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Capital Budgeting Decisions

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### 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 special bulletin on the

### Depreciable Assets special bulletin on the

### Long Periods of Time

### Net Present Value Time

### Practice Exercise 1 Time

### Practice Exercise 2 Time

### Internal Rate of Return Time

### Cost of Capital as a Screening Tool which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

### Compare which will exactly equate the PV of the cash inflows with the PV of the cash outflows.Net Present Value andInternal Rate of Return

### Simplified Approaches to Capital Budgeting which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

### Practice Exercise 3 which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

### Simplified Approaches to Capital Budgeting which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

### Practice Exercise 4 which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

Chapter

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

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

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.

Business Investments special bulletin on the

- Most business investments involve depreciable assets; and
- The returns on business investments extend over long periods of time.

A Theoretical View of Depreciation special bulletin on the

Salvage Value

$1

$5

$4

$3

$2

Time

$1

$1

$1

$1

Consumed as Depreciation Expense

An application of the

Matching Principle

To Illustrate . . . special bulletin on the

- 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? special bulletin on the

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 special bulletin on the

- Provide a returnon the original investment.

+

- A returnof the original investment itself.

To Illustrate . . . special bulletin on the

- 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? special bulletin on the

Why? special bulletin on the

- 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 Time

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

DCF Models . . . Time

- There are two main variations of the discounted cash flow model . . .
- Net Present Value (NPV); and
- Internal Rate of Return (IRR)

NPV

Net Present Value Method Time

Usually Future

Discount

PV$

Cash Inflows

Discount

(PV$)

Cash Outflows

Future and/or Present

NPV

Net Present Value Method Time

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 Method Time

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 Method Time

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 Time

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

Typical Cash Inflows Time

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

PDQ Company – NPV Example Time

- 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?

Item Time

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 . . . Time

- Provides for a recovery of a portion of the original $40,350 investment; and
- Also provides a return of 18% on this investment.

Year Time

(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

Year Time

(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

Calculate Net Present Value (NPV)

Practice Exercise 1 Time

- 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?

Item Time

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

Calculate Net Present Value (NPV)

Practice Exercise 2 Time

- 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 Time

- 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 Time

- 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 Time

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

Item Time

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 . . . Time

- 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 . . . Time

- 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

IRR

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 MethodUsually Future

Discount

PV$

Cash Inflows

Discount

(PV$)

Cash Outflows

Future and/or Present

Resulting in $0 NPV

NPV

$-0-

Internal Rate of Return which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

- When the annual cash flows are even, the IRR formula is simply . . .
- df = I / CF, or
- Investment/Annual Cash Flow

Using the IRR Method which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

- 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 which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

- 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 IRR & NPV . . . which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

- 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.

The Payback Period

The Payback Period . . . which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

- 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 . . . which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

- 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 . . . which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

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

Investment Req

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

Net Annual CF

Calculate the Payback period

Practice Exercise 3 which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

- 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 . . . which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

$41,000

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

$5,000

The Simple Rate of Return

AKA: Accounting Rate of Return

The Simple Rate of Return which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

- 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 which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

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

*Less Salvage Value if any

Calculate the Simple Rate of Return

Practice Exercise 4 which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

- 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 which will exactly equate the PV of the cash inflows with the PV of the cash outflows.

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