Expenditure Capital Decisions
Maher 10e Chapter 8
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Learning Objectives
1.
2.
3.
4.
5.
Explain role of capital expenditure decisions in
strategic planning process.
Describe steps of net present value method for making
long-term decisions using discounted cash flows;
explain effect of income taxes on cash flows.
Describe internal rate of return method of assessing
investment alternatives.
Explain why analysts need more than cash flow
analysis to justify or reject investment.
Identify behavioral issues involved in capital budgeting.
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Capital Budgeting
Capital budgeting involves deciding which
long-term, or capital, investments to undertake
and how to finance them.
The capital budgeting decision involves
estimating future cash flows, deciding on an
appropriate interest rate for discounting those
cash flows, and, finally, deciding on how to
finance the project.
Strategic planning provides the context for
capital expenditure decisions.
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Discounted Cash Flow
Discounted cash flow aids in evaluating
investments involving cash flows over time
where there is a significant difference
between cash payment & receipt.
The discount rate is the interest rate that
analysts use in computing the present
value of future cash flows.
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Net Present Value
C
NPV = (1+ R)t I
I = investment at the beginning of the
period
C = net cash inflow expected in period t
R = required rate of return
t = time period
= summation of all periods
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The Net Present Value Method
The decision rule
If the present value of future cash inflows exceeds
the present value of future cash outflows for a
proposal, the firm should accept the project.
The firm should reject any alternative with negative
net present value of future cash flows.
If the firm must choose one from a set of mutually
exclusive alternatives with the same life span, it
should select the one with the largest net present
value of cash flows.
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Cash Flow Varieties
Initial cash flows:
Occur at beginning of project
Periodic cash flows
Occur during life of project
Terminal cash flows
at Occur end of project
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The Moving Baseline Concept
The moving baseline concept assumes
that cash flows will decrease due to the
competition's superior quality if the
investment is not made.
Traditional methods assume that cash
flow will continue unchanged if the
investment is not made.
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Sensitivity of Net Present Value to
Estimates
The calculation of the net present value of
a proposed project requires three types of
projections or estimates:
The amount of future cash flows
The timing of future cash flows
The discount rate.
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Capital Budgeting at
Pharmaceutical Firms
The average tab for developing a new drug is
$500 million to $800 million.
About half of of that amount isnt actually spent
at all. opportunity cost
Simulation used in conjunction with capital
budgeting
Differing assumptions about the drugs success, its
development costs, and its eventual pricing
A probability distribution
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Internal Rate of Return
Sometime known as the time-adjusted rate
of return.
It is the discount rate that equates the net
present value of a series of cash flows to
zero.
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Capital investment decisions: an exercise
The Chief Finance Officer of Taylor Corporation
has a capital budget of $300,000 in the current
period. She has collected data on three potential
investments; they are described below along
with some relevant figures from capital
budgeting calculations. Taylor's cost of capital
has historically been 10%, but is expected to rise
to 12% within the next few months. Which
project(s) should the CFO accept? Explain your
reasoning.
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Capital investment decisions: an exercise
Project A
Project B
Project C
Improved
disposal methods
for hazardous
wastes
Construction of a
newer, larger
employee cafeteria
180,000
$150,000
$130,000
3 years
5 years
2 years
4.2 years
4.2 years
5.1 years
NPV at 10%
$1,500
$800
$1,200
NPV at 12%
$1,200
$(500)
$1,000
14%
11%
15%
Description
Required initial
investment
Project life
Payback period
IRR
Introduction of
robotics in the
manufacturing
process
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