Capital Budgeting Decisions

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Capital Budgeting Decisions

• Chapter 14

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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

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Prior to sending out requests

• 1. Determination of dollars available for
  capital investments
• 2. Determine the cost of capital (minimum rate of
  return)

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Cost of Capital

• Also called Desired Rate of Return

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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).

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Capital Investment Analysis Methods

• Net Present Value
• Internal Rate of Return
• Payback Period Method
• Simple (Acctg) Rate of Return

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Terms

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

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• 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

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NET PRESENT VALUE METHOD

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

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• 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)

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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

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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 its present value?
• 7.024
• 10,000 7.024 70,240

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Application

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

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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

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Internal Rate of Return

• Investment Required
• Annual Cash inflow
• Rate that causes the PV of the projects 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

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Excercise 14-2

• Only 1 and 2

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Apply NPV and IRR

• Exercise 14-11

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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

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Payback Period cont

• Uneven cash inflows Use following table

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Application

• Exercise 14-5 EVEN OR UNEVEN?

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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

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

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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

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Application of NPV Concept

• Problem 14-27 pg 672

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SRR, IRR and payback methods

• Problem 14-28