Capital Budgeting Decisions

UAA ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee

Introduction to Capital Budgeting

Capital Budgeting is . . .
. . . The making of long-term planning decisions for investments.

Capital Budgeting Decisions

Should we purchase new laborsaving equipment to perform operations presently performed manually

A Cost-Reduction Decision

Capital Budgeting Decisions

Should we replace existing equipment with more efficient, newer equipment.

A Cost-Reduction Decision

Capital Budgeting Decisions

Should we enter a new market with a new product or purchase an existing business already in that market
A Profit-Expansion Decision

The Process of Capital Budgeting

Process of Capital Budgeting

Identification Stage Search Stage Information-Acquisition Stage Selection Stage Financing Stage

Implementation and Control Stage

Project Selection . . .

Selection in capital budgeting

comes in two phases:

Screening, and

Preference

Screening . . .
A specific criterion is used to
eliminate unprofitable and/or high-risk investment proposals.

Projects meeting criteria Projects not meeting criteria

Preference Selection
The surviving projects are subjected
to a ranking criterion.

Outcome: The most favorable

projects are selected for any given amount of capital to be invested.

We interrupt this regularly scheduled program to bring you a special bulletin on the characteristics of business investments.

Characteristics of Business Investments

Business Investments
Most business investments involve
depreciable assets; and

The returns on business investments

extend over long periods of time.

Depreciable Assets

Time
Consumed as Depreciation Expense

To Illustrate . . .
A firm purchases land (a nondepreciable asset) for $5,000; and

Rents it out at $750.00 per year for

ten years.

What is the return?

What is the Return?

Since the asset will still be intact at the end of the 10-year period, each years $750 inflow is a return on the original $5,000 investment. The rate of return is therefore:

$750 15% $5,000

Return on Assets Must

Provide a return

on the original
investment.

A return of the
original investment itself.

To Illustrate . . .
A firm purchases land (a nondepreciable asset) for $5,000; and

Rents it out at $750.00 per year for

ten years.
Hmmm. What now?

What is the Return?

$750 15% $5,000

Why?
Because part of the yearly $750
inflow from the equipment must go to recoup the original $5,000 investment itself, since the equipment will be worthless at the end of its 10-year life.

Long Periods of Time

Long Periods of Time

In approaching capital budgeting
decisions, it is necessary to employ techniques that recognize the time value of money.

Discounted Cash Flow Models (DCF)

DCF Models . . .
Focus on . . .

Cash inflows; and

Cash outflows
Rather than on net income

DCF Models . . .
There are two main variations of the
discounted cash flow model . . .

Net Present Value (NPV); and Internal Rate of Return (IRR)

Net Present Value

Net Present Value Method

Usually Future

PV$ (PV$)

Discount Discount

Cash Inflows Cash Outflows

Future and/or Present

NPV

Net Present Value Method

If the result is positive, the investment Cash Inflows promises more than the interest rate Discount used to evaluate the proposal. Cash Outflows Discount
Future and/or Present Usually Future

PV$ (PV$)

NPV

Net Present Value Method

If the result is zero, the investment Inflows yields exactly theCash interest rate used to Discount evaluate the proposal. Cash Outflows Discount
Future and/or Present Usually Future

PV$ (PV$)

NPV

Net Present Value Method

If the result is negative, the investment Cash Inflows should be rejected because the required Discount rate of return will not be earned. Cash Outflows Discount
Future and/or Present Usually Future

PV$ (PV$)

NPV (NPV)

Typical Cash Outflows

The initial investment

Additional amount of working capital

Repairs and maintenance Additional operating costs

Typical Cash Inflows

Incremental revenues

Reduction in costs
Salvage value Release of working capital

PDQ Company NPV Example PDQ company requires a minimum return of 18% on all investments. The company can purchase a new machine at a cost of $40,350. The new machine would generate cash inflows of $15,000 per year and have a four-year life with no salvage value. What is the net present value of this project?

PDQ Company NPV Example

Item

Yr(s)

Amt of Cash Flow

18% Factor

Present Value of CF

Initial Inv. Annual CF

Now 1-4

(40,350) 15,000

1.000 2.690

(40,350) 40,350 -0-

Net Present Value

Each $15,000 Inflow . . .

Provides for a recovery of a portion of the
original $40,350 investment; and

Also provides a return of 18% on this

investment.

Year

(1) Inv O/S during Year $40,350

(2)

(3)

(4)

Cash Inflow $15,000

PV of ROI Rec of Cash $40,350 - $7,737 (1)*= $32,613 Inv. Flow 18% (2)-(3) (1)-(4) $7,263 $7,737 $32,613

1 2

3
4

$40,350 x 18% = $7,263

$15,000 - $7,263 = $7,737

Year

(1) Inv O/S during Year $40,350 32,613 23,483

(2)

(3)

(4)

Cash Inflow $15,000 15,000 15,000

ROI (1)* 18%

$7,263 5,870 4,227

Rec of Inv. (2)-(3)

$7,737 9,130 10,773

PV of Cash Flow (1)-(4) $32,613 23,483 12,710

1 2 3

12,710

15,000

2,290

12,710

-0-

Practice Exercise 1

Calculate Net Present Value (NPV)

Practice Exercise 1
An investment that costs $10,000 will
return $4,000 per year for four years.

Determine the net present value of the

investment if the required rate of return is 12 percent. Ignore income taxes.

Should the investment be undertaken?

Practice Exercise 1

Item

Yr(s)

Amt of Cash Flow

12% Factor

Present Value of CF

Initial Inv. Annual CF

Now 1-4

(10,000) 4,000

1.000 3.037

($10,000) 12,148 $2,148

Net Present Value

Practice Exercise 2

Calculate Net Present Value (NPV)

Practice Exercise 2
Magnolia Florist is considering replacing
an old refrigeration unit with a larger unit to store flowers.

Because the new refrigeration unit has a

larger capacity, Magnolia estimates that they can sell an additional $6,000 of flowers a year (the cost of the flowers is $3,500).

Practice Exercise 2
In addition, the new unit is energy efficient
and should save $950 in electricity each year.

It will cost an extra $150 per month for

maintenance.

The new refrigeration unit costs $20,000

and has an expected life of 10 years.

Practice Exercise 2
The old unit is fully depreciated and can be
sold for an amount equal to disposal cost.

At the end of 10 years, the new unit has an

expected residual value of $5,000

Determine the NPV of the investment if the

RRR is 14% (ignore taxes).

Should the investment be made.

Practice Exercise 2
Determine the net cash flow for the life of
the equipment.
Item Additional Sales Cost of Sales Savings in Electricity Maintenance Total Cash Flow $6,000 (3,500) 950 (1,800) $1,650

Practice Exercise 2
Amt of Cash Flow

Item

Yr(s)

14% Factor

Present Value of CF

Initial Inv. Annual CF Salvage

Now 1-10 10

(20,000) 1,650 5,000

1.000 5.216 .270

($20,000) 8,606 1,350 ($10,044)

Net Present Value

Limiting Assumptions . . .
All cash flows occur at the end of the
period.

All cash flows generated by an investment

are immediately reinvested in another project which yields a return at least as large as the discount rate used in the first project.

Discount Rate . . .
The rate generally viewed as being the
most appropriate is a firms cost of capital.

This rate is also known as . . .

Hurdle Rate Cutoff Rate Required Rate of Return

Internal Rate of Return

The internal rate of return (IRR) is that Net Value Method ratePresent of interest which will exactly equate the PV of the cash inflows with the PV of the cash outflows. Usually Future

PV$ (PV$)

Discount Discount

Cash Inflows Cash Outflows

Future and/or Present

NPV $-0-

Resulting in $0 NPV

Internal Rate of Return

When the annual cash flows are
even, the IRR formula is simply . . .

df = I / CF, or

Investment/Annual Cash Flow

Cost of Capital as a Screening Tool

Using the IRR Method

The cost of capital takes the form of a
hurdle rate that a project must clear for acceptance.

If the IRR on a project is not great

enough to clear the cost of capital hurdle, then the project is rejected.

Using the NPV Method

The cost of capital becomes the
actual discount rate used to compute the NPV of a proposed project.

Projects yielding negative NPVs are

rejected unless nonquantitative factors, such as social responsibility, employee morale, etc., intervene.

Compare Net Present Value and Internal Rate of Return

Compare IRR & NPV . . .

The NPV method is simpler to use.

Using the NPV method makes it

easier to adjust for risk.

The NPV method provides more

usable information than does the IRR method.

Simplified Approaches to Capital Budgeting

The Payback Period . . .

This method involves a span of time
known as the payback period.

The payback period is the length of

time it takes for an investment project to recoup its own initial cost out of the cash receipts that it generates.

The Payback Period . . .

The basic premise of this method is
that the more quickly the cost of an investment can be recovered, the more desirable is the investment.

The Payback Period . . .

The payback period is expressed in
years. The basic formula is . . .

Investment Req --------------------------- = Payback Period Net Annual CF

Practice Exercise 3

Calculate the Payback period

Practice Exercise 3
The Lower Valley Wheat Cooperative is
considering the construction of a new silo.

It will cost $41,000 to construct the silo. Determine the payback period if the
expected cash inflows are $5,000 per year.

The Payback Period . . .

$41,000
--------------------------- = 8.2 Years $5,000

Simplified Approaches to Capital Budgeting

AKA: Accounting Rate of Return

The Simple Rate of Return

The Simple Rate of Return is equal to

Incremental income from the project
divided by the initial investment in the project.
Simple Rate of Return (SRR)
*Less Salvage Value if any

Inc. NOI Initial Investment*

The Simple Rate of Return

If a cost reduction project is involved,

the formula becomes:
SRR
Cost Savings - Depreciation = Initial Investment*

*Less Salvage Value if any

Practice Exercise 4
Calculate the Simple Rate of Return

Practice Exercise 4
Martin Company is considering the purchase of
a new piece of equipment. Relevant information concerning the equipment follows: Purchase Cost Annual cost savings Useful Life $180,000 37,500 12 Years

Compute the Simple Rate of Return.

Practice Exercise 4