Capital Budgeting Decisions UAA ACCT 202 Principles of

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 year’s $750 inflow is a return on the original $5, 000 investment. The rate of return is therefore:

Return on Assets Must u. Provide a return on the original investment. u. A return of the original investment itself.

To Illustrate. . . n i s i t n ting e m t a § A firm purchases land (a nonr. s s e e r p v a o n i e y e 0 depreciable asset) for $5, 000; and c 0 0 u 1 0 d , r e 5 r o $ f l l r i e a w h t e d y e n § Rents it out at $750. 00 per year for h a m c t u a s n e s e A years. m 750 ten p i u $ q y e sb t s co Hmmm. What now?

What is the Return?

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$ Discount Cash Inflows (PV$) Discount Cash Outflows NPV Future and/or Present

Net Present Value Method Usually Future PV$ (PV$) NPV If the result is positive, the investment Cashthe. Inflows promises more than interest rate Discount used to evaluate the proposal. Cash Outflows Discount Future and/or Present

Net Present Value Method Usually Future PV$ (PV$) NPV If the result is zero, the investment Inflows yields exactly the. Cash interest rate used to Discount evaluate the proposal. Cash Outflows Discount Future and/or Present

Net Present Value Method Usually Future PV$ (PV$) NPV (NPV) If the result is negative, the investment Inflows should be rejected. Cash because the required Discount rate of return will not be earned. Cash Outflows Discount Future and/or Present

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 Yr(s) Amt of Cash Flow 18% Factor Present Value of CF Initial Inv. Now (40, 350) 1. 000 (40, 350) Annual CF 1 -4 15, 000 2. 690 40, 350 Item Net Present Value -0 -

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 2 3 4 (1) Inv O/S during Year (2) Cash Inflow PV of ROI Rec of Cash $40, 350 - $7, 737 (1)*= $32, 613 Inv. Flow 18% (2)-(3) (1)-(4) $40, 350 $15, 000 $7, 263 $40, 350 x 18% = $7, 263 (3) (4) $7, 737 $32, 613 $15, 000 - $7, 263 = $7, 737

(1) Inv O/S during Year 1 (2) (3) (4) Cash Inflow ROI (1)* 18% Rec of Inv. (2)-(3) PV of Cash Flow (1)-(4) $40, 350 $15, 000 $7, 263 $7, 737 $32, 613 2 32, 613 15, 000 5, 870 9, 130 23, 483 3 23, 483 15, 000 4, 227 10, 773 12, 710 4 12, 710 15, 000 2, 290 12, 710 -0 - Year

Practice Exercise 1 Calculate Net Present Value (NPV)

Practice Exercise 1 § An investment that costs $10, 000 will return $4, 000 per year 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 Yr(s) Amt of Cash Flow 12% Factor Present Value of CF Initial Inv. Now (10, 000) 1. 000 ($10, 000) Annual CF 1 -4 4, 000 3. 037 12, 148 Item Net Present Value $2, 148

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 Cash Flow $6, 000 Cost of Sales (3, 500) Savings in Electricity Maintenance Total 950 (1, 800) $1, 650

Practice Exercise 2 Yr(s) Amt of Cash Flow 14% Factor Present Value of CF Initial Inv. Now (20, 000) 1. 000 ($20, 000) Annual CF 1 -10 1, 650 5. 216 8, 606 10 5, 000 . 270 1, 350 Item Salvage Net Present Value ($10, 044)

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 firm’s 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 rate. Present of interest which will exactly equate the PV of the cash inflows with the PV of the cash outflows. Usually Future PV$ Discount Cash Inflows (PV$) Discount Cash Outflows NPV $-0 - Future and/or Present 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 $180, 000 Annual cost savings Useful Life § Compute the Simple Rate of Return. 37, 500 12 Years

Practice Exercise 4