prepared by debby bloom-hill cma, cfm. slide 9-2 chapter 9 capital budgeting and other long-run...

Prepared by Debby Bloom-Hill CMA, CFM

2

CHAPTER 9CHAPTER 9

Capital Budgeting

and

Other Long-Run Decisions

Capital Budgeting

and

Other Long-Run Decisions

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

Slide 9-4



Investment decisions are important because they have a long run impact on a firm’s 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



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

6

Which of the following is not a capital expenditure decision?

a. Building a new factoryb. Purchasing a new piece of equipmentc. Purchasing inventoryd. Purchasing another company

Answer: cPurchasing inventory



Slide 9-7

The Time Value of MoneyThe 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

8

Evaluating Opportunities: Time Value of Money

Approaches

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


9

Basic Time Value of Money Calculations

Basic Time Value of Money Calculations

Formula to convert future value to present value

Where: P = Present valueF = Future amountr = Required rate of returnn = Number of years


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Basic Time Value of Money Calculations - Example

Basic Time Value of Money Calculations - Example

At an interest rate of 10%, how much is $121 received two years from now worth today?


11

Present Value TablesPresent Value Tables

Managers can use present value tables to look up present value factors Present value factors are simply

calculations of Turn to Table 1 in Appendix B of

this chapter To find the factor for r = 12% and n = 5

Go across the top of the table to a discount rate of 12 percent and down five rows Learning objective 1: Define capital expenditure

decisions and capital budgets

12

Using the formula on slide 9-10, what is the present value of $500 received two years in the future if you desire a return of 10%?

a. $413.22b. $468.58c. $471.60d. $480.30

Answer: a


Learning objective 2: Evaluate investment opportunities using the net present value 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


Slide 9-14



Steps in the NPV method1. 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


Slide 9-15



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 requiredrate

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Net Present Value ApproachNet Present Value Approach


17

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

Answer: dThe required rate of return


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Net Present Value ExampleNet Present Value ExampleAn 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%


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Net Present Value ExampleNet Present Value ExampleSince the NPV > 0, the company should buy the equipment


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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


21




Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

Slide 9-22

The Internal Rate of Return (IRR) Method

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

23

The Internal Rate of Return Method

The Internal Rate of Return Method


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An investment should be undertaken 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

Answer: aThe IRR is equal to or greater than the required rate of return Learning objective 3: Evaluate investment opportunities using

the internal rate of return approach

25

The Internal Rate of Return with Equal Cash Flows

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 3: Evaluate investment opportunities using

the internal rate of return approach

26

Internal Rate of Return Example

Internal Rate of Return Example

Investment = $100 Cash flow $60 per year for two years PV factor = 100 / 60 = 1.667 Check PV annuity table, row 2 Closest factor is in 13% column


Present Value of an Annuity11% 12% 13% 14%

1 0.9009 0.8929 0.8850 0.8772 2 1.7125 1.6901 1.6681 1.6467

Factor closest to 1.667, IRR approx 13%

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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


Present Value of an Annuity11% 12% 13% 14%

9 5.5370 5.3282 5.1317 4.9464 10 5.8892 5.6502 5.4262 5.2161

Factor closest to 5.65, IRR approx 12%Do not make investment, IRR less than required return

28

Internal Rate of ReturnInternal Rate of Return


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


30



The IRR is approximately 16%


31

Use of NPV and IRRUse of NPV and IRR


32

Considering “Soft” Benefits in Investment Decisions

Considering “Soft” Benefits in Investment Decisions

It is important that managers consider “soft” benefits in addition to a project’s 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 technologyLearning objective 3: Evaluate investment opportunities using the internal rate of return approach

33

“Soft” Benefits“Soft” Benefits


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 will improve the firm’s reputation as an industry leader

The reputation is difficult to quantify Production can also improve production techniques


35



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


36

Estimating the Required Rate of Return

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


37

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

Answer: cThe weighted average of the costs of debt and equity financing


38

Additional Cash Flow Considerations

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 4: Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes

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



We stated that depreciation is not relevant in present value analysis

Depreciation affects cash flows indirectly Depreciation reduces the amount of

tax a company must pay The term depreciation tax shield

refers to the tax savings from depreciation


Slide 9-41

Example of theDepreciation Tax Shield

Example of theDepreciation Tax Shield

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


43



If inflation is ignored in net present value analysis, worthwhile opportunities might be rejected That 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


44

Other Long-Run DecisionsOther 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 5: Evaluate long-run decisions, other than investment decisions, using time value of money techniques

Learning objective 5: Evaluate long-run decisions, other than investment decisions, using time value of money techniques

Slide 9-45

Other Long-Run DecisionsOther Long-Run Decisions

Evaluation of decision to sponsor a golf tournament

Learning objective 6: Use the payback period and the accounting rate of return methods to evaluate investment opportunities

Slide 9-46

Simplified Approaches to Capital Budgeting

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 MethodPayback 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


Slide 9-48

Payback Period MethodPayback 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

49

Which of the following methods ignores the time value of money (present and future values) in its calculation?

a. Net present valueb. Internal rate of returnc. Payback periodd. External rate of return

Answer: cPayback period


50

Accounting Rate of Return (ARR)

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


51

Conflict Between Performance Evaluation and Capital

Budgeting

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 7: Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values

Learning objective 7: 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

Short-Run Accounting Profit

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prepared by debby bloom-hill cma, cfm. slide 9-2 chapter 9 capital budgeting and other long-run...

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