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Capital Budgeting and Managerial Decisions

Capital Budgeting and Managerial Decisions. Chapter. 25. Learning objectives. Exh. 25-5,6. Capital Budgeting Method Not using Time Value of Money Method using Time Value of Money Managerial Decision Decision and Information Managerial Decision Scenarios Decision Analysis

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Capital Budgeting and Managerial Decisions

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  1. Capital Budgeting and Managerial Decisions Chapter 25

  2. Learning objectives Exh. 25-5,6 • Capital Budgeting • Method Not using Time Value of Money • Method using Time Value of Money • Managerial Decision • Decision and Information • Managerial Decision Scenarios • Decision Analysis • Break-Even Time

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

  4. Payback period Cost of Investment Annual Net Cash Flow = Method Not using Time Value of Money- Payback Period Exh. 25-2 The payback period of an investmentis the time expected to recoverthe initial investment amount. Managers prefer investing in projects with shorter payback periods.

  5. Payback period Cost of Investment Annual Net Cash Flow = Payback period $16,000 $4,100 = = 3.9 years Payback Period with Even Cash Flows FasTrac is considering buying a new machine that will be used in its manufacturing operations. The machine costs $16,000 and is expected to produceannual net cash flows of $4,100. The machine is expected to have an 8-year useful life with no salvage value. Calculate the payback period.

  6. $5,000 $4,100 Payback Period with Uneven Cash Flows In the previous example, we assumed that the increase in cash flows would be the same each year. Now, let’s look at an example where the cash flows vary each year.

  7. Payback Period with Uneven Cash Flows Exh. 25-3 FasTrac wants to install a machine that costs $16,000 and has an 8-year useful life with zero salvage value. Annual net cash flows are:

  8. 4.2 Payback Period with Uneven Cash Flows Exh. 25-3 We recover the $16,000 purchase price between years 4 and 5, about4.2 years for the payback period.

  9. Unacceptable forprojects with longlives where timevalue ofmoney effectsare major. Using the Payback Period Ignores the time value of money. Ignores cash flows after the payback period.

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

  11. Accounting Annual after-tax net incomerate of return Annual average investment = Method Not using Time Value of Money- Accounting Rate of Return Exh. 25-5,6 The accounting rate of return focuses onannual income instead of cash flows. Beginning book value + Ending book value2

  12. Accounting Annual after-tax net incomerate of return Annual average investment = Accounting Rate of Return Exh. 25-5,6 Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute theaccounting rate of return. Beginning book value + Ending book value2

  13. Accounting Annual after-tax net incomerate of return Annual average investment = Accounting Rate of Return Exh. 25-5,6 Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute theaccounting rate of return. Beginning book value + Ending book value2

  14. Accounting $2,100rate of return $8,000 = = 26.25% Accounting Rate of Return Exh. 25-5,6 Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute theaccounting rate of return. $16,000 + $02

  15. Using Accounting Rate of Return • Depreciation may be calculated several ways. • Income may vary from year to year. • Time value ofmoney is ignored. So why would I ever want to use this method anyway?

  16. × 1.1 × 1.1 × 1.1 × 1.1 × 1.1 Method using Time Value of Money- Time Value of Money Future value of $100 today compounded for 5 years at 10 percent. 3 4 1 2 Future Today Compound at 10% FV = $161 $100 $110 $121 $133 $146

  17. ÷1.1 ÷1.1 ÷1.1 ÷1.1 ÷1.1 Method using Time Value of Money- Present Value Present value of $100 paid in 5 years discounted at 10 percent. 2 3 4 Future Today 1 Discount at 10% PV = $62.1 68.3 75.1 82.6 90.9 $100

  18. Method using Time Value of Money- Present Value Table The government will pay you $1,000 30 years later. There is no annual interest payment. If the market interest rate is 8%, how much is the price for the bond? (using Table I) Periods 6% 8% 10% 12% 25 0.2330 0.1460 0.0923 0.0588 30 0.1741 0.0994 0.0573 0.0334 35 0.1301 0.0676 0.0356 0.0189 PV = $1,000 X 0.0994 = $99.4

  19. Method using Time Value of Money- Net Present Value Now let’s look at a capital budgeting modelthat considers the time value of cash flows.

  20. Net Present Value • Discount the future net cash flows from the investment at the required rate of return. • Subtract the initial amount invested from sum of the discounted cash flows. FasTrac is considering the purchase of a conveyor costing $16,000 with an 8-year useful life with zero salvage value that promises annual net cash flows of $4,100. FasTrac requires a 12 percent compounded annual return on its investments.

  21. Net Present Value with Even Cash Flows Exh. 26-7

  22. Net Present Value with Even Cash Flows Exh. 26-7 Present value factorsfor 12 percent

  23. Net Present Value with Even Cash Flows Exh. 26-7 A positive net present value indicates that thisproject earns more than 12 percent on the investment.

  24. Using Net Present Value General decision rule . . .

  25. Net Present Value with Uneven Cash Flows Exh. 26-8 Although all projects require the same investment and havethe same total net cash flows, project B has a higher net present value because of a larger net cash flow in year 1.

  26. Presentvalue ofcashinflows Presentvalue ofcashoutflows = Method using Time Value of Money- Internal Rate of Return (IRR) The interest rate that makes . . . • The net present value equal zero.

  27. Internal Rate of Return (IRR) Exh. 26-9 Projects with even annual cash flows Project life = 3 yearsInitial cost = $12,000Annual net cash inflows = $5,000 Determine the IRR for this project. 1. Compute present value factor. 2. Using present value of annuity table . . .

  28. Internal Rate of Return (IRR) Exh. 26-9 Projects with even annual cash flows Project life = 3 yearsInitial cost = $12,000Annual net cash inflows = $5,000 Determine the IRR for this project. 1. Compute present value factor.$12,000 ÷ $5,000 per year = 2.4000 2. Using present value of annuity table . . .

  29. Internal Rate of Return (IRR) Exh. 26-9 1. Determine the present value factor.$12,000 ÷ $5,000 per year = 2.4000 2. Using present value of annuity table . . . Locate the rowwhose numberequals the periods in theproject’s life.

  30. Internal Rate of Return (IRR) Exh. 26-9 1. Determine the present value factor.$12,000 ÷ $5,000 per year = 2.4000 2. Using present value of annuity table . . . In that row,locate theinterest factorclosest inamount to thepresent valuefactor.

  31. Internal Rate of Return (IRR) Exh. 26-9 1. Determine the present value factor.$12,000 ÷ $5,000 per year = 2.4000 2. Using present value of annuity table . . . IRR isapproximately12%. IRR is theinterest rateof the columnin which thepresent valuefactor is found.

  32. Internal Rate of Return – Uneven Cash Flows If cash inflows are unequal, trial and error solution will result if present value tablesare used. Sophisticated business calculators and electronic spreadsheets can be used to easily solve these problems.

  33. Internal Rate of Return Compare the internal rateof return on a project to a predetermined hurdle rate (cost of capital). To be acceptable, a project’s rate of return cannot be less than thecost of capital. Using Internal Rate of Return

  34. Comparing Methods Exh. 25-10

  35. 2. Managerial Decisions Let’s change topics.

  36. Decision and Information- Decision Making Exh. 25-11 Decision making involves five steps: • Define the problem. • Identify alternatives. • Collect relevant information on alternatives. • Select the preferred alternative. • Analyze decisions made.

  37. 1 2 Decision and Information- Relevant Costs • Costs that are applicableto a particular decision. • Costs that should have a bearing on which alternative a manager selects. • Costs that are avoidable. • Future costs that differbetween alternatives.

  38. Classification by Relevance:Sunk Costs All costs incurred in the past that cannot be changed by any decision made now or in the future. Sunk costs should not be consideredin decisions. • Example:You bought an automobile that cost$10,000 two years ago. The $10,000 cost is sunkbecause whether you drive it, park it, trade it, or sellit, you cannot change the $10,000 cost.

  39. Classification by Relevance:Out-of-Pocket Costs Example:Considering the decision to take a vacation or stay at home, you will have travel costs (out-of-pocket costs) only if you choose a vacation. Future outlays of cash associatedwith a particular decision.

  40. Classification by Relevance: Opportunity Costs The potential benefit that is given up when one alternative is selected over another. Example:If you werenot attending college,you could be earning$20,000 per year. Your opportunity costof attending college for one year is $20,000.

  41. 2. Managerial Decisions - Managerial Decision Tasks We will now examine several different types of managerial decisions.

  42. Managerial Decision Tasks - Accepting Additional Business The decision to accept additional business should be based on incremental costs and incremental revenues. Incremental amounts are those that occur if the company decides to acceptthe new business.

  43. Accepting Additional Business Exh. 25-12 FasTrac currently sells 100,000 units of its product. The company has revenue and costs as shown below:

  44. Accepting Additional Business FasTrac is approached by an overseascompany that offers to purchase10,000 units at $8.50 per unit. If FasTrac accepts the offer, total factory overhead will increase by $5,000; total selling expenses will increase by $2,000; and total administrative expenses will increaseby $1,000. Should FasTrac accept the offer?

  45. Accepting Additional Business First let’s look at incorrect reasoningthat leads to an incorrect decision. Our cost is $9.00per unit. I can’t sell for $8.50 per unit.

  46. 10,000 new units × $8.50 selling price = $85,000 10,000 new units × $3.50 = $35,000 10,000 new units × $2.20 = $22,000 This analysis leads to the correct decision.

  47. Accepting Additional Business Exh. 25-14 Even though the $8.50 selling price is less than the normal $10 selling price, FasTrac should accept theoffer because net income will increase by $20,000.

  48. Managerial Decision Tasks - Make or Buy Decisions • Incremental costs also are important in the decision to make a product or purchase it from a supplier. • The cost to produce an item must include (1) direct materials, (2) direct labor and (3) incremental overhead. • We should not use the predetermined overhead rate to determine product cost.

  49. Make or Buy Decisions FasTrac currently makes part #417, assigning overhead at 100 percent of direct labor cost, withthe following unit cost:

  50. Make or Buy Decisions Exh. 25-15 FasTrac can buy part #417 from a supplier for $1.20. How much overhead do we have to eliminate before we can continue to make this part?

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