capital budgeting decisions chapter 14. capital budgeting how managers plan significant outlays on...

Capital Budgeting Capital Budgeting DecisionsDecisions

Chapter 14

Capital BudgetingCapital Budgeting

How managers plan significant outlays How managers plan significant outlays on projects that have long-term on projects that have long-term

implications such as the purchase of implications such as the purchase of new equipment and introduction of new equipment and introduction of

new products.new products.

How managers plan significant outlays How managers plan significant outlays on projects that have long-term on projects that have long-term

implications such as the purchase of implications such as the purchase of new equipment and introduction of new equipment and introduction of

new products.new products.

Typical Capital Budgeting DecisionsTypical Capital Budgeting Decisions

Plant expansionPlant expansion

Equipment selectionEquipment selection Equipment replacementEquipment replacement

Lease or buyLease or buy Cost reductionCost reduction

Typical Capital Budgeting DecisionsTypical Capital Budgeting Decisions

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

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

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

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

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

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

Time Value of MoneyTime Value of Money

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

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


A dollar today is worth A dollar today is worth more than a dollar a more than a dollar a

year from now since a year from now since a dollar received today dollar received today

can be invested, can be invested, yielding more than a yielding more than a

dollar a year from now.dollar a year from now.

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

At the end of one year: At the end of one year: $100 + 0.08 $100 + 0.08 $100 = (1.08) $100 = (1.08) $100 = $100 =

$108$108At the end of two years: (1.08)$108 = $116.64$116.64

or

(1.08)2 × $100 = $116.64

Interest and the Time Value of MoneyInterest and the Time Value of Money

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

(1 + r)(1 + r)nnP = FP = Fnn11


A bond will pay $100 in two years. What is A bond will pay $100 in two years. What is the present value of the $100 if an investor the present value of the $100 if an investor can earn a return of 12% on investments?can earn a return of 12% on investments?


(1 + .12)(1 + .12)22P = 100P = 10011

P = $100 (0.797)P = $100 (0.797)P = $79.70P = $79.70P = $100 (0.797)P = $100 (0.797)P = $79.70P = $79.70

What does this mean?What does this mean?If $79.70 is put in the bank today, If $79.70 is put in the bank today, it will be worth $100 in two years.it will be worth $100 in two years.

In that sense, $79.70 today is In that sense, $79.70 today is equivalent to $100 in two years.equivalent to $100 in two years.

What does this mean?What does this mean?If $79.70 is put in the bank today, If $79.70 is put in the bank today, it will be worth $100 in two years.it will be worth $100 in two years.

In that sense, $79.70 today is In that sense, $79.70 today is equivalent to $100 in two years.equivalent to $100 in two years.


Present Value = $79.70Present Value = $79.70

A bond will pay $100 in two years. What is A bond will pay $100 in two years. What is the present value of the $100 if an investor the present value of the $100 if an investor can earn a return of 12% on investments?can earn a return of 12% on investments?

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


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

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

Quick Check Quick Check

How much would you have to put in the bank How much would you have to put in the bank today to have $100 at the end of five years if the today to have $100 at the end of five years if the interest rate is 10%?interest rate is 10%?

a. $62.10a. $62.10

b. $56.70b. $56.70

c. $90.90c. $90.90

d. $51.90d. $51.90


a. $62.10a. $62.10

b. $56.70b. $56.70

c. $90.90c. $90.90

d. $51.90d. $51.90


a. $62.10a. $62.10

b. $56.70b. $56.70

c. $90.90c. $90.90

d. $51.90d. $51.90


a. $62.10a. $62.10

b. $56.70b. $56.70

c. $90.90c. $90.90

d. $51.90d. $51.90


$100 $100 0.621 = 0.621 = $62.10$62.10$100 $100 0.621 = 0.621 = $62.10$62.10


11 22 33 44 55 66

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

An investment that involves a series An investment that involves a series of identical cash flows at the end of of identical cash flows at the end of

each year is called an each year is called an annuityannuity..


Lacey Inc. purchased a tract of land on Lacey Inc. purchased a tract of land on which a $60,000 payment will be due which a $60,000 payment will be due

each year for the next five years. What is each year for the next five years. What is the present value of this stream of cash the present value of this stream of cash

payments when the discount rate is 12%?payments when the discount rate is 12%?


We could solve the problem like this . . .We could solve the problem like this . . .

Look in Appendix C 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


We could solve the problem like this . . .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


If the interest rate is 14%, how much would you If the interest rate is 14%, how much would you have to put in the bank today so as to be able to have to put in the bank today so as to be able to withdraw $100 at the end of each of the next withdraw $100 at the end of each of the next five years?five years?

a. $34.33a. $34.33

b. $500.00b. $500.00

c. $343.30c. $343.30

d. $360.50d. $360.50


a. $34.33a. $34.33

b. $500.00b. $500.00

c. $343.30c. $343.30

d. $360.50d. $360.50


a. $34.33a. $34.33

b. $500.00b. $500.00

c. $343.30c. $343.30

d. $360.50d. $360.50


a. $34.33a. $34.33

b. $500.00b. $500.00

c. $343.30c. $343.30

d. $360.50d. $360.50


$100 $100 3.433 = $343.30 3.433 = $343.30$100 $100 3.433 = $343.30 3.433 = $343.30

Typical Cash OutflowsTypical Cash Outflows

Repairs andRepairs andmaintenancemaintenance

IncrementalIncrementaloperatingoperating

costscosts

InitialInitialinvestmentinvestment

WorkingWorkingcapitalcapital

Typical Cash InflowsTypical Cash Inflows

ReductionReductionof costsof costs

SalvageSalvagevaluevalue

IncrementalIncrementalrevenuesrevenues

Release ofRelease ofworkingworkingcapitalcapital

Recovery of the Original Recovery of the Original InvestmentInvestment

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

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

Will we be allowed to invest in the attachment?Will we be allowed to invest in the attachment?

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

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 valuePresent valueof an annuityof an annuityof $1 tableof $1 table

Present valuePresent valueof an annuityof an annuityof $1 tableof $1 table

Recovery of the Original Recovery of the Original InvestmentInvestment


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

a. $ 800a. $ 800

b. $ 196b. $ 196

c. $(196)c. $(196)

d. $(800)d. $(800)

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

a. $ 800a. $ 800

b. $ 196b. $ 196

c. $(196)c. $(196)

d. $(800)d. $(800)

Recovery of the Original InvestmentRecovery of the Original Investment

Depreciation is not deducted in computing Depreciation is not deducted in computing the present value of a project because . . .the present value of a project because . . .It is not a current cash outflow.It is not a current cash outflow.Discounted cash flow methods Discounted cash flow methods automatically automatically

provide for return of the original investment.provide for return of the original investment.

Depreciation is not deducted in computing Depreciation is not deducted in computing the present value of a project because . . .the present value of a project because . . .It is not a current cash outflow.It is not a current cash outflow.Discounted cash flow methods Discounted cash flow methods automatically automatically

provide for return of the original investment.provide for return of the original investment.

Choosing a Discount RateChoosing a Discount Rate

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

The cost of capital is the The cost of capital is the average rate of return the average rate of return the company must pay to its long-company must pay to its long-term creditors and term creditors and stockholders for the use of stockholders for the use of their funds.their funds.

The Net Present Value MethodThe Net Present Value Method

To determine net present value we . . .To determine net present value we . . .Calculate the present value of cash inflows,Calculate the present value of cash inflows,Calculate the present value of cash outflows,Calculate the present value of cash outflows,Subtract the present value of the outflows Subtract the present value of the outflows

from the present value of the inflows.from the present value of the inflows.

General decision rule . . .General decision rule . . .


Lester Company has been offered a five year Lester Company has been offered a five year contract to provide component parts for a contract to provide component parts for a

large manufacturer.large manufacturer.


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

Lester Company uses a discount rate of 10%.Lester Company uses a discount rate of 10%.

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

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

Lester Company uses a discount rate of 10%.Lester Company uses a discount rate of 10%.

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


Annual net cash inflows from operationsAnnual net cash inflows from operations



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

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

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



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


Internal Rate of Return MethodInternal Rate of Return Method

The The internal rate of returninternal rate of return is the rate of is the rate of returnreturn promised by an investment project promised by an investment project over its useful life.over its useful life.

The internal rate of return is computed by The internal rate of return is computed by finding the discount rate that will cause the finding the discount rate that will cause the net present valuenet present value of a project to be of a project to be zerozero..


Decker Company can purchase a new Decker Company can purchase a new machine at a cost of $104,320 that will save machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. $20,000 per year in cash operating costs.

The machine has a 10-year life.The machine has a 10-year life.




Future cash flows are the same every year in Future cash flows are the same every year in this example, so we can calculate the internal this example, so we can calculate the internal

rate of return as follows:rate of return as follows:

Future cash flows are the same every year in Future cash flows are the same every year in this example, so we can calculate the internal this example, so we can calculate the internal

rate of return as follows:rate of return as follows:

Investment required Net annual cash flows

PV factor for theinternal rate of return

=

$104, 320 $20,000

= 5.216


Find the 10-period row, move across until you find the factor

5.216. Look at the top of the column and you find a rate of 14%14%.

Find the 10-period row, move across until you find the factor

5.216. Look at the top of the column and you find a rate of 14%14%.

Periods 10% 12% 14%1 0.909 0.893 0.877 2 1.736 1.690 1.647

. . . . . . . . . . . .9 5.759 5.328 4.946 10 6.145 5.650 5.216

Periods 10% 12% 14%1 0.909 0.893 0.877 2 1.736 1.690 1.647

. . . . . . . . . . . .9 5.759 5.328 4.946 10 6.145 5.650 5.216

Using the present value of an annuity of $1 table . . .




The internal rate of return internal rate of return on this project is 14%.

The internal rate of return internal rate of return on this project is 14%.

If the internal rate of return is equal to or If the internal rate of return is equal to or greater than the company’s required rate of greater than the company’s required rate of

return, the project is acceptable.return, the project is acceptable.


The expected annual net cash inflow from a The expected annual net cash inflow from a project is $22,000 over the next 5 years. The project is $22,000 over the next 5 years. The required investment now in the project is required investment now in the project is $79,310. What is the internal rate of return on $79,310. What is the internal rate of return on the project?the project?

a. 10%a. 10%

b. 12%b. 12%

c. 14%c. 14%

d. Cannot be determinedd. Cannot be determined

The expected annual net cash inflow from a The expected annual net cash inflow from a project is $22,000 over the next 5 years. The project is $22,000 over the next 5 years. The required investment now in the project is required investment now in the project is $79,310. What is the internal rate of return on $79,310. What is the internal rate of return on the project?the project?

a. 10%a. 10%

b. 12%b. 12%

c. 14%c. 14%

d. Cannot be determinedd. Cannot be determined

Net Present Value vs. Internal Rate of Net Present Value vs. Internal Rate of ReturnReturn

NPV is easier to use.NPV is easier to use.

AssumptionsAssumptions NPV assumes cash inflows NPV assumes cash inflows

will be reinvested at the will be reinvested at the discount rate.discount rate.

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

Ranking Investment ProjectsRanking 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, theThe higher the profitability index, themore desirable the project.more desirable the project.

The higher the profitability index, theThe higher the profitability index, themore desirable the project.more desirable the project.

capital budgeting decisions chapter 14. capital budgeting how managers plan significant outlays on...

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