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Capital Budgeting

Chapter 25. Capital Budgeting. Investment involves a long-term commitment. Outcome is uncertain. Decision may be difficult or impossible to reverse. Large amounts of money are usually involved. Capital Investment Decisions.

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Capital Budgeting

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  1. Chapter25 Capital Budgeting

  2. Investment involves along-term commitment. Outcomeis uncertain. Decision may bedifficult or impossibleto reverse. Large amounts ofmoney are usuallyinvolved. Capital Investment Decisions Capital budgeting:Analyzing alternative long-term investments and deciding which assets to acquire or sell.

  3. I will choose theproject with the mostprofitable return onavailable funds. Capital Investment Decisions PlantExpansion ? LimitedInvestmentFunds NewEquipment ? ? OfficeRenovation

  4. Initial investment Repairs and maintenance Incremental operating costs Capital Investment Decisions: Typical Cash Outflows

  5. Capital Investment Decisions: Typical Cash Inflows Salvage value Cost savings Incremental revenues

  6. Capital Investment Decisions:Nonfinancial Considerations Employee working conditions Environmental concerns Corporate image Employee morale Product quality

  7. Evaluating Capital Investment Proposals: An Illustration Let’s look at methods used to make capitalinvestmentdecisions.

  8. Stars’ Stadium is considering purchasingvending machines with a 5-year life. Evaluating Capital Investment Proposals: An Illustration ($75,000 - $5,000) ÷ 5 years

  9. Most capital budgeting techniques useannual net cash flow. Depreciation is not a cash outflow. Evaluating Capital Investment Proposals: An Illustration

  10. Payback period Cost of Investment Annual Net Cash Flow = Payback Period The payback period of an investmentis the time expected to recoverthe initial investment amount. Managers prefer investing in projects with shorter payback periods.

  11. Payback period Cost of Investment Annual Net Cash Flow = Payback Period The payback period of an investmentis the time expected to recoverthe initial investment amount. Payback period $75,000 $24,000 = = 3.125 years

  12. Ignores the time value of money. Ignores cash flows after the payback period. Payback Period

  13. Consider two projects, each with a five-year life and each costing $6,000. Payback Period Would you invest in Project One just because it has a shorter payback period?

  14. ROI focuses on annual incomeinstead of cash flows. Average estimated net income Average investment ROI = Return on Average Investment (ROI) Original cost + Salvage value2

  15. ROI focuses on annual incomeinstead of cash flows. $10,000$40,000 ROI = = 25% Return on Average Investment (ROI) $75,000 + $5,0002

  16. Income may vary from year to year. Time value ofmoney is ignored. Return on Average Investment (ROI) So why would I ever want to use this method anyway?

  17. Now let’s look at a capital budgeting model that considers the time value of cash flows. Discounting Future Cash Flows

  18. A comparison of the present value of cash inflows with the present value of cash outflows Net Present Value (NPV)

  19. Chose a discount rate – the minimum required rate of return. • Calculate the presentvalue of cash inflows. • Calculate the presentvalue of cash outflows. NPV = – Net Present Value (NPV)

  20. General decision rule . . . Net Present Value (NPV)

  21. Net Present Value (NPV)Question Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a. $ 4,300 b. $12,700 c. $11,000 d. $17,000

  22. Net Present Value (NPV)Question Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a. $ 4,300 b. $12,700 c. $11,000 d. $17,000 Using the present value of an annuity (table 2) PV of inflows = $20,000 × 5.650 = $113,000 NPV = $113,000 - $96,000 = $17,000

  23. Net Present Value (NPV)Question Calculate the NPV if Savak Company’s required return is 15 percent instead of 12 percent. Using the present value of an annuity (table 2) PV of inflows = $20,000 × 5.019 = $100,380 NPV = $100,380 - $96,000 = $4,380 Note that the NPV is smallerusing the larger interest rate.

  24. Net Present Value (NPV) Now that you have mastered the basic concept of net present value, it’s time for a more sophisticated checkup! Let’s return to Stars’ Stadium.

  25. Stars’ Stadium is considering purchasingvending machines with a 5-year life. Evaluating Capital Investment Proposals: An Illustration ($75,000 - $5,000) ÷ 5 years

  26. Most capital budgeting techniques use annual net cash flow. Depreciation is not a cash outflow. Evaluating Capital Investment Proposals: An Illustration

  27. Net Present Value (NPV) Star’s Stadium Net Present Value Analysis Stars uses a 15% discount rate.

  28. Net Present Value (NPV) Star’s Stadium Net Present Value Analysis Present value of an annuity of $1 factor for 5 years at 15%. $24,000 × 3.352 = $80,448

  29. Net Present Value (NPV) Star’s Stadium Net Present Value Analysis Present value of $1 factor for 5 years at 15%.

  30. Net Present Value (NPV) Star’s Stadium Net Present Value Analysis Since the NPV is positive, we know the rate of return is greater than the 15 percent discount rate.

  31. Net Present Value (NPV)Replacing Assets Let’s use NPVconcepts withan asset replacement decision.

  32. The Maine LobStars are considering replacing an old bus with a new bus, each with a 5-year life and zero salvage. Evaluating Capital Investment Proposals: An Illustration

  33. Depreciation is not a cash outflow. Evaluating Capital Investment Proposals: An Illustration Tax savings from loss ondisposal of old bus: $15,000 × 40% = $6,000

  34. Net Present Value (NPV) LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.

  35. Net Present Value (NPV) LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.

  36. Net Present Value (NPV) LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.

  37. Net Present Value (NPV) LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate. Since the NPV is negative, we know the rate of return is less than the 15 percent discount rate.

  38. Capital budgeting involves many estimates. Estimates may be pessimistic or optimistic. Uncertainty about the future may impact estimates. Behavioral Issuesin Capital Budgeting

  39. Conflicts may exist between short-run performance measures and long-run capital budgeting criteria. Behavioral Issuesin Capital Budgeting

  40. A follow-up after the project has been approved to see whether or not expected results are actually realized. Capital Budget Audit

  41. THE END I told you that’s the end. You can’t work any more accounting problems in my class!

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