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Capital budgeting

Capital budgeting. Chapter 10 Adelman & Marks. Key terms. Capital budgeting The method used to justify the acquisition of capital goods Capital goods Assets that have a useful life greater than 1 year. Why capital budgeting?.

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Capital budgeting

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  1. Capital budgeting Chapter 10 Adelman & Marks

  2. Key terms • Capital budgeting • The method used to justify the acquisition of capital goods • Capital goods • Assets that have a useful life greater than 1 year

  3. Why capital budgeting? • A company should make the decision to enter into a specific project, acquire another company, or purchase a specific long-term asset if the present value of the benefits exceeds the the present value of the costs. • Remember that assets are tools your business uses to help generate revenues • Example: Capital budgeting helps a business to make the most profitable decisions regarding purchase of delivery vehicles.

  4. Factors Affecting Capital Budgeting • Changes in regulations (CFC banned in air conditioning) • Research and Development investments (half of all new products fail) • Changes in business strategy (when economy changes or opportunities/threats arise

  5. Five Steps in Capital Budgeting • Write a proposal that identifies projected costs and benefits • Evaluate the data with respect to expected benefits and costs • Make a decision that provides greatest value while minimizing costs • Follow up on decision through post-audit to compare costs to benefits • Take corrective action if post-audit indicates benefits are not meeting expectations

  6. Costs in capital budgeting • Start-up costs – total $ spent to start a project (equipment, training costs, maintenance, service agreements, hiring new people, storage space, etc) • Working capital costs – cash, investments, A/R, and inventory to show bank you can make monthly payments ($ is legally committed to lender, so it’s an opportunity cost) • Tax factor costs – additional taxes that have to be paid

  7. Benefits in capital budgeting • Investments in capital equipment should increase cash flows • Capital equipment investments can be written off and provide reduced tax liability • MACRS! (see MACRS worksheet)

  8. Techniques • Payback • Net present value (NPV) • Profitability index (PI) • Internal rate of return (IRR) • Accounting rate of return (ARR) • Lowest total cost (LTC)

  9. Payback • # of years it takes to get back the money it invested in project or asset • Payback = C / ATB • C = cost of project • ATB = annual after-tax benefit of project • Example – invest in $25,000 project that creates $3,000 in ATB • Payback occurs in $25,000/$3,000 = 8.33 yrs

  10. Net present value • Uses time value of $ by discounting future costs and benefits to present • Combines: • PV of stream of payments for even cash flows and • PV of future lump sum of unequal yearly cash flows • Important considerations – (1) interest rate of lender and (2) interest rate you could make by investing in some other project or asset

  11. Weighted Average Cost of Capital • Multiplies cost of debt by its proportion of total funds raised and multiplies cost of equity (opportunity cost to owner) by its proportion of total funds raised • Key terms: • Real rate of return (return received after factoring out inflation) • Inflation premium (expected average inflation for term of investment) • Risk premium (rate added to interest rate to account for risk of investment) (see Techniques)

  12. Getting to NPV • NPV = PVB - PVC • NPV is net present value of investment • PVB is present value of the benefit • PVC is present value of the cost of the investment • If NPV is negative, do not make the investment (see example)

  13. Profitability Index • PI = PVB / PVC • From example: $170,394/$100,000 = 1.70 • This project returns $1.70 for every $1 invested

  14. Accounting rate of return • ARR = (average annual income)/(average cost of investment over its life) • Does not incorporate time value of $ • Example: spend $10,000 on software that will help you earn $3,000/yr for 4 yrs • ARR = $3,000/$10,000 = 30%

  15. Lowest total cost • Include all costs associated with two or more competing investments • Calculate PVs of these costs • Add the present value of any residual benefits (salvage value) that investment can provide • Select investment with lowest total cost

  16. Recommendations • Use NPV for new projects or assets • For existing operations (replacing equipment and service contracts) use LTC

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