Slide 9-2 CHAPTER 9 Capital Budgeting and Other Long-Run Decisions Capital Budgeting and Other Long-Run Decisions Slide 9-3 Capital Budgeting Decisions Companies, like individuals, make investments in long-lived assets Examples include Duke Energy invests in 400 roof-top solar panel installations Pfizer invests in a $294 million biotechnology factory in Ireland Nordstrom invests in a new store in New Jersey Starbucks invests in a new product: instant coffee Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-4 Capital Budgeting Decisions Investment decisions are important because they have a long run impact on a firms operations Decisions involving the acquisition of long-lived assets are referred to as capital expenditure decisions They often require that capital (company funds) be expended to acquire additional resources Also called capital budgeting decisions Slide 9-5 Capital Budgeting Decisions Most firms carefully analyze the potential projects in which they may invest The process of evaluating the investment opportunities is referred to as capital budgeting The final list of approved projects is referred to as the capital budget Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-6 Which of the following is not a capital expenditure decision? Building a new factory Purchasing a new piece of equipment Purchasing inventory Purchasing another company Answer: c Purchasing inventory Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-7 The Time Value of Money In evaluating an investment opportunity, a company must not only know how much but also when cash is received or paid Time value of money recognizes that it is better to receive a dollar today than in the future This is because a dollar received today can be invested so that it amounts to more than a dollar in the future Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-8 Evaluating Opportunities: Time Value of Money Approaches Companies invest money today hoping to receive more money in the future By how much must the future cash flows exceed the cost of the investment? Money in the future is not equivalent to money today A company needs to convert future dollars into their equivalent current, or present value Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-9 Basic Time Value of Money Calculations Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-10 Basic Time Value of Money Calculations - Example Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-11 Present Value Tables Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-12 Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-13 The Net Present Value Method The only relevant cash flows are those that are incremental The cash flows that will be incurred if the project is undertaken Cash flows that have already been incurred are sunk They have no bearing on a current investment decision Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-14 The Net Present Value Method Steps in the NPV method 1.Identify the amount and time period of each cash flow associated with a potential investment 2. Discount the cash flows to their present values using a required rate of return 3.Evaluate the net present value, which is the sum of the present value of all cash inflows and outflows Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-15 The Net Present Value Method Evaluate the investment opportunity If the NPV is zero, the investment earns the required rate of return The investment should be undertaken If the NPV is positive It should also be undertaken because it earns more than the required rate Investments that have a negative NPV are not accepted because they earn less than the required rate Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-16 Net Present Value Approach Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-17 If the net present value of a project is zero, the project is earning a return equal to: Zero The rate of inflation The accounting rate of return The required rate of return Answer: d The required rate of return Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-18 Net Present Value Example An auto repair shop is considering the purchase of an automated paint spraying machine. The machine will last five years. Following information is available: Each year $2,000 will be saved on paint It will reduce labor costs by $20,000 each year It will require maintenance costs of $1,000 each year The machine costs $70,000 The expected residual value is $5,000 The required rate of return is 12% Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-19 Net Present Value Example Since the NPV > 0, the company should buy the equipment Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-20 Comparing Alternatives with NPV Calculate the NPV of each alternative and choose the alternative with the highest NPV The difference between the NPVs of any two alternatives is the incremental value of the highest NPV investment Another method to evaluate alternatives is to compute the present value of their incremental cash flows Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-21 Comparing Alternatives with NPV Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-22 The Internal Rate of Return (IRR) Method The internal rate of return is that rate of return that equates the present value of the future cash flows to the investment outlay The rate of return that makes the net present value equal to zero If the IRR of a potential investment is equal to or greater than the required rate of return, the investment should be undertaken Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-23 The Internal Rate of Return Method Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-24 An investment should be undertaken if: The IRR is equal to or greater than the required rate of return The IRR is equal to or greater than zero The IRR is greater than the accounting rate of return The IRR is greater than the present value factor Answer: a The IRR is equal to or greater than the required rate of return Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-25 The Internal Rate of Return with Equal Cash Flows Equal cash flows are called an annuity For an annuity, PV = PV factor x Annuity Therefore: Use the table to find the closest PV factor for the same number of years Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-26 Internal Rate of Return Example Investment = $100 Cash flow $60 per year for two years PV factor = 100 / 60 = Check PV annuity table, row 2 Closest factor is in 13% column Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-27 Investment costs = $79,100 Returns $14,000 a year for 10 years Required return is 18% Calculate IRR and evaluate PV Factor = 79,100 / 14,000 = 5.65 Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-28 Internal Rate of Return Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-29 Internal Rate of Return With Unequal Cash Flows Utilized when annual cash flows are not equal amounts Use trial and error Must estimate IRR Use estimated IRR to calculate the NPV of the project If NPV > 0, increase estimated IRR If NPV < 0, decrease estimated IRR Recalculate until NPV is equal to or close to zero Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-30 Internal Rate of Return With Unequal Cash Flows The IRR is approximately 16% Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-31 Use of NPV and IRR Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-32 Considering Soft Benefits in Investment Decisions It is important that managers consider soft benefits in addition to a projects NPV or IRR Soft benefits are difficult to quantify Ignoring soft benefits may lead firms to pass up investments that are of strategic importance Especially investments in advanced manufacturing technology Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-33 Soft Benefits Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-34 Calculating the Value of Soft Benefits Example Dynamic Medical Equipment is considering production of a high tech wheelchair Suppose the finance department fails to consider that production of the wheelchair will improve the firms reputation as an industry leader The reputation is difficult to quantify New construction techniques will be developed for producing future products Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-35 Calculating the Value of Soft Benefits Suppose the project has a negative NPV of $80,000 With a required return of 15%, benefits of $15,989 per year would make NPV zero Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-36 Estimating the Required Rate of Return In previous examples the required rate of return was simply stated In practice, management must estimate the required rate of return In some cases, the required rate of return should equal cost of capital The cost of capital is the weighted average of debt and equity financing used Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-37 The cost of capital is: The cost of debt financing The cost of equity financing The weighted average of the costs of debt and equity financing The internal rate of return Answer: c The weighted average of the costs of debt and equity financing Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Slide 9-38 Additional Cash Flow Considerations Both NPV and IRR consider cash inflows and outflows, not revenues and expenses Only cash inflows and outflows are discounted back to present value: Must consider the timing of collection of revenues Depreciation does not require cash outflow in the period it is recorded Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net present value approach and the internal rate of return approach. Learning objective 2: Calculate the depreciation tax shield and evaluate long-run decisions, other than investment decisions, using time value of money techniques. Slide 9-39 Cash Flows, Taxes, and the Depreciation Tax Shield In the previous examples we ignored the effect of taxes on cash flow Tax considerations play a major role in capital budgeting If a project generates taxable revenue, cash inflows will be reduced by taxes paid on the revenue If a project generates tax deductible expenses, cash inflows will be increased by the tax savings generated Slide 9-40 Cash Flows, Taxes, and the Depreciation Tax Shield We stated that depreciation is not relevant in present value analysis Depreciation affects cash flows in directly Depreciation reduces the amount of tax a company must pay The term depreciation tax shield refers to the tax savings from depreciation Learning objective 2: Calculate the depreciation tax shield and evaluate long-run decisions, other than investment decisions, using time value of money techniques. Slide 9-41 Example of the Depreciation Tax Shield Learning objective 2: Calculate the depreciation tax shield and evaluate long-run decisions, other than investment decisions, using time value of money techniques. Slide 9-42 Adjusting Cash Flows for Inflation It may be important to consider inflation when estimating the cash flows associated with investment opportunities Inflation can be taken into account by multiplying the current cash flows by the expected rate of inflation Learning objective 2: Calculate the depreciation tax shield and evaluate long-run decisions, other than investment decisions, using time value of money techniques. Slide 9-43 Adjusting Cash Flows for Inflation If inflation is ignored in net present value analysis, worthwhile opportunities might be rejected This is because current rates of return for debt and equity financing already include estimates of future inflation Cash flows will be low Required rates of return will be high Learning objective 2: Calculate the depreciation tax shield and evaluate long-run decisions, other than investment decisions, using time value of money techniques. Slide 9-44 Other Long-Run Decisions Time value of money techniques are also applicable to the analysis of other long- run decisions Examples of these decisions include: Decision to outsource grounds maintenance Decision to drop a product line Decision to buy rather than make a subcomponent of a product Learning objective 2: Calculate the depreciation tax shield and evaluate long-run decisions, other than investment decisions, using time value of money techniques. Slide 9-45 Other Long-Run Decisions Evaluation of decision to sponsor a golf tournament Learning objective 2: Calculate the depreciation tax shield and evaluate long-run decisions, other than investment decisions, using time value of money techniques. Learning objective 3: Use the payback period and the accounting rate of return methods to evaluate investment opportunities. And explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values. Slide 9-46 Simplified Approaches to Capital Budgeting Many companies continue to use simpler approaches Two of these are Payback period method Accounting rate of return Both methods have significant limitations in comparison to NPV and IRR Slide 9-47 Payback Period Method The payback period is the length of time it takes to recover the initial cost of an investment An investment which costs $1,000 and yields cash flows of $500 per year has a payback period of 2 years ($1,000 / $500) If an investment costs $1,000 and yields cash flows of $300 per year it has a payback period of 3 1/3 years Learning objective 3: Use the payback period and the accounting rate of return methods to evaluate investment opportunities. And explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values. Slide 9-48 Payback Period Method One approach is to accept projects that have a payback period less than some specified requirement This can lead to poor decisions The payback method does not take into account the total cash flows It only considers the stream of cash flows up until the investment is repaid It does not consider the time value of money Learning objective 3: Use the payback period and the accounting rate of return methods to evaluate investment opportunities. And explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values. Slide 9-49 Which of the following methods ignores the time value of money (present and future values) in its calculation? Net present value Internal rate of return Payback period External rate of return Answer: c Payback period Learning objective 3: Use the payback period and the accounting rate of return methods to evaluate investment opportunities. And explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values. Slide 9-50 Accounting Rate of Return (ARR) Accounting Rate of Return Formula: ARR = Average Net Income Average Investment Average investment is the initial investment divided by 2 Like the payback period method, the accounting rate of return ignores the time value of money Learning objective 3: Use the payback period and the accounting rate of return methods to evaluate investment opportunities. And explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values. Slide 9-51 Conflict Between Performance Evaluation and Capital Budgeting Managers may be discouraged from using PV techniques for evaluating investments depending on how their performance is evaluated An investment may have high depreciation in the early years, or revenue may be low Managers need to be assured that if they approve projects with long run positive NPV their compensation will take the expected benefits into account Learning objective 3: Use the payback period and the accounting rate of return methods to evaluate investment opportunities. And explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values. Slide 9-52 Short-Run Accounting Profit Learning objective 3: Use the payback period and the accounting rate of return methods to evaluate investment opportunities. And explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values. 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