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