Capital budgeting Decisions

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Chapter 20

• Capital budgeting Decisions

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What is a Capital Expenditure?

• A long-term decision of whether or not to make an
  investment today which will bring future returns.
• Those future returns must be greater than the
  initial cost of the investment.
• This creates a complication - the time value of
  money!

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Cash Flows

• The initial cash outlay is compared to the future
  cash inflows
• These future inflows can include
• cash receipts
• cash receipts less cash payments
• savings of cash payments

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Cost of Capital

• In order to make a capital expenditure, a Co.
  must have cash.
• Obtaining financing from creditors and investors
  costs .
• This is called the cost of capital.
• An investment S/B made as long as the C of C is or the return on investment.

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The Cost of Capital represents the minimum
required rate of return needed before a capital
expenditure should be made.

• In other words, it is the cuttoff rate.

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Time Value of Money

• A dollar today is worth more than a dollar
  tomorrow.
• Why?

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Since the initial capital expenditure is made in
todays dollars, we must convert future cash
flows to todays dollars in order to determine
whether to make the investment.
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Present Value (pages 711-716)

• Assume the following You made a 100 investment
  in a savings account which earns 6 interest
  compounded annually. After three years you have
  the following
• Yr1 (100 x .06) 100 106
• Yr2 (106 x .06) 106 112.36
• yr3 (112.36 x .06) 112.36 119.10
• 119.10 is the future value 100 is the
  present value.

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Think of the present value as the amount of the
future value with the interest taken out!

• What if we know the future value is 119.10 and
  want to convert it to present value?
• Use the table on page 732 6 for 3 periods
  factor of .8396
• .8396 x 119.10 99.996 (or 100 rounded)

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Above Example - single amount was used.

• A series of equal payments is an annuity.
• Use table on page 733!

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Firms use a variety of Tools to make capital
budgeting decisions

• NPV
• Payback
• Aver. Rate of Return

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NPV - steps

• 1. Calculate, using PV tables, the PV of future
  cash flows
• Use the cost of capital (ie, the required rate of
  return)
• 2. Calculate the amount of the initial cash
  outlay for the investment
• This is already the PV!
• 3. 1-2 the NPV

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How to evaluate the NPV

• if zero or positive, accept investment because
  the return if or the cost of capital.
• If negative - dont accept the project because
  the return is

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Payback

• evaluates how long it will take to recap your
  initial investment.
• Ignores the time value of money the return on
  investment.
• Only takes return of investment into
  consideration.

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Average rate of return

• Usually expressed as a
• ARR Total Cash Receipts-Total cash payment
• Years X Investment
• If ARR
• Also ignores the time value of

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Be sure to read through the examples in the text!
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The End