Capital budgeting decisions
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Capital Budgeting Decisions. Chapter 14. Capital Investments. Long Term in nature covering many years Large amounts of capital Investments are not easily or quickly disposed Critical to long-term profitability Affect human resources needs and composition. Prior to sending out requests.

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Capital investments
Capital Investments

  • Long Term in nature covering many years

  • Large amounts of capital

  • Investments are not easily or quickly disposed

  • Critical to long-term profitability

  • Affect human resources needs and composition


Prior to sending out requests
Prior to sending out requests

  • 1. Determination of dollars available for capital investments

  • 2. Determine the cost of capital (minimum rate of return)


Cost of capital
Cost of Capital

  • Also called Desired Rate of Return


Steps in choosing a proposal
Steps in choosing a proposal

  • Step 1: Identification of capital investment needs

  • Step 2: Formal requests for capital investments

  • Step 3: Preliminary screening (remove those that are not appropriate for the project)

  • Step 4: Evaluate the proposal based on Acceptance – rejection standards previously determined

  • Step 5: Rank the proposals

  • Step 6: Choose the best proposal (s).


Capital investment analysis methods
Capital Investment Analysis Methods

  • Net Present Value

  • Internal Rate of Return

  • Payback Period Method

  • Simple (Acctg) Rate of Return


Terms
Terms

  • Cash InFlows

    Increase in Net cash inflows

    Cost Savings

    Reduce Costs


  • Undiscounted Cash Inflows

    Rate of Return X Cash Inflows

  • Discounted Cash Inflows

    Adjusted for the loss of value over time

    Present Value Multiplier X Cash Inflows


Net present value method
NET PRESENT VALUE METHOD

Uses PRESENT VALUE Table

  • Columns: % Return

  • Rows: Number of Period

  • Multiplier or factor is where the rate intersects the period.


Periods (Not just years) Can be Semi Annual, Quarterly, Monthly

%- estimate return rate

Based on the number of periods

  • 10% for yearly

  • 5% for seimannual

  • 2.5% for quarterly

    Present Value of Cash InFlows ( How much is the money received in following years worth today)


What present value table
What Present Value Table

  • Present Value of $1

    • Received at the end of a period of time

    • Uneven cash inflows

  • Present Value of a Ordinary Annuity of $1

    • Received the same amount every period

    • Even Cash Inflows


  • Practice reading table
    PRACTICE READING TABLE

    • 1. What multiplier do you use if you receive $100,000 at the end of 10 years assuming a return of 7%? What is its present value?

    • .508

    • $100,000 * .508 = $50,800

    • 2. What multiplier do you use if you receive $10,000 every year for 10 years assuming a return of 7%. What is it’s present value?

    • 7.024

    • $10,000* 7.024 = $70,240


    Application
    Application

    • Exercise 14-1 Compare discounted cash flow with undiscounted cash flow

    • Exercise 14-9 Evaluating projects based on PV concept

    • Is 16% reasonable?


    Project profitability index
    Project Profitability Index

    Net Present Value of Project

    Investment required

    • Helpful to decide what project to select.

    • The higher the better

    • Amount of cash inflow generated for each dollar of investment


    Internal rate of return
    Internal Rate of Return

    Investment Required

    Annual Cash inflow

    • Rate that causes the PV of the project’s cash inflows to equal the PV of the investment

    • How much interest you need to receive to pay it back

    • Do not know the rate of return %.

    • Divide Investment required by Annual Cash Inflows

    • Gives you the multiplier factor.

    • Go to the number of periods and find this multiplier

    • Go to the top of the column to get the % = IRR


    Excercise 14 2
    Excercise 14-2

    • Only 1 and 2


    Apply npv and irr
    Apply NPV and IRR

    • Exercise 14-11


    Payback method
    Payback Method

    Investment Required

    Net Annual Cash Inflows

    • Time it takes for the investment to pay for itself.

    • In years.

    • Same as IRR

    • Use formula only if even cash inflows


    Payback period con t
    Payback Period con’t

    • Uneven cash inflows – Use following table


    Application1
    Application

    • Exercise 14-5 EVEN OR UNEVEN?


    Simple rate of return
    Simple Rate of Return

    Annual Incremental Net Income

    Initial Investment

    • Not Cash Inflow

    • Includes depreciation

    • Annual Revenue-Annual expenses/Invest.

    • Easier than Acctg rate of return but not accurate

    • No present value considered



    Ranking of investments
    Ranking of investments

    • Problem 14-26 pg 672

    • Rank based on NPV (inferior to PPI)

    • 1,2,4,3

    • Rank based on PPI (most dependable)

    • 3,2,1,4

    • Rank based on IRR (payback)

    • 4,3,2,1


    Application of npv concept
    Application of NPV Concept

    • Problem 14-27 pg 672



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