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McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

May 1-4, 2014

Capital Budgeting Decisions


Today’s Agenda

n Capital Budgeting

n Time Value of Money

n Decision Making – Example

n Simple Return and Payback Methods


Typical Capital Budgeting Decisions

Plant expansion

Equipment selection Equipment replacement

Lease or buy Cost reduction

n  Capital budgeting analysis is used to decide when to invest in capital (typically hard assets).

n  Investment is tested against return requirements, or alternative investments


Typical Capital Budgeting Decisions

Capital budgeting tends to fall into two broad categories. 1.  Screening decisions. Does a proposed project meet some preset

standard of acceptance?

2.  Preference decisions. Selecting from among several competing courses of action.


Time Value of Money

A dollar today is worth more than a dollar a year from now.

Therefore, projects that promise earlier returns are preferable to those that promise later returns.


Time Value of Money

n  Analysis of whether to invest capital requires the expectation of long term returns

n  Therefore we need to identify the cash flows associated with the investment over years

n  Time Value of Money methodologies are required to n  Compare one investment against an alternative n  See if an investment meets return requirements


Time Value of Money

n  Time Value of Money n  Money now is worth more than money in the future n  How much more is determined by the discount rate

n  Discounted Cash Flows n  The stating of cash inflows and outflows over time and

discounted to a given point in time n  Internal Rate of Return (IRR)

n  The discount rate that results from discounting the cash flows n  Net Present Value (NPV)

n  Yields an absolute value after DCF of cash flows at a discount rate


Time Value of Money

n  Note: Focus is on Cash Flows, not accounting income. Why? n  Accounting Net Income is based on accruals n  Accruals ignore the timing of cash flows into and out of an

organization

n  Examples? n  Accounts Receivable – recognized as income, but cash not yet

received n  Payroll Payable – expensed on income statement, but cash not

yet paid to employees


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.


Typical Cash Flows

n  Inflows n  Incremental revenue n  Cash from disposal of assets n  Reductions in working capital n  Incremental cost reduction

n  Outflows n  Initial and on-going capital investment n  Incremental operating costs n  Increases in working capital


If the Net Present Value is . . . Then the Project is . . .

Positive . . . Acceptable because it promises

a return greater than the required rate of return.

Zero . . . Acceptable because it promises

a return equal to the required rate of return.

Negative . . . Not acceptable because it

promises a return less than the required rate of return.

The Net Present Value Method

n  The outcome is dependent upon the selected Discount Rate


Choosing a Discount Rate

n  The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds.

n  The firm’s cost of capital is usually regarded as

the minimum required rate of return.


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.

Two Simplifying Assumptions

n  Two simplifying assumptions are usually made in net present value analysis:

n  More complex models can be built; eg, periods can be shrunk to quarterly, monthly, etc. to increase accuracy.


Net Present Value Method

The net present value of one project cannot be directly compared to the net present value of another project

unless the investments are equal.


Preference Decision – The Ranking of Investment Projects

Screening Decisions

Pertain to whether or not some proposed investment is

acceptable; these decisions come first.

Preference Decisions

Attempt to rank acceptable alternatives from the most to

least appealing.


NPV - Example

n  Capital Budget Decision - n  Should May Company buy new or refurbish old jet fleet n  New jets cost $30m, training will cost $2m, but they only require

$1m/yr to maintain and $4m/yr to operate. Also, May can charge $3m/yr extra to customers

n  Refurbishing the old fleet would cost $10m, but maintenance would still be $3m/yr and operating costs $5m/yr

n  At the end of 5 years, the new jets would be worth $10m and the refurbished jets, $2m

n  What should May Co do?


NPV - Example

May CompanyCapital Budgeting Decision ($ millions)

Now Y1 Y2 Y3 Y4 Y5Purchase New Jets

Purchase Price 30-‐ Training 2-‐ Maintenance -‐ 1-‐ 1-‐ 1-‐ 1-‐ Operating Costs 4-‐ 4-‐ 4-‐ 4-‐ 4-‐ Incremental Revenue 3 3 3 3 3 Value at Y5 10 Cash Flow (net) 32-‐ 1-‐ 2-‐ 2-‐ 2-‐ 8 NPV (10%) -‐$29.51

Overhaul Existing FleetRepair and Overhaul 10-‐ Maintenance 3-‐ 3-‐ 3-‐ 3-‐ 3-‐ Operating Costs 5-‐ 5-‐ 5-‐ 5-‐ 5-‐ 5-‐ Value at Y5 2 Cash Flow (net) 15-‐ 8-‐ 8-‐ 8-‐ 8-‐ 6-‐ NPV (10%) -‐$40.08


NPV – Evaluation of Alternatives Approach



Revenue 30 30 31 33 35Purchase Price 30-‐ Training 2-‐ Maintenance -‐ 1-‐ 1-‐ 1-‐ 1-‐ Operating Costs 4-‐ 4-‐ 4-‐ 4-‐ 4-‐ Value at Y5 10 Cash Flow (net) 32-‐ 26 25 26 28 40

20% NPV $43.04

Overhaul Existing FleetRevenue 27 27 28 30 32Repair and Overhaul 10-‐ Maintenance 3-‐ 3-‐ 3-‐ 3-‐ 3-‐ Operating Costs 5-‐ 5-‐ 5-‐ 5-‐ 5-‐ 5-‐ Value at Y5 2 Cash Flow (net) 15-‐ 19 19 20 22 26

20% NPV $38.88


Ranking Investment Projects

Profitability Net present value of the project index Investment required =

A BNet present value (a) $800 $1,000Investment required (b) $80,000 $5,000Profitability index (a) ÷ (b) 0.01 0.20

Investment

The higher the profitability index, the more desirable the project. Therefore, investment B is

more desirable than investment A.

n  Another name for Return on Investment (ROI)


IRR Test – Evaluation of Alternatives



Revenue 30 30 31 33 35Purchase Price 30-‐ Training 2-‐ Maintenance -‐ 1-‐ 1-‐ 1-‐ 1-‐ Operating Costs 4-‐ 4-‐ 4-‐ 4-‐ 4-‐ Value at Y5 10 Cash Flow (net) 32-‐ 26 25 26 28 40

20% NPV $43.04IRR 78%

Overhaul Existing FleetRevenue 27 27 28 30 32Repair and Overhaul 10-‐ Maintenance 3-‐ 3-‐ 3-‐ 3-‐ 3-‐ Operating Costs 5-‐ 5-‐ 5-‐ 5-‐ 5-‐ 5-‐ Value at Y5 2 Cash Flow (net) 15-‐ 19 19 20 22 26

20% NPV $38.88IRR 127%


Decision Time

May CompanyCapital Budget Decision

New Old"Least Cost" NPV -‐$29.51 -‐$40.08Full P&L -‐ NPV $43.04 $38.88Full P&L -‐ IRR 78% 127%

n  What should May Co do?

n  NPV’s are not comparable if investments are not equivalent n  All other factors being equal (including investment amount),

May Co should refurbish the old planes n  Achieves maximum profitability

n  However, all other factors are never equal n  Potentially, market value may be maximized by employing

more capital at 78% IRR than less at 127%


Decision Time

May CompanyCapital Budget Decision

New Old"Least Cost" NPV -‐$29.51 -‐$40.08Full P&L -‐ NPV $43.04 $38.88Full P&L -‐ IRR 78% 127%

n  The ultimate decision requires knowledge of the following: n  Is capital constrained? Can the company actually raise

further capital at 20%? n  What other alternative investments can the company deploy

capital into, and at what rate of return. n  If the company has the money, and the second best IRR is

below 78%, then profit is maximized by making the new investment.


Net Present Value Method

The net present value of one project cannot be directly compared to the net present value of another project

unless the investments are equal.


Simple Rate of Return Method

n Does not focus on cash flows -- rather it focuses on accounting net operating income.

n The following formula is used to calculate the simple rate of return:

Simple rate of return =

Annual Incremental Net Operating Income

Initial investment*

*Should be reduced by any salvage from the sale of the old equipment


The Payback Method

The payback period is the length of time that it takes for a project to recover its initial cost out

of the cash receipts that it generates. When the net annual cash inflow is the same

each year, this formula can be used to compute the payback period:

Payback period = Investment required Net annual cash inflow


Postaudit of Investment Projects

A postaudit is a follow-up after the project has been completed to see whether or not expected results were actually realized.


Tutorial

n Assignment n Review Build versus Buy Decisions n Study Review Problems

n  Interim Progress Reports on Group Projects n Tutorial session on Group Projects

n Bring laptops and financial statements


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

The Mathematics of Interest


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 F1 = $100(1 + .08)1

F1 = $108.00

The Mathematics of Interest


Compound Interest

Fn = P(1 + r)n

What if the $108 was left in the bank for a second year? How much would the

original $100 be worth at the end of the second year?


Compound Interest

The interest that is paid in the second year on the interest earned in the first year is known

as compound interest.

F2 = $100(1 + .08)2

F2 = $116.64


Present Value

Future Value

An investment can be viewed in two ways—its future value or its present

value.

Let’s look at a situation where the future value is known and the present

value is the unknown.

Computation of Present Value


Present Value

If 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 + r)n P = Fn


Present Value

This process is called discounting. We have discounted the $100 to its present value of $79.72. The interest rate used to find the present value is called the discount rate.

(1 + .12)2 P = $100

P = $79.72


Present Value

Let’s verify that if we put $79.72 in the bank today at 12% interest that it would grow to $100 at the

end of two years.

Year 1 Year 2Beginning balance 79.72$ 89.29$ Interest @ 12% 9.57$ 10.71$ Ending balance 89.29$ 100.00$

If $79.72 is put in the bank today and earns 12%, it will be worth $100 in two years.


RatePeriods 10% 12% 14%

1 0.909 0.893 0.877 2 0.826 0.797 0.769 3 0.751 0.712 0.675 4 0.683 0.636 0.592 5 0.621 0.567 0.519

$100 × 0.797 = $79.72 present value (rounded)

Present value factor of $1 for 2 periods at 12%.

Present Value – An Example


Quick Check ü

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


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 ü

$100 × 0.621 = $62.10


1 2 3 4 5 6

$100 $100 $100 $100 $100 $100

Present Value of a Series of Cash Flows

An investment that involves a series of identical cash flows at the end of

each year is called an annuity.



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%?



We could solve the problem like this . . .

Periods 10% 12% 14%1 0.909 0.893 0.877 2 1.736 1.690 1.647 3 2.487 2.402 2.322 4 3.170 3.037 2.914 5 3.791 3.605 3.433

Present Value of an Annuity of $1

$60,000 × 3.605 = $216,300


Quick Check ü

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


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 ü

$100 × 3.433 = $343.30


Quick Check ü

If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? a. $866.90 b. $178.60 c. $ 86.90 d. $300.00


If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? a. $866.90 b. $178.60 c. $ 86.90 d. $300.00

Quick Check ü

$100 × (3.433 - 1.647) = $100 × 1.786 = $178.60 or

$100 × (0.675 + 0.592 + 0.519) = $100 × 1.786 = $178.60

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