chapter 9 capital budgeting and other long-run decisions

CHAPTER 9CHAPTER 9CHAPTER 9CHAPTER 9

Capital Budgeting and Other Capital Budgeting and Other Long-Run DecisionsLong-Run Decisions

Capital Budgeting and Other Capital Budgeting and Other Long-Run DecisionsLong-Run Decisions

Capital Budgeting Capital Budgeting DecisionsDecisions

Capital Budgeting Capital Budgeting DecisionsDecisions

Capital Expenditure Decisions Decisions involving the acquisition of

long-lived assets Capital Budgeting

Process of evaluating investment opportunities

The final list of approved projects is referred to as the capital budget

Capital Budgeting Decision Capital Budgeting Decision ExamplesExamples

Capital Budgeting Decision Capital Budgeting Decision ExamplesExamples

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Evaluating Opportunities: Evaluating Opportunities: Time Value of Money Time Value of Money

ApproachesApproaches


ApproachesApproachesTime Value of Money

A dollar today is worth more than a dollar tomorrow!

Must convert future dollars into their equivalent present value

Basic Time Value of Money Basic Time Value of Money CalculationsCalculations

Basic Time Value of Money Basic Time Value of Money CalculationsCalculations

`Formula to convert future value to present value

P = ___F___ (1 + i)n

Where: P = Present ValueF = Future Valuei = Interest Rate (rate of

return)n = Number of units of

time

Basic Time Value of Money Basic Time Value of Money Calculations - ExampleCalculations - Example

Basic Time Value of Money Basic Time Value of Money Calculations - ExampleCalculations - Example

What is the present value of $1,000 receive five years from now if your required rate of return is 12%?

P = __$1,000__ (1 + .12)5

= __$1,000__1.7623417

= $567.43


ApproachesApproaches


ApproachesApproachesTwo Methods

Net Present Value Method Internal Rate of Return Method

The Net Present Value The Net Present Value MethodMethod

The Net Present Value The Net Present Value MethodMethod

Steps in the NPV Method1. Identify the amount and time

period of each cash flow associated with a potential investment

2. Identify required rate of return and calculate the present values of the cash flows

3. Evaluate the net present value

Net Present Value Net Present Value ApproachApproach

Net Present Value Net Present Value ApproachApproach

Net Present Value ExampleNet Present Value ExampleNet Present Value ExampleNet Present Value ExampleAn auto repair shop considering the purchase of an automated paint spraying machine. The machine will last five years and the following information is available: Each year $2,000 will be saved on wasted

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%

Net Present Value ExampleNet Present Value ExampleNet Present Value ExampleNet Present Value Example

Since the Net Present Value is positive, the company should purchase the equipment.

Example Exercise #1Example Exercise #1Example Exercise #1Example Exercise #1

An investment that costs $50,000 will return $22,000 per year for five years. Determine the net present value of the investment if the required rate of return is 14%. Ignore taxes. Should the investment be undertaken?

Example Exercise #1 Example Exercise #1 SolutionSolution


Net Present Value Calculation PV of Return (Table 2, PV of Annuity where

n=5 and i = 14%) = 3.4331 So,

$22,000 x 3.4331 $75,528.20($50,000) x 1.000 _($50,000)

$25,528.20

Should it be undertaken? Yes, NPV is positive

The Internal Rate of Return The Internal Rate of Return MethodMethod


IRR Method An alternative to the net present

value method Takes into account the time

value of money Rate of return that equates the

present value of future cash flows to the investment outlay

Internal Rate of Return Internal Rate of Return ExampleExample


A company invests $100 to yield $60 at the end of year one and $60 at the end of year two. What rate of return equates the two-year, $60 annuity to $100? Calculate Present Value Factor

=__Initial Outlay_ Annuity Amount



Present Value Factor= $100

$60

= 1.667

Compare with PV of Annuity table for two periods 1.667 very close to 1.6681 IRR is approximately 13%


An investment that costs $79,100 will reduce operating costs by $14,000 per year for ten years. Determine the internal rate of return of the investment (ignore taxes). Should the investment be undertaken if the required rate of return is 18%?



IRR Calculation=Initial Outlay / Annuity Amount=$79,100 / $14,000= 5.6500

PV of Annuity Identification 5.6500 @ 10 years is approximately 5.6502 So, IRR = 12%

Should the project be undertaken? No, IRR is less than required rate of return

Study Break #1Study Break #1Study Break #1Study Break #1

Which of the following is not a capital expenditure decision?a. Building a new factoryb. Purchasing a new piece of equipmentc. Purchasing a new computer systemd. All are capital expenditure decisions


If the net present value of a project is zero, the project is earning a return equal to:a. Zerob. The rate of inflationc. The accounting rate of returnd. The required rate of return


An investment should be made if:a. The IRR is equal to or greater than the

required rate of returnb. The IRR is equal to or greater than

zeroc. The IRR is greater than the accounting

rate of returnd. The IRR is greater than the present

value factor


An investment should be made if:a. The IRR is equal to or greater than

the required rate of returnb. The IRR is equal to or greater than

zeroc. The IRR is greater than the

accounting rate of returnd. The IRR is greater than the

present value factor

Internal Rate of Return With Internal Rate of Return With Unequal Cash FlowsUnequal Cash Flows

Internal Rate of Return With Internal Rate of Return With Unequal Cash FlowsUnequal Cash Flows

Utilized when yearly cash flows are not equal amounts

Must estimate the IRR and calculate the NPV of the project

If NPV > Zero, then IRR should be increased

If NPV < Zero, then IRR should be decreased

Internal Rate of Return With Internal Rate of Return With Unequal Cash Flows ExampleUnequal Cash Flows ExampleInternal Rate of Return With Internal Rate of Return With Unequal Cash Flows ExampleUnequal Cash Flows Example

The IRR is approximately 16%

CFO use of NPV and IRRCFO use of NPV and IRRCFO use of NPV and IRRCFO use of NPV and IRR

Considering “Soft” Benefits in Considering “Soft” Benefits in Investment DecisionsInvestment Decisions

Considering “Soft” Benefits in Considering “Soft” Benefits in Investment DecisionsInvestment Decisions

NPV and IRR allow for a quantitative analysis of a situation

“Soft” benefits include a project’s impact on Future Sales Firm’s Reputation

“Soft” benefits are difficult to quantify

Calculating the Value of “Soft” Calculating the Value of “Soft” BenefitsBenefits


Managers should make a reasonable attempt to quantify the value of soft benefits A high-tech wheelchair project has a

NPV of negative $80,000. The finance department used a required rate of return of 15% with a 10-year life. What must be the value of the soft benefits each year?



This implies that as long as the soft benefits are worth at least $15,959 per year, the project should be funded

Estimating the Required Rate Estimating the Required Rate of Returnof Return

Estimating the Required Rate Estimating the Required Rate of Returnof Return

In previous examples the required rate of return was simply stated

In practice, management must estimate the required rate of return Typically, the required rate of return must

equal the cost of capital for the firm

Cost of CapitalCost of CapitalCost of CapitalCost of Capital

Weighted average of the costs of debt and equity financing used to generate the capital for investments

Cost of Debt Financing Interest paid to individuals, banks, or

other companies that lend money to the firm

Cost of Equity Financing Return demanded by shareholders

Cost of Capital ExamplesCost of Capital ExamplesCost of Capital ExamplesCost of Capital Examples

Additional Cash Flow Additional Cash Flow ConsiderationsConsiderations

Additional Cash Flow Additional Cash Flow ConsiderationsConsiderations

Both NPV and IRR consider cash flows, but not revenues and expenses

Two Special Topics Depreciation Inflation

Cash Flows, Taxes, and the Cash Flows, Taxes, and the Depreciation Tax Shield Depreciation Tax Shield

Cash Flows, Taxes, and the Cash Flows, Taxes, and the Depreciation Tax Shield Depreciation Tax Shield

Depreciation indirectly affects cash flows

Depreciation reduces the amount of tax a company must pay Referred to as the Depreciation Tax Shield

Adjusting Cash Flow for Adjusting Cash Flow for InflationInflation

Adjusting Cash Flow for Adjusting Cash Flow for InflationInflation

It is important to consider the rate of inflation for investment decisions Typically, inflation is factored into the

cost of capital If inflation is not factored into

expected cash flows, suitable projects may appear to have a negative NPV

– The cash inflows will be relatively low, although the required rate of return will be relatively high

Other Long-Run DecisionsOther Long-Run DecisionsOther Long-Run DecisionsOther Long-Run Decisions Decisions that affect cash flows for a

number of future periods Utilize NPV and IRR to analyze Examples include

Simplified Approaches to Simplified Approaches to Capital BudgetingCapital Budgeting

Simplified Approaches to Simplified Approaches to Capital BudgetingCapital Budgeting

Payback Period Method Calculating the length of time it takes to

recover the initial cost of an investment; does not consider the

Time value of money Total stream of cash flows

Accounting Rate of Return Used to evaluate investment opportunities by

comparing the accounting rates of return with a required accounting rate of return

Payback Period Method Payback Period Method ExamplesExamples

Payback Period Method Payback Period Method ExamplesExamples

If an investment opportunity costs $1,000 and yields cash flows of $500 per year, it has a payback period of 2 years.

If an investment opportunity costs $1,000 and yields cash flows of $300 per year, it has a payback period of 3-1/3 years.


The Sunny Valley Wheat Cooperative is considering the construction of a new silo. It will cost $55,000 to construct the silo. Determine the payback period if the expected cash inflows are $10,000 per year.



Payback Period= $55,000 / $10,000= 5.5

The payback period is 5.5 years

Accounting Rate of ReturnAccounting Rate of ReturnAccounting Rate of ReturnAccounting Rate of Return

Formula Average Net Income

Average Investment Example

Conflict Between Performance Conflict Between Performance Evaluation and Capital Evaluation and Capital

BudgetingBudgeting

Conflict Between Performance Conflict Between Performance Evaluation and Capital Evaluation and Capital

BudgetingBudgeting Managers may be discouraged from

using present value techniques for evaluating investments because of the way in which their own performance is evaluated Manager’s performance could be evaluated

based on short-term outcomes Managers who wish to maximize

shareholder wealth should use present value techniques to evaluate investments


Which of the following methods equates future dollars to current dollars?a. Net present value methodb. Internal rate of return methodc. Payback period methodd. Both a and b


The cost of capital is:a. The cost of debt financingb. The cost of equity financingc. The weighted average of the

costs of debt and equity financingd. The internal rate of return

NPV and IRRNPV and IRRNPV and IRRNPV and IRR

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