Chapter 12 The Capital Budgeting Decision PPT 12

Chapter 12 The Capital Budgeting Decision

PPT 12 -1 FIGURE 12 -1 Capital budgeting procedures Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

PPT 12 -2 TABLE 12 -1 Cash flow for Alston Corporation Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

PPT 12 -2 TABLE 12 -2 Revised cash flow for Alston Corporation Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

PPT 12 -3 TABLE 12 -3 Investment alternatives Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

PPT 12 -3 TABLE 12 -4 Capital budgeting results Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

PPT 12 -4 TABLE 12 -6 The reinvestment assumption− net present value ($10, 000 investment) Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

PPT 12 -5 TABLE 12 -7 Capital rationing Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

PPT 12 -6 FIGURE 12 -2 Net present value profile Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

PPT 12 -7 FIGURE 12 -3 Net present value profile with crossover Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

TABLE 12 -8 Categories for depreciation write-off Mc. Graw-Hill/Irwin PPT 12 -8 © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

PPT 12 -9 TABLE 12 -9 Depreciation percentages (expressed in decimals) Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

PPT 12 -10 TABLE 12 -10 Depreciation schedule Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

PPT 12 -11 TABLE 12 -11 Cash flow related to the purchase of machinery Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

PPT 12 -12 TABLE 12 -12 Net present value analysis Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

PPT 12 -13 TABLE 12 -15 Analysis of incremental depreciation benefits Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

PPT 12 -14 TABLE 12 -16 Analysis of incremental cost savings benefits Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

PPT 12 -15 TABLE 12 -17 Present value of the total incremental benefits Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Chapter 12 - Outline LT 12 -1 n What is Capital Budgeting? n 3 Methods of Evaluating Investment Proposals n Accept/Reject Decision n Capital Rationing n Net Present Value Profile n Determining Whether to Purchase a Machine Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

What is Capital Budgeting? LT 12 -2 Capital Budgeting: – represents a long-term investment decision – involves the planning of expenditures for a project with a life of many years – usually requires a large initial cash outflow with the expectation of future cash inflows – uses present value analysis – emphasizes cash flows rather than income Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

3 Methods of Evaluating Investment Proposals LT 12 -3 n There are 3 widely used methods of evaluating investment proposals: n Payback Method (PB) n Internal Rate of Return (IRR) n Net Present Value (NPV) Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Payback Method LT 12 -4 Payback Method (PB): – computes the amount of time required to recoup the initial investment – a cutoff period is established Advantages: – easy to use (“quick and dirty” approach) – emphasizes liquidity Disadvantages: – ignores inflows after the cutoff period and fails to consider the time value of money – is inferior to the other 2 methods Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Internal Rate of Return LT 12 -5 Internal Rate of Return (IRR): – represents a yield on an investment or an interest rate – requires calculating the interest rate that equates the cash outflows (cost) with the cash inflows – is the interest rate where the cash outflows equal the cash inflows (or NPV = 0) Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Net Present Value LT 12 -6 Net Present Value (NPV): – the present value of the cash inflows minus the present value of the cash outflows – the cash inflows are discounted back over the life of the investment – the basic discount rate is usually the firm’s cost of capital (WACC) Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Accept/Reject Decision LT 12 -7 Payback Method (PB): –if PB period < cutoff period, accept the project – if PB period > cutoff period, reject the project Internal Rate of Return (IRR): – if IRR > cost of capital, accept the project – if IRR < cost of capital, reject the project Net Present Value (NPV): – if NPV > 0, accept the project – if NPV < 0, reject the project Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Capital Rationing LT 12 -8 n. A limit or constraint on the amount of funds that can be invested n Firm must rank investments based on their NPVs n Those with positive NPVs are accepted until all funds are exhausted Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Net Present Value Profile LT 12 -9 Net Present Value Profile: – a graph of the NPV of a project at 3 different discount rates: n a zero discount rate n the normal discount rate (or cost of capital) n the IRR for the investment – allows an easy way to visualize whether or not an investment should be undertaken Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Determining Whether to Purchase a Machine LT 12 -10 To make the actual investment decision: – calculate a depreciation schedule using the appropriate MACRS class – figure earnings and cash flow (CF) – discount the cash flows back to the present to determine whether the machine should be purchased (only if NPV > 0) Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.