Capital Budgeting Decisions

Chapter

12

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 2

Capital Budgeting

How managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment

and introduction of new products.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 3

Typical Capital Budgeting Decisions

Plant expansion

Equipment selection Equipment replacement

Lease or buy Cost reduction

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 4

Typical Capital Budgeting Decisions

Capital budgeting tends to fall into two broad categories . . .

Screening decisions. Does a proposed project meet some present standard of acceptance?

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

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 5

Time Value of Money

Business investments extend over long periods of time, so we must recognize the time value of money.

Investments that promise returns earlier in time are preferable to those that promise returns later in time.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 6

Time Value of Money

A dollar today is worth more than a dollar a

year from now since a dollar received today

can be invested, yielding more than a

dollar a year from now.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 7

Interest and the Time Value of Money

If $100 is invested today at 8% interest, how much will you have in two years?

At the end of one year:

$100 + 0.08$100 = (1.08)$100 = $108

At the end of two years:

$108 + 0.08$108 = (1.08)$108

= (1.08)[(1.08)$100]

= (1.08)2 $100 = $116.64

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 8

Interest and the Time Value of Money

If P dollars are invested today at the annual interest rate r, then in n years you would have Fn dollars computed as follows:

Fn = P(1 + r)n

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 9

Interest and the Time Value of Money

The present value of any sum to be received in the future can be computed by turning the interest formula around and solving for P:

P nF1

n1 r

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 10

Interest and the Time Value of Money

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?

P = $100 (0.797)

P = $79.70

P $1001

210.12

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 11

Interest and the Time Value of Money

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?

Present Value = $79.70

What does this mean?If $79.70 is put in the bank today, it

will be worth $100 in two years.In that sense, $79.70 today is

equivalent to $100 in two years.

What does this mean?If $79.70 is put in the bank today, it

will be worth $100 in two years.In that sense, $79.70 today is

equivalent to $100 in two years.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 12

Interest and the Time Value of Money

Let’s verify that if we put $79.70 in the bank today at 12% interest that it would grow to $100 at the end of two years.

Year 1 Year 2Beginning balance 79.70$ 89.26$ Interest @ 12% 9.56$ 10.71$ Ending balance 89.26$ 99.97$

Year 1 Year 2Beginning balance 79.70$ 89.26$ Interest @ 12% 9.56$ 10.71$ Ending balance 89.26$ 99.97$

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 13

Time Value of Money

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?

We can also determine the present We can also determine the present value using present value tables.value using present value tables.

We can also determine the present We can also determine the present value using present value tables.value using present value tables.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 14

Time Value of Money

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

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

Excerpt from Present Value of $1 Table in the Appendix to Chapter 12

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 15

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

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

Time Value of Money

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

$100 $100 ×× 0.797 = $79.70 present value 0.797 = $79.70 present value

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 16

Quick Check 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

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 18

Time Value of Money

11 22 33 44 55 66

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

An investment that involves a series of identical cash flows at the end of each year is called an

annuityannuity.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 19

Time Value of Money

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%?

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 20

Time Value of Money

We could solve the problem like this . . .

Look in Appendix B of this Chapter for thePresent Value of an Annuity of $1 Table

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

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 21

Time Value of Money

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

$60,000 × 3.605 = $216,300$60,000 × 3.605 = $216,300

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 22

Quick Check 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

c. $343.30

d. $360.50

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 24

Quick Check 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

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 26

Typical Cash Outflows

Repairs andRepairs andmaintenancemaintenance

IncrementalIncrementaloperatingoperating

costscosts

InitialInitialinvestmentinvestment

WorkingWorkingcapitalcapital

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 27

Typical Cash Inflows

ReductionReductionof costsof costs

SalvageSalvagevaluevalue

IncrementalIncrementalrevenuesrevenues

Release ofRelease ofworkingworkingcapitalcapital

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 28

Illustration of the NPV Method

Carver Hospital is considering the purchase of an attachment for its X-ray machine.

No investments are to be made unless they have an annual return of at least 10%.

Will we be allowed to invest in the attachment?

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 30

Illustration of the NPV Method

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 valueof an annuity

of $1 table

Present valueof an annuity

of $1 table

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 31

Illustration of the NPV Method

Because the net present value is equal to zero,the investment in the attachment for the X-ray

machine provides exactly a 10% return.

Because the net present value is equal to zero,the investment in the attachment for the X-ray

machine provides exactly a 10% return.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 32

Quick Check Suppose that the investment in the attachment

for the X-ray machine had cost $4,000 and generated an increase in annual cash inflows of $1,200. What is the net present value of the investment?

a. $ 800

b. $ 196

c. $(196)

d. $(800)

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 34

Choosing a Discount Rate

The firm’s cost of capital is usually regarded as the most appropriate choice for the discount rate.

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.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 35

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.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 36

The Net Present Value Method

General decision rule . . .

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 37

The Net Present Value Method

Let’s look atLet’s look athow we usehow we use

present value topresent value tomake businessmake business

decisions.decisions.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 38

The Net Present Value MethodLester Company has been offered a five year contract

to provide component parts for a large manufacturer.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 39

The Net Present Value Method

At the end of five years the working capital will be released and may be used elsewhere by Lester.

Lester Company uses a discount rate of 10%.

Should the contract be accepted?Should the contract be accepted?

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 40

The Net Present Value Method

Annual net cash inflows from operations

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 41

The Net Present Value Method

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 42

The Net Present Value Method

Present value of an annuity of $1 factor for 5 years at 10%.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 43

The Net Present Value Method

Present value of $1 factor for 3 years at 10%.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 44

The Net Present Value Method

Present value of $1 factor for 5 years at 10%.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 45

The Net Present Value Method

Accept the contract because the project has a positivepositive net present value.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 46

Quick Check DataDenny Associates has been offered a four-year contract to

supply the computing requirements for a local bank.

The working capital would be released at the end of the contract.

Denny Associates requires a 14% return.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 47

Quick Check What is the net present value of the contract

with the local bank?

a. $150,000

b. $ 28,230

c. $ 92,340

d. $132,916

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 49

Expanding the Net Present Value Method

To compare competing investment projects we can use the following net present

value approaches:Total-cost

Incremental cost

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 50

The Total-Cost Approach

White Co. has two alternatives: (1) remodel an old car wash or, (2) remove it and install a new one.

The company uses a discount rate of 10%.

New Car Wash

Old Car Wash

Annual revenues 90,000$ 70,000$ Annual cash operating costs 30,000 25,000 Net annual cash inflows 60,000$ 45,000$

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 51

The Total-Cost Approach

If White installs a new washer . . .

Cost $300,000 Productive life 10 yearsSalvage value 7,000Replace brushes at   the end of 6 years 50,000Salvage of old equip. 40,000

Let’s look at the present valueof this alternative.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 57

The Total-Cost Approach

If we install the new washer, the investment will yield a positive net

present value of $83,202.

Install the New Washer

YearCash Flows

10% Factor

Present Value

Initial investment Now (300,000)$ 1.000 (300,000)$ Replace brushes 6 (50,000) 0.564 (28,200) Net annual cash inflows 1-10 60,000 6.145 368,700 Salvage of old equipment Now 40,000 1.000 40,000 Salvage of new equipment 10 7,000 0.386 2,702 Net present value 83,202$

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 58

The Total-Cost Approach

If White remodels the existing washer . . .

Remodel costs $175,000 Replace brushes at   the end of 6 years 80,000

Let’s look at the present valueof this second alternative.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 62

The Total-Cost Approach

If we remodel the existing washer, we will produce a positive net present

value of $56,405.

Remodel the Old Washer

YearCash Flows

10% Factor

Present Value

Initial investment Now (175,000)$ 1.000 (175,000)$ Replace brushes 6 (80,000) 0.564 (45,120) Net annual cash inflows 1-10 45,000 6.145 276,525 Net present value 56,405$

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 63

The Total-Cost Approach

Both projects yield a positive net present value.

However, investing in the new washer will produce a higher net present value than

remodeling the old washer.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 64

The Incremental-Cost Approach

Under the incremental-cost approach, only those cash flows that differ between the two

alternatives are considered.

Let’s look at an analysis of the White Co. Let’s look at an analysis of the White Co. decision using the incremental-cost decision using the incremental-cost

approach.approach.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 68

The Incremental-Cost Approach

YearCash Flows

10% Factor

Present Value

Incremental investment Now $(125,000) 1.000 $(125,000)Incremental cost of brushes 6 30,000$ 0.564 16,920 Increased net cash inflows 1-10 15,000 6.145 92,175 Salvage of old equipment Now 40,000 1.000 40,000 Salvage of new equipment 10 7,000 0.386 2,702 Net present value $ 26,797

We get the same answer under either thetotal-cost or incremental-cost approach.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 69

Quick Check Consider the following alternative projects. Each project

would last for five years.Project A Project B

Initial investment $80,000 $60,000 Annual net cash inflows 20,000 16,000 Salvage value 10,000 8,000

The company uses a discount rate of 14% to evaluate projects. Which of the following statements is true?

a. NPV of Project A > NPV of Project B by $5,230

b. NPV of Project B > NPV of Project A by $5,230

c. NPV of Project A > NPV of Project B by $2,000

d. NPV of Project B > NPV of Project A by $2,000

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 71

Least Cost Decisions

In decisions where revenues are not directly involved, managers should

choose the alternative that has the least total cost from a present value

perspective.

Let’s look at the Home Furniture CompanyLet’s look at the Home Furniture Company..

HomeFurniture

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 72

Least Cost Decisions

Home Furniture Company is trying to decide whether to overhaul an old delivery truck now or purchase a new one.

The company uses a discount rate of 10%.

HomeFurniture

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 73

Least Cost Decisions

Old TruckOverhaul cost now 4,500$ Annual operating costs 10,000 Salvage value in 5 years 250 Salvage value now 9,000

Here is information about the trucks . . .Here is information about the trucks . . .

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 74

Least Cost DecisionsBuy the New Truck

YearCash Flows

10% Factor

Present Value

Purchase price Now $(21,000) 1.000 $ (21,000)Annual operating costs 1-5 (6,000) 3.791 (22,746)Salvage value of old truck Now 9,000 1.000 9,000 Salvage value of new truck 5 3,000 0.621 1,863 Net present value (32,883)

Keep the Old Truck

YearCash Flows

10% Factor

Present Value

Overhaul cost Now $ (4,500) 1.000 $ (4,500)Annual operating costs 1-5 (10,000) 3.791 (37,910)Salvage value of old truck 5 250 0.621 155 Net present value (42,255)

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 75

Least Cost Decisions

Home Furniture should purchase the new truck.

Net present value of costs associated with purchase of new truck (32,883)$ Net present value of costs associated with remodeling existing truck (42,255) Net present value in favor of purchasing the new truck 9,372$

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 76

Ranking Investment Projects

Profitability Present value of cash inflows index Investment required=

A BPresent value of cash inflows $81,000 $6,000Investment required 80,000 5,000Profitability index 1.01 1.20

Investment

The higher the profitability index, themore desirable the project.

The higher the profitability index, themore desirable the project.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 77

Other Approaches toCapital Budgeting Decisions

Other methods of making capital budgeting decisions include . . .

The Payback Method.Simple Rate of Return.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 78

The Payback Method

The payback periodpayback 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

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 79

The Payback Method

Management at The Daily Grind wants to install an espresso bar in its restaurant.

The espresso bar:Costs $140,000 and has a 10-year life.Will generate net annual cash inflows of $35,000.

Management requires a payback period of 5 years or less on all investments.

What is the payback period for the espresso What is the payback period for the espresso bar?bar?

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 80

The Payback Method

Payback period = Payback period = Investment required Investment required Net annual cash inflowNet annual cash inflow

Payback period = Payback period = $140,000 $140,000 $35,000$35,000

Payback period = Payback period = 4.0 years4.0 years

According to the company’s criterion, According to the company’s criterion, management would invest in the management would invest in the

espresso bar because its payback espresso bar because its payback period is less than 5 years.period is less than 5 years.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 81

Quick Check Consider the following two investments:

Project X Project YInitial investment $100,00 $100,000Year 1 cash inflow $60,000 $60,000Year 2 cash inflow $40,000 $35,000Year 3-10 cash inflows $0 $25,000

Which project has the shortest payback period?

a. Project X

b. Project Y

c. Cannot be determined

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 83

Evaluation of the Payback Method

Ignores the Ignores the time valuetime valueof money.of money.

Ignores cashIgnores cashflows after flows after the paybackthe payback

period.period.

Short-comingsShort-comingsof the Paybackof the Payback

Period.Period.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 84

The Simple Rate of Return Method

Does not focus on cash flows -- rather it focuses on accounting incomeaccounting income.

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

--Simple rateSimple rateof returnof return ==

Incremental Incremental expenses,Incremental Incremental expenses, revenues including depreciationrevenues including depreciation

Initial investmentInitial investment

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 85

The Simple Rate of Return Method

Management of The Daily Grind wants to install an espresso bar in its restaurant.

The espresso bar:Cost $140,000 and has a 10-year life.Will generate incremental revenues of $100,000

and incremental expenses of $65,000 including depreciation.

What is the simple rate of return on the investment project?

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 86

The Simple Rate of Return Method

Simple rateSimple rateof returnof return

$100,000 - $65,000 $100,000 - $65,000 $140,000$140,000 = 25%= 25%==

The simple rate of return method is not recommended for a variety of

reasons, the most important of which is that it ignores the time

value of money.

The simple rate of return method is not recommended for a variety of

reasons, the most important of which is that it ignores the time

value of money.

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 87

Quick Check Inland Airlines is considering the purchase of an

aircraft for $20 million that would last for 10 years and generate incremental revenues of $9 million per year and incremental expenses, excluding depreciation, of $5 million per year. What is the simple rate of return on the aircraft?

a. 10%

b. 15%

c. 20%

d. 25%

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 89

Postaudit of Investment Projects

A postaudit is a follow-up after the project has been approved to see whether or not

expected results are actually realized.