Chapter 13 - Chapter 13 Capital Budgeting Decisions...

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Chapter 13 Capital Budgeting Decisions Suggested Homework: E13-1, E13-2, E13-5, E13-6, E13-7, E13-13
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Typical Capital Budgeting Decisions Plant expansion Equipment selection Equipment replacement Lease or buy Cost reduction
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Typical Capital Budgeting Decisions Capital budgeting tends to fall into two broad Capital budgeting tends to fall into two broad categories . . . categories . . . Screening decisions . Does a proposed project Does a proposed project meet some preset standard of acceptance? meet some preset standard of acceptance? Preference decisions . Selecting from among Selecting from among several competing courses of action. several competing courses of action.
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Time Value of Money A dollar today is worth more than a dollar a year from now. Therefore, investments that promise earlier returns are preferable to those that promise later returns.
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Time Value of Money The capital budgeting techniques that best recognize the time value of money are those that involve discounted cash flows.
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The Net Present Value Method To determine net present value we . . . 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.
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General decision rule . . . The Net Present Value Method
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The Net Present Value Method Net present value analysis emphasizes cash flows and not accounting net income. The reason is that accounting net income is based on accruals that ignore the timing of cash flows into and out of an organization.
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Typical Cash Outflows Repairs and maintenance Incremental operating costs Initial investment Working capital
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Typical Cash Inflows Reduction of costs Salvage value Incremental revenues Release of working capital
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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.
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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?
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Periods 1 0.909 2 1.736 3 2.487 4 3.170 3.037 2.914 5 3.791 3.605 3.433 Present value of an annuity of $1 table Recovery of the Original Investment
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Recovery of the Original Investment (1) (2) (3) (4) (5) Year Investment Outstanding during the year Cash Inflow Return on Investment (1) × 10% Recover of Investment during the (2) - (3) Unrecovered Investment at the end of the (1) - (4) 1 3,170 $ 1,000 $ 317 $ 683 $ 2,487 $ 2 2,487 $ 1,000 $ 249 $ 751 $ 1,736 $ 3 1,736 $ 1,000 $ 173 $ 827 $ 909 $ 4 909 $ 1,000 $ 91 $ 909 $ - $ Total investment recovered 3,170 $ This implies that the cash inflows are sufficient to recover the $3,170 initial investment (therefore depreciation is unnecessary) and to provide exactly a 10% return on the investment.
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Two Simplifying Assumptions Two simplifying assumptions are usually made in net present value analysis: All cash flows other than the initial investment occur at the end of periods.
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Chapter 13 - Chapter 13 Capital Budgeting Decisions...

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