Chapter 15

1. Chapter 15 Capital Budgeting Applications

2. The Discount Rate • Affects the firm’s long-term financial survival • Firm’s return on capital must be at least equal to the industry’s rate • The higher the discount rate, the harder it is to find acceptable investments • The firm’s discount rate is its weighted average cost of debt, retained earnings, and equity capital

3. The Effect of the Discount Rate on NPV

4. The Effect of Taxes • Adjust cash flows for taxes, not the discount rate • Government encourages business capital investment through — Accelerated cost recovery programs —Investment tax credits • Depreciation is a non-cash expense that lowers the firm’s tax bill

5. How Depreciation Expense Lowers the Tax Bill

6. Handling Mutually Exclusive Investments with Unequal Lives • Select a common termination date — if one option has a 3-year life and the other one has a 5-year life, stop both projects at the end of year 3 • Use a replacement cycle until projects have a common ending time — if one option has a 3-year life and the other a 5-year life, each is assumed to be replaced until the end of year 15—a common ending date

7. Ways to Deal withUncertainty and Risk • Develop alternative outcomes — The most optimistic — The most likely — The worst case • Calculate break-even cash flows

8. Types of Leases • Operating Lease — short periods — used for machinery and equipment rental • Financial Lease — long periods • Lease-Purchase Option — leasee may purchase item at end of lease

9. Use Net Present Value to Evaluate theLease, Borrow or BuyDecision Select the option with the lowest cost (least negative NPV)

10. The Cash Purchase Option

11. The Purchasing with Borrowed Money Option

12. The Financial Lease Option

13. Discussion Questions • Explain why a firm must generate a return at least equal to the average return on capital for that industry. • Explain why an inverse relationship exists between the present value of an investment and the discount rate. • Explain in your own words how the firm’s cost of capital is determined. In your answer describe how the cost of each part is determined.

14. Discussion Questions • Explain why depreciation is a non-cash expense and how the depreciation tax shield affects a firm’s capital budgeting decisions. • Develop a simple capital budgeting example using the net present value (NPV) procedure that shows how the accelerated cost recovery system increases the likelihood of greater capital investment by an agribusiness. Do the same thing for the investment tax credits.

15. Discussion Questions • Give your reaction to the statement that programs like accelerated cost recovery and investment tax credits distort financial markets and lead to over-investment in capital goods. • Explain how you would decide whether it is better to use the common termination period method or the replacement cycle method when evaluating mutually exclusive capital budgeting projects.

16. Discussion Questions • Define the terms risk and uncertainty. Explain how a manager can best deal with both of them. • Describe the procedures for developing alternative outcomes and break-even cash flows. Explain how an agribusiness manager would use them in making capital budgeting decisions.

17. Discussion Questions • Give three advantages of owning assets rather than leasing them. Give three advantages of leasing for an agribusiness. • Explain the financial procedures you would use to evaluate whether it is better to acquire assets by leasing, buying with cash, or buying with borrowed money. What financial calculations and other factors would you use to decide which one is best?