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Unformatted text preview: Typical Capital Budgeting
Decisions
Decisions
Capital budgeting tends to fall into two broad
Capital
categories . . .
categories
Screening decisions. Does a proposed
project meet some present standard of
acceptance?
acceptance?
Preference decisions. Selecting from
among several competing courses of action. Time Value of Money
Time
A dollar today is worth
dollar
more than a dollar a
year from now.
Therefore, investments
that promise earlier
returns are preferable to
those that promise later
returns. The capital budgeting
techniques that best
recognize the time
value of money are
those that involve
discounted cash flows. The Net Present Value Method
The
To determine net present value we . . .
Calculate the present value of cash inflows,
Calculate the present value of cash
Calculate
outflows,
outflows,
Subtract the present value of the outflows
Subtract
from the present value of the inflows.
from The Net Present Value Method
General decision rule . . .
General The Net Present Value Method
The
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. Recovery of the Original
Investment
Investment
Depreciation is not deducted in computing the present
Depreciation
value of a project because . . .
value
It is not a current cash outflow. Discounted cash flow methods automatically
Discounted
provide for return of the original investment.
provide Two Simplifying Assumptions
Two
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. All cash flows
generated by an
investment project
are immediately
reinvested at a rate of
return equal to the
discount rate. Choosing a Discount Rate
Choosing The firm’s cost of capital is
cost
usually regarded as the
minimum required rate of
return.
return. The cost of capital is the
The
average rate of return the
company must pay to its
longterm creditors and
stockholders for the use of
their funds.
their The Net Present Value Method
Lester Company has been offered a five year
contract to provide component parts for a large
manufacturer.
manufacturer. The Net Present Value Method At the end of five years the working capital will
At
be released and may be used elsewhere by
Lester.
Lester. Lester Company uses a discount rate of 10%.
Should the contract be accepted? The Net Present Value Method
Annual net cash inflows from operations
Annual The Net Present Value Method Accept the contract because the project has a
positive net present value.
positive Internal Rate of Return Method
Internal The internal rate of return is the rate of return
The internal
promised by an investment project over its
useful life. It is computed by finding the discount
rate that will cause the net present value of a
net
project to be zero.
zero It works very well if a project’s cash flows are
It
identical every year. If the annual cash flows
are not identical, a trial and error process must
be used to find the internal rate of return.
be Internal Rate of Return Method
Internal
General decision rule . . .
If the Internal Rate of Return is . . . Then the Project is . . . Equal to or greater than the minimum
required rate of return . . . Acceptable. Less than the minimum required rate
of return . . . Rejected. When using the internal rate of return,
the cost of capital acts as a hurdle rate
that a project must clear for acceptance. Internal Rate of Return Method
Internal
Future cash flows are the same every year
Future
in this example, so we can calculate the
internal rate of return as follows:
internal
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
Internal
Using the present value of an annuity of $1 table . . .
Find the 10period row, move
across until you find the factor
5.216. Look at the top of the column
and you find a rate of 14%.
14%
Periods
1
2
...
9
10 10%
0.909
1.736
...
5.759
6.145 12%
0.893
1.690
...
5.328
5.650 14%
0.877
1.647
...
4.946
5.216 Internal Rate of Return Method
Internal Decker Company can purchase a new machine at
Decker
a cost of $104,320 that will save $20,000 per year
in cash operating costs. The machine has a 10year life. The internal rate of return on
this project is 14%.
If the internal rate of return is equal to or
If
greater than the company’s required rate of
return, the project is acceptable.
return, The TotalCost Approach
The White Co. has two alternatives:
(1) remodel an old car wash or,
(1)
(2) remove it and install a new one.
(2) The company uses a discount rate of 10%. New Car
W ash
Annual revenues
$ 90,000
Annual cash operating costs
30,000
Net annual cash inflows
$ 60,000 Old Car
W ash
$ 70,000
25,000
$ 45,000 The TotalCost Approach
The
If White installs a new washer . . . Cost
Productive life
Salvage value
Replace brushes at
the end of 6 years
Salvage of old equip. $300,000
10 years
7,000
50,000
40,000 Let’s look at the present value
of this alternative. The TotalCost Approach
The
Install the New Washer
Cash
Year
Flows
Initial investment
Now
$ (300,000)
Replace brushes
6
(50,000)
Net annual cash inflows
110
60,000
Salvage of old equipment
Now
40,000
Salvage of new equipment
10
7,000
Net present value 10%
Factor
1.000
0.564
6.145
1.000
0.386 If we install the new washer, the
If
investment will yield a positive net
present value of $83,202.
present Present
Value
$ (300,000)
(28,200)
368,700
40,000
2,702
$
83,202 The TotalCost Approach
The
If White remodels the existing washer . .
If
.
Remodel costs
Replace brushes at
the end of 6 years $175,000
80,000 Let’s look at the present value
of this second alternative. The TotalCost Approach
The
Remodel the Old Washer
Cash
10%
Year
Flows
Factor
Initial investment
Now
$ (175,000)
1.000
Replace brushes
6
(80,000)
0.564
Net annual cash inflows
110
45,000
6.145
Net present value Present
Value
$ (175,000)
(45,120)
276,525
$ 56,405 If we remodel the existing washer, we will
If
produce a positive net present value of
$56,405.
$56,405. The TotalCost Approach
The
Both projects yield a positive net
Both
present value.
present However, investing in the new washer will
However,
produce a higher net present value than
remodeling the old washer.
remodeling The IncrementalCost Approach
The
Incremental investment
Incremental cost of brushes
Increased net cash inflows
Salvage of old equipment
Salvage of new equipment
Net present value Year
Now
6
110
Now
10 Cash
Flows
$(125,000)
$ 30,000
15,000
40,000
7,000 10%
Factor
1.000
0.564
6.145
1.000
0.386 We get the same answer under either the
We
totalcost or incrementalcost approach. Present
Value
$(125,000)
16,920
92,175
40,000
2,702
$ 26,797 Least Cost Decisions
Least
In decisions where revenues are not
In
directly involved, managers should
choose the alternative that has the least
total cost from a present value
perspective.
perspective.
Let’s look at the Home Furniture Company. Least Cost Decisions
Least
Home Furniture Company is trying to
Home
decide whether to overhaul an old
delivery truck now or purchase a new
one.
one.
The company uses a discount rate of
The
10%.
10%. Least Cost Decisions
Least
Here is information about the trucks . . .
Here
Old Truck
Overhaul cost now
Annual operating costs
Salvage value in 5 years
Salvage value now $ 4,500
10,000
250
9,000 Least Cost Decisions
Least
Buy the New Truck
Cash
Year
Flows
Purchase price
Now
$ (21,000)
Annual operating costs
15
(6,000)
Salvage value of old truck
Now
9,000
Salvage value of new truck
5
3,000
Net present value
Keep the Old Truck
Cash
Year
Flows
Overhaul cost
Now
$ (4,500)
Annual operating costs
15
(10,000)
Salvage value of old truck
5
250
Net present value 10%
Factor
1.000
3.791
1.000
0.621 10%
Factor
1.000
3.791
0.621 Present
V alue
$ (21,000)
(22,746)
9,000
1,863
(32,883) Present
Value
$ (4,500)
(37,910)
155
(42,255) Least Cost Decisions
Least
Home Furniture should purchase
Home
the new truck.
the
Net present value of costs
associated with purchase
of new truck
Net present value of costs
associated with remodeling
existing truck
Net present value in favor of
purchasing the new truck $(32,883) (42,255)
$ 9,372 Uncertain Cash Flows – An Example
Uncertain
Assume that all of the cash flows related to
Assume
an investment in a supertanker have been
estimated except for its salvage value in 20
years.
years.
Using a discount rate of 12%, management
Using
has determined that the net present value of
all the cash flows except the salvage value is
a negative $1.04 million.
negative
How large would the salvage value need to be to
make this investment attractive? Uncertain Cash Flows – An
Example
Example
Net present value to be offset
Present value factor $1,040,000
= $ 10,000,000
0.104 This equation can be used to determine that
if the salvage value of the supertanker is at
least $10,000,000, the net present value of
the investment would be positive and
therefore acceptable. NPV & IRR Rules of Thumb
NPV
The net present value of one project cannot
be directly compared to the net present
value of another project unless the
investments are equal. The higher the internal
rate of return, the
more desirable the
project. The Payback Method
The
The payback period is the length of time that it
payback
takes for a project to recover its initial cost out
of the cash receipts that it generates.
of
When the net annual cash inflow is the same
each year, this formula can be used to
compute the payback period:
compute Payback period = Investment required
Net annual cash inflow Evaluation of the Payback
Method
Method
Ignores the
Ignores
time value
time
of money.
Shortcomings
of the payback
period. Ignores cash
flows after
flows
the payback
the
period. Evaluation of the Payback
Method
Method
Serves as
Serves
screening
tool.
tool.
Strengths
of the payback
period. Identifies
Identifies
investments that
recoup cash
investments
quickly.
quickly. Identifies
Identifies
products that
recoup initial
investment
quickly.
quickly. Payback and Uneven Cash
Flows
Flows
When the cash flows associated with an
investment project change from year to year,
the payback formula introduced earlier cannot
be used.
Instead, the unrecovered investment must be
tracked year by year.
$1,000 1 $0 $2,000 $1,000 2 3 4 $500 5 Simple Rate of Return Method
Simple Does not focus on cash flows  rather it
Does
focuses on accounting net operating income.
accounting The following formula is used to calculate the
The
simple rate of return:
simple
Simple rate
=
of return Incremental Incremental expenses,
Incremental
revenues
including depreciation
revenues
Initial investment* *Should be reduced by any salvage from the sale of the old equipment The Mathematics of Interest –
An Example
An
Assume a bank pays 8% interest on a
$100 deposit made today. How much
will the $100 be worth in one year? Fn = P(1 + r) n Fn = $100(1 + .08)1
Fn = $108.00 The Mathematics of Interest –
An Example
An
Assume a bank pays 8% interest on a
$100 deposit made today. How much
will the $100 be worth in one year?
Periods
1
2
3
4
5 Future Value of $1
8%
10%
1.080
1.100
1.166
1.210
1.260
1.331
1.360
1.464
1.469
1.611 12%
1.120
1.254
1.405
1.574
1.762 Compound Interest – An
Example
Example
What if the $108 was left in the bank for a
What
second year? How much would the
original $100 be worth at the end of the
second year? Fn = P(1 + r) n Compound Interest – An
Example
Example Fn = $100(1 + .08) 2 Fn = $116.64
The interest that is paid in the second year
The
on the interest earned in the first year is
known as compound interest.
compound Computation of Present Value
Computation
An investment can be viewed in two
ways—its future value or its present
value.
Present
Value Future
Value Let’s look at a situation where the
future value is known and the present
value is the unknown. Present Value – An Example
Present If a bond will pay $100 in two years,
If
what is the present value of the $100 if
an investor can earn a return of 12% on
investments?
investments? Fn
P=
(1 + r)n Present Value – An Example
Present
$100
P=
(1 + .12)2
(1
P = $79.72
This process is called discounting. We have
This
discounting We
discounted the $100 to its present value of
$79.72. The interest rate used to find the
present value is called the discount rate.
discount Present Value of a Series of
Cash Flows
Cash
An investment that involves a
An
series of identical cash flows at
the end of each year is called an
annuity.
annuity
$100 1 $100 $100 2 $100 3 $100 4 $100 5 6 Present Value of a Series of Cash
Flows – An Example
Flows
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%?
payments Present Value of a Series of Cash
Flows – An Example
Flows
We could solve the problem like this . . .
Present
Periods
1
2
3
4
5 Value of an Annuity
10%
12%
0.909
0.893
1.736
1.690
2.487
2.402
3.170
3.037
3.791
3.605 of $1
14%
0.877
1.647
2.322
2.914
3.433 $60,000 × 3.605 = $216,300 Homework
Homework Exercises: 137 1314 Questions? Jason.Gonsalves@Humber.ca ...
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This note was uploaded on 12/31/2011 for the course ACCT 441 taught by Professor Johnvermeer during the Spring '08 term at Humber.
 Spring '08
 JohnVermeer
 Cost Accounting

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