CHAPTER 26. C APITAL B UDGETING LONGRANGE PLANNING. Capital Budgeting . It is the process of considering alternative capital projects and selecting those alternatives that provide the most profitable return on available funds.
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I will choose theproject with the mostprofitable return onavailable funds.
Alternatives:
PlantExpansion
?
LimitedInvestmentFunds
NewEquipment
?
?
OfficeRenovation
Capital BudgetingImplementation of a capital project involves . . .
.
IncrementalOperatingCosts
RepairsandMaintenance
IncreasedWorking Capital
Capital BudgetingCash Flow AnalysisTypicalCash Outflows
ReducedOperatingCosts
ReleasedWorkingCapital
SalvageValue
Capital BudgetingCash Flow AnalysisTypicalCash Inflows
.
Cost of capital
Sunkcosts
Futurecashoutflows
Interest rateindicating thecost of debtand equityinvestmentfunds
Past cashoutflows
Avoided by not selectinga project
Not avoidedby currentdecision
Capital BudgetingTerminologyDepreciation itself is not a cash flow.
However, depreciation results in a reduction of cash outflows by reducing federal income taxes.
(
)
]
[
]
Aftertax net Beforetax net Tax Depreciation Tax cash inflow cash inflow rate expense rate
×
×
=
1 
+
×
×
[$20,000 (1  .4)] + [$6,000 .4] = $14,400
Depreciation and TaxesExample
Aftertax net cash inflow
Alternatively, reducing this analysis to a formula yields:
.
Time required for the sumof the annual net cashinflows to equal theinitial cash outlay.
Initial cash outlay Annual net cash inflow
Payback period =
Payback Period
When the annual net cash inflows are equal, use the following formula:
Initial cash outlay Annual net cash inflow
Payback period =
$150,000$30,000 per year
Payback period =
= 5.0 years
Payback PeriodExample
Gators should invest in the seafood bar
because the payback period is less than 6 years.
Consider two projects, each with a fiveyear life and each costing $6,000.
Which project has the better payback period?
Unadjusted Average annual incomerate of return Average amount of investment
=
Beginning balance + Ending balance2
Project Selection Method 2:Unadjusted Rate of ReturnThe unadjusted rate of return focuses on annual income instead of cash flows.
Unadjusted Rate of ReturnExample
Reconsider the Gators example:
What is the the unadjustedrate of return on the seafood bar?
)×(1  )
Unadjusted Average annual before Average annual TaxRate of tax net cash inflow depreciation rate return Average amount of investment

=
Unadjusted Average annual income after taxrate of return Average amount of investment
=
Unadjusted Rate of ReturnExample
Annual net cash inflows
$
30,000
Depreciation ($150,000 ÷ 10 years)
15,000
Annual income before tax
$
15,000
.
Unadjusted (30,000  15,000) x (1  .40)rate of return (150,000 + 0) ÷ 2
=
= 12.0%
Unadjusted Rate of ReturnLimitations
A comparison of the present value of cash inflows with the present value of cash outflows
Savak Company can buy a new machine for $96,000 which will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV (rounded)?
a. $ 4,306
b. $12,721
c. $11,553
d. $17,004
Savak Company can buy a new machine for $96,000 which will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV (rounded)?
a. $ 4,306
b. $12,721
c. $11,553
d. $17,004
Use present value of annuity table (A.4)
PV of inflows = $20,000 × 5.65022 = $113,004
NPV = $113,004  $96,000 = $17,004
Calculate the NPV if Savak Company’s required return is 14 percent instead of 12 percent.
Calculate the NPV if Savak Company’s required return is 14 percent instead of 12 percent.
Use present value of annuity table (A.4)
PV of inflows = $20,000 × 5.21612 = $104,322
NPV = $104,322  $96,000 = $8,322
Note that the NPV is smallerusing the larger interest rate.
Now that you have mastered the basic concept of net present value, it’s time for a more sophisticated checkup!
Harper Co. has been offered a fiveyear contract to provide parts for a large manufacturer, requiring an investment in new equipment.
The contract is expected to produce the following annual cash flows:
Harper uses a 10 percent discount rate. Ignoring income taxes, compute the net present value of the contract.
Harper Company Net Present Value Analysis
Harper Company Net Present Value Analysis
Harper Company Net Present Value Analysis
Present value of an annuity of $1
factor for 5 years at 10%.
Harper Company Net Present Value Analysis
Present value of $1
factor for 3 years at 10%.
Harper Company Net Present Value Analysis
Present value of $1
factor for 5 years at 10%.
Harper Company Net Present Value Analysis
Since the contract has positive NPV, we know the rate of return is greater than the 10 percent discount rate.
Present value of net cash inflows Present value of cash outflows
Profitability index =
Project Selection Method 4: Profitability Index.
Presentvalue ofcash outflows
=
Also known as theinternal rate of return.
Project Selection Method 5:Time Adjusted Rate of ReturnThe interest rate that makes . . .
For projects with equal annual cash flows (i.e., annuities)
Say that:
Project life = 4 yearsInitial cost = $42,523Annual net cash inflows = $14,000
Determine the IRR for this project.
1. Determine the payback period.
($42,523 ÷ $14,000 per year = 3.03736 years)
1. Determine the payback period. ($42,523 ÷ $14,000 per year = 3.03736 years)
2. Using present value of annuity table . . .
Locate the rowwhose numberequals the lifeof the project.
1. Determine the payback period. ($42,523 ÷ $14,000 per year = 3.03736 years)
2. Using present value of annuity table . . .
In that row,locate theinterest factorclosest inamount to thepayback period.
1. Determine the payback period. ($42,523 ÷ $14,000 per year = 3.03736 years)
2. Using present value of annuity table . . .
IRR is theinterest rateof the columnin which theinterest factoris found.
Decker Company can purchase a new machine at a cost of $104,322 that will save $20,000 per year in cash operating costs. The machine will have a 10year life.
What is the internal rate of return on this investment project?
Initial cash outlay Annual net cash inflow
Payback period =
$104,322 $20,000 per year
Payback period =
= 5.21610
Internal Rate of ReturnExample
In Table A4 in the appendix of your textbook, look across the 10period row until you find an interest factor of 5.21610 in the 14 percent column. The internal rate of return is 14 percent.
If 14 percent is greater than Decker’s required rate of return, Decker should purchase the new machine.
Here’s the proof . . .
If the exact interest rate is not found in the present value table, an estimate of the interest rate is required.
For a project with a fiveyear life and a payback periodof 3.65000, the IRR would be approximately 11.5 percent.
If cash inflows involve both annuities and onetime amounts, a trial and error solution will result if present value tables are used.
Sophisticated business calculators and electronic spreadsheets can be used to easily solve these problems.
Compare the cost of capital to the internal rate of return on a project.
To be acceptable, a project’s rate of return cannot be less than the cost of capital.
Net Present Value
The cost of capital is used as the actual discount rate.
Any project with a negative net present value is rejected.
Net Present Value vs.Internal Rate of ReturnI’m telling you, that’s the end. There isn’t any more of thisvirtual lecture.