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Chapter Twelve

Chapter Twelve. Capital Investment Decisions and the Time Value of Money. What is Capital Budgeting. Planning and analytical techniques utilized by managers in determining whether to purchase capital assets or other long-term company investments.

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Chapter Twelve

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  1. Chapter Twelve Capital Investment Decisions and the Time Value of Money ACG 2071 - Spring 2011

  2. What is Capital Budgeting Planning and analytical techniques utilized by managers in determining whether to purchase capital assets or other long-term company investments. ACG 2071 - Spring 2011

  3. Examples of Capital Assets and Long-Term Investments • Machinery and Equipment • Buildings • Manufacturing Facilities • New products • New Business Segments . ACG 2071 - Spring 2011

  4. Specific Methods Utilized to Analyze Capital Budgeting Decisions (1) Payback Period - doesnot consider time value of money (2) Accounting Rate of Return (ARR) - doesnot consider time value of money (3) Net Present Value (NPV) -does consider time value of money (4) Internal Rate of Return (IRR) - does consider time value of money . ACG 2071 - Spring 2011

  5. What is the focus of capital budgeting? Except for ARR, the other methods focus on expected net cash inflows from acquisition of the asset. Net Cash Inflowsare the difference between: - Cash Inflows or Savings such as additional revenues, cost reductions, etc. - Cash Outflows such as original investment cash outlay, ongoing cash payments, etc. . ACG 2071 - Spring 2011

  6. Payback Period Payback Period measures length of time to “recover” initial investment. It does not consider any cash flows after the payback period The shorter the payback period, the more desirable the investment If net cash inflows are equal for each year, then Payback period= Amount Invested Expected Annual net cash inflow . ACG 2071 - Spring 2011

  7. Accounting Rate of Return (ARR) Method focuses on operating income, not net cash inflows. Measures average annual rate of return over asset’s life ARR = Average annual operating income from asset Initial Investment Or *Aver. annual net cash flow – depreciation expense Initial Investment *Assumes depreciation expense is only non-cash expense . ACG 2071 - Spring 2011

  8. The other two methods (1) NPV and (2) IRR use the concept of the time value of money • Basic premise that a dollar received today is worth more than a dollar expected to be received in the future • Conversely, a dollar expected to be received in the future is worth less than a dollar received today. • The present value (today’s value) of future cash flows is calculated by multiplying (1) the future cash flow amount x (2) present value discount factor . ACG 2071 - Spring 2011

  9. Formula for Present Value discount Factor • PV Discount Factor = 1 / (1+i)n where; i = interest rate n = number of periods • Note – the PV Discount Factors can also be found in Appendix 12A in the book . ACG 2071 - Spring 2011

  10. What is the Present Value (today’s value) of receiving a lump sum of $10,000 at the end of one year, given a 12% rate? PV = FV x PV Discount factor • PV = FV x 1 / (1+i)n • PV = 10,000 x 1 / (1+.12)1 • PV = 10,000 x .893 • PV = $ 8,930 • Note – .893 can also be found in Appendix 12A, Table A under period 1, 12% . ACG 2071 - Spring 2011

  11. What is the Present Value of receiving a lump sum of $10,000 at the end of five years, given a 12% rate? • PV = FV x 1 / (1+i)n • PV = 10,000 x 1 / (1+.12)5 • PV = 10,000 x 1 / 1.762 • PV = 10,000 x .567 • PV = $ 5,670 • Note – .567 can also be found in Appendix 12A, Table A under period 5, 12% . ACG 2071 - Spring 2011

  12. Annuities An Annuity is a series of cash flows of equal amount paid or received at regular intervals. To solve for the Present Value of an Annuity, you essentially “add” together each period amount. Easier method is to use Appendix A, Table B (PV of an annuity) to get the discount factor of an annuity ACG 2071 - Spring 2011

  13. What is the Present Value of receiving $10,000 each year for five years, given a 12% rate? • PV = FV x PV Factor of an Annuity • PV = 10,000 x 3.605 • PV = $ 36,050 • Note – 3.605 can be found in Appendix A, Table B under period 5, 12% . ACG 2071 - Spring 2011

  14. Net Present Value Method (NPV) • Net Present Value (NPV) of an investment is the difference between the present value of the net cash inflows less the investment’s cost. • NPV uses a discount (interest) rate that is based on the company’s required rate of return for a project. • If the NPV is greater than zero, that means the investment return exceeded the required rate of return and management will generally make the investment . ACG 2071 - Spring 2011

  15. Internal Rate of Return Method (IRR) The internal rate of return (IRR) is the actual yield or return earned by an investment. The IRR is the discount rate that makes the NPV = 0. ACG 2071 - Spring 2011

  16. How does a company’s decide on the required rate of return? Company could use their “cost of capital” as a basis Cost of Capital represents the company costs to raise and use funds, either through borrowing (bonds) or equity (stock) To adjust for risk in investment decisions, company may increase the discount rate above the company’s cost of capital . ACG 2071 - Spring 2011

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