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Chapter 15. Capital Budgeting Applications. The Discount Rate. Affects the firm’s long-term financial survival Firm’s return on capital must be at least equal to the industry’s rate The higher the discount rate, the harder it is to find acceptable investments

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Chapter 15

Chapter 15

Capital Budgeting

Applications


The discount rate
The Discount Rate

  • Affects the firm’s long-term financial survival

  • Firm’s return on capital must be at least equal to the industry’s rate

  • The higher the discount rate, the harder it is to find acceptable investments

  • The firm’s discount rate is its weighted average cost of debt, retained earnings, and equity capital



The effect of taxes
The Effect of Taxes

  • Adjust cash flows for taxes, not the discount rate

  • Government encourages business capital investment through

    — Accelerated cost recovery programs

    —Investment tax credits

  • Depreciation is a non-cash expense that lowers the firm’s tax bill



Handling mutually exclusive investments with unequal lives
Handling Mutually Exclusive Investments with Unequal Lives

  • Select a common termination date

    — if one option has a 3-year life and the other one has a 5-year life, stop both projects at the end of year 3

  • Use a replacement cycle until projects have a common ending time

    — if one option has a 3-year life and the other a 5-year life, each is assumed to be replaced until the end of year 15—a common ending date


Ways to deal with uncertainty and risk
Ways to Deal withUncertainty and Risk

  • Develop alternative outcomes

    — The most optimistic

    — The most likely

    — The worst case

  • Calculate break-even cash flows


Types of leases
Types of Leases

  • Operating Lease

    — short periods

    — used for machinery and equipment rental

  • Financial Lease

    — long periods

  • Lease-Purchase Option

    — leasee may purchase item at end of lease


Use net present value to evaluate the lease borrow or buy decision
Use Net Present Value to Evaluate theLease, Borrow or BuyDecision

Select the option with the lowest cost

(least negative NPV)



The Purchasing with Borrowed Money Option



Discussion questions
Discussion Questions

  • Explain why a firm must generate a return at least equal to the average return on capital for that industry.

  • Explain why an inverse relationship exists between the present value of an investment and the discount rate.

  • Explain in your own words how the firm’s cost of capital is determined. In your answer describe how the cost of each part is determined.


Discussion questions1
Discussion Questions

  • Explain why depreciation is a non-cash expense and how the depreciation tax shield affects a firm’s capital budgeting decisions.

  • Develop a simple capital budgeting example using the net present value (NPV) procedure that shows how the accelerated cost recovery system increases the likelihood of greater capital investment by an agribusiness. Do the same thing for the investment tax credits.


Discussion questions2
Discussion Questions

  • Give your reaction to the statement that programs like accelerated cost recovery and investment tax credits distort financial markets and lead to over-investment in capital goods.

  • Explain how you would decide whether it is better to use the common termination period method or the replacement cycle method when evaluating mutually exclusive capital budgeting projects.


Discussion questions3
Discussion Questions

  • Define the terms risk and uncertainty. Explain how a manager can best deal with both of them.

  • Describe the procedures for developing alternative outcomes and break-even cash flows. Explain how an agribusiness manager would use them in making capital budgeting decisions.


Discussion questions4
Discussion Questions

  • Give three advantages of owning assets rather than leasing them. Give three advantages of leasing for an agribusiness.

  • Explain the financial procedures you would use to evaluate whether it is better to acquire assets by leasing, buying with cash, or buying with borrowed money. What financial calculations and other factors would you use to decide which one is best?


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