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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

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

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

A Cost-Reduction Decision

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

A Cost-Reduction Decision

- 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

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

- Selection in capital budgeting comes in two phases:
- Screening, and
- Preference

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

- Projects meeting criteria

- Projects not meeting criteria

- 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

- 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

- 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?

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:

- Provide a returnon the original investment.

+

- A returnof the original investment itself.

- 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?

- 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

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

Discounted Cash Flow Models (DCF)

Focus on . . .

- Cash inflows; and
- Cash outflows
Rather than on net income

- 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

Usually Future

Discount

PV$

Cash Inflows

Discount

(PV$)

Cash Outflows

Future and/or Present

NPV

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!

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!

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!

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

- 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?

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-

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

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

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

Calculate Net Present Value (NPV)

- 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

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

Calculate Net Present Value (NPV)

- 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).

- 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.

- 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.

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

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

- 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.

- 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

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.

Usually Future

Discount

PV$

Cash Inflows

Discount

(PV$)

Cash Outflows

Future and/or Present

Resulting in $0 NPV

NPV

$-0-

- 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

- 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.

- 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

- 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

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

Investment Req

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

Net Annual CF

Practice Exercise 3

Calculate the Payback period

- 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.

$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 is equal to
- Incremental income from the project divided by
- the initial investment in the project.

*Less Salvage Value if any

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

*Less Salvage Value if any

Practice Exercise 4

Calculate the Simple Rate of Return

- Martin Company is considering the purchase of a new piece of equipment. Relevant information concerning the equipment follows:
- Compute the Simple Rate of Return.