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Capital Budgeting Decisions

Chapter 12. Capital Budgeting Decisions. Capital Budgeting. How managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment and introduction of new products. Typical Capital Budgeting Decisions. Plant expansion. Equipment selection.

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Capital Budgeting Decisions

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  1. Chapter12 Capital Budgeting Decisions

  2. Capital Budgeting How managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment and introduction of new products.

  3. Typical Capital Budgeting Decisions Plant expansion Equipment selection Equipment replacement Lease or buy Cost reduction

  4. Typical Capital Budgeting Decisions Capital budgeting tends to fall into two broad categories . . . • Screening decisions. Does a proposed project meet some present standard of acceptance? • Preference decisions. Selecting from among several competing courses of action.

  5. Time Value of Money • Business investments extend over long periods of time, so we must recognize the time value of money. • Investments that promise returns earlier in time are preferable to those that promise returns later in time.

  6. Time Value of Money A dollar today is worth more than a dollar a year from now since a dollar received today can be invested, yielding more than a dollar a year from now.

  7. Interest and the Time Value of Money If $100 is invested today at 8% interest, how much will you have in two years? At the end of one year: $100 + 0.08$100 = (1.08)$100 = $108 At the end of two years: $108 + 0.08$108 = (1.08)$108 = (1.08)[(1.08)$100] = (1.08)2 $100 = $116.64

  8. Interest and the Time Value of Money If P dollars are invested today at the annual interest rate r, then in n years you would have Fn dollars computed as follows: Fn = P(1 + r)n

  9. Interest and the Time Value of Money The present value of any sum to be received in the future can be computed by turning the interest formula around and solving for P:

  10. Interest and the Time Value of Money A bond will pay $100 in two years. What is the present value of the $100 if an investor can earn a return of 12% on investments? P = $100 (0.797) P = $79.70

  11. Interest and the Time Value of Money A bond will pay $100 in two years. What is the present value of the $100 if an investor can earn a return of 12% on investments? Present Value = $79.70 What does this mean? If $79.70 is put in the bank today, it will be worth $100 in two years. In that sense, $79.70 today is equivalent to $100 in two years.

  12. Interest and the Time Value of Money Let’s verify that if we put $79.70 in the bank today at 12% interest that it would grow to $100 at the end of two years.

  13. Time Value of Money A bond will pay $100 in two years. What is the present value of the $100 if an investor can earn a return of 12% on investments? We can also determine the present value using present value tables.

  14. Time Value of Money Excerpt from Present Value of $1Table in the Appendix to Chapter 12

  15. Present value factor of $1 for 2 periods at 12%. Time Value of Money $100 × 0.797 = $79.70 present value

  16. Quick Check  How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62.10 b. $56.70 c. $90.90 d. $51.90

  17. $100 $100 $100 $100 $100 $100 1 2 3 4 5 6 Time Value of Money An investment that involves a series of identical cash flows at the end of each year is called an annuity.

  18. Time Value of Money Lacey Inc. purchased a tract of land on which a $60,000 payment will be due each year for the next five years. What is the present value of this stream of cash payments when the discount rate is 12%?

  19. Time Value of Money We could solve the problem like this . . . Look in Appendix B of this Chapter for the Present Value of an Annuity of $1 Table

  20. Time Value of Money We could solve the problem like this . . . $60,000 × 3.605 = $216,300

  21. Quick Check  If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? a. $34.33 b. $500 c. $343.30 d. $360.50

  22. Quick Check  If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? a. $866.90 b. $178.60 c. $ 86.90 d. $300.00

  23. Repairs and maintenance Working capital Initial investment Incremental operating costs Typical Cash Outflows

  24. Salvage value Release of working capital Reduction of costs Incremental revenues Typical Cash Inflows

  25. Illustration of the NPV Method Carver Hospital is considering the purchase of an attachment for its X-ray machine. No investments are to be made unless they have an annual return of at least 10%.Will we be allowed to invest in the attachment?

  26. Present value of an annuity of $1 table Illustration of the NPV Method

  27. Illustration of the NPV Method Because the net present value is equal to zero, the investment in the attachment for the X-ray machine provides exactly a 10% return.

  28. Quick Check  Suppose that the investment in the attachment for the X-ray machine had cost $4,000 and generated an increase in annual cash inflows of $1,200. What is the net present value of the investment? a. $ 800 b. $ 196 c. $(196) d. $(800)

  29. Choosing a Discount Rate • The firm’scost of capitalis usually regarded as the most appropriate choicefor the discount rate. • The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds.

  30. The Net Present Value Method To determine net present value we . . . • Calculate the present value of cash inflows, • Calculate the present value of cash outflows, • Subtract the present value of the outflows from the present value of the inflows.

  31. The Net Present Value Method General decision rule . . .

  32. Let’s look at how we use present value to make business decisions. The Net Present Value Method

  33. The Net Present Value Method Lester Company has been offered a five year contract to provide component parts for a large manufacturer.

  34. The Net Present Value Method • At the end of five years the working capital will be released and may be used elsewhere by Lester. • Lester Company uses a discount rate of 10%.Should the contract be accepted?

  35. The Net Present Value Method Annual net cash inflows from operations

  36. The Net Present Value Method

  37. Present value of an annuity of $1 factor for 5 years at 10%. The Net Present Value Method

  38. Present value of $1 factor for 3 years at 10%. The Net Present Value Method

  39. Present value of $1 factor for 5 years at 10%. The Net Present Value Method

  40. The Net Present Value Method Accept the contract because the project has a positivenet present value.

  41. Quick Check Data Denny Associates has been offered a four-year contract to supply the computing requirements for a local bank. • The working capital would be released at the end of the contract. • Denny Associates requires a 14% return.

  42. Quick Check  What is the net present value of the contract with the local bank? a. $150,000 b. $ 28,230 c. $ 92,340 d. $132,916

  43. Expanding the Net Present Value Method To compare competing investment projects we can use the following net present value approaches: • Total-cost • Incremental cost

  44. The Total-Cost Approach • White Co. has two alternatives: (1) remodel an old car wash or, (2) remove it and install a new one. • The company uses a discount rate of 10%.

  45. The Total-Cost Approach If White installs a new washer . . . Let’s look at the present valueof this alternative.

  46. The Total-Cost Approach If we install the new washer, the investment will yield a positive net present value of $83,202.

  47. The Total-Cost Approach If White remodels the existing washer . . . Let’s look at the present valueof this second alternative.

  48. The Total-Cost Approach If we remodel the existing washer, we will produce a positive net present value of $56,405.

  49. The Total-Cost Approach Both projects yield a positive net present value. However, investing in the new washer will produce a higher net present value than remodeling the old washer.

  50. The Incremental-Cost Approach Under the incremental-cost approach, only those cash flows that differ between the two alternatives are considered. Let’s look at an analysis of the White Co. decision using the incremental-cost approach.

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