studied in this module. More closely adhering to current theory increases corporate profitability and overall economic efficiency and, therefore, is of significant interest. A recent study1 of Canadian businesses found:
Exhibit 14: Preferred Project Evaluation Methods in Canada
Exhibit 15: Use of Risk-adjustment Methods in Canada
Agency Costs in Capital BudgetingAnother important area of research relates to how agency costs affect the capital budgeting process. According to corporate finance theory, firms should work in the best interest of their shareholders and attempt to maximize the value of the firm by selecting projects with the highest NPV. In practice, managers pursuing their own self-interests prevent companies from achieving this goal. Some typical management behaviours include:
Senior management and capital expenditure planning committees must be cognizant of these problems and take steps to mitigate their impact. A company’s strategic plans and performance evaluation and compensation systems must be adjusted so they do not encourage these behaviours. 1Baker, H., Dutta, S., Saadi, S. (2011). Corporate Finance Practices in Canada: Where Do We Stand? Multinational Finance Journal, vol. 15, no. 3/4, 157-192. A. Problem: Project Evaluation Methods at TopleyTopley Ltd. is analyzing the purchase of new equipment at a cost of CAD 220,000. It is estimated that it will reduce company cash outflows from operations by CAD 50,000 per year. Its estimated life is ten years, and it will have zero terminal disposal value. The RRR is 16.0%. REQUIRED:
B. Problem: Project Evaluation Methods at Cott BeveragesCott Beverages is considering the purchase of a bottling machine for CAD 28,000. It is expected to have a useful life of seven years with a zero terminal disposal price. The plant manager estimates the following cash savings:
Cott has an RRR of 16.0%. REQUIRED:
C. Problem: Standalone Decision at RogersRogers Company has the opportunity to invest in a new business which requires the purchase of a machine for CAD 120,000. The machine is expected to last for four years and have a salvage value of CAD 10,000. Rogers’ staff has prepared the following budgeted income statement for each of the four years, based on expected sales of 450 units per year.
Other Information
REQUIRED:
D. Problem: Replacement Decision at RubyOn January 1, 2003, Ruby Company was contemplating whether to replace a lathe that it uses to produce Widgets. The current contribution margin (profit after variable costs) is CAD 4.00 per unit. A new lathe could be purchased for CAD 500,000 and it would last eight years at which time it would be worth CAD 80,000. The old lathe could be sold for CAD 50,000 currently, but could continue to be used for another eight years after which it would have a salvage value of CAD 10,000. The company currently produces and sells 200,000 Widgets a year, which is expected to increase by 20,000 units with the purchase of the new lathe. Variable production costs are expected to fall by CAD 2.00 per unit. Inventory requirements are expected to increase by CAD 10,000 initially. The lathe is subject to a CCA rate of 20%. Ruby’s RRR is 10.0% and its tax rate is 35%. The inflation rate is negligible. REQUIRED:
E. Problem: Replacement Decision at ZebraZebra Technology Ltd. is a manufacturing firm specializing in the production of sophisticated product components. The company is considering the purchase of a new piece of equipment. The equipment would cost CAD 141,000 and have a salvage value of CAD 18,000 at the end of its six-year life. The new equipment would replace existing devices that are fully depreciated, but have a current market value of CAD 10,000. If the old equipment is kept for another six years, it would have a salvage value of zero. Zebra Technology is currently selling 50,000 units a year. The new equipment should allow it to sell 15,000 additional units per year over the next six years. Each unit sells for CAD 12.00 and this is not expected to change over the next six years. Variable costs of production are CAD 7.50 per unit, but this should fall to CAD 5.75 per unit with the more efficient machine. Fixed costs are expected to fall by CAD 10,000 per year. The new equipment will also reduce the required investment in NWC by CAD 30,000. Zebra Technology has an RRR of 11.5% after tax. These two pieces of equipment are both in a CCA pool with a rate of 20%. The marginal tax rate is 31%. The inflation rate is negligible. REQUIRED:
F. Problem: Standalone Decision with Inflation at WeatherlyWeatherly Ltd. operates a large mine. The company wants to purchase equipment to mine additional ore from an undeveloped area of the site. Bernice Janzen, Weatherly’s controller, is analyzing whether to undertake this project. The cost of purchasing and installing the equipment is CAD 3.5 million. The useful life of the equipment is five years with a salvage value of CAD 450,000. Weatherly estimates that an additional 6,000 pounds of the metal (16 ounces per pound) will be mined annually for the next five years using the equipment. Janzen has estimated the price of this metal will average CAD 17.21 per ounce over this period. The metal prices are uncertain and are a significant risk in this project. Two new employees are required to operate the new equipment. Salary and benefit costs for each of these employees are estimated to be CAD 115,000 annually over the next five years. Equipment maintenance is expected to be CAD 65,000 per year. The variable costs to mine and process the ore is CAD 5.24 per ounce. Allocated existing fixed overhead is CAD 1.95 per ounce. Janzen uses an RRR of 9.0% and a 21% tax rate to analyze this project. The equipment has a 30% CCA rate. Inflation is estimated to be 2.0% over the next five years. REQUIRED:
G. Problem: Standalone Decision with Inflation at QuakerQuaker Ltd. produces breakfast cereal, but is considering expanding into the packaged salad business. This expansion will require an initial investment in new equipment of CAD 2,500,000. The new equipment will be placed in a class with a CCA rate of 20%. At the end of the project, the equipment is estimated to have a salvage value of CAD 350,000. Sales from the new venture are forecasted at CAD 2,900,000 per year for the first six years and CAD 3,500,000 per year for years 7 through 12. Variable operating costs for the new venture are estimated at CAD 1,900,000 for the first six years, and CAD 2,100,000 for years 7 through 12. Fixed costs will be CAD 800,000 per year for the entire 12-year period which includes rent for the new production facility. NWC will average 30.0% of sales throughout the life of the project. At the end of year 6, an CAD 850,000 overhaul of the new equipment will be undertaken. Under the Income Tax Act, this expenditure is capitalized in the same pool as the original equipment. The half-year rule applies to this expenditure. It is assumed that at the end of year 12, the equipment will be sold for its estimated salvage value and the overhaul will not affect this estimate. The firm’s marginal tax rate is 30%. The acquisition of the new equipment and any subsequent betterment are subject to an ITC of 5%. Its RRR is 5.0%, which is used in all NPV analysis. Company policy is to add an additional 3.0% to this discount rate to allow for the extra risk resulting from a new project. All estimates are expressed in today’s dollars and inflation is estimated to be 2.5% per year for the duration of the project. REQUIRED:
H. Problem: Capital Rationing at BosieBosie Ltd. is considering the following capital projects:
Bosie’s capital budget is CAD 12 million and Charlie and Delta are mutually exclusive. REQUIRED:
I. Problem: Projects of Varying Lives at WilsonWilson Company is trying to decide between two mutually exclusive projects. The relevant cash flows are:
Wilson’s RRR is 7.0%. REQUIRED:
J. Problem: Projects of Varying Lives at JensenJensen Industries is considering two mutually exclusive investments. The relevant cash flows are:
The RRR is 8.0%. REQUIRED:
K. Problem: Changes in Net Working Capital at AmsterdamAmsterdam Ltd. has the option to buy a new machine that will increase sales each year over the project’s 3-year life beginning in 2013.
Prior to the undertaking the project in 2013, Amsterdam’s NWC turnover ratio in days was 40.0. This is estimated to increase to 46 days in 2013 due to increased inventory requirements relating to the new machine and then remain the same over the life of the project. REQUIRED:
L. Problem: Taxation Effects of Terminal Cash FlowsREQUIRED: For each case below, determine the relevant incremental terminal cash flows.
M. Problem: Managing Risk by Adjusting the Discount Rate at RexallOn June 1, 2006, Rexall Ltd. was investigating whether to replace one of its existing injection molding machines with a new model being sold by one of its equipment vendors. The new equipment will cost CAD 85,600 plus sales taxes of CAD 5,992, transportation of CAD 1,000, and installation of CAD 2,500. It is expected to last 10 years at which time it will have an estimated salvage value of CAD 12,000. The current injection molding machine has a market value of CAD 45,500 and will also last another 10 years at which time it will have a salvage value of approximately CAD 1,500. The current machine produces 580,000 units per year, which sell at CAD 1.50. The new model is expected to increase output by 55,000 units and decrease current variable production costs of CAD 1.29 by CAD 0.35. Fixed costs will rise by an estimated CAD 10,000 per year due to more complicated maintenance. The new machine is considered more reliable than the current model, so the company feels it will be able to reduce its inventory requirements by CAD 25,000. All additional output can be sold. Engineers estimate that the machine will have to be overhauled after five years and that this will cost CAD 200,000. Output is expected to be no more than 580,000 units for the five years after the overhaul. The injection-molding machine is subject to a CCA rate of 25%. Rexall’s nominal RRR is 11.0%, and profits are subject to a marginal tax rate of 32%. Inflation is estimated to remain at 2.5% over the life of the machine. The policy at Rexall is to adjust the company’s required rate of return to reflect the specific risk of each project. The following adjustment table is used:
REQUIRED:
N. Problem: Managing Risk by Adjusting the Discount Rate at DodsonDodson Industries is trying to select the best of three mutually exclusive projects with varying levels of risk. Project A is in risk class 5, Project B is in risk class 2, and Project C is in risk class 3.
Inflation is negligible. REQUIRED:
O. Problem: Managing Risk through Management Options at HansenHansen Industries is contemplating developing a new product for sale in the domestic market. It has decided to utilized decision tree analysis with management options and has broken down the project into the following phases: Phase 1 At the start of Year 1, Hansen will complete a technical feasibility study at a cost of CAD 620,000. They estimate there is a 70% chance that the results will favour further development. Phase 2 At the start of Year 2, if Hansen decides to proceed, they will invest CAD 1,000,000 to build a protype of the product. Hansen estimates there is 60% chance that the protype will be suitable for sale. Phase 3 At the end of Year 2, if Hansen decides to proceed, they will build a manufacturing facility for CAD 9,000,000 Phase 4 During Year 3, Hansen will begin selling their product. There is a 50% chance that demand will be strong generating net cash flows of CAD 17,500,000 a year for three years. There is a 30% chance that demand will be average generating net cash flows of CAD 7,500,000 a year for three years. There is also a 20% chance that demand will be low generating negative net cash flows of CAD 3,000,000 a year for three years. If demand is low in Year 3, the firm will terminate the project and avoid the negative cash flows in Years 4 and 5. If demand is high, the capacity of the plant will be expanded and the price of the product raised increasing cash flows to CAD 22,500,000 in Years 4 and 5. Hansen’s RRR is 9.5%. Inflation is negligible and all cash flows are after tax. REQUIRED:
P. Problem: Managing Risk through Management Options at AcmeAcme Auto Parts is contemplating developing a new transmission. Development costs are high and the chances of failure at the different stages of the project are significant. In order to accurately estimate the NPV and reduce risk, Acme has decided to incorporate management options using decision trees. Initially, Acme plans to spend CAD 500,000 for basic designs. It believes that there is a 60% chance these plans will be successful. If the basic designs fail, the company thinks it can get back part of the expense by selling its ideas to a foreign manufacturer for CAD 125,000. The next stage, at the end of Year 1, involves developing five prototypes at a cost of CAD 95,000 each. Once developed, the prototypes will be thoroughly tested and the company expects there is a 50% chance that these tests will be successful. If unsuccessful, the prototypes and specially purchased production can be sold for CAD 150,000. At the end of Year 2, a new production line will be built at a cost of CAD 5,000,000. If demand is strong, net cash flows will be CAD 3,500,000 a year for 4 years. There is a 60% chance this will occur. If demand is moderate, net cash flows will be CAD 2,000,000 a year for 2 years and there is a 20% chance of this happening. Finally, if the product is a failure, net cash flows will only be CAD 1,000,000 a year for one year. If the production equipment is only used for one or two years, it could be sold for CAD 3,000,000. If demand is high, management can expand the production line at a cost of CAD 1,000,000 in Year 3 in order to increase net cash flows to CAD 4,500,000 in Years 4, 5, and 6. Acme’s RRR is 12.0%. Inflation is negligible and all cash flows are after tax. REQUIRED:
Q. Problem: Complex Capital Budgeting with Spreadsheets at MagnumMagnum Ltd. produces auto parts and assemblies for car and truck manufacturers around the world. Its headquarters are in Toronto, Ontario, but it currently has production facilities in Canada, the U.S., Europe, and China. Magnum began operations in 1975 in Oshawa, Ontario and has grown to be one of the world’s largest auto parts producers. Its keys to success have been its ability to remain non-unionized in the highly organized North American auto sector and relying heavily on flexible, automated production systems. It has been able to keep the union out of most of its plants by recruiting primarily immigrant workers who traditionally do not support unions. Magnum has been growing at double-digit rates over most of the last 25 years, but has seen its growth fall dramatically in the last few years as the company has matured and competition has intensified. The falling growth rates have hurt the company’s share price creating considerable concern among shareholders and a lot of pessimism on the part of equity analysts. The CEO and founder, Heinz Becker, hopes to return growth rates to their previous levels by diversifying operations into new areas of manufacturing. The two options for expansion that Magnum is currently contemplating are the design and assembly of an electric car and the production of solar generators for the industrial market. Ford Motors, Magnum’s biggest North American customer, has asked the company to design and manufacture an electric commuter car modelled after the new General Motors Volt, which it would sell in its dealerships. It was felt that this car would appeal to young and environmentally conscious drivers who would be attracted by the vehicle’s low operating costs and emissions. Ford did not feel it could manufacture the product economically due its high labour costs, but still felt that it needed to include such a vehicle in its product line to attract younger buyers who might trade up to larger, higher-margin Ford cars, SUVs, or trucks as their incomes grow. Magnum is experienced in the manufacturing of auto parts and assemblies, and does not feel that the production of a complete vehicle would be beyond the company’s abilities. The production of solar generators might prove more problematic for Magnum. In the past, it has produced engine parts, but never a full engine unit. The major concern though is that Magnum would have to establish a distribution system for this product. This would mean either establishing its own sales network or selling it though an existing system. A considerable number of John Deere, Caterpillar, and Komatsu dealers have expressed interest in selling this product and providing service. Electric Cars In order to build the electric cars, an assembly plant will have to be constructed. Magnum currently has enough capacity to manufacture most of the components for the new car and can buy the remainder from other suppliers. The building is estimated to cost CAD 8,050,000 and the production equipment CAD 35,600,000. The plant will be located in a rural area so the land will be inexpensive at CAD 1,350,000. It is estimated the plant and equipment will have a life of 15 years before the product becomes obsolete and the facility is sold off. At that time, the land is expected to be worth CAD 2,900,000, the building CAD 1,360,000 and the equipment a negligible amount in today’s dollars. The building is subject to CCA at a rate of 10% and the equipment at rate of 30%. The building must be amortized separately in its own pool as per the Income Tax Act. Magnum is a large company, so the equipment pool includes numerous purchases and sales each year. The capacity of the proposed plant is 48,000 vehicles per year. Sales are only expected to be 14,000 initially due to production “ramp up” problems and weak initial demand as Ford builds customer interest. Demand is expected to grow at 25.0% for the first 5 years followed by growth of 4.0% for the remaining 10 years. Demand for the electric cars is seasonal and is expected to adhere to the following demand pattern:
Magnum’s net working capital will increase with the addition of this new facility. An NWC Turnover Ratio of 8.0 based on monthly sales is likely to be required over the life of the project. Electric cars will be sold directly to Ford for CAD 10,760 who will distribute them through their dealer network. Magnum expects it will cost approximately CAD 10,250 to produce a vehicle. An additional CAD 1,580,000 in non-traceable factory costs are expected along with CAD 510,000 in incremental corporate overhead related to the project per year. Prices and costs are expected to rise at the inflation rate of 2.0% per year for the duration of the project. Other than sales and costs of goods sold, all costs are incurred uniformly throughout the year. Solar Generators A new assembly plant will have to be built to manufacture the solar generators. Existing capacity could be used to produce most of the components; otherwise, parts production will be outsourced. Land for the new facility is estimated to cost CAD 2,320,000 and the building CAD 6,640,000. Production equipment worth CAD 24,550,000 will also be required with a maximum capacity of 23,500 units per year. The plant will have a life of 10 years at which time the land can be disposed for CAD 3,700,000 and the building for CAD 590,000. The estimated salvage value of the equipment is negligible. All estimates are in today’s dollars. The building is subject to a CCA rate of 10% and the equipment a rate of 30%. The building is being amortized in a separate pool as required in the Income Tax Act. Magnum will have to increase its net working capital to support this project. The NWC ratio is expected to be 6.5 based on monthly sales. Magnum is confident it can sell 5,300 generators in the first year. This will grow by 20.0% annually in the first five years followed by a normal growth rate of 3.0% for the remainder of the project. The selling price will be CAD 25,400 per unit. Sales are expected to adhere to the following seasonal pattern:
The cost of goods sold is estimated at CAD 24,250 per unit. Non-traceable factory costs are expected to be CAD 885,000 and incremental corporate overhead should approximate CAD 856,000 annually. Magnum has decided to sell the product through its own sales network as it feels neither John Deere, Caterpillar, or Komatsu dealers will put the needed effort into marketing the product. A national sales manager with a base salary of CAD 84,000 and a commission of 20.0% of gross profit would be hired along with five salespeople at a base salary of CAD 40,000 and a commission also of 20.0% of gross profit. Prices and costs are expected to rise at the inflation rate of 2.0% per year over the duration of the project. Other than sales and costs of goods sold, all costs are incurred uniformly throughout the year. Cost of Financing Magnum’s has a corporate cost of capital equal to 10.0%. It is expected that the electric cars project will have a similar risk level as the project is directed at the same customers and is influenced in a similar manner by the business cycle. The solar generator project’s cost of capital is 13.0% given the more cyclical nature of the construction industry and the high level of global competition. In addition, as this is a venture into a new product area, Magnum’s policy is to raise the cost of capital by 3.0% to reflect greater project risk. The corporate tax rate is 30%. REQUIRED:
What does the modified internal rate of return Mirr assume quizlet?The modified internal rate of return (MIRR) assumes that cash flows from all projects are reinvested at the cost of capital as opposed to the project's own IRR. This makes the modified internal rate of return a better indicator of a project's true profitability.
Which capital budgeting method is better NPV IRR or MIRR?The correct answer is NPV. Net present value is the best capital budgeting method as it provides an actual dollar value for the project instead of just a return percentage.
Which of the following is an alternative to NPV?Though the NPV formula estimates how much value a project will produce, it doesn't tell you whether it is an efficient use of your investment dollars. The payback period, or payback method, is a simpler alternative to NPV. The payback method calculates how long it will take to recoup an investment.
Which one of these is a weakness of Mirr?What is the one weakness with MIRR? When mutually exclusive project's sizes are unequal, you can't trust MIRR to choose the project that will add the most value.
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True or false: the mirr function eliminates multiple irrs and should replace npv.
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