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CHAPTER 14: CAPITAL BUDGETING DECISIONS I. OVERVIEW A. What is capital budgeting? The process of making decisions regarding long-term investments Process of managing supply & demand of capital; investments must earn an acceptable return These investments usually provide a return over a long period of time. Thus the best techniques do consider the time value of money Two types of decisions: screen decisions vs. preference decisions B. Most techniques focus on incremental cash inflows and outflows ; Typical cash flows: Cash outflows: Initial investment Increased working capital. Repairs and maintenance. Incremental operating costs. Cash inflows: Incremental revenues. Reductions in costs. Salvage value. Release of working capital. 1
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: If necessary, cash flows can be estimated by taking net income for the project and adding back related depreciation expense. II. TIME VALUE OF MONEY – APPENDIX 14A (Present Value) A. A dollar received today is worth more than a dollar to be received in the future o The further away in future the cash flow will occur, the less it is worth today o The process of finding the present value of a future cash flow is called discounting . B. Present Value of $1 (Exhibit 14B-1 in Text) Present Value = Future Value X Present Value Interest Factor · Use table to find PVIF -- must specify interest rate & number of time periods Example: Your long lost uncle left you a substantial inheritance. With the money, you plan to travel and continue your education, but you want to put enough away in the bank today, earning 6% per year, so that in 5 years, you will have the $200,000 necessary to buy your first house. How much money needs to be deposited today? C. Present Value of an Annuity (Exhibit 14B-2 in Text) Annuity-a series of equal payments over equal time periods PV = annuity amount X PVIF for annuity Example: You won a $200,000 sweepstakes. You can have the $200,000 today, or payments of $10,000/year for 20 years. 2
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