Capital Budgeting DecisionsChapter 13

ACTG 202 – Principles of Managerial Accounting

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Typical Capital Budgeting Decisions

Plant expansionPlant expansion

Equipment selectionEquipment selection

Lease or buyLease or buy Cost reductionCost reduction

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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.

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Time Value of Money

The discussion of capital budgeting begins with a discussion of the 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.

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Time Value of Money

The capital budgeting

techniques that best recognize the time value of money are those that involve discounted cash

flows.

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Present Value and Future Value

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Learning Objective 1

Determine the payback period for an investment.

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The payback method focuses on the

payback period, which is the length of time that it takes for a project to recoup its initial cost out of

the cash receipts that it generates.

The Payback Method

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Evaluation of the Payback Method

Ignores the Ignores the time valuetime valueof of money..

Ignores cashflows after the payback

period.

Short-comingsof the payback

method.

Shorter payback Shorter payback period does not period does not always mean a always mean a more desirable more desirable

investment.investment.

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Evaluation of the Payback Method

Serves as screening

tool.Identifies

investments that recoup cash investments

quickly.Identifies

products that recoup initial investment

quickly.

Strengthsof the payback

period.

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Learning Objective 2

Evaluate the acceptability of an

investment project using the net present value

method.

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The Net Present Value Method

The net present value method compares the present value of a project’s cash inflows

with the present value of its cash outflows. The difference between these two streams

of cash flows is called the net present value.

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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.

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The Net Present Value Method

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iClicker Quick Check

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

• Denny Associates requires a 14% return.

Denny Associates has been offered a four-year contract to supply the computing requirements for a local bank.

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The Net Present Value Method

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Choosing a Discount Rate

•The company’s cost of capital is usually regarded as the minimum required rate of return.

•The cost of capital is the average return the company must pay to its long-term creditors and stockholders.

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Learning Objective 3

Evaluate the acceptability of an

investment project using the internal rate of return

method.

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Internal Rate of Return Method•The internal rate of return is the rate of return

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 project to be zero.

•It works very well if a project’s cash flows are identical every year. If the annual cash flows are not identical software, such as Excel, must be used for the calculation.

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Internal Rate of Return MethodGeneral 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.

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Comparing the Net Present Value andInternal Rate of Return Methods

•NPV is often simpler to use.

•Questionable assumption:▫Internal rate of return

method assumes cash inflows are reinvested at the internal rate of return.

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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.

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Learning Objective 4

Evaluate an investment project that has

uncertain cash flows.

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Uncertain Cash Flows – An Example• Assume that all of the cash flows related to an Assume that all of the cash flows related to an

investment in a supertanker have been investment in a supertanker have been estimated, except for its salvage value in 20 estimated, except for its salvage value in 20 years.years.

• Using a discount rate of 12%, management has Using a discount rate of 12%, management has determined that the net present value of all the determined that the net present value of all the cash flows, except the salvage value is a cash flows, except the salvage value is a negative $1.04 million.negative $1.04 million.

• Assume that all of the cash flows related to an Assume that all of the cash flows related to an investment in a supertanker have been investment in a supertanker have been estimated, except for its salvage value in 20 estimated, except for its salvage value in 20 years.years.

• Using a discount rate of 12%, management has Using a discount rate of 12%, management has determined that the net present value of all the determined that the net present value of all the cash flows, except the salvage value is a cash flows, except the salvage value is a negative $1.04 million.negative $1.04 million.

How large would the salvage value need to be to make this investment attractive?

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Uncertain Cash Flows – An Example

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.

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Learning Objective 5

Rank investment projects in order of

preference.

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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.

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Internal Rate of Return Method

The higher the internal rate of return, the more desirable the project.

When using the internal rate of return method to rank competing investment

projects, the preference rule is:

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Net Present Value MethodThe net present value of one project cannot

be directly compared to the net present value of another project unless the

investments are equal.

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Ranking Investment Projects Project Net present value of the project profitability Investment required index

=

Project A Project B

Net present value (a) 1,000$ 1,000$

Investment required (b) $ 10,000 $ 5,000

Profitability index (a) ÷ (b) 0.10 0.20

The higher the profitability index, themore desirable the project.

The higher the profitability index, themore desirable the project.

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Time Value of Money CalculationsThere are a variety of resources for doing time value of money calculations:▫Financial Calculator (such as your TI)▫Excel

Excel contains a number of functions for doing time value of money calculations

These functions include: PV function IRR function FV function PMT function RATE function

▫Tables and factors?