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Capital Budgeting Decisions

- UAA ACCT 202

Principles of Managerial Accounting

Dr. Fred Barbee

Introduction to Capital Budgeting

Capital Budgeting is . . .

- . . . The making of long-term planning decisions

for investments.

Capital Budgeting Decisions

- Should we purchase new labor-saving equipment to

perform operations presently performed manually

A Cost-Reduction Decision

Capital Budgeting Decisions

- Should we replace existing equipment with more

efficient, newer equipment.

A Cost-Reduction Decision

Capital Budgeting Decisions

- Should we enter a new market with a new product

or purchase an existing business already in that

market

A Profit-Expansion Decision

The Process of Capital Budgeting

Process of Capital Budgeting

- Identification Stage
- Search Stage
- Information-Acquisition Stage
- Selection Stage
- Financing Stage
- Implementation and Control Stage

Project Selection . . .

- Selection in capital budgeting comes in two

phases - Screening, and
- Preference

Screening . . .

- A specific criterion is used to eliminate

unprofitable and/or high-risk investment

proposals.

- Projects meeting criteria

- Projects not meeting criteria

Preference Selection

- The surviving projects are subjected to a ranking

criterion. - Outcome The most favorable projects are selected

for any given amount of capital to be invested.

We interrupt this regularly scheduled program to

bring you a special bulletin on the

characteristics of business investments.

Characteristics of Business Investments

Business Investments

- Most business investments involve depreciable

assets and - The returns on business investments extend over

long periods of time.

Depreciable Assets

A Theoretical View of Depreciation

Salvage Value

1

5

4

3

2

Time

1

1

1

1

Consumed as Depreciation Expense

An application of the

Matching Principle

To Illustrate . . .

- A firm purchases land (a non-depreciable asset)

for 5,000 and - Rents it out at 750.00 per year for ten years.

What is the return?

What is the Return?

- Since the asset will still be intact at the end

of the 10-year period, each years 750 inflow is

a return on the original 5,000 investment. The

rate of return is therefore

Return on Assets Must

- Provide a return on the original investment.

- A return of the original investment itself.

To Illustrate . . .

- A firm purchases land (a non-depreciable asset)

for 5,000 and - Rents it out at 750.00 per year for ten years.

Assume the 5,000 investment is in equipment and

will reduce operating costs by 750 each year for

10 years.

Hmmm. What now?

What is the Return?

Why?

- Because part of the yearly 750 inflow from the

equipment must go to recoup the original 5,000

investment itself, since the equipment will be

worthless at the end of its 10-year life.

Long Periods

of Time

Long Periods of Time

- In approaching capital budgeting decisions, it is

necessary to employ techniques that recognize the

time value of money.

Discounted Cash Flow Models (DCF)

DCF Models . . .

- Focus on . . .
- Cash inflows and
- Cash outflows
- Rather than on net income

DCF Models . . .

- There are two main variations of the discounted

cash flow model . . . - Net Present Value (NPV) and
- Internal Rate of Return (IRR)

Net Present Value

NPV

Net Present Value Method

Usually Future

Discount

Cash Inflows

PV

Discount

Cash Outflows

(PV)

Future and/or Present

NPV

Net Present Value Method

If the result is positive, the investment

promises more than the interest rate used to

evaluate the proposal.

Usually Future

Discount

Cash Inflows

PV

Discount

Cash Outflows

(PV)

Future and/or Present

NPV

Go For It!

Net Present Value Method

If the result is zero, the investment yields

exactly the interest rate used to evaluate the

proposal.

Usually Future

Discount

Cash Inflows

PV

Discount

Cash Outflows

(PV)

Future and/or Present

NPV

Go For It!

Net Present Value Method

If the result is negative, the investment should

be rejected because the required rate of return

will not be earned.

Usually Future

Discount

Cash Inflows

PV

Discount

Cash Outflows

(PV)

Future and/or Present

NPV

(NPV)

No Way!

Typical Cash Outflows

- The initial investment
- Additional amount of working capital
- Repairs and maintenance
- Additional operating costs

Typical Cash Inflows

- Incremental revenues
- Reduction in costs
- Salvage value
- Release of working capital

PDQ Company NPV Example

- PDQ company requires a minimum return of 18 on

all investments. - The company can purchase a new machine at a cost

of 40,350. The new machine would generate cash

inflows of 15,000 per year and have a four-year

life with no salvage value. - What is the net present value of this project?

PDQ Company NPV Example

Initial Inv.

Now

(40,350)

1.000

(40,350)

Annual CF

1-4

15,000

2.690

40,350

Net Present Value

-0-

Each 15,000 Inflow . . .

- Provides for a recovery of a portion of the

original 40,350 investment and - Also provides a return of 18 on this investment.

40,350 - 7,737 32,613

15,000

7,263

7,737

32,613

40,350

40,350 x 18 7,263

15,000 - 7,263 7,737

Return

On

Return

Of

The Investment

The Investment

15,000

7,263

7,737

32,613

40,350

15,000

5,870

9,130

23,483

32,613

Practice Exercise 1

- Calculate Net Present Value

(NPV)

Practice Exercise 1

- An investment that costs 10,000 will return

4,000 per year for four years. - Determine the net present value of the investment

if the required rate of return is 12 percent.

Ignore income taxes. - Should the investment be undertaken?

Practice Exercise 1

Initial Inv.

Now

(10,000)

1.000

(10,000)

Annual CF

1-4

4,000

3.037

12,148

Net Present Value

2,148

Practice Exercise 2

- Calculate Net Present Value

(NPV)

Practice Exercise 2

- Magnolia Florist is considering replacing an old

refrigeration unit with a larger unit to store

flowers. - Because the new refrigeration unit has a larger

capacity, Magnolia estimates that they can sell

an additional 6,000 of flowers a year (the cost

of the flowers is 3,500).

Practice Exercise 2

- In addition, the new unit is energy efficient and

should save 950 in electricity each year. - It will cost an extra 150 per month for

maintenance. - The new refrigeration unit costs 20,000 and has

an expected life of 10 years.

Practice Exercise 2

- The old unit is fully depreciated and can be sold

for an amount equal to disposal cost. - At the end of 10 years, the new unit has an

expected residual value of 5,000 - Determine the NPV of the investment if the RRR is

14 (ignore taxes). - Should the investment be made.

Practice Exercise 2

- Determine the net cash flow for the life of the

equipment.

Practice Exercise 2

Initial Inv.

Now

(20,000)

1.000

(20,000)

Annual CF

1-10

1,650

5.216

8,606

Salvage

10

5,000

.270

1,350

(10,044)

Net Present Value

Limiting Assumptions . . .

- All cash flows occur at the end of the period.
- All cash flows generated by an investment are

immediately reinvested in another project which

yields a return at least as large as the discount

rate used in the first project.

Discount Rate . . .

- The rate generally viewed as being the most

appropriate is a firms cost of capital. - This rate is also known as . . .
- Hurdle Rate
- Cutoff Rate
- Required Rate of Return

Internal Rate of Return

IRR

Net Present Value Method

The internal rate of return (IRR) is that rate of

interest which will exactly equate the PV of the

cash inflows with the PV of the cash outflows.

Usually Future

Discount

Cash Inflows

PV

Discount

Cash Outflows

(PV)

Future and/or Present

Resulting in 0 NPV

NPV

-0-

Internal Rate of Return

- When the annual cash flows are even, the IRR

formula is simply . . . - df I / CF, or
- Investment/Annual Cash Flow

Cost of Capital as a Screening Tool

Using the IRR Method

- The cost of capital takes the form of a hurdle

rate that a project must clear for acceptance. - If the IRR on a project is not great enough to

clear the cost of capital hurdle, then the

project is rejected.

Using the NPV Method

- The cost of capital becomes the actual discount

rate used to compute the NPV of a proposed

project. - Projects yielding negative NPVs are rejected

unless nonquantitative factors, such as social

responsibility, employee morale, etc., intervene.

CompareNet Present Value andInternal Rate of

Return

Compare IRR NPV . . .

- The NPV method is simpler to use.
- Using the NPV method makes it easier to adjust

for risk. - The NPV method provides more usable information

than does the IRR method.

Simplified Approaches to Capital Budgeting

The Payback Period

The Payback Period . . .

- This method involves a span of time known as the

payback period. - The payback period is the length of time it takes

for an investment project to recoup its own

initial cost out of the cash receipts that it

generates.

The Payback Period . . .

- The basic premise of this method is that the more

quickly the cost of an investment can be

recovered, the more desirable is the investment.

The Payback Period . . .

- The payback period is expressed in years. The

basic formula is . . .

Investment Req ---------------------------

Payback Period Net Annual CF

Practice Exercise 3

- Calculate the Payback

period

Practice Exercise 3

- The Lower Valley Wheat Cooperative is considering

the construction of a new silo. - It will cost 41,000 to construct the silo.
- Determine the payback period if the expected cash

inflows are 5,000 per year.

The Payback Period . . .

41,000 --------------------------- 8.2

Years 5,000

Simplified Approaches to Capital Budgeting

The Simple Rate of Return

AKA Accounting Rate of Return

The Simple Rate of Return

- The Simple Rate of Return is equal to
- Incremental income from the project divided by
- the initial investment in the project.

Less Salvage Value if any

The Simple Rate of Return

- If a cost reduction project is involved, the

formula becomes

Less Salvage Value if any

Practice Exercise 4

- Calculate the Simple

Rate of Return

Practice Exercise 4

- Martin Company is considering the purchase of a

new piece of equipment. Relevant information

concerning the equipment follows - Compute the Simple Rate of Return.

Practice Exercise 4

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