capital budgeting decisions uaa – acct 202 principles of managerial accounting dr. fred barbee
TRANSCRIPT
Capital Budgeting DecisionsCapital Budgeting Decisions
UAA – ACCT 202 Principles of Managerial Accounting
Dr. Fred Barbee
Capital Budgeting is . . .Capital Budgeting is . . .
. . . The making of long-term planning decisions for investments.
Capital Budgeting DecisionsCapital Budgeting Decisions
Should we purchase new labor-saving equipment to perform operations presently performed manually
A Cost-Reduction Decision
Capital Budgeting DecisionsCapital Budgeting Decisions
Should we replace existing equipment with more efficient, newer equipment.
A Cost-Reduction Decision
Capital Budgeting DecisionsCapital Budgeting Decisions
Should we enter a new market with a new product or purchase an existing business already in that market
A Profit-Expansion Decision
Process of Capital BudgetingProcess of Capital Budgeting
Identification Stage
Search Stage
Information-Acquisition Stage
Selection Stage
Financing Stage
Implementation and Control Stage
Project Selection . . .Project Selection . . .
Selection in capital budgeting comes in two phases:
Screening, and
Preference
Screening . . .Screening . . .
A specific criterion is used to eliminate unprofitable and/or high-risk investment proposals.
Projects meeting criteria
Projects not meeting criteria
Preference SelectionPreference Selection
The surviving projects are subjected to a ranking criterion.
Outcome: The most favorable projects are selected for any given amount of capital to be invested.
We interrupt this regularly scheduled program to bring you a special bulletin
on the characteristics of business investments.
We interrupt this regularly scheduled program to bring you a special bulletin
on the characteristics of business investments.
Business InvestmentsBusiness Investments
Most business investments involve depreciable assets; and
The returns on business investments extend over long periods of time.
To Illustrate . . .To Illustrate . . .
A firm purchases land (a non-depreciable asset) for $5,000; and
Rents it out at $750.00 per year for ten years.
What is the return?
Since the asset will still be intact at the end of the 10-year period, each year’s $750 inflow is a return on the original $5,000 investment. The rate of return is therefore:
%15000,5$
750$
What is the Return?What is the Return?
Return on Assets MustReturn on Assets Must
Provide a return on the original investment.
A return of the original investment itself.
To Illustrate . . .To Illustrate . . .
A firm purchases land (a non-depreciable asset) for $5,000; and
Rents it out at $750.00 per year for ten years.Assume the $5,000 investment is in
equipment and will reduce operating
costs by $750 each year for 10 years.
Hmmm. What now?
Why?Why?
Because part of the yearly $750 inflow from the equipment must go to recoup the original $5,000 investment itself, since the equipment will be worthless at the end of its 10-year life.
In approaching capital budgeting decisions, it is necessary to employ techniques that recognize the time value of money.
Long Periods of TimeLong Periods of Time
DCF Models . . .DCF Models . . .
Focus on . . .
Cash inflows; and
Cash outflows
Rather than on net income
DCF Models . . .DCF Models . . .
There are two main variations of the discounted cash flow model . . .
Net Present Value (NPV); and
Internal Rate of Return (IRR)
Cash Inflows
Cash Outflows
PV$
(PV$)
Usually Future
Future and/or PresentNPV
Discount
Discount
Net Present Value MethodNet Present Value Method
Cash Inflows
Cash Outflows
PV$
(PV$)
Usually Future
Future and/or PresentNPV
Discount
Discount
Net Present Value MethodNet Present Value MethodIf the result is positive, the investment promises more than the interest rate used to evaluate the proposal.
Cash Inflows
Cash Outflows
PV$
(PV$)
Usually Future
Future and/or PresentNPV
Discount
Discount
Net Present Value MethodNet Present Value Method
If the result is zero, the investment yields exactly the interest rate used to evaluate the proposal.
Cash Inflows
Cash Outflows
PV$
(PV$)
Usually Future
Future and/or PresentNPV
Discount
Discount
Net Present Value MethodNet Present Value MethodIf the result is negative, the investment should be rejected because the required rate of return will not be earned.
(NPV)
Typical Cash OutflowsTypical Cash Outflows
The initial investment
Additional amount of working capital
Repairs and maintenance
Additional operating costs
Typical Cash InflowsTypical Cash Inflows
Incremental revenues
Reduction in costs
Salvage value
Release of working capital
PDQ Company – NPV Example
•PDQ company requires a minimum return of 18% on all investments.
•The company can purchase a new machine at a cost of $40,350. The new machine would generate cash inflows of $15,000 per year and have a four-year life with no salvage value.
•What is the net present value of this project?
Initial Inv.
Annual CF
Net Present Value
Now
1-4
(40,350)
15,000
1.000
2.690
Item Yr(s)Amt of Cash Flow
18% Factor
Present Value of
CF
(40,350)
40,350
-0-
PDQ Company – NPV Example
Each $15,000 Inflow . . .Each $15,000 Inflow . . .
Provides for a recovery of a portion of the original $40,350 investment; and
Also provides a return of 18% on this investment.
$15,000 $7,263 $7,737 $32,6131
2
3
4
$40,350
(2)
Cash Inflow
(3)
ROI (1)* 18%
(4)
Rec of Inv.
(2)-(3)
PV of Cash Flow
(1)-(4)
Year
(1)Inv O/S
during Year
$40,350 x 18% = $7,263
$15,000 - $7,263 = $7,737
$40,350 - $7,737 = $32,613
$15,000
15,000
$7,263
5,870
$7,737
9,130
$32,613
23,483
1
2
3
4
$40,350
32,613
(2)
Cash Inflow
(3)
ROI (1)* 18%
(4)
Rec of Inv.
(2)-(3)
PV of Cash Flow
(1)-(4)
Year
(1)Inv O/S
during Year
15,000 4,227 10,773 12,71023,483
15,000 2,290 12,710 -0-12,710
An investment that costs $10,000 will return $4,000 per year for four years.
Determine the net present value of the investment if the required rate of return is 12 percent. Ignore income taxes.
Should the investment be undertaken?
Practice Exercise 1Practice Exercise 1
Initial Inv.
Annual CF
Net Present Value
Now
1-4
(10,000)
4,000
1.000
3.037
Item Yr(s)Amt of Cash Flow
12% Factor
Present Value of CF
($10,000)
12,148
$2,148
Practice Exercise 1
Magnolia Florist is considering replacing an old refrigeration unit with a larger unit to store flowers.
Because the new refrigeration unit has a larger capacity, Magnolia estimates that they can sell an additional $6,000 of flowers a year (the cost of the flowers is $3,500).
Practice Exercise 2Practice Exercise 2
In addition, the new unit is energy efficient and should save $950 in electricity each year.
It will cost an extra $150 per month for maintenance.
The new refrigeration unit costs $20,000 and has an expected life of 10 years.
Practice Exercise 2Practice Exercise 2
The old unit is fully depreciated and can be sold for an amount equal to disposal cost.
At the end of 10 years, the new unit has an expected residual value of $5,000
Determine the NPV of the investment if the RRR is 14% (ignore taxes).
Should the investment be made.
Practice Exercise 2Practice Exercise 2
Determine the net cash flow for the life of the equipment.
Practice Exercise 2Practice Exercise 2
Item Cash Flow
Additional Sales $6,000
Cost of Sales (3,500)
Savings in Electricity 950
Maintenance (1,800)
Total $1,650
Initial Inv.
Annual CF
Net Present Value
Now
1-10
(20,000)
1,650
1.000
5.216
Item Yr(s)Amt of Cash Flow
14% Factor
Present Value of CF
($20,000)
8,606
Practice Exercise 2
Salvage 10 5,000 .270 1,350
($10,044)
Limiting Assumptions . . .Limiting Assumptions . . .
All cash flows occur at the end of the period.
All cash flows generated by an investment are immediately reinvested in another project which yields a return at least as large as the discount rate used in the first project.
Discount Rate . . .Discount Rate . . .
The rate generally viewed as being the most appropriate is a firm’s cost of capital.
This rate is also known as . . .
Hurdle Rate
Cutoff Rate
Required Rate of Return
Cash Inflows
Cash Outflows
PV$
(PV$)
Usually Future
Future and/or PresentNPV
Discount
Discount
Net Present Value MethodNet Present Value Method
$-0-
The internal rate of return (IRR) is that rate of interest which will exactly equate the PV of the cash inflows with the PV of
the cash outflows.
Resulting in $0 NPV
Internal Rate of ReturnInternal Rate of Return
When the annual cash flows are even, the IRR formula is simply . . .
df = I / CF, or
Investment/Annual Cash Flow
Using the IRR MethodUsing the IRR Method
The cost of capital takes the form of a hurdle rate that a project must clear for acceptance.
If the IRR on a project is not great enough to clear the cost of capital hurdle, then the project is rejected.
Using the NPV MethodUsing the NPV Method
The cost of capital becomes the actual discount rate used to compute the NPV of a proposed project.
Projects yielding negative NPVs are rejected unless nonquantitative factors, such as social responsibility, employee morale, etc., intervene.
CompareNet Present Value andInternal Rate of Return
CompareNet Present Value andInternal Rate of Return
Compare IRR & NPV . . .Compare IRR & NPV . . .
The NPV method is simpler to use.
Using the NPV method makes it easier to adjust for risk.
The NPV method provides more usable information than does the IRR method.
The Payback Period . . .The Payback Period . . .
This method involves a span of time known as the payback period.
The payback period is the length of time it takes for an investment project to recoup its own initial cost out of the cash receipts that it generates.
The Payback Period . . .The Payback Period . . .
The basic premise of this method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment.
The Payback Period . . .The Payback Period . . .
The payback period is expressed in years. The basic formula is . . .
Investment Req --------------------------- = Payback Period Net Annual CF
The Lower Valley Wheat Cooperative is considering the construction of a new silo.
It will cost $41,000 to construct the silo.
Determine the payback period if the expected cash inflows are $5,000 per year.
Practice Exercise 3Practice Exercise 3
The Payback Period . . .The Payback Period . . .
$41,000 --------------------------- = 8.2 Years $5,000
Simplified Approaches to Capital Budgeting
Simplified Approaches to Capital Budgeting
AKA: Accounting Rate of Return
The Simple Rate of ReturnThe Simple Rate of Return
The Simple Rate of Return is equal to Incremental income from the project
divided by the initial investment in the project.
Simple Rate of Return (SRR)
=Inc. NOI
Initial Investment*
*Less Salvage Value if any
The Simple Rate of ReturnThe Simple Rate of Return
If a cost reduction project is involved, the formula becomes:
SRR =Cost Savings - Depreciation
Initial Investment*
*Less Salvage Value if any
Practice Exercise 4Practice Exercise 4
Martin Company is considering the purchase of a new piece of equipment. Relevant information concerning the equipment follows:
Compute the Simple Rate of Return.
Purchase Cost $180,000
Annual cost savings 37,500
Useful Life 12 Years