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Capital Budgeting
Decisions
UAA – ACCT 202
Principles of Managerial Accounting
Dr. Fred Barbee
Introduction to Capital
Budgeting
Capital Budgeting is . . .
. . . The making of long-term planning
decisions for investments.
Capital Budgeting Decisions
 Should we purchase new laborsaving 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
The Process of
Capital Budgeting
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.
Characteristics of
Business Investments
Business Investments
 Most business investments involve
depreciable assets; and
 The returns on business investments
extend over long periods of time.
Depreciable Assets
Time
Consumed as
Depreciation
Expense
To Illustrate . . .
 A firm purchases land (a nondepreciable 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:
$750
 15%
$5,000
Return on Assets Must
Provide a return
on the original
investment.
A return of the
original investment
itself.
To Illustrate . . .
 A firm purchases land (a nondepreciable asset) for $5,000; and
 Rents it out at $750.00 per year for
ten years.
Hmmm. What
now?
What is the Return?
$750
 15%
$5,000
Why?
 Because part of the yearly $750
inflow from the equipment must
go to recoup the original $5,000
investment itself, since the
equipment will be worthless at the
end of its 10-year life.
Long Periods
of Time
Long Periods of Time
 In approaching capital budgeting
decisions, it is necessary to
employ techniques that recognize
the time value of money.
Discounted
Cash Flow
Models (DCF)
DCF Models . . .
Focus on . . .
 Cash inflows; and
 Cash outflows
Rather than on net income
DCF Models . . .
 There are two main variations of the
discounted cash flow model . . .
 Net Present Value (NPV); and
 Internal Rate of Return (IRR)
Net Present Value
Net Present Value Method
Usually Future
PV$
Discount
Cash Inflows
(PV$)
Discount
Cash Outflows
NPV
Future and/or Present
Net Present Value Method
Usually Future
PV$
(PV$)
NPV
If the result is positive, the investment
CashtheInflows
promises more than
interest rate
Discount
used to evaluate the proposal.
Cash Outflows
Discount
Future and/or Present
Net Present Value Method
Usually Future
PV$
(PV$)
NPV
If the result is zero, the investment
Inflows
yields exactly theCash
interest
rate used to
Discount
evaluate the proposal.
Cash Outflows
Discount
Future and/or Present
Net Present Value Method
Usually Future
PV$
(PV$)
NPV
(NPV)
If the result is negative, the investment
Inflows
should be rejectedCash
because
the required
Discount
rate of return will not be earned.
Cash Outflows
Discount
Future and/or Present
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?
PDQ Company – NPV Example
Yr(s)
Amt of
Cash
Flow
18%
Factor
Present
Value of
CF
Initial Inv.
Now
(40,350)
1.000
(40,350)
Annual CF
1-4
15,000
2.690
40,350
Item
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
2
3
4
(1)
Inv
O/S
during
Year
(2)
Cash
Inflow
PV of
ROI
Rec
of
Cash
$40,350
- $7,737
(1)*= $32,613
Inv.
Flow
18%
(2)-(3)
(1)-(4)
$40,350
$15,000
$7,263
$40,350 x 18% =
$7,263
(3)
(4)
$7,737
$32,613
$15,000 - $7,263
= $7,737
(1)
Inv
O/S
during
Year
1
(2)
(3)
(4)
Cash
Inflow
ROI
(1)*
18%
Rec of
Inv.
(2)-(3)
PV of
Cash
Flow
(1)-(4)
$40,350
$15,000
$7,263
$7,737
$32,613
2
32,613
15,000
5,870
9,130
23,483
3
23,483
15,000
4,227
10,773
12,710
4
12,710
15,000
2,290
12,710
-0-
Year
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?
Practice Exercise 1
Yr(s)
Amt of
Cash
Flow
12%
Factor
Present
Value
of CF
Initial Inv.
Now
(10,000)
1.000
($10,000)
Annual CF
1-4
4,000
3.037
12,148
Item
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
Additional Sales
Cash Flow
$6,000
Cost of Sales
(3,500)
Savings in Electricity
Maintenance
Total
950
(1,800)
$1,650
Practice Exercise 2
Yr(s)
Amt of
Cash
Flow
14%
Factor
Present
Value
of CF
Initial Inv.
Now
(20,000)
1.000
($20,000)
Annual CF
1-10
1,650
5.216
8,606
10
5,000
.270
1,350
Item
Salvage
Net Present Value
($10,044)
Limiting Assumptions . . .
 All cash flows occur at the end of the
period.
 All cash flows generated by an investment
are immediately reinvested in another
project which yields a return at least as
large as the discount rate used in the first
project.
Discount Rate . . .
 The rate generally viewed as being the
most appropriate is a firm’s cost of capital.
 This rate is also known as . . .
 Hurdle Rate
 Cutoff Rate
 Required Rate of Return
Internal Rate of Return
The internal rate of return (IRR) is that
Net
Value
Method
ratePresent
of interest which
will exactly
equate
the PV of the cash inflows with the PV of
the cash outflows. Usually Future
PV$
Discount
Cash Inflows
(PV$)
Discount
Cash Outflows
NPV
$-0-
Future and/or Present
Resulting in $0 NPV
Internal Rate of Return
 When the annual cash flows are
even, the IRR formula is simply . . .
 df = I / CF, or
 Investment/Annual Cash Flow
Cost of Capital as a
Screening Tool
Using the IRR Method
 The cost of capital takes the form of a
hurdle rate that a project must clear
for acceptance.
 If the IRR on a project is not great
enough to clear the cost of capital
hurdle, then the project is rejected.
Using the NPV Method
 The cost of capital becomes the
actual discount rate used to compute
the NPV of a proposed project.
 Projects yielding negative NPVs are
rejected unless nonquantitative
factors, such as social responsibility,
employee morale, etc., intervene.
Compare
Net Present Value and
Internal Rate of Return
Compare IRR & NPV . . .
 The NPV method is simpler to use.
 Using the NPV method makes it
easier to adjust for risk.
 The NPV method provides more
usable information than does the IRR
method.
Simplified Approaches to
Capital Budgeting
The Payback Period . . .
 This method involves a span of time
known as the payback period.
 The payback period is the length of
time it takes for an investment project
to recoup its own initial cost out of the
cash receipts that it generates.
The Payback Period . . .
 The basic premise of this method is
that the more quickly the cost of an
investment can be recovered, the
more desirable is the investment.
The Payback Period . . .
 The payback period is expressed in
years. The basic formula is . . .
Investment Req
--------------------------- = Payback Period
Net Annual CF
Practice Exercise 3
Calculate the
Payback period
Practice Exercise 3
 The Lower Valley Wheat Cooperative is
considering the construction of a new silo.
 It will cost $41,000 to construct the silo.
 Determine the payback period if the
expected cash inflows are $5,000 per year.
The Payback Period . . .
$41,000
--------------------------- = 8.2 Years
$5,000
Simplified Approaches to
Capital Budgeting
AKA: Accounting Rate of Return
The Simple Rate of Return
 The Simple Rate of Return is equal to
 Incremental income from the project
divided by
 the initial investment in the project.
Simple Rate of
Return (SRR)
*Less Salvage Value if any
=
Inc. NOI
Initial Investment*
The Simple Rate of Return
 If a cost reduction project is involved,
the formula becomes:
SRR
Cost Savings - Depreciation
=
Initial Investment*
*Less Salvage Value if any
Practice Exercise 4
Calculate the
Simple Rate of Return
Practice Exercise 4
 Martin Company is considering the purchase of
a new piece of equipment. Relevant information
concerning the equipment follows:
Purchase Cost
$180,000
Annual cost savings
Useful Life
 Compute the Simple Rate of Return.
37,500
12 Years
Practice Exercise 4