Capital budgeting decisions
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14. Chapter. 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.

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Capital budgeting decisions

14

Chapter

Capital Budgeting Decisions

UAA – ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee


Introduction to capital budgeting

Introduction to Capital Budgeting


Capital budgeting is

Capital Budgeting is . . .

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


Capital budgeting decisions1

Capital Budgeting Decisions

  • Should we purchase new labor-saving equipment to perform operations presently performed manually

A Cost-Reduction Decision


Capital budgeting decisions2

Capital Budgeting Decisions

  • Should we replace existing equipment with more efficient, newer equipment.

A Cost-Reduction Decision


Capital budgeting decisions3

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

The Process of Capital Budgeting


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

Project Selection . . .

  • Selection in capital budgeting comes in two phases:

    • Screening, and

    • Preference


Screening

Screening . . .

  • A specific criterion is used to eliminate unprofitable and/or high-risk investment proposals.

  • Projects meeting criteria

  • Projects not meeting criteria


Preference selection

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.


Capital budgeting decisions

We interrupt this regularly scheduled program to bring you a special bulletin on the characteristics of business investments.


Characteristics of business investments

Characteristics of Business Investments


Business investments

Business Investments

  • Most business investments involve depreciable assets; and

  • The returns on business investments extend over long periods of time.


Depreciable assets

Depreciable Assets


Capital budgeting decisions

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

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

What is the Return?

Since the asset will still be intact at the end of the 10-year period, each year’s $750 inflow is a return on the original $5,000 investment. The rate of return is therefore:


Return on assets must

Return on Assets Must

  • Provide a returnon the original investment.

+

  • A returnof the original investment itself.


To illustrate1

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 return1

What is the Return?


Capital budgeting decisions

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


Long periods of time1

Long Periods of Time

  • In approaching capital budgeting decisions, it is necessary to employ techniques that recognize the time value of money.


Capital budgeting decisions

Discounted Cash Flow Models (DCF)


Dcf models

DCF Models . . .

Focus on . . .

  • Cash inflows; and

  • Cash outflows

    Rather than on net income


Dcf models1

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

Net Present Value

NPV


Net present value method

Net Present Value Method

Usually Future

Discount

PV$

Cash Inflows

Discount

(PV$)

Cash Outflows

Future and/or Present

NPV


Net present value method1

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

PV$

Cash Inflows

Discount

(PV$)

Cash Outflows

Future and/or Present

NPV

Go For It!


Net present value method2

Net Present Value Method

If the result is zero, the investment yields exactly the interest rate used to evaluate the proposal.

Usually Future

Discount

PV$

Cash Inflows

Discount

(PV$)

Cash Outflows

Future and/or Present

NPV

Go For It!


Net present value method3

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

PV$

Cash Inflows

Discount

(PV$)

Cash Outflows

Future and/or Present

NPV

(NPV)

No Way!


Typical cash outflows

Typical Cash Outflows

  • The initial investment

  • Additional amount of working capital

  • Repairs and maintenance

  • Additional operating costs


Typical cash inflows

Typical Cash Inflows

  • Incremental revenues

  • Reduction in costs

  • Salvage value

  • Release of working capital


Capital budgeting decisions

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?


Capital budgeting decisions

Item

Yr(s)

Amt of Cash Flow

18% Factor

Present Value of CF

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

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.


Capital budgeting decisions

Year

(1)

Inv O/S during Year

(2)

Cash Inflow

(3)

ROI (1)* 18%

(4)

Rec of Inv.

(2)-(3)

PV of Cash Flow

(1)-(4)

1

2

3

4

$40,350 - $7,737 = $32,613

$40,350

$15,000

$7,263

$7,737

$32,613

$40,350 x 18% = $7,263

$15,000 - $7,263 = $7,737

Return

On

Return

Of

The Investment

The Investment


Capital budgeting decisions

Year

(1)

Inv O/S during Year

(2)

Cash Inflow

(3)

ROI (1)* 18%

(4)

Rec of Inv.

(2)-(3)

PV of Cash Flow

(1)-(4)

1

2

3

23,483

15,000

4,227

10,773

12,710

4

12,710

15,000

2,290

12,710

-0-

$40,350

$15,000

$7,263

$7,737

$32,613

32,613

15,000

5,870

9,130

23,483


Practice exercise 1

Practice Exercise 1

Calculate Net Present Value (NPV)


Practice exercise 11

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?


Capital budgeting decisions

Item

Yr(s)

Amt of Cash Flow

12% Factor

Present Value of CF

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

Practice Exercise 2

Calculate Net Present Value (NPV)


Practice exercise 21

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 22

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 23

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 24

Practice Exercise 2

  • Determine the net cash flow for the life of the equipment.


Capital budgeting decisions

Item

Yr(s)

Amt of Cash Flow

14% Factor

Present Value of CF

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

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

Discount Rate . . .

  • The rate generally viewed as being the most appropriate is a firm’s cost of capital.

  • This rate is also known as . . .

    • Hurdle Rate

    • Cutoff Rate

    • Required Rate of Return


Internal rate of return

Internal Rate of Return

IRR


Net present value method4

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.

Net Present Value Method

Usually Future

Discount

PV$

Cash Inflows

Discount

(PV$)

Cash Outflows

Future and/or Present

Resulting in $0 NPV

NPV

$-0-


Internal rate of return1

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

Cost of Capital as a Screening Tool


Using the irr method

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

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.


Compare net present value and internal rate of return

CompareNet Present Value andInternal Rate of Return


Compare irr npv

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

Simplified Approaches to Capital Budgeting

The Payback Period


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 period1

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 period2

The Payback Period . . .

  • The payback period is expressed in years. The basic formula is . . .

Investment Req

--------------------------- = Payback Period

Net Annual CF


Practice exercise 3

Practice Exercise 3

Calculate the Payback period


Practice exercise 31

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 period3

The Payback Period . . .

$41,000

--------------------------- = 8.2 Years

$5,000


Simplified approaches to capital budgeting1

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

  • 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 return1

The Simple Rate of Return

  • If a cost reduction project is involved, the formula becomes:

*Less Salvage Value if any


Practice exercise 4

Practice Exercise 4

Calculate the Simple Rate of Return


Practice exercise 41

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 42

Practice Exercise 4


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