Capital ExpendituresCapital Expenditures

Team 6Team 6

Managerial AccountingManagerial Accounting

Nov. 2, 2006Nov. 2, 2006

What is a Capital Expenditure?What is a Capital Expenditure?

When a firm is faced with a major financial When a firm is faced with a major financial decision such as:decision such as: Building a new plantBuilding a new plant Starting a new branchStarting a new branch Buying new machineryBuying new machinery Make or buy decisionsMake or buy decisions

Capital BudgetingCapital Budgeting Long-term investments the firm undertakes and the decisions Long-term investments the firm undertakes and the decisions

made to finance them:made to finance them: Estimating future cash flowsEstimating future cash flows Deciding on an appropriate interest rate for discounting those cash Deciding on an appropriate interest rate for discounting those cash

flowsflows Deciding how to finance the projectDeciding how to finance the project

What tools or analysis would a company use to make these What tools or analysis would a company use to make these decisions?decisions?

Tools for Making DecisionsTools for Making Decisions

Discount Cash Flow MethodsDiscount Cash Flow Methods Aid in evaluating investments over timeAid in evaluating investments over time

Net Present Value – NPVNet Present Value – NPV The value in today’s dollars of future The value in today’s dollars of future

payments received at a predetermined payments received at a predetermined discount ratediscount rate

Internal Rate of Return – IRR Internal Rate of Return – IRR The discount rate that equates the net present The discount rate that equates the net present

value to zerovalue to zero

What is the Discount Rate?What is the Discount Rate?

Interest rate used for computing the Interest rate used for computing the present value of future cash flowspresent value of future cash flows Interest Rate consists of three main Interest Rate consists of three main

componentscomponents Pure Rate – the interest rate of a risk less Pure Rate – the interest rate of a risk less

investmentinvestment Risk of Project - more risk equals higher expected Risk of Project - more risk equals higher expected

returnreturn Increase in future inflation – expected future Increase in future inflation – expected future

inflation should be accounted forinflation should be accounted for

Other ConsiderationsOther Considerations

The decision making process also The decision making process also includes:includes: Past experiencePast experience JudgmentJudgment CompetitionCompetition And many others…And many others…

AT&T ExampleAT&T Example

Limited Space: Significant FundingIncrease will require additional

Headcount at AT&T site

Limited Space: Significant FundingIncrease will require additional

Headcount at AT&T site

Future Cash FlowsOH Generation from AT&T

employees

Future Cash FlowsOH Generation from AT&T

employees

3rd Fl @ CurrentFacility is Available

LONG TERMLEASE REQUIRED

3rd Fl @ CurrentFacility is Available

LONG TERMLEASE REQUIRED

Findings ExceedAT&T thresholds

For approval

Findings ExceedAT&T thresholds

For approval

Find additionalspace

Find additionalspace

Financial analysisrequired for

affordability and profitability

Financial analysisrequired for

affordability and profitability

3rd Fl @ CurrentFacility ApprovedMove in Nov 2006

3rd Fl @ CurrentFacility ApprovedMove in Nov 2006

Evaluation of NPV & IRRof expansion

AT&T building 30Miles away

NO LONG TERM LEASE REQUIRED

AT&T building 30Miles away

NO LONG TERM LEASE REQUIRED

AT&T ResultsAT&T Results Using NPV and IRR allowed AT&T to financially Using NPV and IRR allowed AT&T to financially

evaluate the two alternatives.evaluate the two alternatives. Both alternatives provided positive cash flow to Both alternatives provided positive cash flow to

AT&T AT&T Alternate facility was less capital intensive Alternate facility was less capital intensive

however…however… Too far from customerToo far from customer Local Travel CostsLocal Travel Costs Time LossTime Loss

Current Facility 3Current Facility 3rdrd Floor provided Floor provided Positive cash flowPositive cash flow No time loss for travel No time loss for travel Maximize customer interactionsMaximize customer interactions

Disney Cruise Line CaseDisney Cruise Line Case Should Disney Cruise Line create a new Should Disney Cruise Line create a new

itinerary in the Mediterranean?itinerary in the Mediterranean?

AnalysisAnalysis

TRIP 1 -- Cruise from Port Canaveral to TRIP 1 -- Cruise from Port Canaveral to Barcelona (14-night Trans-Atlantic itinerary)Barcelona (14-night Trans-Atlantic itinerary)

Days 14 Days 14Occupancy 50% 1,350 Crew (1,000) $25 10 $3,500,000Average Cost Per Person 4 $1,500 Fuel 27,000 $2 $756,000Guest purchases/day $50 $945,000 Marketing $500,000Ticket Revenue $2,025,000 Food Total $1,036,000Total Revenue $2,970,000 Total Costs 5,792,000$

NIBT (2,822,000)$

TRIP 1 (Florida to Barcelona)Revenue Cost

Trips 2-6Trips 2-6

All Trips now 10 daysAll Trips now 10 days Trip 3 95% OccupancyTrip 3 95% Occupancy Trip 4 – 5 100% OccupancyTrip 4 – 5 100% Occupancy Trip 6 75% OccupancyTrip 6 75% Occupancy

Days 10 Days 10Occupancy 90% 2,430 Crew (1,000) $25 10 $2,500,000Cost Guests (4) 4 $2,000 Fuel 27,000 $2 $540,000Guest purchases/day $50 $1,215,000 Marketing $0Revenue $4,860,000 Food Total $1,172,000Total Revenue 6,075,000$ Total Costs 4,212,000$

NIBT 1,863,000$

TRIP 2 (Barcelona)Revenue Cost

Results of ModelResults of Model

Total NIBT = $7,560,000Total NIBT = $7,560,000 Assume 12.5% Interest RateAssume 12.5% Interest Rate IRR = 67%IRR = 67% NPV @ 12.5% (3/12) = $6,462,085NPV @ 12.5% (3/12) = $6,462,085

Trip NIBT1 -$2,822,0002 $1,863,0003 $2,146,5004 $2,430,0005 $2,430,0006 $1,512,500

Disney Cruise Line ExampleDisney Cruise Line Example

Other ConsiderationsOther Considerations Reasons for new guests to sail aboard DCL Reasons for new guests to sail aboard DCL

and repeat guests to come backand repeat guests to come back Highly successfully Mexican Riviera itinerary Highly successfully Mexican Riviera itinerary

from Los Angeles in 2005 (past experiences)from Los Angeles in 2005 (past experiences) Other cruise lines prove successful with Other cruise lines prove successful with

Mediterranean itineraries (competitors)Mediterranean itineraries (competitors)

Who uses this informationWho uses this information

People of influence to the organizationPeople of influence to the organization Managers Managers AnalystsAnalysts Executives (CFO, CEO)Executives (CFO, CEO)

Goal AchievementGoal Achievement

Allows managers to make sound financial Allows managers to make sound financial decisions based upon a mathematical decisions based upon a mathematical modelmodel

Helps foster growth and assists company Helps foster growth and assists company in reaching goalsin reaching goals Production GoalsProduction Goals Financial GoalsFinancial Goals Sales GoalsSales Goals

Questions?Questions?