Capital Budgeting Decisions Chapter 14 Capital Investments Long

Capital Budgeting Decisions Chapter 14

Capital Investments �Long Term in nature covering many years �Large amounts of capital �Investments are not easily or quickly disposed �Critical to long-term profitability �Affect human resources needs and composition

Prior to sending out requests � 1. Determination of dollars available for capital investments � 2. Determine the cost of capital (minimum rate of return)

Cost of Capital �Also called Desired Rate of Return Type Loan $ % Interest % % Time Share 30, 000 6. 6 13% . 9 Auto 20, 000 4. 4 4% . 2 Rental 200, 000 44. 5 6% 2. 7 Residence 200, 000 44. 5 5% 2. 2 TOTAL 100% 450, 000 6. 0

Steps in choosing a proposal �Step 1: Identification of capital investment needs �Step 2: Formal requests for capital investments �Step 3: Preliminary screening (remove those that are not appropriate for the project) �Step 4: Evaluate the proposal based on Acceptance – rejection standards previously determined �Step 5: Rank the proposals �Step 6: Choose the best proposal (s).

Capital Investment Analysis Methods � Net Present Value � Internal Rate of Return � Payback Period Method � Simple (Acctg) Rate of Return

Terms �Cash In. Flows Increase in Net cash inflows Cost Savings Reduce Costs

�Undiscounted Cash Inflows Rate of Return X Cash Inflows �Discounted Cash Inflows Adjusted for the loss of value over time Present Value Multiplier X Cash Inflows

NET PRESENT VALUE METHOD Uses PRESENT VALUE Table �Columns: % Return �Rows: Number of Period �Multiplier or factor is where the rate intersects the period.

Periods (Not just years) Can be Semi Annual, Quarterly, Monthly % - estimate return rate Based on the number of periods � 10% for yearly � 5% for seimannual � 2. 5% for quarterly Present Value of Cash In. Flows ( How much is the money received in following years worth today)

What Present Value Table �Present Value of $1 � Received at the end of a period of time � Uneven cash inflows �Present Value of a Ordinary Annuity of $1 �Received the same amount every period �Even Cash Inflows

PRACTICE READING TABLE � 1. What multiplier do you use if you receive $100, 000 at the end of 10 years assuming a return of 7%? What is its present value? �. 508 � $100, 000 *. 508 = $50, 800 � 2. What multiplier do you use if you receive $10, 000 every year for 10 years assuming a return of 7%. What is it’s present value? � 7. 024 � $10, 000* 7. 024 = $70, 240

Application �Exercise 14 -1 Compare discounted cash flow with undiscounted cash flow �Exercise 14 -9 Evaluating projects based on PV concept �Is 16% reasonable?

Project Profitability Index Net Present Value of Project Investment required �Helpful to decide what project to select. �The higher the better �Amount of cash inflow generated for each dollar of investment

Internal Rate of Return Investment Required Annual Cash inflow �Rate that causes the PV of the project’s cash inflows to equal the PV of the investment �How much interest you need to receive to pay it back �Do not know the rate of return %. �Divide Investment required by Annual Cash Inflows �Gives you the multiplier factor. �Go to the number of periods and find this multiplier �Go to the top of the column to get the % = IRR

Excercise 14 -2 �Only 1 and 2

Apply NPV and IRR �Exercise 14 -11

Payback Method Investment Required Net Annual Cash Inflows �Time it takes for the investment to pay for itself. �In years. �Same as IRR �Use formula only if even cash inflows

Payback Period con’t �Uneven cash inflows – Use following table Year Investment Cash Inflows Unrecovered 1 4, 000 1, 000 3, 000 2 -0 - 3, 000 3 2, 000 1, 000 2, 000 5 500 1, 500 6 3, 000 0 7 2, 000 0 4 2, 000

Application �Exercise 14 -5 EVEN OR UNEVEN?

Simple Rate of Return Annual Incremental Net Income Initial Investment �Not Cash Inflow �Includes depreciation �Annual Revenue-Annual expenses/Invest. �Easier than Acctg rate of return but not accurate �No present value considered

�Exercise 14 -6 �Both Payback period and SRR �Exercise 14 -13

Ranking of investments �Problem 14 -26 pg 672 �Rank based on NPV (inferior to PPI) � 1, 2, 4, 3 �Rank based on PPI (most dependable) � 3, 2, 1, 4 �Rank based on IRR (payback) � 4, 3, 2, 1

Application of NPV Concept �Problem 14 -27 pg 672

SRR, IRR and payback methods �Problem 14 -28