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Capital Budgeting DecisionsPowerPoint Presentation

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

- 1. Determination of dollars available for capital investments
- 2. Determine the cost of capital (minimum rate of return)

Cost of Capital

- Also called Desired Rate of Return

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

- Net Present Value
- Internal Rate of Return
- Payback Period Method
- Simple (Acctg) Rate of Return

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

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 Present Value of a Ordinary Annuity of $1

- Present Value of $1
- Received at the end of a period of time
- Uneven cash inflows

- Received the same amount every period
- Even Cash Inflows

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

- 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

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

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

- Only 1 and 2

Apply NPV and IRR

- Exercise 14-11

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

- Uneven cash inflows – Use following table

Application

- Exercise 14-5 EVEN OR UNEVEN?

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

- Exercise 14-6
- Both Payback period and SRR
- Exercise 14-13

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

- Problem 14-27 pg 672

SRR, IRR and payback methods

- Problem 14-28

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