Chapter 14 Capital Budgeting Decisions Capital Budgeting How
Chapter 14 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.
Typical Capital Budgeting Decisions Plant expansion Equipment selection Lease or buy Equipment replacement Cost reduction
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.
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.
Time Value of Money A dollar today is worth more than a dollar a year from now since a dollar received today can be invested, yielding more than a dollar a year from now.
Interest and the Time Value of Money If $100 is invested today at 8% interest, how much will you have in two years? At the end of one year: $100 + 0. 08 $100 = (1. 08) $100 = $108 At the end of two years: (1. 08) $108 = $116. 64 or (1. 08)2 × $100 = $116. 64
Interest and the Time Value of Money The present value of any sum to be received in the future can be computed by turning the interest formula around and solving for P: P = Fn 1 n (1 + r)
Interest and the 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 investments? 1 P = 100 (1 +. 12)2 P = $100 (0. 797) P = $79. 70
Interest and the 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 investments? Present Value = $79. 70 What does this mean? If $79. 70 is put in the bank today, it will be worth $100 in two years. In that sense, $79. 70 today is equivalent to $100 in two years.
Time Value of Money $100 × 0. 797 = $79. 70 present value Present value factor of $1 for 2 periods at 12%.
Quick Check How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62. 10 b. $56. 70 c. $90. 90 d. $51. 90
Quick Check How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62. 10 $100 0. 621 = $62. 10 b. $56. 70 c. $90. 90 d. $51. 90
Time Value of Money An investment that involves a series of identical cash flows at the end of each year is called an annuity. $100 1 $100 2 $100 3 $100 4 $100 5 6
Time Value of Money Lacey Inc. 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%?
Time Value of Money We could solve the problem like this. . . Look in Appendix C of this Chapter for the Present Value of an Annuity of $1 Table
Time Value of Money We could solve the problem like this. . . $60, 000 × 3. 605 = $216, 300
Quick Check If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? a. $34. 33 b. $500. 00 c. $343. 30 d. $360. 50
Quick Check If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? a. $34. 33 b. $500. 00 c. $343. 30 $100 3. 433 = $343. 30 d. $360. 50
Typical Cash Outflows Repairs and maintenance Working capital Initial investment Incremental operating costs
Typical Cash Inflows Salvage value Release of working capital Reduction of costs Incremental revenues
Recovery of the Original Investment Carver Hospital is considering the purchase of an attachment for its X-ray machine. No investments are to be made unless they have an annual return of at least 10%. Will we be allowed to invest in the attachment?
Recovery of the Original Investment Present value of an annuity of $1 table
Quick Check Suppose that the investment in the attachment for the X-ray machine had cost $4, 000 and generated an increase in annual cash inflows of $1, 200. What is the net present value of the investment? a. $ 800 b. $ 196 c. $(196) d. $(800)
Recovery of the Original Investment 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.
Choosing a Discount Rate The firm’s 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 longterm creditors and stockholders for the use of their funds.
The Net Present Value Method To determine net present value we. . . 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.
The Net Present Value Method General decision rule. . .
The Net Present Value Method Lester Company has been offered a five year contract to provide component parts for a large manufacturer.
The Net Present Value Method At the end of five years the working capital will be released and may be used elsewhere by Lester Company uses a discount rate of 10%. Should the contract be accepted?
The Net Present Value Method Annual net cash inflows from operations
The Net Present Value Method
The Net Present Value Method Present value of an annuity of $1 factor for 5 years at 10%.
The Net Present Value Method Present value of $1 factor for 3 years at 10%.
The Net Present Value Method Present value of $1 factor for 5 years at 10%.
The Net Present Value Method Accept the contract because the project has a positive net present value.
Internal Rate of Return Method The internal rate of return is the rate of return 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.
Internal Rate of Return Method 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.
Internal Rate of Return Method 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 Net annual cash flows = 5. 216
Internal Rate of Return Method 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%
Internal Rate of Return Method 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 company’s required rate of return, the project is acceptable.
Quick Check The expected annual net cash inflow from a project is $22, 000 over the next 5 years. The required investment now in the project is $79, 310. What is the internal rate of return on the project? a. 10% b. 12% c. 14% d. Cannot be determined
Net Present Value vs. Internal Rate of Return v NPV is easier to use. v Assumptions v NPV assumes cash inflows will be reinvested at the discount rate. v Internal rate of return method assumes cash inflows are reinvested at the internal rate of return.
Ranking Investment Projects Profitability = index Present value of cash inflows Investment required The higher the profitability index, the more desirable the project.
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