Typical Capital Budgeting Decisions

Plant expansion

Equipment selection

Lease or buy Cost reduction

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Typical Capital Budgeting DecisionsCapital budgeting tends to fall into two broad

categories . . .Screening decisions. Does a proposed

project meet some present standard of acceptance?

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

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

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

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

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The Net Present Value Method

To determine net present value we . . .Calculate the present value of cash inflows,Calculate the present value of cash outflows,The difference between the two streams of

cash flows is called the net present value.

To determine net present value we . . .Calculate the present value of cash inflows,Calculate the present value of cash outflows,The difference between the two streams of

cash flows is called the net present value.

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The Net Present Value MethodGeneral decision rule . . .General decision rule . . .

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Net present value analysis Net present value analysis emphasizes cash flows and not emphasizes cash flows and not

accounting net income.accounting net income.

Net present value analysis Net present value analysis emphasizes cash flows and not emphasizes cash flows and not

accounting net income.accounting net income.

The reason is that accounting net income is

based on accruals that ignore the timing of cash flows into and out of an

organization.

The reason is that accounting net income is

based on accruals that ignore the timing of cash flows into and out of an

organization.

The Net Present Value Method

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Repairs andRepairs andmaintenancemaintenance

IncrementalIncrementaloperatingoperating

costscosts

InitialInitialinvestmentinvestment

WorkingWorkingcapitalcapital

Typical Cash Outflows

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ReductionReductionof costsof costs

SalvageSalvagevaluevalue

IncrementalIncrementalrevenuesrevenues

Release ofRelease ofworkingworkingcapitalcapital

Typical Cash Inflows

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Two simplifying assumptions are usually Two simplifying assumptions are usually made in net present value analysis:made in net present value analysis:

All cash flows other than the initial

investment occur at the end of periods.

All cash flows other than the initial

investment occur at the end of periods.

All cash flows generated by an

investment project are immediately

reinvested at a rate of return equal to the

discount rate.

All cash flows generated by an

investment project are immediately

reinvested at a rate of return equal to the

discount rate.

Two Simplifying Assumptions

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Choosing a Discount Rate•The company’s cost of

capital is usually regarded as the minimum required rate of return.

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

•The company’s cost of capital is usually regarded as the minimum required rate of return.

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

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Expanding the Net Present Value Method

To compare competing investment projects, we can use the following net

present value approaches:▫Total-cost

▫Incremental cost

To compare competing investment projects, we can use the following net

present value approaches:▫Total-cost

▫Incremental cost

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Least Cost DecisionsIn decisions where revenues are not In decisions where revenues are not

directly involved, managers should directly involved, managers should choose the alternative that has the least choose the alternative that has the least

total cost from a present value total cost from a present value perspective.perspective.

Let’s look at the Home Furniture CompanyLet’s look at the Home Furniture Company..

In decisions where revenues are not In decisions where revenues are not directly involved, managers should directly involved, managers should

choose the alternative that has the least choose the alternative that has the least total cost from a present value total cost from a present value

perspective.perspective.

Let’s look at the Home Furniture CompanyLet’s look at the Home Furniture Company..

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Screening Decisions

Pertain to whether or not some proposed

investment is acceptable; these

decisions come first.

Preference Decisions

Attempt to rank acceptable alternatives from the most to least

appealing.

Preference Decision – The Ranking of Investment Projects

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The net present value of one project cannot be directly compared to the net present

value of another project unless the investments are equal.

Net Present Value Method

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Ranking Investment Projects Project Net present value of project Profitability Investment required Index

=

A BNet present value of project $1,000 $1,000Investment required 80,000 5,000Project profitability index 1% 20%

Investment

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

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The higher the internal The higher the internal rate of return, the rate of return, the

more desirable the more desirable the project.project.

The higher the internal The higher the internal rate of return, the rate of return, the

more desirable the more desirable the project.project.

When using the internal rate of return method to rank competing investment

projects, the preference rule is:

Internal Rate of Return Method

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The Payback Method

The payback period is the length of time that it takes for a project to recover its initial cost out

of the cash receipts that it generates. When the net annual cash inflow is the same

each year, this formula can be used to compute the payback period:

The payback period is the length of time that it takes for a project to recover its initial cost out

of the cash receipts that it generates. When the net annual cash inflow is the same

each year, this formula can be used to compute the payback period:

Payback period = Investment required Net annual cash inflow

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The Payback Method

Management at The Daily Grind wants to install an Management at The Daily Grind wants to install an espresso bar in its restaurant.espresso bar in its restaurant. The espresso bar:The espresso bar:

1.1. Costs $140,000 and has a 10-year life.Costs $140,000 and has a 10-year life.2.2. Will generate annual net cash inflows of $35,000.Will generate annual net cash inflows of $35,000.

Management requires a payback period of 5 years or Management requires a payback period of 5 years or less on all investments.less on all investments.

What is the payback period for the espresso bar?What is the payback period for the espresso bar?

Management at The Daily Grind wants to install an Management at The Daily Grind wants to install an espresso bar in its restaurant.espresso bar in its restaurant. The espresso bar:The espresso bar:

1.1. Costs $140,000 and has a 10-year life.Costs $140,000 and has a 10-year life.2.2. Will generate annual net cash inflows of $35,000.Will generate annual net cash inflows of $35,000.

Management requires a payback period of 5 years or Management requires a payback period of 5 years or less on all investments.less on all investments.

What is the payback period for the espresso bar?What is the payback period for the espresso bar?

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Payback period = Payback period = Investment required Investment required Net annual cash inflowNet annual cash inflow

Payback period = Payback period = $140,000 $140,000 $35,000$35,000

Payback period = Payback period = 4.0 years4.0 years

The payback period is 4.0 years. Therefore, management would choose

to invest in the bar.

The payback period is 4.0 years. Therefore, management would choose

to invest in the bar.

The Payback Method

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Ignores the Ignores the time valuetime valueof money.of money.

Ignores cashIgnores cashflows after flows after the paybackthe payback

period.period.

CriticismsCriticismsof the paybackof the payback

period.period.

Evaluation of the Payback Method

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Identifies Identifies investments that investments that

recoup cash recoup cash investments investments

quickly.quickly.

Evaluation of the Payback Method

StrengthsStrengthsof theof the

paybackpaybackmethod.method.

Serves as Serves as screening screening

tool.tool.

If productsIf productsbecome obsolete,become obsolete,It will help focus It will help focus on short paybackon short paybackperiod projects.period projects.

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11 22 33 44 55

$1,000$1,000 $0$0 $2,000$2,000 $1,000$1,000 $500$500

When the cash flows associated with an investment project change from year to year,

the payback formula introduced earlier cannot be used.

Instead, the un-recovered investment must be tracked year by year.

When the cash flows associated with an investment project change from year to year,

the payback formula introduced earlier cannot be used.

Instead, the un-recovered investment must be tracked year by year.

Payback and Uneven Cash Flows

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Simple Rate of Return Method•Does not focus on cash flows -- rather it

focuses on accounting net operating accounting net operating incomeincome.

•The following formula is used to calculate the simple rate of return:

Simple rateSimple rateof returnof return ==

Annual IncrementalAnnual IncrementalNet Operating IncomeNet Operating Income

Initial investmentInitial investment**

**Should be reduced by any salvage from the sale of the old equipment

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Simple Rate of Return Method

Management of The Daily Grind wants to install an espresso bar in its restaurant. The espresso bar:

1. Cost $140,000 and has a 10-year life.2. Will generate incremental revenues of

$100,000 and incremental expenses of $65,000, including depreciation.

What is the simple rate of return on the investment project?

Management of The Daily Grind wants to install an espresso bar in its restaurant. The espresso bar:

1. Cost $140,000 and has a 10-year life.2. Will generate incremental revenues of

$100,000 and incremental expenses of $65,000, including depreciation.

What is the simple rate of return on the investment project?

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Simple rateSimple rateof returnof return

$100,000 - $65,000 $100,000 - $65,000 $140,000$140,000 = 25%= 25%==

The simple rate of return method is The simple rate of return method is not not recommended because it ignores the time recommended because it ignores the time

value of money and the simple rate of value of money and the simple rate of return can fluctuate from year to year.return can fluctuate from year to year.

The simple rate of return method is The simple rate of return method is not not recommended because it ignores the time recommended because it ignores the time

value of money and the simple rate of value of money and the simple rate of return can fluctuate from year to year.return can fluctuate from year to year.

Simple Rate of Return Method

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Postaudit of Investment Projects

A postaudit is a follow-up after the project has been completed to see

whether or not expected results were actually realized.

A postaudit is a follow-up after the project has been completed to see

whether or not expected results were actually realized.

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