Capital Budgeting Decisions

Capital Budgeting Decisions
Capital Budgeting
How managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment and introduction of new products.
July 8, 2011
Typical Capital Budgeting Decisions

Plant expansion Equipment selection Lease or buy Equipment replacement Cost reduction
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Typical Capital Budgeting Decisions

Capital budgeting tends to fall into two broad
categories

Screening decisions. Does a proposed project meet some present standard of acceptance? Preference decisions. Selecting from among several competing courses of action.
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Time Value of Money

Business investments
extend over long periods of time, so we must recognize the time value of money. Investments that promise returns earlier in time are preferable to those that promise returns later in time.
July 8, 2011
Time Value of Money

A bond will pay $100 in two years. What is the present value of the $100 if an investor can earn a return of 12% on the investment?
The present value factor can be computed using a formula or using present value tables.
July 8, 2011
Time Value of Money

Excerpt from Present Value of $1 Table
Periods 1 2 3 4 5
10% 0.909 0.826 0.751 0.683 0.621
Rate 12% 0.893 0.797 0.712 0.636 0.567
14% 0.877 0.769 0.675 0.592 0.519
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Time Value of Money

$100 0.797 = $79.70 present value
Periods 1 2 3 4 5 10% 0.909 0.826 0.751 0.683 0.621 Rate 12% 0.893 0.797 0.712 0.636 0.567 14% 0.877 0.769 0.675 0.592 0.519
Present value factor of $ for 2 periods at 12%.

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Time Value of Money

An investment that involves a series of identical cash flows at the end of each year is called an annuity annuity.
$100
$100
$100
$100
$100
$100
July 8, 2011
Time Value of Money

Lacey Company purchased a tract of land on which a $60,000 payment will be due each year for the next five years. What is the present value of this stream of cash payments when the discount rate is 12%?
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Time Value of Money

Refer to the Present Value of an Annuity of $1 Table
Perio s 1 1 9 9 17 87 17 791 1 89 1 9 7 1 877 1 7 91
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Time Value of Money

$60,000 3.605 = $216,300
Periods 1 2 3 4 5
10% 0.909 1.7 2.487 3.170 3.791
12% 0.89 1.690 2.402 3.037 3.605
14% 0.877 1.647 2.322 2.914 3.433
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Typical Cash Outflows

Repairs and maintenance
Working capital
Initial investment
Incremental operating costs

Typical Cash Inflows

Salvage value
Release of working capital Incremental revenues

July 8, 2011 Capital Budgeting Decisions
Reduction of costs
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Recovery of the Original Investment

Carver Hospital is considering the purchase of an attachment for its Xray machine.
ost $ , ie ea s Salva e value ze o In ease in annual ash lo s ,

No investments are to be made unless they have an annual return of at least 10%. Should the investment be made?

resent Value of Cash Flows $ 3,170 (3,170) $ -0-
Item Annual cash inflows Initial investment(outflow) Net present value
Year( ) 1-4 Now
m t of Cash Flow $ 1,000 (3,170)
10% Factor 3.170 1.000
P e r io ds 1 2 3 4 5
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10% 0 . 90 9 1 .7 3 6 2. 4 87 3 .1 7 0 3 . 7 91
1 2% 0 . 893 1 . 690 2. 4 0 2 3 .0 3 7 3 . 60 5
14% 0 . 87 7 1 . 64 7 2. 3 22 2. 91 4 3 .4 3 3
Present value of an annuity of $1 table

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resent a ue of Cash Fo s $ 3 170 (3 170) $ -0-
Item nnua cash nf o s In t a nvestment( utf o ) Net present va ue
Year(s) 1-4 N
mount of Cash F o $ 1 000 (3 170)
10 Factor 3 170 1 000
Because the net present va ue s equa to zero the attachment nvestment prov des exact y a 10 return

Depreciation is not deducted in computing the
present value of a project because

It is not a current cash outflow. Discounted cash flow methods automatically provide for return of the original investment.
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Choosing a Discount Rate

The firms cost of capital is
usually regarded as the most appropriate choice for the discount rate. The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds.
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The Net Present Value Method

To determine net present value

Calculate the present value of cash inflows Calculate the present value of cash outflows Subtract the present value of the outflows from the present value of the inflows.
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General decision rule
If the Net Present Value is . . . Positive . . . Then the Project is . . . Acceptable, since it promises a return greater than the required rate of return. Acceptable, since it promises a return equal to the required rate of return. Not acceptable, since it promises a return less than the required rate of return.
Capital Budgeting Decisions 21
Zero . . .
Negative . . .
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How is PV used to make business decisions?
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Lester Company has been offered a five year contract to provide component parts for a large manufacturer.
Cost and revenue information Cost of special equipment $160,000 Working capital required 100,000 Relining equipment in 3 years 30,000 Salvage value of equipment in 5 years 5,000 Annual cash revenue and costs: Sales revenue from parts 750,000 Cost of parts sold 400,000 Salaries, shipping, etc. 270,000

At the end of five years the working capital will be
released and may be used elsewhere by Lester. Lester Company uses a discount rate of 10%.
Should the contract be accepted?
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Annual net cash inflows from operations
Sales re enue ost of parts sol Salaries shippin etc Annual net cash inflows
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nvestment in equipment Working capital needed Years Now Now Cash Flows $ (160,000) (100,000) 10% Factor 1.000 1.000 Present Value $ (160,000) (100,000)
Net present value
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nvestment in equipment Working capital needed Annual net cash inflows Years Now Now 1-5 Cash Flows $ (160,000) (100,000) 80,000 10% Factor 1.000 1.000 3.791 Present Value $ (160,000) (100,000) 303,280
Net present value
Present value of an annuity of $1 factor for 5 years at 10%.
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nvestment in equipment Wo king capital needed Annual net cash inflows Relining of equipment Yea s Now Now 1-5 3 Cash Flows $ (160,000) (100,000) 80,000 (30,000) 10 Facto 1.000 1.000 3.791 0.751 P esent Value $ (160,000) (100,000) 303,280 (22,530)
Net p esent value
Present value of $1 factor for 3 years at 10%.
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nvestment in equipment Wo king capital needed Annual net cash inflows Relining of equipment Salvage value of equip. Net p esent value Yea s Now Now 1-5 3 5 Cash Flows $ (160,000) (100,000) 80,000 (30,000) 5,000 10 Facto 1.000 1.000 3.791 0.751 0.621 P esent Value $ (160,000) (100,000) 303,280 (22,530) 3,105
Present value of $1 factor for 5 years at 10%.
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nvestment in equipment Working capital needed Annual net cash inflows Relining of equipment Salvage value of equip. Working capital released Net present value Years Now Now 1-5 3 5 5 Cash Flows $ (160,000) (100,000) 80,000 (30,000) 5,000 100,000 10% Factor 1.000 1.000 3.791 0.751 0.621 0.621 Present Value $ (160,000) (100,000) 303,280 (22,530) 3,105 62,100 $ 85,955
Accept the contract because the project has a positive net present value.
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The Internal Rate of Return Method

The internal rate of return is the interest yield
promised by an investment project over its useful life. The internal rate of return is computed by finding the discount rate that will cause the net present value of a project to be zero.
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Decker Company can purchase a new machine at a cost
of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life.
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Future cash flows are the same every year in this example, so we can calculate the internal rate of return as follows:
PV factor for the = internal rate of return $104 320 $20 000 Investment required et annual cash flows = 5.216
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Using the present value of an annuity of $1 table . . . Find the 10-period row move across until you find the factor 5.216. Look at the top of the column and you find a rate of 14%. 14%
e r io d s 1 2 . . . 10 10% 0. 0 1. 6 . . . 5. 5 6 .1 4 5 12% 0. 1 .6 0 . . . 5. 2 5 .6 5 0 14% 0. 1 .6 4 . . . 4. 46 5 .2 1 6
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Decker Company can purchase a new machine at a cost
of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life.
The internal rate of return on this project is 14%. If the internal rate of return is equal to or greater than the companys required rate of return, the project is acceptable.
Net Present Value vs. Internal Rate of Return
Net Present Value Easier to use.

Assumes cash inflows will be
reinvested at the discount rate. This is a realistic assumption.
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Expanding the Net Present Value Method

To compare competing investment projects we can use the following net present value approaches:

Total-cost Incremental cost

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The Total-Cost Approach

White Co. has two alternatives: (1) remodel an old car
wash or, (2) remove it and install a new one. The company uses a discount rate of 10%.
New Car Wash Annual revenues $ 90,000 Annual cash operating costs 30,000 Net annual cash inflows $ 60,000
Old Car Wash $ 70,000 25,000 $ 45,000
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If White installs a new washer . . .
Cost oduct f Salvage value Replace brushes at the end of 6 years Salvage of old equip.
s 7,000 50,000 40,000
Lets look at the present value of this alternative.


Install the ear ow 0 ow 0 ew asher ash Flows $ 300 000 0 000 0 000 0 000 000 0 Fa tor .000 0. . .000 0.3 resent Value $ 300 000 2 200 3 00 0 000 2 02 $ 3 202
Initial investment Repla e rushes et annual ash inflows alva e of old e uipment alva e of new e uipment et present value
If we install the new washer the investment will yield a positive net present value of $ 3 202.

If White remodels the existing washer . . .
Rem e c sts Re ace s es at t ee f 6 ea s
$175 000 80 000
Lets look at the present value of this second alternative.
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emodel the Old ear ow 6 0 asher ash lows $ 5 000 0 000 45 000 0 actor .000 0.564 6. 45 resent alue $ 5 000 45 0 65 5 $ 56 405
Initial investment eplace rushes et annual cash inflows et present value
If we remodel the existing washer we will produce a positive net present value of $56 405.
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Both projects yield a positive net present value.
et resent alue
nvest in ne asher e odel e istin asher n avor o ne asher

Ho ever investin in the ne asher ill produce a hi her net present value than re odelin the old asher.
The Incremental-Cost Approach

Under the incremental-cost approach, only those
cash flows that differ between the two alternatives are considered.
Lets look at an analysis of the White Co.
decision using the incremental-cost approach.
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Year Now Cash Flows $(125,000) 10% Factor 1.000 Present Value $(125,000)
Incremental investment
Net present value
$300 000 new - $1 5 000 remodel = $125 000
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Year Now 6 Cash Flows $(125,000) $ 30,000 10% Factor 1.000 0.564 Present Value $(125,000) 16,920
Incremental investment Incremental cost of brushes
Net present value
$ 0 000 remodel - $50 000 new = $30 000
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Year Now 6 1-10 Cash Flows $(125,000) $ 30,000 15,000 10% Factor 1.000 0.564 6.145 Present Value $(125,000) 16,920 92,175
Incremental investment Incremental cost of brushes Increased net cash inflows
Net present value
$60 000 new - $45 000 remodel = $15 000
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Year Now 6 1-10 Now 10 Cash Flows $(125,000) $ 30,000 15,000 40,000 7,000 10% Factor 1.000 0.564 6.145 1.000 0.386 Present Value $(125,000) 16,920 92,175 40,000 2,702 $ 26,797
Incremental investment Incremental cost of brushes Increased net cash inflows Salvage of old equipment Salvage of new equipment Net present value
We get the same answer under either the total-cost or incremental-cost approach.
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Least Cost Decisions

In decisions where revenues are not directly involved, managers should choose the alternative that has the least total cost from a present value perspective.
Lets look at the Home Furniture Company.
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Home Furniture Company is trying to decide
whether to overhaul an old delivery truck now or purchase a new one. The company uses a discount rate of 10%.
Home Furniture
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Here is information about the trucks . . .
Old Truck
Overhaul cost now Annual operating costs Salvage value in 5 years Salvage value now $ 4,500 10,000 250 9,000
New Truck Purchase price Annual operating costs Salvage value in 5 years
$ 21,000 6,000 3,000

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Buy the New Truck Cash Year Flows Purchase price Now $(21,000) Annual operating costs 1-5 (6,000) Salvage value of old truck Now 9,000 Salvage value of new truck 5 3,000 Net present value Keep the Old Truck Cash Year Flows Overhaul cost Now $ (4,500) Annual operating costs 1-5 (10,000) Salvage value of old truck 5 250 Net present value
10% Factor 1.000 3.791 1.000 0.621
Present Value $ (21,000) (22,746) 9,000 1,863 (32,883)
10% Factor 1.000 3.791 0.621
Present Value $ (4,500) (37,910) 155 (42,255)

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Home Furniture should purchase the new truck.
Net present value of costs associated with purchase of new truck Net present value of costs associated with remodeling existing truck Net present value in favor of purchasing the new truck
$(32,883)
(42,255) $ 9,372
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Investments in Automated Equipment

Investments in automated equipment tend to be very
large in dollar amount. The benefits received are often indirect and intangible.
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Ranking Investment Projects

Profitability = index Present value of cash inflows Investment required
Investment B Present value of cash inflows Investment required Profitability index
The higher the profitability index the more desirable the project.
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Other Approaches to Capital Budgeting Decisions

Other methods of making capital budgeting decisions include . . .
The Payback Method. Simple Rate of Return.
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The Payback Method

The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates.
When the net annual cash inflow is the same each year, this
formula can be used to compute the payback period:
Payback period =
Investment required Net annual cash inflow

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July 8, 2011
The Payback Method

Management at The Daily Grind wants to install an espresso
bar in its restaurant. The espresso bar:

Costs $140,000 and has a 10-year life. Will generate net annual cash inflows of $35,000.
Management requires a payback period of 5 years or less on
all investments.
What is the payback period for the espresso bar?
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The Payback Method

Payback period = Investment required Net annual cash inflow $140 000 $35 000
Payback period =
Payback period =
4.0 years
According to the companys criterion management would invest in the espresso bar because its payback period is less than 5 years.
Evaluation of the Payback Method

Ignores the time value of money. ShortShort-comings of the Payback Period.
Ignores cash flows after the payback period.
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The Simple Rate of Return Method

Does not focus on cash flows -- rather it focuses
on accounting income income. The following formula is used to calculate the simple rate of return:
Incremental Incremental expenses revenues including depreciation Initial investment
Simple rate = of return
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Management of The Daily Grind wants to install an espresso bar in
its restaurant. The espresso bar: Cost $140,000 and has a 10-year life. Will generate incremental revenues of $100,000 and incremental expenses of $65,000 including depreciation.
What is the simple rate of return on the investment project?
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Simple rate = of return $100 000 - $65 000 $140 000 = 25%
The simple rate of return method is not recommended for a variety of reasons the most important of being that it ignores the time value of money.
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Post Audit of Investment Projects

A post audit is a follow-up after the project has been approved to see whether or not expected results are actually realized.
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Capital Budgeting Decisions

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