Capital Budgeting Decisions

Capital Budgeting Decisions Chapter 14

Capital Investments • Long Term in nature covering many years • Large amounts of capital • Investments are not easily or quickly disposed • Critical to long-term profitability • Affect human resources needs and composition

Prior to sending out requests • 1. Determination of dollars available for capital investments • 2. Determine the cost of capital (minimum rate of return)

Cost of Capital • Also called Desired Rate of Return

Steps in choosing a proposal • Step 1: Identification of capital investment needs • Step 2: Formal requests for capital investments • Step 3: Preliminary screening (remove those that are not appropriate for the project) • Step 4: Evaluate the proposal based on Acceptance – rejection standards previously determined • Step 5: Rank the proposals • Step 6: Choose the best proposal (s).

Capital Investment Analysis Methods • Net Present Value • Internal Rate of Return • Payback Period Method • Simple (Acctg) Rate of Return

Terms • Cash InFlows Increase in Net cash inflows Cost Savings Reduce Costs

Undiscounted Cash Inflows Rate of Return X Cash Inflows • Discounted Cash Inflows Adjusted for the loss of value over time Present Value Multiplier X Cash Inflows

NET PRESENT VALUE METHOD Uses PRESENT VALUE Table • Columns: % Return • Rows: Number of Period • Multiplier or factor is where the rate intersects the period.

Periods (Not just years) Can be Semi Annual, Quarterly, Monthly %- estimate return rate Based on the number of periods • 10% for yearly • 5% for seimannual • 2.5% for quarterly Present Value of Cash InFlows ( How much is the money received in following years worth today)

What Present Value Table • Present Value of $1 • Received at the end of a period of time • Uneven cash inflows • Present Value of a Ordinary Annuity of $1 • Received the same amount every period • Even Cash Inflows

PRACTICE READING TABLE • 1. What multiplier do you use if you receive $100,000 at the end of 10 years assuming a return of 7%? What is its present value? • .508 • $100,000 * .508 = $50,800 • 2. What multiplier do you use if you receive $10,000 every year for 10 years assuming a return of 7%. What is it’s present value? • 7.024 • $10,000* 7.024 = $70,240

Application • Exercise 14-1 Compare discounted cash flow with undiscounted cash flow • Exercise 14-9 Evaluating projects based on PV concept • Is 16% reasonable?

Project Profitability Index Net Present Value of Project Investment required • Helpful to decide what project to select. • The higher the better • Amount of cash inflow generated for each dollar of investment

Internal Rate of Return Investment Required Annual Cash inflow • Rate that causes the PV of the project’s cash inflows to equal the PV of the investment • How much interest you need to receive to pay it back • Do not know the rate of return %. • Divide Investment required by Annual Cash Inflows • Gives you the multiplier factor. • Go to the number of periods and find this multiplier • Go to the top of the column to get the % = IRR

Excercise 14-2 • Only 1 and 2

Apply NPV and IRR • Exercise 14-11

Payback Method Investment Required Net Annual Cash Inflows • Time it takes for the investment to pay for itself. • In years. • Same as IRR • Use formula only if even cash inflows

Payback Period con’t • Uneven cash inflows – Use following table

Application • Exercise 14-5 EVEN OR UNEVEN?

Simple Rate of Return Annual Incremental Net Income Initial Investment • Not Cash Inflow • Includes depreciation • Annual Revenue-Annual expenses/Invest. • Easier than Acctg rate of return but not accurate • No present value considered

Exercise 14-6 • Both Payback period and SRR • Exercise 14-13

Ranking of investments • Problem 14-26 pg 672 • Rank based on NPV (inferior to PPI) • 1,2,4,3 • Rank based on PPI (most dependable) • 3,2,1,4 • Rank based on IRR (payback) • 4,3,2,1

Application of NPV Concept • Problem 14-27 pg 672

SRR, IRR and payback methods • Problem 14-28

Capital Budgeting Decisions