Transcript Chapter 1
Chapter
12
Capital Investments
Capital Budgeting
How managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment and introduction of new products.
Typical Capital Budgeting Decisions Plant expansion Equipment selection Equipment replacement Lease or buy
Cost reduction
Cost reduction
Lease or buy
Typical Capital Budgeting Decisions
Capital budgeting tends to fall into two broad categories . . .
Screening decisions
. Does a proposed project meet some present standard of acceptance?
Preference decisions
. Selecting from among several competing courses of action.
Time Value of Money
Business investments extend over long periods of time, so we must recognize the time value of money.
Investments that promise returns earlier in time are preferable to those that promise returns later in time.
Can you compare cash flows in different time periods?
Yes! Using the market interest rate, you can discount each value to find its present value. Remember, you CANNOT compare cash flows in different time periods without first adjusting them to the present using an interest rate.
Economic equivalence
Economic equivalence is when we are indifferent between a future payment, or series of future payments, and a present sum of money.
That is, the present value of the cash inflows exactly equals the present value of the cash outflows.
Time Value of Money
Lacey Company purchased a tract of land on which a $60,000 payment will be due each year for the next five years. What is the present value of this stream of cash payments when the discount rate is 12%?
Time Value of Money
We could solve the problem like this . . .
$60,000 × 3.605 = $216,300
Periods 1 2 3 4 5 10% 0.909
1.736
2.487
3.170
3.791
12% 0.893
1.690
2.402
3.037
3.605
14% 0.877
1.647
2.322
2.914
3.433
Present Value of Annual Cash Inflows-Unequal Annual Cash Flows When annual cash inflows are unequal, we cannot use annuity tables to calculate their present value. Instead tables showing the present value of a single future amount must be applied to each annual cash inflow.
Year 1 2 3 4 5 6 7 8 9 10 Assumed Annual Cash Inflows (1) $36,000 32,000 29,000 27,000 26,000 24,000 23,000 22,000 21,000 20,000 Discount Factor 12% (2) .89286 .79719 .71178 .63552 .56743 .50663 .45235 .40388 .36061 .32197 15% (3) .86957 .75614 .65752 .57175 .49718 .43233 .37594 .32690 .28426 .24719 Present Value 12% (1) x (2) $32,143 25,510 20,642 17,159 14,753 12,159 10,404 8,885 7,573 6,439 15% (1) x (3) $31,305 24,196 19,068 15,437 12,927 10,376 8,647 7,192 5,969 4,944
Typical Cash Outflows
Repairs and maintenance Working capital Incremental operating costs Initial investment
Typical Cash Inflows
Salvage value Release of working capital Incremental revenues Reduction of costs
Recovery of the Original Investment
Carver Hospital is considering the purchase of an attachment for its X-ray machine.
Cost Life $3,170 4 years Salvage value zero Increase in annual cash flows 1,000
No investments are to be made unless they can earn at least 10% return on their investment.
Will we be allowed to invest in the attachment?
Recovery of the Original Investment
Item Annual cash inflows Initial investment(outflow) Net present value Year(s) 1-4 Now Amount of Cash Flow $ 1,000 (3,170) 10% Factor 3.170
1.000
Present Value of Cash Flows $ 3,170 (3,170) $ -0 Periods 1 2 3 4 5 10% 0.909
1.736
2.487
3.170
3.791
12% 0.893
1.690
2.402
3.037
3.605
14% 0.877
1.647
2.322
2.914
3.433
Present value of an annuity of $1 table
Recovery of the Original Investment
Item Annual cash inflows Initial investment(outflow) Net present value Year(s) 1-4 Now Amount of Cash Flow $ 1,000 (3,170) 10% Factor 3.170
1.000
Present Value of Cash Flows $ 3,170 (3,170) $ -0 Because the net present value is equal to zero, the attachment investment provides exactly a 10% return.
Recovery of the Original Investment
Depreciation is not deducted in computing the present value of a project because . . .
It is not a current cash outflow.
Discounted cash flow methods
automatically
provide for return of the original investment.
Choosing a Discount Rate
The firm’s
cost of capital
is usually regarded as the most appropriate choice for the discount rate.
The cost of capital is the average rate of return the company must pay to its long term creditors and stockholders for the use of their funds.
Net Present Value Method
Under the net present value method , cash inflows are discounted to their present value and then compared with the capital outlay required by the investment.
The interest rate used in discounting the future cash inflows is the required minimum rate of return.
A proposal is acceptable when NPV positive .
is zero or
The higher the positive NPV, the more attractive the investment.
The Net Present Value Method
To determine net present value we . . .
Calculate the present value of cash inflows, Calculate the present value of cash outflows, Subtract the present value of the outflows from the present value of the inflows.
The Net Present Value Method
General decision rule . . .
If the Net Present Value is . . .
Positive . . .
Zero . . .
Negative . . .
Then the Project is . . . Acceptable, since it promises a return greater than the required rate of return. Acceptable, since it promises a return equal to the required rate of return. Not acceptable, since it promises a return less than the required rate of return.
The Net Present Value Method
Let’s look at how we use present value to make business decisions.
The Net Present Value Method
Lester Company has been offered a five year contract to provide component parts for a large manufacturer.
Cost and revenue information Cost of special equipment $160,000 Working capital required Relining equipment in 3 years 100,000 30,000 5,000 Salvage value of equipment in 5 years Annual cash revenue and costs: Sales revenue from parts Cost of parts sold Salaries, shipping, etc.
750,000 400,000 270,000
The Net Present Value Method
At the end of five years the working capital will be released and may be used elsewhere by Lester.
Lester Company uses a discount rate of 10%.
Should the contract be accepted?
The Net Present Value Method
Annual net cash inflows from operations Sales revenue Cost of parts sold Salaries, shipping, etc.
Annual net cash inflows $ 750,000 (400,000) (270,000) $ 80,000
The Net Present Value Method
Investment in equipment Working capital needed Years Now Now Cash Flows $ (160,000) (100,000) 10% Factor 1.000
1.000
Present Value $ (160,000) (100,000) Net present value
The Net Present Value Method
Investment in equipment Working capital needed Annual net cash inflows Years Now Now 1-5 Cash Flows $ (160,000) (100,000) 80,000 10% Factor 1.000
1.000
3.791
Present Value $ (160,000) (100,000) 303,280 Net present value Present value of an annuity of $1 factor for 5 years at 10%.
The Net Present Value Method
Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Years Now Now 1-5 3 Cash Flows $ (160,000) (100,000) 80,000 (30,000) 10% Factor 1.000
1.000
3.791
0.751
Present Value $ (160,000) (100,000) 303,280 (22,530) Net present value Present value of $1 factor for 3 years at 10%.
The Net Present Value Method
Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Salvage value of equip.
Net present value Years Now Now 1-5 3 5 Cash Flows $ (160,000) (100,000) 80,000 (30,000) 5,000 10% Factor 1.000
1.000
3.791
0.751
0.621
Present value of $1 factor for 5 years at 10%.
Present Value $ (160,000) (100,000) 303,280 (22,530) 3,105
The Net Present Value Method
Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Salvage value of equip.
Working capital released Net present value Years Now Now 1-5 3 5 5 Cash Flows $ (160,000) (100,000) 80,000 (30,000) 5,000 100,000 10% Factor 1.000
1.000
3.791
0.751
0.621
0.621
Present Value $ (160,000) (100,000) 303,280 (22,530) 3,105 62,100 $ 85,955
Accept the contract because the project has a
positive
net present value.
The Internal Rate of Return Method
The internal rate of return is the
interest yield
promised by an investment project over its useful life.
The internal rate of return is computed by finding the discount rate that will cause the
net present value
of a project to be
zero
.
The Internal Rate of Return Method
Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life.
The Internal Rate of Return Method
Future cash flows are the same every year in this example, so we can calculate the internal rate of return as follows:
PV factor for the internal rate of return = Investment required Net annual cash flows $104, 320 $20,000 = 5.216
The Internal Rate of Return Method Using the present value of an annuity of $1 table . . .
Find the 10-period row, move across until you find the factor 5.216. Look at the top of the column and you find a rate of 14%.
Periods 1 2 . . .
9 10 10% 0.909
1.736
. . .
5.759
6.145
12% 0.893
1.690
. . . 5.328
5.650
14% 0.877
1.647
. . .
4.946
5.216
The Internal Rate of Return Method
Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life.
The internal rate of return on this project is 14%.
If the internal rate of return is equal to or greater than the company’s required rate of return, the project is acceptable.
Net Present Value vs. Internal Rate of Return Net Present Value
Easier to use.
Assumes cash inflows will be reinvested at the discount rate. This is a realistic assumption.
Investments in Automated Equipment
Investments in automated equipment tend to be very large in dollar amount.
The benefits received are often indirect and intangible.
Ranking Investment Projects
Profitability Present value of cash inflows index Investment required Investment A Present value of cash inflows $81,000 Investment required 80,000 Profitability index 1.01
B $6,000 5,000 1.20
The higher the profitability index, the more desirable the project.
Other Approaches to Capital Budgeting Decisions
Other methods of making capital budgeting decisions include . . .
The Payback Method.
Simple Rate of Return.
The Payback Method
The
payback period
is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates.
When the net annual cash inflow is the same each year, this formula can be used to compute the payback period:
Payback period = Investment required Net annual cash inflow
The Payback Method
Management at The Daily Grind wants to install an espresso bar in its restaurant.
The espresso bar: Costs $140,000 and has a 10-year life.
Will generate net annual cash inflows of $35,000.
Management requires a payback period of 5 years or less on all investments.
What is the payback period for the espresso bar?
The Payback Method
Payback period = Investment required Net annual cash inflow Payback period = $140,000 $35,000 Payback period = 4.0 years According to the company’s criterion, management would invest in the espresso bar because its payback period is less than 5 years.
Evaluation of the Payback Method
Ignores the time value of money.
Short-comings of the Payback Period.
Ignores cash flows after the payback period.
The Annual Rate of Return Method (Simple)
Does not focus on cash flows -- rather it focuses on accounting income .
The following formula is used to calculate the simple rate of return:
Annual rate of return = Incremental Incremental expenses, revenues including depreciation Average Investment
The Annual Rate of Return Method
Management of The Daily Grind wants to install an espresso bar in its restaurant.
The espresso bar: Cost $140,000 with a 10-year life, no salvage.
Will generate incremental revenues of $100,000 and incremental expenses of $65,000 including depreciation.
What is the simple rate of return on the investment project?
The Annual Rate of Return Method
Annual rate of return = $100,000 - $65,000 $140,000 = 25% The simple rate of return method is not recommended for a variety of reasons, the most important of being that it ignores the time value of money.
Postaudit of Investment Projects
A postaudit is a follow-up after the project has been approved to see whether or not expected results are actually realized.