Download Presentation
## Capital Budgeting Decisions

- - - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - - -

**14**Chapter Capital Budgeting Decisions UAA – ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee**Capital Budgeting is . . .**. . . The making of long-term planning decisions for investments.**Capital Budgeting Decisions**• Should we purchase new labor-saving equipment to perform operations presently performed manually A Cost-Reduction Decision**Capital Budgeting Decisions**• Should we replace existing equipment with more efficient, newer equipment. A Cost-Reduction Decision**Capital Budgeting Decisions**• Should we enter a new market with a new product or purchase an existing business already in that market A Profit-Expansion Decision**Process of Capital Budgeting**• Identification Stage • Search Stage • Information-Acquisition Stage • Selection Stage • Financing Stage • Implementation and Control Stage**Project Selection . . .**• Selection in capital budgeting comes in two phases: • Screening, and • Preference**Screening . . .**• A specific criterion is used to eliminate unprofitable and/or high-risk investment proposals. • Projects meeting criteria • Projects not meeting criteria**Preference Selection**• The surviving projects are subjected to a ranking criterion. • Outcome: The most favorable projects are selected for any given amount of capital to be invested.**We interrupt this regularly scheduled program to bring you a**special bulletin on the characteristics of business investments.**Business Investments**• Most business investments involve depreciable assets; and • The returns on business investments extend over long periods of time.**A Theoretical View of Depreciation**Salvage Value $1 $5 $4 $3 $2 Time $1 $1 $1 $1 Consumed as Depreciation Expense An application of the Matching Principle**To Illustrate . . .**• A firm purchases land (a non-depreciable asset) for $5,000; and • Rents it out at $750.00 per year for ten years. What is the return?**What is the Return?**Since the asset will still be intact at the end of the 10-year period, each year’s $750 inflow is a return on the original $5,000 investment. The rate of return is therefore:**Return on Assets Must**• Provide a returnon the original investment. + • A returnof the original investment itself.**To Illustrate . . .**• A firm purchases land (a non-depreciable asset) for $5,000; and • Rents it out at $750.00 per year for ten years. Assume the $5,000 investment is in equipment and will reduce operating costs by $750 each year for 10 years. Hmmm. What now?**Why?**• Because part of the yearly $750 inflow from the equipment must go to recoup the original $5,000 investment itself, since the equipment will be worthless at the end of its 10-year life.**Long Periods of**Time**Long Periods of Time**• In approaching capital budgeting decisions, it is necessary to employ techniques that recognize the time value of money.**DCF Models . . .**Focus on . . . • Cash inflows; and • Cash outflows Rather than on net income**DCF Models . . .**• There are two main variations of the discounted cash flow model . . . • Net Present Value (NPV); and • Internal Rate of Return (IRR)**Net Present Value Method**Usually Future Discount PV$ Cash Inflows Discount (PV$) Cash Outflows Future and/or Present NPV**Net Present Value Method**If the result is positive, the investment promises more than the interest rate used to evaluate the proposal. Usually Future Discount PV$ Cash Inflows Discount (PV$) Cash Outflows Future and/or Present NPV Go For It!**Net Present Value Method**If the result is zero, the investment yields exactly the interest rate used to evaluate the proposal. Usually Future Discount PV$ Cash Inflows Discount (PV$) Cash Outflows Future and/or Present NPV Go For It!**Net Present Value Method**If the result is negative, the investment should be rejected because the required rate of return will not be earned. Usually Future Discount PV$ Cash Inflows Discount (PV$) Cash Outflows Future and/or Present NPV (NPV) No Way!**Typical Cash Outflows**• The initial investment • Additional amount of working capital • Repairs and maintenance • Additional operating costs**Typical Cash Inflows**• Incremental revenues • Reduction in costs • Salvage value • Release of working capital**PDQ Company – NPV Example**• PDQ company requires a minimum return of 18% on all investments. • The company can purchase a new machine at a cost of $40,350. The new machine would generate cash inflows of $15,000 per year and have a four-year life with no salvage value. • What is the net present value of this project?**Item**Yr(s) Amt of Cash Flow 18% Factor Present Value of CF PDQ Company – NPV Example Initial Inv. Now (40,350) 1.000 (40,350) Annual CF 1-4 15,000 2.690 40,350 Net Present Value -0-**Each $15,000 Inflow . . .**• Provides for a recovery of a portion of the original $40,350 investment; and • Also provides a return of 18% on this investment.**Year**(1) Inv O/S during Year (2) Cash Inflow (3) ROI (1)* 18% (4) Rec of Inv. (2)-(3) PV of Cash Flow (1)-(4) 1 2 3 4 $40,350 - $7,737 = $32,613 $40,350 $15,000 $7,263 $7,737 $32,613 $40,350 x 18% = $7,263 $15,000 - $7,263 = $7,737 Return On Return Of The Investment The Investment**Year**(1) Inv O/S during Year (2) Cash Inflow (3) ROI (1)* 18% (4) Rec of Inv. (2)-(3) PV of Cash Flow (1)-(4) 1 2 3 23,483 15,000 4,227 10,773 12,710 4 12,710 15,000 2,290 12,710 -0- $40,350 $15,000 $7,263 $7,737 $32,613 32,613 15,000 5,870 9,130 23,483**Practice Exercise 1**Calculate Net Present Value (NPV)**Practice Exercise 1**• An investment that costs $10,000 will return $4,000 per year for four years. • Determine the net present value of the investment if the required rate of return is 12 percent. Ignore income taxes. • Should the investment be undertaken?**Item**Yr(s) Amt of Cash Flow 12% Factor Present Value of CF Practice Exercise 1 Initial Inv. Now (10,000) 1.000 ($10,000) Annual CF 1-4 4,000 3.037 12,148 Net Present Value $2,148**Practice Exercise 2**Calculate Net Present Value (NPV)**Practice Exercise 2**• Magnolia Florist is considering replacing an old refrigeration unit with a larger unit to store flowers. • Because the new refrigeration unit has a larger capacity, Magnolia estimates that they can sell an additional $6,000 of flowers a year (the cost of the flowers is $3,500).**Practice Exercise 2**• In addition, the new unit is energy efficient and should save $950 in electricity each year. • It will cost an extra $150 per month for maintenance. • The new refrigeration unit costs $20,000 and has an expected life of 10 years.**Practice Exercise 2**• The old unit is fully depreciated and can be sold for an amount equal to disposal cost. • At the end of 10 years, the new unit has an expected residual value of $5,000 • Determine the NPV of the investment if the RRR is 14% (ignore taxes). • Should the investment be made.**Practice Exercise 2**• Determine the net cash flow for the life of the equipment.**Item**Yr(s) Amt of Cash Flow 14% Factor Present Value of CF Practice Exercise 2 Initial Inv. Now (20,000) 1.000 ($20,000) Annual CF 1-10 1,650 5.216 8,606 Salvage 10 5,000 .270 1,350 ($10,044) Net Present Value**Limiting Assumptions . . .**• All cash flows occur at the end of the period. • All cash flows generated by an investment are immediately reinvested in another project which yields a return at least as large as the discount rate used in the first project.**Discount Rate . . .**• The rate generally viewed as being the most appropriate is a firm’s cost of capital. • This rate is also known as . . . • Hurdle Rate • Cutoff Rate • Required Rate of Return