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Business Finance© Thomson/South-Western
Chapter
Long-Term Financial Activities
6
6.1 CAPITAL PROJECTS 6.2 CAPITAL BUDGETING PROCESS 6.3 CAPITAL PROJECT ANALYSIS 6.4 BUSINESS EXPANSION STRATEGIES
Business Finance© Thomson/South-Western
Chapter 6Slide 2
Lesson 6.1
Capital Projects
GoalsDescribe types of capital projects used in business.Explain factors that affect capital spending decisions.
Business Finance© Thomson/South-Western
Chapter 6Slide 3
Termscapital projectintellectual propertymutually exclusive projectscomplementary projects
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Chapter 6Slide 4
Capital Spending Activities
capital project (capital expenditures)the construction or purchase of a long-term asset
capital spendingthe process of spending money to pay for capital projects
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Chapter 6Slide 5
REPLACEMENT PROJECTFailure to replace items in a timely manner can result in
higher costslost salesreduced profits
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Chapter 6Slide 6
COST-SAVING PROJECT
New technology enables companies to purchase equipment that reduces operating costs.
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Chapter 6Slide 7
NEW PRODUCT OR NEW MARKET
When a new product is manufactured or when an existing product is revised, new equipment is often required.
capital spending results
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Chapter 6Slide 8
intangible assets used by companiestrademarksbrand namescopyrightspatentssoftware licensing agreements
intellectual property
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Chapter 6Slide 9
GOVERNMENT-REQUIRED PROJECT
Government regulations require compliance from every organization.
Business Finance© Thomson/South-Western
Chapter 6Slide 10
SOCIAL BENEFIT PROJECT
Sometimes a company will undertake a project not directly related to its business.
Business Finance© Thomson/South-Western
Chapter 6Slide 11
Describe the five main types of capital projects.
Business Finance© Thomson/South-Western
Chapter 6Slide 12
Project Selection Factors
INDEPENDENT PROJECTSindependent projects
projects are not affected by each other
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Chapter 6Slide 13
MUTUALLY EXLUSIVE PROJECTS
mutually exclusive projectssituations in which the acceptance of one project does not allow acceptance of others
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Chapter 6Slide 14
COMPLEMENTARY PROJECTS
complementary projectswhen two or more projects are dependent on each other
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Chapter 6Slide 15
How do mutually exclusive projects differ from complementary projects?
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Chapter 6Slide 16
Lesson 6.2
Capital Budgeting Process
GoalsDiscuss the steps in the capital budgeting process.Explain factors that affect the cost of capital.
Business Finance© Thomson/South-Western
Chapter 6Slide 17
Terms
cost of capitalcost of debtcost of equityoptimal capital structureweighted average cost of capital (WACC)
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Chapter 6Slide 18
Making Capital Decisions
The purchase of long-term assets is vital for the current and future success of every organization.capital budgeting
the process of selecting long-term assets
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Chapter 6Slide 20
1. SET CAPITAL SPENDING GOALS
Organizational goals should influence the selection of capital projects.maximize the value of the firm
the goal of a business
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Chapter 6Slide 21
improved community servicereduced operating costsexpanded visibility to attract additional donations
Non-profits have different capital spending goals.
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Chapter 6Slide 22
2. DETERMINE POTENTIAL PROJECTS
The clear identification of capital spending goals helps determine appropriate projects to work on in support of those goals.
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Chapter 6Slide 23
3. FORECAST CASH FLOWS
A quantitative project analysis needs to be prepared.
reflecting the cash inflows and outflows that are a direct result of the project
cash inflowsadditional net sales and revenuesreduced operating expenses
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Chapter 6Slide 24
inflationdepreciation
the decrease in the value of an item as a result of time and usenot part of cash flow calculations
non-cash itemmoney is not paid out when depreciation is recorded
Other factors to consider include:
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Chapter 6Slide 25
4. IDENTIFY COST OF CAPITAL AND RISK
cost of capital (discount rate)the interest rate used to evaluate a capital project a percentage
potential risks are identified and assessedhigh risk can increase the cost of capital
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Chapter 6Slide 26
5. SELECT AND IMPLEMENT PROJECT
Managers decide which capital projects will be selected.
quantitative and qualitative factors will be considered
The management team puts the selected projects into operation.
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Chapter 6Slide 27
What are the steps of the capital budgeting process?
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Chapter 6Slide 28
Cost of Capital
cost of capital (required rate of return)the rate required by lenders and investors who are letting the company use their money
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Chapter 6Slide 29
COST OF DEBT
cost of debtthe rate of return required by creditors
Benefits associated with using debt include:
The company is using the money of others, allowing the business to keep its funds available for other uses.
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Chapter 6Slide 30
The cost of capital is lower than other funding sources as a result of the lower risk for lenders.Interest payments on debt are tax deductible as a business expense.
Creditor risk is lower since debts are legal obligations.
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Chapter 6Slide 31
COST OF EQUITY
cost of equitythe required return of the owners of a companythe percent the company owners expect to earn based on the money they have invested in the companyreturn might be in
dividendsincreased market value of company
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Chapter 6Slide 32
OPTIMAL CAPITAL STRUCTURE
optimal capital structurean appropriate balance between the amount of debt and the amount of equitythe financing combination of a low cost of capital and maximum market value
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Chapter 6Slide 33
The company’s current debt obligationsThe company’s ability to borrow additional funds or issue additional bondsStockholders’ sensitivity to current risk because of existing debtHistorical and projected profitability of the company
Factors to consider when seeking optimal cash structure include
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Chapter 6Slide 34
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
weighted average cost of capital(WACC)
calculated by multiplying the proportions of debt and equity times the capital cost for each
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Chapter 6Slide 35
Every organization attempts to minimize its WACC.
occurs when a certain combination of debt and equity are usedthe exact combination varies across companies and changes as risk and interest rates change
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Chapter 6Slide 36
Why is the cost of debt lower than the cost of equity?
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Chapter 6Slide 37
Lesson 6.3
Capital Project Analysis
GoalsDescribe tools used to analyze capital projects.Explain factors that influence capital project decisions.
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Chapter 6Slide 38
Termspayback methodnet present value (NPV)internal rate of return (IRR)sunk cost
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Chapter 6Slide 39
Capital Decision Tools
PAYBACK METHODpayback method
determines how long it will take for the cash flows of a capital project to equal the original cost
drawbacks to the payback methodfavors short-term projects which may not be in the best interest of the companyneglects the time value of money
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Chapter 6Slide 40
NET PRESENT VALUE
net present value (NPV)calculates the present value of cash flows for a project minus the initial investment
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Chapter 6Slide 41
initial investment (start-up cost)cost of the project
cash flowsannual amounts of increased sales or decreased coststhe financial benefits of the project
cost of capital (discount rate)the interest rate the company will use to calculate the present value of the cash flows
Components of NPV include:
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Chapter 6Slide 42
CALCULATE NET PRESENT VALUE
Step 1Calculate the present value of cash flows.
Step 2Subtract the initial cost from the total in Step 1.
Step 3Evaluate the result.
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Chapter 6Slide 43
If the NPV is negative, reject the project.When considering several projects, accept the one with the highest NPV.
If the NPV is positive, accept the project.
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Chapter 6Slide 44
INTERNAL RATE OF RETURN
internal rate of return (IRR)the discount rate at which the net present value is zeroprovides a rate of return for a capital projectreports a percentage rather than a dollar amount
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Chapter 6Slide 45
What three decision-making tools are commonly used to evaluate capital projects?
Business Finance© Thomson/South-Western
Chapter 6Slide 46
Additional Analysis Factors
OPPORTUNITY COSTthe value of the alternative that is given up when a decision is madecannot always be measured in monetary value
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Chapter 6Slide 47
SUNK COST
sunk costan expense that has been paid that will not affect capital decisions
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Chapter 6Slide 48
RISK ANALYSIS
Risk can be viewed from a variety of perspectives.
GeographyEconomic Conditions
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Chapter 6Slide 49
informal trade barrierscultural differences that lead to uncertainties when doing business in different regions
Political and Legal Restrictionsformal trade barriers
specific government regulations restricting certain business activities
Social and Cultural Factors
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Chapter 6Slide 50
How do opportunity costs and sunk costs differ?
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Chapter 6Slide 51
Lesson 6.4
Business Expansion Strategies
GoalsExplain business growth and expansion actions.Identify actions for reducing global business risks.
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Chapter 6Slide 52
Termscentralized organizationdecentralized organizationhorizontal integrationvertical integrationdiversificationjoint venture
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Chapter 6Slide 53
Business Growth Actions
ORGANIZATIONAL STRATEGIEScentralized organization
decisions are made at company headquarters
decentralized organizationallows company decisions to be made at lower levels of the organization
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Chapter 6Slide 54
EXPANSION METHODS
horizontal integrationa merger between two or more companies in the same type of business
vertical integrationa company expands through increased involvement in different stages of production and distribution
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Chapter 6Slide 55
PRODUCT VARIATIONS
Growth often occurs by offering more and different products.
new flavorsdifferent package sizesvaried brands
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Chapter 6Slide 56
DIVERSITY OF MARKETS
marketwhere and to whom a business sells
B2C (business to consumer)B2B (business to business)
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Chapter 6Slide 57
How does a centralized organization differ from a decentralized one?
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Chapter 6Slide 58
Reducing Global Risks
There are four suggested methods for reducing international business risk.
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Chapter 6Slide 59
CONDUCT BUSINESS IN SEVERAL REGIONS
Political unrest or poor economic conditions can lead to lower profits.
Conducting business in multiple regions of the world reduces risk.
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Chapter 6Slide 60
DIVERSIFY PRODUCT LINES
diversificationoffering a variety of products or servicesallows a company to balance lower sales in one division with higher sales in its other product lines
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Chapter 6Slide 61
INVOLVE LOCAL OWNERSHIP
joint venturean agreement between two or more companies to share a business project
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Chapter 6Slide 62
EMPLOY LOCAL MANAGEMENT
local managerscan create favorable business relationships in a foreign business environmenthave knowledge of local customs and cultural business practices
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Chapter 6Slide 63
What actions can be taken to reduce global business risk?
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Chapter 6Slide 64
Performance Indicators Evaluated
Identify the business’s customer service offerings.Design a marketing research study to determine the clientele’s customer service preferences.Conduct the market research.Compare customer service offerings.
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Chapter 6Slide 65
Prepare a promotional campaign to promote the business’s proposed customer service offerings based on the market research.Present the research findings and proposed promotional campaign to the business’s manager in a role-play situation.
Recommend improvements for customer service offerings.
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Chapter 6Slide 66
Think Critically1. Why is it important for a company to know
what the competition offers for customer service?
2. Why is accurate marketing research so important?