12 Capital Budgeting Decisions Chapter

Transcript 12 Capital Budgeting Decisions Chapter

Chapter

Capital Budgeting Decisions

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.

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Typical Capital Budgeting Decisions

Plant expansion Equipment selection Equipment replacement Lease or buy Cost reduction

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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.

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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.

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Time Value of Money

A dollar today is worth more than a dollar a year from now since a dollar received today can be invested, yielding more than a dollar a year from now.

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Interest and the Time Value of Money

If $100 is invested today at 8% interest, how much will you have in two years?

At the end of one year: $100 + 0.08

 $100 = (1.08)  $100 = $108 At the end of two years: $108 + 0.08

 $108 = (1.08)  $108 = (1.08)  [(1.08)  $100] = (1.08) 2  $100 = $116.64

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Interest and the Time Value of Money

If P dollars are invested today at the annual interest rate r, then in n years you would have F n follows: dollars computed as

F

= P(1 + r)

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Interest and the Time Value of Money

The present value of any sum to be received in the future can be computed by turning the interest formula around and solving for P:



F n

 



1 r





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Interest and the Time Value of Money

A bond will pay $100 in two years. What is the present value of the $100 if an investor can earn a return of 12% on investments?



$100

  





0.12



   P = $100 (0.797) P = $79.70

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Interest and the Time Value of Money

A bond will pay $100 in two years. What is the present value of the $100 if an investor can earn a return of 12% on investments?

Present Value = $79.70

What does this mean?

If $79.70 is put in the bank today, it will be worth $100 in two years.

In that sense, $79.70 today is equivalent to $100 in two years.

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Interest and the Time Value of Money

Let’s verify that if we put $79.70 in the bank today at 12% interest that it would grow to $100 at the end of two years.

Beginning balance Interest @ 12% Ending balance

Year 1

$ 79.70

$ 9.56

$ 89.26

Year 2

$ 89.26

$ 10.71

$ 99.97

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Time Value of Money

A bond will pay $100 in two years. What is the present value of the $100 if an investor can earn a return of 12% on investments?

We can also determine the present value using present value tables.

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Time Value of Money

Excerpt from

Present Value of $1

Table in the Appendix to Chapter 12

Periods 1 2 3 4 5 10% 0.909

0.826

0.751

0.683

0.621

Rate 12% 0.893

0.797

0.712

0.636

0.567

14% 0.877

0.769

0.675

0.592

0.519

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Time Value of Money $100

×

0.797 = $79.70 present value

Periods 1 2 3 4 5 10% 0.909

0.826

0.751

0.683

0.621

Rate 12% 0.893

0.797

0.712

0.636

0.567

14% 0.877

0.769

0.675

0.592

0.519

Present value factor of $1 for 2 periods at 12%.

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Quick Check

 How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%?

a. $62.10

b. $56.70

c. $90.90

d. $51.90

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Time Value of Money

An investment that involves a series of identical cash flows at the end of each year is called an annuity .

$100 $100 $100 $100 $100 $100

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1 2 3 4 5

Time Value of Money

Lacey Inc. 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%?

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Time Value of Money

We could solve the problem like this . . .

Look in Appendix B of this Chapter for the Present Value of an Annuity of $1 Table Periods 1 2 3 4 5

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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

Time Value of Money

We could solve the problem like this . . .

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

$60,000 × 3.605 = $216,300

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Quick Check

 If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years?

a. $34.33

b. $500 c. $343.30

d. $360.50

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Quick Check

 If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years?

a. $866.90

b. $178.60

c. $ 86.90

d. $300.00

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Typical Cash Outflows

Repairs and maintenance Working capital

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Initial investment Incremental operating costs

Typical Cash Inflows

Salvage value Release of working capital Incremental revenues

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Reduction of costs

Illustration of the NPV Method

Carver Hospital is considering the purchase of an attachment for its X-ray machine.

Cost Life Salvage value Increase in annual cash inflows $3,170 4 years zero 1,000

No investments are to be made unless they have an annual return of at least 10%.

Will we be allowed to invest in the attachment?

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Illustration of the NPV Method

Item Initial investment(outflow) Annual cash inflows Net present value Year(s) Now 1-4 Amount of Cash Flow (3,170) $ 1,000 10% Factor 1.000

3.170

Present Value of Cash Flows (3,170) $ 3,170 $ -0 Periods 1 2 3 4 5

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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

Illustration of the NPV Method

Item Initial investment(outflow) Annual cash inflows Net present value Year(s) Now 1-4 Amount of Cash Flow (3,170) $ 1,000 10% Factor 1.000

3.170

Present Value of Cash Flows (3,170) $ 3,170 $ -0 Because the net present value is equal to zero, the investment in the attachment for the X-ray machine provides exactly a 10% return.

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Quick Check

 Suppose that the investment in the attachment for the X-ray machine had cost $4,000 and generated an increase in annual cash inflows of $1,200. What is the net present value of the investment?

a. $ 800 b. $ 196 c. $(196) d. $(800)

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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.

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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.

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The Net Present Value Method

General decision rule . . .

If the Net Present Value is . . .

Positive . . .

Zero . . .

Negative . . .

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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.

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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

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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?

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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

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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

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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%.

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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%.

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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

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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

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.

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Quick Check Data

Denny Associates has been offered a four-year contract to supply the computing requirements for a local bank.

Cash flow information Cost of computer equipment Working capital required Upgrading of equipment in 2 years Salvage value of equipment in 4 years Annual net cash inflow $ 250,000 20,000 90,000 10,000 120,000

 The working capital would be released at the end of the contract.

 Denny Associates requires a 14% return.

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Quick Check

 What is the net present value of the contract with the local bank?

a. $150,000 b. $ 28,230 c. $ 92,340 d. $132,916

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Expanding the Net Present Value Method

To compare competing investment projects we can use the following net present value approaches:  Total-cost  Incremental cost

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The Total-Cost Approach

 White Co. has two alternatives: (1) remodel an old car wash or, (2) remove it and install a new one.

 The company uses a discount rate of 10%.

Annual revenues Annual cash operating costs Net annual cash inflows New Car Wash $ 90,000 30,000 $ 60,000 Old Car Wash $ 70,000 25,000 $ 45,000

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The Total-Cost Approach

If White installs a new washer . . .

Cost Productive life Salvage value Replace brushes at the end of 6 years Salvage of old equip.

$300,000 10 years 7,000 50,000 40,000 Let’s look at the present value of this alternative.

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The Total-Cost Approach

Initial investment Replace brushes Net annual cash inflows Salvage of old equipment Salvage of new equipment Net present value Install the New Washer Cash Year Now $ Flows (300,000) 6 1-10 Now 10 (50,000) 60,000 40,000 7,000 10% Factor 1.000

0.564

6.145

1.000

0.386

Present Value $ (300,000) (28,200) 368,700 40,000 2,702 $ 83,202

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If we install the new washer, the investment will yield a positive net present value of $83,202.

The Total-Cost Approach

If White remodels the existing washer . . .

Remodel costs Replace brushes at the end of 6 years $175,000 80,000

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Let’s look at the present value of this second alternative.

The Total-Cost Approach

Initial investment Replace brushes Net annual cash inflows Net present value Remodel the Old Washer Cash Year Now $ Flows (175,000) 6 1-10 (80,000) 45,000 10% Factor 1.000

0.564

6.145

Present Value $ (175,000) (45,120) 276,525 $ 56,405 If we remodel the existing washer, we will produce a positive net present value of $56,405.

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The Total-Cost Approach

Both projects yield a positive net present value.

Invest in new washer Remodel existing washer In favor of new washer Net Present Value $ 83,202 56,405 $ 26,797 However, investing in the new washer will produce a higher net present value than remodeling the old washer.

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The Incremental-Cost Approach

Under the incremental-cost approach, only those cash flows that differ between the two alternatives are considered.

Let’s look at an analysis of the White Co. decision using the incremental-cost approach.

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The Incremental-Cost Approach

Incremental investment Incremental cost of brushes Increased net cash inflows Salvage of old equipment Salvage of new equipment Net present value Year Now 6 1-10 Now 10 Cash Flows $(125,000) $ 30,000 15,000 40,000 7,000 10% Factor 1.000 0.564

6.145

1.000

0.386

Present Value $(125,000) 16,920 92,175 40,000 2,702 $ 26,797 We get the same answer under either the total-cost or incremental-cost approach.

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Quick Check

 Consider the following alternative projects. Each project would last for five years.

Initial investment Annual net cash inflows Salvage value

Project A

$80,000 20,000 10,000

Project B

$60,000 16,000 8,000 The company uses a discount rate of 14% to evaluate projects. Which of the following statements is true?

a. NPV of Project A > NPV of Project B by $5,230 b. NPV of Project B > NPV of Project A by $5,230 c. NPV of Project A > NPV of Project B by $2,000 d. NPV of Project B > NPV of Project A by $2,000

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Least Cost Decisions

In decisions where revenues are not directly involved, managers should choose the alternative that has the least total cost from a present value perspective.

Let’s look at the Home Furniture Company

.

Home Furniture

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Least Cost Decisions

 Home Furniture Company is trying to decide whether to overhaul an old delivery truck now or purchase a new one.

 The company uses a discount rate of 10%.

Home Furniture

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Least Cost Decisions

Here is information about the trucks . . .

Old Truck Overhaul cost now Annual operating costs Salvage value in 5 years Salvage value now $ 4,500 10,000 250 9,000

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New Truck Purchase price Annual operating costs Salvage value in 5 years

$ 21,000 6,000 3,000

Least Cost Decisions

Purchase price Annual operating costs Salvage value of old truck Salvage value of new truck Net present value Buy the New Truck Cash Year Flows Now 1-5 Now 5 $(21,000) (6,000) 9,000 3,000 10% Factor Present Value 1.000 $ (21,000) 3.791

(22,746) 1.000

0.621

9,000 1,863 (32,883) Overhaul cost Annual operating costs Salvage value of old truck Net present value Keep the Old Truck Cash Year Now Flows $ (4,500) 1-5 5 (10,000) 250

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10% Factor 1.000 3.791

0.621

Present Value $ (4,500) (37,910) 155 (42,255)

Least Cost Decisions

Home Furniture should purchase the new truck.

Net present value of costs associated with purchase of new truck Net present value of costs associated with remodeling existing truck Net present value in favor of purchasing the new truck $ (32,883) (42,255) $ 9,372

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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

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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.

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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

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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.

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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.

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Quick Check

 Consider the following two investments: Initial investment Year 1 cash inflow Year 2 cash inflow Year 3-10 cash inflows

Project X Project Y

$100,00 $100,000 $60,000 $40,000 $0 $60,000 $35,000 $25,000 Which project has the shortest payback period?

a. Project X b. Project Y c. Cannot be determined

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Evaluation of the Payback Method

Ignores the time value of money.

Short-comings of the Payback Period.

Ignores cash flows after the payback period.

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The Simple Rate of Return Method

 Does not focus on cash flows -- rather it focuses on accounting income .

 The following formula is used to calculate the simple rate of return:

Simple rate of return = Incremental Incremental expenses, revenues including depreciation Initial investment

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The Simple Rate of Return Method

 Management of The Daily Grind wants to install an espresso bar in its restaurant.

 The espresso bar:  Cost $140,000 and has a 10-year life.

 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?

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The Simple Rate of Return Method

Simple 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 which is that it ignores the time value of money.

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Quick Check

 Inland Airlines is considering the purchase of an aircraft for $20 million that would last for 10 years and generate incremental revenues of $9 million per year and incremental expenses, excluding depreciation, of $5 million per year. What is the simple rate of return on the aircraft?

a. 10% b. 15% c. 20% d. 25%

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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.

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12 Capital Budgeting Decisions Chapter

Transcript 12 Capital Budgeting Decisions Chapter

Chapter

Capital Budgeting Decisions