Hayenga, Wayne A.

Texas A&amp;M Repository

MAY 6 '76QiCIOfY'L-1091INVESTMENT ANALYSIS --CAPITAL BUDGETING METHODSVVayne A. Hayenga*Net cash investment$20,000 = 3 77$ 5,300 .Payback MethodThe payback method of capital budgeting esti-mates the number of years that it takes to recoverthe net cash investment. The general formula forthe payback period is:Payback period =IThe methods in this fact sheet are to determine the profit-ability of the asset in question-not its financing plan ortax benefits. If different financing plans are available forassets under consideration or tax conseq uences will benefitone investment alternative more than another, the capitalbudgeting technique can be expanded to take these itemsinto consideration.the net cash differences that will result from thechange. Annual net cash inflows are obtained byfirst estimating the annual sales or income thatwill result. From this, subtract the annual cashoperating expenses needed to generate that levelof sale, to obtain the return on the total project.Do not subtract interest and depreciation! Interestand depreciation expenses are taken into consid-eration in the capital budgeting methods of analysisand should not be subtracted at this point, evenif money is borrowed for the project.1Now the investment can be evaluated by eitherof the capital budgeting techniques.Average annual cash inflowsFor example, if a $20,000 net cash investmentreturned an additional annual net cash inflow of$5,300 per year, the payback period (in years)would beFor some investments the future net cash inflowschange over time. For example, consider aninvestment having a net cash outflow of $16,000and expected net cash inflows of $4,000 for threeyears which then drop to $2,500 for three years.Payback periods for this type investment are de-termined by the countdown method until the netcash flow is recovered.·Extension economist-agribusiness, The Texas A&M Univer-sity System.As business managers and owners sign purchasecontracts for new equipment they often ask them-selves, "Is this the best use I can make of mycapital?" Two types of analysis that can assistin answering this question are discussed in thisfact sheet. They are the payback and the netpresent value capital budgeting techniques. Bothmethods have strengths and shortcomings, butwhen used appropriately they can help managersimprove investment decisions.Steps in Capital BudgetingBoth capital budgeting techniques have thefollowing requirements:Step 1. Identify the feasible alternatives. Man-agement is alw<qs concerned about finding newinvestments to modernize, expand or increase theprofitability of the firm. Capital budgeting meth-ods can be used to evaluate the following typeinvestments: (a) maintenance and/or replacementof capital equipment, (b) adoption of new cost-reducing technology and (c) adding new enterprisesor product lines.Step 2. Calculate the net cash investment foreach alternative. Total cash expenditures for analternative may be more or less than the contractualcost of a piece of machinery or equipment. Installa-tion costs, costs of additional storage facilities orother remodeling costs may be necessary to make anew piece of equipment functional. On the otherhand, there may be some items currently in usethat can be sold when a new process is undertaken.The net price received from these items should besubtracted from the cash outlay to determine thenet cash investment. Also, there may be tax creditsthat will effectively reduce the net cash investment.Step 3. Estimate the net annual cash inflowsfor each alternative. The most difficult step inevaluating any investment is to accurately predict38.15r • Colir lty Y m. . O. Kun onInitial investmentYear 1Year 2Year 3Year 4Year 5Year 6Net cashinflowo$4,0004,0004,0002,5002,500*2,500Remaininginvestment$16,00012,0008,0004,0001,500oo·Need $1,500/.2,500 or 3/5 of year to recover the last $1,500.Payback period = 4 3/5 years.The payback method is one of the simplestmethods of capital budgeting. It has a high valuefor firms with a low liquidity position that musthave a fast cash recovery. It is also useful forcomparing assets for which future cash inflows arequite uncertain. This technique infers that thefaster an asset returns the invested capital, the less"risky" the asset is considered.Net Present Value MethodMany managers prefer the net present valuemethod of capital budgeting because it takes intoconsideration the time value of the returns. Inthis method the present value of the net cashinflows is subtracted from the net cash investment.If the present value of the net cash inflows isgreater than the net cash investment, the invest-ment alternative in question will be "profitable."A present value factor adjusts the future net cashinflows downward. It does this because of theidea that the money could be invested in anotherinterest-paying way. The factor indicates how muchmoney would have to be invested for a given timeat a selected interest rate to equal a net cash inflowat a future time.For example, if a person could invest moneynow at 8 percent interest compounded annually,how much would have to be invested today to have$1.00 in five years? Table 1, a present value table,gives us a present value factor of .6806 at the 8percent interest rate and 5-year time period. Thismeans that 68.06 cents invested now at 8 percentinterest compounded annually will be worth $1.00in five years. The following calculations show this.8 percent Value ofBeginning interest earned investmentof year Investment (end of year) (end of year)0 $0.6806 $0.0544 $0.73501 0.7350 0.0588 0.79382 0.7938 0.0635 0.85733 0.8573 0.0686 0.92594 0.9259 0.0741 1.000Table IPresent Value of $1(l + r)-nYear (n) 6~o 8% 10% 12% 15% 20% 25%1 0.9434 0.9259 0.9091 0.8929 0.8696 0.8333 0.80002 0.8900 0.8573 0.8264 0.7972 0.7561 0.6944 0.64003 0.8396 0.7938 0.7513 0.7Il8 0.6575 0.5787 0.51204 0.7921 0.7350 0.6830 0.6355 0.5718 0.4823 0.40965 0.7473 0.6806 0.6209 0.5674 0.4972 0.4019 0.32776 0.7050 0.6302 0.5645 0.5066 0.4323 0.3349 0.26217 0.6651 0.5835 0.5132 0.4523 0.3759 0.2791 0.20978 0.6274 0.5403 0.4665 0.4039 0.3269 0.2326 0.16789 0.5919 0.5002 0.4241 0.3606 0.2843 0.1938 0.134210 0.5584 0.4632 0.3855 0.3220 0.2472 0.1615 0.1074II 0.5268 0.4289 0.3505 0.2875 0.2149 0.1346 0.085912 0.4970 0.3971 0.3186 0.2567 0.1869 0.1122 0.068713 0.4688 0.3677 0.2897 0.2292 0.1625 0.0935 0.055014 0.4423 0.3405 0.2633 0.2046 0.1413 0.0779 0.044015 0.4173 0.3152 0.2394 0.1827 0.1229 0.0649 0.035216 0.3936 0.2919 0.2176 0.1631 0.1069 0.0541 0.028117 0.3714 0.2703 0.1978 0.1456 0.0929 0.0451 0.022518 0.3503 0.2502 0.1799 0.1300 0.0808 0.0376 0.018019 0.3305 0.2317 0.1635 0.1161 0.0703 0.0313 0.014420 0.3118 0.2145 0.1486 0.1037 0.06Il 0.0261 0.OIl5Presentvalue factor NetYear Amount 8 percent present value1 $5,300 0.9259 4,907.272 5,300 0.8573 4,543.693 5,300 0.7938 4,207.144 5,300 0.7350 3,895.505 5,300 0.6806 3,607.18ote that the value of the investment at the endof each year corresponds to the number on thepresent value table.As an example, if a $20,000 inve tment gen-erated the additional net cash inflow of 5,300 peryear for 5 years, would the investment be profitableif the firm manager required an 8 percent returnon the investment? This investment would beanalyzed as follows:Return to investmentCash outflowsCash inflows$20,000above the 8 percent return required on the invest-ment.If the manager required a 12 percent return onthe investment, the following calculations wouldapply:Ca h outflows $20,000Cash inflowsPresentvalue factor NetYear Amount 12 percent present valueI 5,300 0.8929 4,732.372 5,300 0.7972 4,225.163 5,300 0.7Il8 3,772.544 5,300 0.6355 3,368.155 5,300 0.5674 3,007.22Total net present valueof cash inflows = $19,105.44= loss of $ 894.56Total net present valueof cash inflows = $21,160.78Return to investment = $ 1,160.78 profitIn this example, the firm would receive total netpresent value cash inflows of $21,160.78 or $1,160.78The above calculations indicate that the pro-posed investment would not be profitable for a firmthat required a 12 percent return on its capital.The current $20,000 investment would generateonly total net present value cash inflows of$19,105.44, 894.56 short of a 12 percent return.Selection of Discount RateIn the examples above, arbitrary discount ratesof 8 and 12 percent were u ed by the author. Itcan be seen that different discount rates may resultin different answers to investment questions.Although discount rate selection is entirely a man-agement decision, several factors should be con-sidered.1. What is the firm's opportunity cost? Thatis: How much can the firm receive from an alterna-tive investment? In the example above, 8 percentwas chosen because a firm can obtain this returnin a relatively secure corporate bond. The 12 per-cent rate was chosen because it would give someadjustment for risk in the investment in question.2. What is the firm's cost of capital? Capitalcosts can vary with the interest charge for loanfunds, tax deductibility of capital costs and thesource of equity capital.3. What is the firm's planning horizon? Eco-nomic outlook for some firms' products may beextremely stable, so that a low interest rate couldbe selected for proposed purchases. On the otherhand, a manager may want to select a relativelyhigh interest rate when making an investment thatwill increase production for a volatile market.4. What is the technological stability of theassets? Some production processes use the sametypes of assets for many years, but new technologyis developed rapidly for other processes. The moreunstable the technological process, the higher theinterest rate should be.Discount rates for evaluating investment alter-natives of major U.S. firms vary from 8 percentfor some well-capitalized firms in stable industriesto 33 percent for les well-financed firms in unstableindustries. In the past, several major firms haveused rules of thumb such as prime rate + 5 percent,double corporate bond rate or an arbitrarily selectedrate such as 20 percent for investment analyses.Again, remember that the interest rate is a mana-gerial decision and represents the rate of returnthat management requires on capital investments.Table 1, the present value table, shows the presentvalue factors for seven interest rates for 20 years.SummaryCapital budgeting methods are useful in deter-mining the investment resulting in the best use ofcapital. The payback method is a simple tool toidentify how fast an investment is recovered. Thenet present value method can be used to determineif a prospective investment will earn a sufficientamount on the capital to justify the investment.Capital budgeting methods, when used in con-junction with enterprise budgeting and break-evenanalysis, can give management valuable assistancein making investment decisions.(This is a nonconventional problem, so a count-down method must be used.)et cash outflowPayback period = ----;-------:,-------------:,--------,,---:;:-:,------Annual average cash inflows34,350 = 5.73 years6,000Example ProblemA farmer i considering buying an irrigationystem for a pecan grove. There are two alterna-tives that he would like to consider. Alternative 1will require a net cash outlay of 34,350 and willgenerate returns of 6,000 per year for 10 years.Alternative 2 requires an outlay of 50,000 but willgenerate returns of 10,000 for the first 4 years,then 8,000 per year for 3 years, and then $3,000per year for 3 years. What is the payback periodfor each investment? If the farmer's discount rateis 10 percent, which alternative would be mostprofitable?PAYBACK METHOD34,350Present valueCash of cash inflows etYear inflow IO percent present valueI $6,000 0.9091 $5,454.602 6,000 0.8264 4,958.403 6,000 0.7513 4,507.804 6,000 0.6830 4,098.005 6,000 0.6209 3,725.406 6,000 0.5645 3,387.007 6,000 0.5132 3,079.208 6,000 0.4665 2,799.009 6,000 0.4241 2,554.6010 6,000 0.3855 2,313.00Total net present value 36,877.00Investment profits36,877.00 34,350.00 $ 2,527.00Solution to Alternative 2Net cash outflow 50,000Net cash inflowsPresent valueCash of cash inflows etYear inflow 10 percent present valueI 10,000 0.9091 9,091.002 10,000 0.8264 8,264.003 10,000 0.7513 7,513.004 10,000 0.6830 6,830.005 8,000 0.6209 4,967.206 8,000 0.5654 4,516.007 8,000 0.5132 4,105.608 3,000 0.4665 1,399.509 3,000 0.4241 1,272.3010 3,000 0.3855 1,165.50Total net present value $49,124.10Investment loss $ 875.90NET PRESENT VALUE METHODSolution to Alternative 1et cash outflowet cash inflows34,3506,000Amount$10,00010,00010,00010,0008,0008,0008,0003,0003,0003,000$50,000Payback period = 5.25 yearsSolution to Alternative 1et ca'h outflowAverage net ca h inflowsSolution to Alternative 2Net cash outflowet cash inflowsYear12345678910This Fact Sheet is one in a series on investment analysis. Others inthe series include Investment Analysis-Partial Budget Method (L-I092,Texas Agricultural Extension Service) and Investment Analysis-Break-Even Method (L-I093, Texas Agricultural Extension Service).Educational programs conducted by the Texas Agricultural Extension Service serve people of all ages regardless of socio-economiclevels, race, color, sex, religion or national origin.Cooperative Extension Work in Agriculture and Horne Economics, The Texas A&M University System and the United StatesDepartment of Agriculture cooperating. Distributed in furtherance of the Acts of Congress of May 8, 1914, as amended, andJune 30, 1914.IOM-4-76, Reprint AECO 1

Investment Analysis--Capital Budgeting Methods.

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Investment Analysis--Capital Budgeting Methods.

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Investment Analysis--Capital Budgeting Methods.

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