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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

slide8

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.
slide10

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
slide22

Exercise 14-6

  • Both Payback period and SRR
  • Exercise 14-13
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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