Capital Budgeting Decisions

1
Capital Budgeting Decisions
2
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
4
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.

5
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
  Fn dollars computed as follows
• Fn P(1 r)n

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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

10
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?
• P 100 (0.797)
• P 79.70

11
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.
12
Interest and the Time Value of Money

• Lets 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.

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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

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Time Value of Money
100 0.797 79.70 present value
16
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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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

100 ? 0.621 62.10
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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.

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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
21
Time Value of Money

• We could solve the problem like this . . .

60,000 3.605 216,300
22
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, 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

100 ? 3.433 343.33
24
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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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

100?(3.433-1.647) 100?1.786
178.60 or 100?(0.6750.5920.519) 100?1.786
178.60
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Typical Cash Outflows
27
Typical Cash Inflows
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Illustration of the NPV Method

• Carver Hospital is considering the purchase of an
  attachment for its X-ray machine. 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
30
Illustration of the NPV Method
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Illustration of the NPV Method
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)

33
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)

-4,0001,200?3.170 -4,000 3,804 -196
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Choosing a Discount Rate

• The firms 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 . . .

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The Net Present Value Method
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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.

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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

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The Net Present Value Method
42
The Net Present Value Method
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The Net Present Value Method
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The Net Present Value Method
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The Net Present Value Method
Accept the contract because the project has a
positive net present value.
46
Quick Check Data

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

• 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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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.

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The Total-Cost Approach

• If White installs a new washer . . .

Lets look at the present valueof this
alternative.
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The Total-Cost Approach
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The Total-Cost Approach
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The Total-Cost Approach
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The Total-Cost Approach
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The Total-Cost Approach
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The Total-Cost Approach
If we install the new washer, the investment will
yield a positive net present value of 83,202.
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The Total-Cost Approach

• If White remodels the existing washer . . .

Lets look at the present valueof this second
alternative.
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The Total-Cost Approach
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The Total-Cost Approach
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The Total-Cost Approach
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The Total-Cost Approach
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.
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.
• Lets look at an analysis of the White Co.
  decision using the incremental-cost approach.

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The Incremental-Cost Approach
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The Incremental-Cost Approach
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The Incremental-Cost Approach
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The Incremental-Cost Approach
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Quick Check ?

• Consider the following alternative projects.
  Each project would last for five years.
• Project A Project B
• Initial investment 80,000 60,000
• Annual net cash inflows 20,000 16,000
• Salvage value 10,000 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 gt NPV of Project B by 5,230
• b. NPV of Project B gt NPV of Project A by 5,230
• c. NPV of Project A gt NPV of Project B by 2,000
• d. NPV of Project B gt NPV of Project A by 2,000

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Quick Check ?

• Consider the following alternative projects.
  Each project would last for five years.
• Project A Project B
• Initial investment 80,000 60,000
• Annual net cash inflows 20,000 16,000
• Salvage value 10,000 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 gt NPV of Project B by 5,230
• b. NPV of Project B gt NPV of Project A by 5,230
• c. NPV of Project A gt NPV of Project B by 2,000
• d. NPV of Project B gt 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.
• Lets look at the Home Furniture Company.

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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.

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Least Cost Decisions
Here is information about the trucks . . .
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Least Cost Decisions
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Least Cost Decisions

• Home Furniture should purchase the new truck.

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Ranking Investment Projects
The higher the profitability index, the more
desirable the project.
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Other Approaches toCapital 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

79
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?

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The Payback Method
According to the companys 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
• Project X Project Y
• Initial investment 100,00 100,000
• Year 1 cash inflow 60,000 60,000
• Year 2 cash inflow 40,000 35,000
• Year 3-10 cash inflows 0 25,000
• Which project has the shortest payback period?
• a. Project X
• b. Project Y
• c. Cannot be determined

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Quick Check ?
Project X has a payback period of 2 years.
Project Y has a payback period of slightly more
than 2 years. Which project do you think is
better?

• Consider the following two investments
• Project X Project Y
• Initial investment 100,00 100,000
• Year 1 cash inflow 60,000 60,000
• Year 2 cash inflow 40,000 35,000
• Year 3-10 cash inflows 0 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
Short-comings of 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

-
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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
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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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

9 (5 2) / 20 15
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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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End of Chapter 12