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### Chapter 11

### Supplement 11A

Capital Budgeting

Capital Budgeting Process

Plant expansion

Equipment replacement

Equipment selection

Capital budgeting is a decision-making approach aimed at helping managers make decisions about investments in major capital assets, such as new facilities, equipment, new products, and research and development projects.

Lease or buy

Cost reduction

There are two main types ofcapital investment decisions.

Capital Investment DecisionsScreening Decisions

Preference Decisions

Pertain to whether or not some proposed investment is acceptable; these decisions come first.

Attempt to rank acceptable alternatives from the most to least appealing.

Capital budgeting decisions canbe placed into two categories.

Capital Investment DecisionsIndependent Projects

Mutually Exclusive Projects

Projects are unrelated, so investing in one does not preclude or eliminate investing in the other projects.

Investment choices are competing alternatives, so accepting one leads to rejection of the others.

Capital Budgeting Methods

To illustrate how the five capital budgeting methods work, assume that managers in Apple’s iPod division are considering producing a special version of the iPod Touch that would be marketed to children and their parents. The new device, called the iKids Touch, would be designed to appeal to children, with durable components, “kid friendly” controls, and bright colors.

The basic question that managers must answer is whether this proposed project is worth the $1 million up-front investment.

Learning Objective 11-1

Calculate the accounting rate of return and describe its major weaknesses.

Accounting Rate of Return

AnnualNetIncome

Initial Investment

AccountingRate of

Return

÷

=

$108,000

$1,000,000

10.8%

÷

=

Accounting Rate of Return

Shortcoming and Criticisms

- The time value of money is ignored.
- The accounting rate of return is based on accounting netincome instead of cash flow.
- Depreciation may be calculated several waysand, in addition, other accounting method alternatives may have an impact on reported net income.

Net Cash Flow versus Net Income

To convert from net income to net cash flow, we must add back the depreciation that was deducted in the computation of net income, as shown below.

Learning Objective 11-2

Calculate the payback period and describe its major weaknesses.

Payback Period

InitialInvestment

Annual Net Cash

Flow

PaybackPeriod

=

÷

Net Income + Depreciation

$1,000,000

$308,000

3.25 years

=

÷

$108,000 + $200,000

Payback Period

When annual cash flows are unequal, the payback period must be computed on a year by year basis by subtracting the net cash flow from the unpaid investment balance each year.

The payback period is somewherebetween 3 and 4 years.

Payback Period

Shortcoming and Criticisms

- The time value of money is ignored.
- The payback period ignores cash flows after the payback period.

Time Value of Money

One dollar received today is worth more than one dollar received a year from now because the dollar can be invested to earn interest.

Time Value of Money

Discounting is exactly the opposite of compounding. Just as interest builds up over time through compounding, discounting involves backing out the interest to determine the equivalent value in today’s present value dollars.

Time Value of Money

Discounted Cash Flow Methods

Net Present Value

Internal Rate of Return

Profitability Index

Assumptions:

All future cash flows happen at the end of the year.

Cash inflows are immediately reinvested in another project.

All cash flows can be projected with 100 percent certainty.

Learning Objective 11-3

Calculate net present value and describe why it is superior to the other capital budgeting techniques.

Net Present Value (NPV)

The net present value (NPV) method compares the present value (PV) of a project’s future cash inflows to the PV of the cash outflows.

The reason is that accounting net income is based on accruals that ignore the timing of cash flows into and out of an organization.

- Chose a discount rate – the minimum required rate of return.

- Calculate the presentvalue of cash inflows.

- Calculate the presentvalue of cash outflows.

NPV = –

Net Present Value (NPV)Net Present Value (NPV)

Relationship Between NPV andthe Required Rate of Return

Net Present Value (NPV)

Let’s return to iKids Touch’s proposal. Recall that the up-front investment is $1,000,000, and the product’s estimated life is 5 years. iKids Touch’s required rate of return is 12%. iKids Touch estimates the new product will generate $308,000 in cash flow for each of the next five years.

Since the NPV is positive, we know the rate of returnis greater than the 12 percent discount rate.

Net Present Value (NPV)

Assume that the expected cash flows for the iKids Touch project for years 1 to 5 are $250,000, $300,000, $340,000, $375,000, and $300,000, respectively. The project will still require an investment of $1,000,000 and the cost of capital is still 12 percent.

Relationship Between NPV and Discount Rates

Learning Objective 11-4

Predict the internal rate of return and describe its relationship to net present value.

Presentvalue ofcash inflows

Presentvalue ofcash outflows

=

Internal Rate of Return (IRR)The internal rate of return is the interest rate that makes . . .

- The net present value equal zero.

Computing IRR in Excel

One important note about the IRR function is that you must include the original cash outflow in the calculation.

Profitability Index

The profitability index is the ratio of a project’s benefits (measured by the present value of the future cash flows) to its costs (or required investment).

Profitability Index > 1 = Project Acceptable

Profitability Index < 1 = Project Unacceptable

Learning Objective 11-5

Use the net present value method to analyze mutually exclusive capital investments.

Case 1: Lease or Buy Equipment

iKids Touch is trying to decide whether to buy a new copier or lease it from a copier company, and has gathered the following information about the two options:

iKids Touch uses net present value to evaluateinvestment options. If the discount rate is 10%,should the company lease or buy?

Case 1: Lease or Buy Equipment

To analyze this decision, we can use the NPV method to compare the relevant costs (in present dollar values) of each option.

Lease option costs $1,419 less.

Case 2: Investing in Automation

- iKids Touch is thinking of spending $10,000,000 to automate a production facility. The investment is expected to have the following effects:
- Automation will increase the capacity of the plant and allow it to boost production and sales by 20 percent.
- The company will be able to reduce packaging labor cost per unit by 30 percent.
- Factory supervision costs will increase by $500,000 per year.
- The estimated useful life of the equipment is six years, at which point it will have a residual value of $1,000,000. Straight-line depreciation of the assets will be $1,500,000 per year [($10,000,000 – 1,000,000) ÷ 6 years = $1,500,000].

Case 2: Investing in Automation

This table summarizes the effects on net income. The per-unit costs in the first column are assumed. Note that automation increases net income by $1,100,000.

iKids Touch uses net present value to evaluateinvestments. If the discount rate is 12%, shouldthe company make the $10,000,000 investment?

Case 2: Investing in Automation

Remember that the net present value method is based on cash flow rather than net income. So, we need to add back the depreciation (a noncash expense) to net income to get net cash flow. We also need to incorporate the initial investment (at time zero) and the salvage value of the machinery at the end of six years.

The positive net present value of $1,196,240 means that the proposed investment in automation will generate a return in excess of the 12% cost of capital.

Learning Objective 11-6

Use the profitability index to prioritize independent capital investment projects.

Prioritizing Independent Projects

The profitability index is used to prioritize capital investment projects.

Present Value of Future Cash flows

ProfitabilityIndex

Initial Investment

÷

=

When using the profitability index to prioritize projects, the preference rule is: the higher the profitability index, the more desirable the project.

Prioritizing Independent Projects

iKids Touch is trying to decide how to prioritize their limitedresearch and development budget. They areconsidering these three independent projects.

How should iKids Touch prioritize these three projects?

A, then B, then C

Time Value of Money

Learning Objective 11-S1

Use present value and future value tables to incorporate the time value of money.

Time Value of Money

Present and future value problems may involve two types of cash flow: a single payment or an annuity (a fancy word for a series of equal cash payments)

Future Value of a Single Amount

To solve a future value problem, you need to know three things:

Amount to be invested.

Interest rate (i) the amount will earn.

Number of periods (n) in which the amount will earn interest.

Using Table 11.1A.: $1,000 × 1.3310 = $1,331

Present Value of a Single Amount

The present value of a single amount is the value to you today of receiving some amount of money in the future. To compute the present value of an amount to be received in the future, we must discount (a procedure that is the opposite of compounding) at i interest rate for n periods.

Assume that today is January 1, 2013, and you have the opportunity to receive $1,000 cash on December 31, 2015 (three years from today). At an interest rate of 10 percent per year, how much is the $1,000 payment worth to you on January 1, 2013 (today)? You could discount the amount year by year, but it is easier to use Table 11.2A , Present Value of $1.

Using Table 11.2A.: $1,000 × 0.7513 = $751.30

Future Value of an Annuity

The future value of an annuity includes compound interest on each payment from the date of payment to the end of the term of the annuity. Each new payment accumulates less interest than prior payments because the number of periods in which to accumulate interest decreases.

Assume that each year for three years, you deposit $1,000 cash into a savings account that earns 10 percent interest per year. You make the first $1,000 deposit on December 31, 2013, the second one on December 31, 2014, and the third and last one on December 31, 2015. To calculate the future value of this annuity, use Table 11.3A , Future Value of an Annuity of $1.

Using Table 11.3A.: $1,000 × 3.3100 = $3,310

Present Value of an Annuity

The present value of an annuity is the value now of a series of equal amounts to be received (or paid out) for some specified number of periods in the future.

Assume you are to receive $1,000 cash on each December 31 for three years: 2013, 2014, and 2015. How much would the sum of these three $1,000 future amounts be worth on January 1, 2013, assuming an interest rate of 10 percent per year? To calculate the present value of this annuity, use Table 11.4A , Present Value of an Annuity of $1.

Using Table 11.4A.: $1,000 × 2.4869 = $2,487 (rounded)

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