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Capital budgeting. Chapter 10 Adelman & Marks. Key terms. Capital budgeting The method used to justify the acquisition of capital goods Capital goods Assets that have a useful life greater than 1 year. Why capital budgeting?.

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capital budgeting

Capital budgeting

Chapter 10

Adelman & Marks

key terms
Key terms
  • Capital budgeting
    • The method used to justify the acquisition of capital goods
  • Capital goods
    • Assets that have a useful life greater than 1 year
why capital budgeting
Why capital budgeting?
  • A company should make the decision to enter into a specific project, acquire another company, or purchase a specific long-term asset if the present value of the benefits exceeds the the present value of the costs.
  • Remember that assets are tools your business uses to help generate revenues
  • Example: Capital budgeting helps a business to make the most profitable decisions regarding purchase of delivery vehicles.
factors affecting capital budgeting
Factors Affecting Capital Budgeting
  • Changes in regulations (CFC banned in air conditioning)
  • Research and Development investments (half of all new products fail)
  • Changes in business strategy (when economy changes or opportunities/threats arise
five steps in capital budgeting
Five Steps in Capital Budgeting
  • Write a proposal that identifies projected costs and benefits
  • Evaluate the data with respect to expected benefits and costs
  • Make a decision that provides greatest value while minimizing costs
  • Follow up on decision through post-audit to compare costs to benefits
  • Take corrective action if post-audit indicates benefits are not meeting expectations
costs in capital budgeting
Costs in capital budgeting
  • Start-up costs – total $ spent to start a project (equipment, training costs, maintenance, service agreements, hiring new people, storage space, etc)
  • Working capital costs – cash, investments, A/R, and inventory to show bank you can make monthly payments ($ is legally committed to lender, so it’s an opportunity cost)
  • Tax factor costs – additional taxes that have to be paid
benefits in capital budgeting
Benefits in capital budgeting
  • Investments in capital equipment should increase cash flows
  • Capital equipment investments can be written off and provide reduced tax liability
  • MACRS! (see MACRS worksheet)
  • Payback
  • Net present value (NPV)
  • Profitability index (PI)
  • Internal rate of return (IRR)
  • Accounting rate of return (ARR)
  • Lowest total cost (LTC)
  • # of years it takes to get back the money it invested in project or asset
  • Payback = C / ATB
    • C = cost of project
    • ATB = annual after-tax benefit of project
  • Example – invest in $25,000 project that creates $3,000 in ATB
  • Payback occurs in $25,000/$3,000 = 8.33 yrs
net present value
Net present value
  • Uses time value of $ by discounting future costs and benefits to present
  • Combines:
    • PV of stream of payments for even cash flows and
    • PV of future lump sum of unequal yearly cash flows
  • Important considerations – (1) interest rate of lender and (2) interest rate you could make by investing in some other project or asset
weighted average cost of capital
Weighted Average Cost of Capital
  • Multiplies cost of debt by its proportion of total funds raised and multiplies cost of equity (opportunity cost to owner) by its proportion of total funds raised
  • Key terms:
    • Real rate of return (return received after factoring out inflation)
    • Inflation premium (expected average inflation for term of investment)
    • Risk premium (rate added to interest rate to account for risk of investment) (see Techniques)
getting to npv
Getting to NPV
  • NPV = PVB - PVC
  • NPV is net present value of investment
  • PVB is present value of the benefit
  • PVC is present value of the cost of the investment
  • If NPV is negative, do not make the investment (see example)
profitability index
Profitability Index
  • PI = PVB / PVC
  • From example: $170,394/$100,000 = 1.70
  • This project returns $1.70 for every $1 invested
accounting rate of return
Accounting rate of return
  • ARR = (average annual income)/(average cost of investment over its life)
  • Does not incorporate time value of $
  • Example: spend $10,000 on software that will help you earn $3,000/yr for 4 yrs
  • ARR = $3,000/$10,000 = 30%
lowest total cost
Lowest total cost
  • Include all costs associated with two or more competing investments
  • Calculate PVs of these costs
  • Add the present value of any residual benefits (salvage value) that investment can provide
  • Select investment with lowest total cost
  • Use NPV for new projects or assets
  • For existing operations (replacing equipment and service contracts) use LTC