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Chapter 10 Capital Budgeting
Learning Objectives • Understand the purpose and need for capital budgeting. • Explain the impact that government regulations may have on a company’s capital budgeting decision. • List and explain the steps required in making a capital budgeting decision. • Distinguish between startup costs, working capital commitment costs, and tax factor costs and the role each plays in the capital budgeting decision.
Learning Objectives (continued) • Compare the relationship between increased efficiency benefits and tax factor benefits and understand their effect on a company’s cash flow. • Understand payback, net present value, profitability index, internal rate of return, and accounting rate of return as techniques of capital budgeting. • Compute the payback of a capital budgeting project. • Using time value of money, compute the net present value of a capital budgeting project.
Learning Objectives (continued) • Given a company’s investment costs, calculate the weighted average cost of capital. • Calculate and compare a company’s internal rate of return to its accounting rate of return. • Determine how a company’s capital budgeting decision makes a project mutually exclusive. • Determine how a company’s capital budgeting decision is influenced by capital rationing. • Understand the importance of following up, controlling, and taking corrective action after a capital budgeting decision has been made.
Capital Budgeting • Capital budgeting is the method we use to justify the acquisition of capital goods (those items that have a useful life in excess of one year). • Assumptions: • Long-term assets generate increased cash flow by improving efficiency and effectiveness. • Rates of return on investments and current inflation rate will remain the same.
Factors Affecting Capital Budgeting • Changes in government regulations • Research and development • Changes in business strategy
Steps in Capital Budgeting • Formulate a proposal • Evaluate the data • Make a decision • Follow up • Take corrective action
Formulating a Proposal • Costs in capital budgeting • Startup costs • Working capital commitment cost • Tax factor costs • Benefits in capital budgeting • Increased efficiency • Reducing taxable income • Tax factor benefits • Depreciation
Evaluating the Data-techniques of Capital Budgeting • There are six methods that are used to evaluate the capital budgeting proposal. • Payback • Net present value (NPV) • Profitability index (PI) • Internal rate of return (IRR) • Accounting rate of return (ARR, also known as average rate of return) • Lowest total cost (LTC)
Payback • Payback deals with the number of years that it will take a business to get back the money that it has invested in a project or asset. Where C = Cost of the project ATB = Annual after-tax benefit of the project
Net Present Value, or NPV • The net present value method of capital budgeting uses the time value of money by discounting future benefits and costs back to the present. • It applies the present-value-of-a-stream-of-payments technique for even cash flows and the present-value-of-a-future-lump-sum technique for unequal yearly cash flows. • The calculations are made using an interest rate that matches our cost of capital for the investment. This rate is used because the company must pay this cost on an annual basis to obtain the financial capital necessary to make the investment.
Net Present Value, or NPV (continued) • There are two interest rates that we must consider: • The interest rate charged by the supplier of funds, or the lender • The interest rate that the borrower could receive by investing in some other enterprise (the latter is the borrower’s opportunity cost)
Net Present Value, or NPV (continued) • There are three components that determine the lenders’ interest rate: • The real rate of return (the return that will be received after factoring out inflation) • The inflation premium (the expected average inflation rate for the term of the investment) • The risk premium (the rate added to the interest rate to take into account the risk of the investment)
Net Present Value, or NPV (continued) • Weighted average cost of capital (WACC) is obtained by multiplying the cost of debt (rate that the lender charges) by its proportion of total funds raised, and multiplying the cost of equity (opportunity cost to the owner) by its proportion of total funds raised.
Net Present Value, or NPV (continued) • WACC Example: You are buying a piece of equipment for $100,000. You will put $30,000 down and finance the remaining $70,000. Your opportunity cost is 4.00% for the $30,000 and 8.75% for the $70,000 loan.
Net Present Value, or NPV (continued) • Calculations of WACC:
Net Present Value, or NPV (continued) • NPV considers all of the future cash flows over the asset’s entire economic life. Where • NPV = Net present value of the investment • PVB = Present value of the benefit as calculated in the following example • PVC = Present value of the cost of the investment as calculated in the following example
Net Present Value, or NPV (continued) • Making the decision using NPV: • If NPV is positive using the WACC, the investment should be made. • If NPV is negative using the WACC, the investment should not be made. • NPV has two primary advantages: • Future cash flows that will be paid and received can be discounted back to the present so that a decision on the investment can be made now. • Interest rates are determined by and based on the weighted average cost of capital that takes risk into consideration.
Profitability Index, or PI • The profitability index is the ratio of the present value of the benefits to the present value of the costs. The formula for PI is:
Internal Rate of Return, or IRR • The internal rate of return is the actual rate of return of an investment and uses the time value of money in its calculation. The IRR is the interest rate that matches the present value of the cost of our investment directly with the present value of the future benefits received.
Internal Rate of Return, or IRR (continued) • The future benefits can be in the form of a stream of payments over a period of time or a lump sum (salvage value) received. • The IRR is the interest rate that occurs when the NPV is zero. If the NPV is zero, then by definition, the present value of the costs must equal the present value of the benefits. • The IRR is an interest rate that corresponds to a present value annuity factor that is found by dividing the present value of the cost by the period’s cash flow.
Internal Rate of Return, or IRR (continued) • This is interpolation based on the data in the previous tables:
Accounting Rate of Return, or ARR • The accounting rate of return is the average annual income from a project divided by the average cost of the project. • The formula is: • Example: Invest $10,000. Receive royalties of $3,000 per year. Using ARR, $3,000 divided by $10,000 is a 30% accounting rate of return.
Lowest Total Cost • The lowest total cost (LTC) method of capital budgeting is similar to the net present value (NPV) method because it uses the time value of money by discounting future costs and benefits back to the present.
Lowest Total Cost (continued) • The method used to determine the lowest present value of total cost is as follows: • Include all costs associated with two or more competing investments. • Calculate the present value of these costs. Add the present value of any benefits (salvage value) that may be obtained on the investment. • Select the investment with the lowest overall total cost.
Making the Decision • The methods previously discussed are often used in making a capital budgeting decision. However, two other scenarios exist. • Mutually Exclusive: Some investments are mutually exclusive because one is chosen and the others are automatically sacrificed or excluded. • Capital Rationing: Capital rationing is a constraint placed on the amount of funds that can be invested in a given time period.
Following Up • Following up consists of monitoring and controlling our cash flows. • A post-audit requires the owner or manager to establish procedures that will determine how well the outcome of the decision correlates with the proposal. • Controlling, as we have said before, is a three-step process: (1) establish standards for measuring the project, (2) measure actual performance against the standards established, and (3) take corrective action if required.
Table Solutions to Problems The following slides contain the Excel spreadsheets for problems that require solutions using tables.