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Capital Budgeting DecisionsCapital Budgeting DecisionsCapital Budgeting DecisionsCapital Budgeting Decisions
Chapter 26
Capital BudgetingCapital BudgetingCapital BudgetingCapital Budgeting
Budgeting for the acquisition of “capital assets”
Capital budgeting techniques
(a) Payback period
(b) Accounting Rate of Return
(c) Net Present Value
(d) Internal Rate of Return
Analyzing alternative long-term investments and deciding which assets to acquire or sell.
Outcomeis uncertain.
Large amounts ofmoney involved.
Investment involveslong-term commitment.
Decision may bedifficult or impossible
to reverse.
Capital BudgetingCapital BudgetingCapital BudgetingCapital Budgeting
ExampleExampleExampleExampleCasey Co. is considering an investment of $130,000 in
new equipment. The new equipment is expected to last 10 years. It will have zero salvage value at the end of its useful life. The straight-line method of depreciation is used for accounting purposes. The expected annual revenues and costs of the new product that will be produced from the investment are:
Sales $200,000Cost of goods sold $145,000Depreciation expense 13,000Selling & Admin expense 22,000 180,000Income before income tax $20,000Income tax expense 7,000Net Income $13,000
Payback PeriodPayback PeriodPayback PeriodPayback Period
Time period required to recover the cost of the investment from the annual cash inflow produced by the investment.
Amount investedExpected annual net cash inflow
Computation of Annual Cash Computation of Annual Cash InflowInflow
Computation of Annual Cash Computation of Annual Cash InflowInflow
Expected annual net cash inflow =
Net income $13,000
Depreciation expense 13,000
$26,000
Cash Payback PeriodCash Payback PeriodCash Payback PeriodCash Payback Period
$130,000 $26,000 5 years/ =
Casey Co. wants to install a machine that costs $16,000 and has an 8-year useful life with zero salvage value. Annual net cash flows are:
YearAnnual Net Cash Flows
Cumulative Net Cash
Flows0 (16,000)$ (16,000)$ 1 3,000 (13,000) 2 4,000 (9,000) 3 4,000 (5,000) 4 4,000 (1,000) 5 5,000 6 3,000 7 2,000 8 2,000
Payback Period –Payback Period –Uneven Cash FlowsUneven Cash Flows
Payback Period –Payback Period –Uneven Cash FlowsUneven Cash Flows
YearAnnual Net Cash Flows
Cumulative Net Cash
Flows0 (16,000)$ (16,000)$ 1 3,000 (13,000) 2 4,000 (9,000) 3 4,000 (5,000) 4 4,000 (1,000) 5 5,000 6 3,000 7 2,000 8 2,000
4.2
Payback Period –Payback Period –Uneven Cash FlowsUneven Cash Flows
Payback Period –Payback Period –Uneven Cash FlowsUneven Cash Flows
We recover the $16,000purchase price between
years 4 and 5, about4.2 years for the payback period.
Consider two projects, each with a 5-year life and each costing $6,000.
Project One Project TwoNet Cash Net Cash
Year Inflows Inflows
1 2,000$ 1,000$ 2 2,000 1,000 3 2,000 1,000 4 2,000 1,000 5 2,000 1,000,000
Would you invest in Project One just because it has a shorter payback period?
Using the Payback PeriodUsing the Payback PeriodUsing the Payback PeriodUsing the Payback PeriodPayback = 3 years
Payback = 5 years
Accounting Rate of ReturnAccounting Rate of ReturnAccounting Rate of ReturnAccounting Rate of Return
Compare accounting rate of return to company’s required minimum rate of return for investments of similar risk.
The minimum return is based on the company’s cost of capital.
Average annual operating income from assetAverage amount invested in asset
Accounting Rate of ReturnAccounting Rate of Return
For Casey, average investment =
($130,000 + $0)/ 2 = $65,000
Average Investment =
Original Investment + Residual Value2
Solution to Accounting Rate of Solution to Accounting Rate of Return ProblemReturn Problem
Solution to Accounting Rate of Solution to Accounting Rate of Return ProblemReturn Problem
$13,000 / $65,000 = 20%
Average annual operating income from assetAverage amount invested in asset
Accounting Rate of ReturnAccounting Rate of ReturnAccounting Rate of ReturnAccounting Rate of Return
The decision rule is: A project is acceptable if its rate of return is
greater than management’s minimum rate of return.
The higher the rate of return for a given risk, the more attractive the investment.
Discounted Cash FlowsDiscounted Cash FlowsDiscounted Cash FlowsDiscounted Cash Flows
Considers both the estimated total cash inflows and the time value of money.
Two methods
1) net present value
2) internal rate of return
Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method
Find PV of future cash flows and compare with capital outlay
Interest rate used = required minimum rate of return
Proposal is acceptable when NPV is zero or positive.
The higher the positive NPV, the more attractive the investment.
Net Present ValueNet Present ValueNet Present ValueNet Present Value
We will assume that Casey Co’s annual cash inflows of $26,000 are uniform over the asset’s useful life.
The present value of the annual cash inflows can be computed by using the present value of an annuity of 1 for 10 periods. Assume the company requires a minimum return of 12%.
Net Present ValueNet Present ValueNet Present ValueNet Present Value
Cash Flow
When? Type of cash flow
Present value factor
Present value of
cash flows
(130,000) Now ($130,000)
NPV
26,000 Yrs 1-10 Annuity 5.650 146,900
$16,900
Analysis of the proposal: The proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive
Net Present ValueNet Present ValueNet Present ValueNet Present Value
When annual cash inflows are unequal, use present value of one tables.
Net Present ValueNet Present ValueNet Present ValueNet Present ValueCash Flow
When? Type of cash flow
PV factor Present value
(130,000) Now ($130,000)
36,000 1 Lump sum .893 32,148
32,000 2 “ .797 25,504
29,000 3 “ .712 20,648
27,000 4 “ .636 17,172
26,000 5 “ .567 14,742
24,000 6 “ .507 12,168
23,000 7 “ .452 10,396
22,000 8 “ .404 8,888
21,000 9 “ .361 7,581
20,000 10 “ .322 6,440
NPV $25,687
,,
Internal Rate of ReturnInternal Rate of ReturnInternal Rate of ReturnInternal Rate of Return
Interest yield of the potential investment
The interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows.
Internal Rate of ReturnInternal Rate of ReturnInternal Rate of ReturnInternal Rate of Return
STEP 1.Compute the internal rate of return factor using this formula:
Capital InvestmentAnnual Cash Inflows
$130,000 / $26,000 = 5.0
Internal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return MethodSTEP 2. Use the factor and the
present value of an annuity of 1 table to find the internal rate of return.
Locate the discount factor that is closest to 5.0 on the line for 10 periods.
Internal Rate of Return Internal Rate of Return Decision CriteriaDecision Criteria
The decision rule is:
Accept when internal rate of return is equal to or greater than the required rate of return
Reject when internal rate of return is less than required rate
Internal Rate of Return –Internal Rate of Return –Uneven Cash FlowsUneven Cash Flows
Internal Rate of Return –Internal Rate of Return –Uneven Cash FlowsUneven Cash Flows
If cash inflows are unequal, trial and error solution will result if present value tablesare used.
Use business calculators and electronic spreadsheets
Payback Accounting Net present Internal rateperiod rate of return value of return
Basis of Cash Accrual Cash flows Cash flowsmeasurement flows income Profitability Profitability
Measure Number Percent Dollar Percentexpressed as of years Amount
Easy to Easy to Considers time Considers timeUnderstand Understand value of money value of money
Strengths Allows Allows Accommodates Allowscomparison comparison different risk comparisons
across projects across projects levels over of dissimilara project's life projects
Doesn't Doesn't Difficult to Doesn't reflectconsider time consider time compare varying risk
value of money value of money dissimilar levels over theLimitations projects project's life
Doesn't Doesn't giveconsider cash annual rates
flows after over the lifepayback period of a project
Comparing MethodsComparing MethodsComparing MethodsComparing Methods