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Chapter 8

Chapter 8. The Capital Budget: Evaluating Capital Expenditures. Learning Objective 1. Describe the overall planning process and where the capital budget fits in that process. The Business Planning Process.

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Chapter 8

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  1. Chapter 8 The Capital Budget: Evaluating Capital Expenditures

  2. Learning Objective 1 Describe the overall planning process and where the capital budget fits in that process.

  3. The Business Planning Process The business planning process involves answering the following questions: WHY? WHAT? HOW? WHO?

  4. The Business Planning Process Organization goals constitute the core beliefs and values of the company. These goals are theWHY of the business.

  5. Nonfinancial Goals A company typically has many goals that are not centered around money. The nonfinancial goals are often highlighted in a mission statement or a similar document.

  6. Financial Goals The main financial goal for most businesses is to “earn a profit.” This might be stated as “achieving superior financial performance,” “earning a reasonable return for the stockholders,” or similar language.

  7. Johnson & JohnsonMission Statement Our Credo We believe our first responsibility is to the doctors, nurses and patients, to mothers and fathers and all others who use our products and services… We are responsible to our employees, the men and women who work with us throughout the world. Everyone must be considered an individual…

  8. The Strategic Plan: The What This plan will identify those actions that the firm will take to achieve its goals. It is important that these plans support, rather than conflict with, the company’s goals. This is the WHAT of doing business.

  9. The Capital Budget: The How The capital budget identifies scarce resource allocations over the next several years. This is the HOW of the business. The capital budget focuses on acquiring and replacing long-lived expensive assets.

  10. The Operating Budget: The Who The operating budget establishes who is responsible for the day-to-day operations of the organization. The operating budget is the WHO of the business.

  11. Interrelationship Among the Planning Elements Goals WHY? Strategic Plan WHAT? Capital Budget HOW? Operating Budget WHO?

  12. Learning Objective 2 Explain in your own words the process of capital budgeting.

  13. The Capital Budget: What is it? Long-lived assets are commonly referred to as capital assets. Whenever an expenditure is made to purchase something, the cost of that item will either be shown as an expense or as an asset.

  14. Capitalizing Assets Capitalizing the expenditure is the process of recording the expenditure as an asset rather than an expense. There are no rules for setting the capitalization threshold.

  15. Learning Objective 3 Discuss the four shared characteristics of all capital projects.

  16. Characteristics of Capital Projects What are the four shared characteristics of capital projects? Long lives High cost Quickly sunk costs High degree of risk

  17. Learning Objective 4 Describe the cost of capital and the concept of scarce resources.

  18. The Cost of Capital The cost of capital represents a firm’s cost of acquiring debt or equity financing. The cost of capital is also called the cost of capital rate, required rate of return, or the hurdle rate.

  19. The Cost of Capital The cost of debt capital is the interest a company pays to its creditors. The cost of equity capital is what equity investors relinquish when they invest in one company rather than in another.

  20. Blended Cost of Capital Combining the cost of debt financing with the cost of equity financing is called the blended cost of capital. Financing% of TotalCost RateWeighted Debt 60% × 7.5% = 4.5% Equity 40% × 20.0% = 8.0% Blended cost of capital 12.5%

  21. Learning Objective 5 Determine the information relevant to the capital budgeting decision.

  22. Evaluating PotentialCapital Projects Managers will evaluate capital projects by: – identifying possible capital projects – determining the relevant cash flows for alternative projects – selecting a method of evaluating the alternatives – evaluating the alternatives and selecting the capital projects to be funded

  23. Identifying PotentialCapital Projects The majority of capital projects are intended to either increase revenue or reduce costs, or a combination of the two. Occasionally, a project is considered that will result in neither.

  24. Determining Relevant Cash Flows for Alternative Projects The project’s expected cash inflows minus its cash outflows for a specific period equals net cash flow. Relevant net cash flows are future cash flows that differ between or among alternatives.

  25. Learning Objective 6 Evaluate potential capital investments using four capital budgeting decision models: net present value, internal rate of return, payback period method, and accounting rate of return.

  26. Selecting a Method ofEvaluating the Alternatives • Net present value • Internal rate of return • Payback period method • Accounting rate of return

  27. Capital BudgetingDecision Methods A dollar received at some point in the future does not have the same value as a dollar received today. The increase in the value of cash over time due to investment income is referred to as the time value of money.

  28. Discounted Cash Flow Methods The discounted cash flows methods are: • net present value • internal rate of return

  29. Net Present Value The net present value (NPV) of a capital project is calculated by subtracting the present value of future cash outflows from the present value of future cash inflows. The net cash flows for all years are discounted using the firm’s blended cost of capital.

  30. NPV Example Assume that the Whitewater Adventure Company is considering a computer upgrade of $100,000. This project should result in net cash inflows of $31,000 per year for the next four years. The blended cost of capital is equal to 14%. Therefore, the discount rate used is 14%.

  31. NPV Example Years in the Life of the Project 0 1 2 3 4 5 $(100,000) $31,000 $31,000 $31,000 $31,000 $31,000 $ 106,423 $ 6,423 $31,000 × 3.433 = $106,423 NPV = $106,423 – $100,000 NPV = $6,423

  32. NPV Example Assume that Whitewater’s computer upgrade will require $12,000 in maintenance fees in year 3. Also that the system can be sold at the end of year 5 for $6,000.

  33. NPV Example Year Initial investment Maintenance Operating costs Residual value Net cash flow 0 ($100,000) ($100,000) 1 $31,000 $ 31,000 2 $31,000 $ 31,000 3 ($12,000) $31,000 $ 19,000 4 $31,000 $ 31,000 5 $31,000 $6,000 $ 37,000

  34. Year Net cash flow PV of $1, Factor at 14% Present Value 0 ($100,000) ($100,000) 1 $ 31,000 0.877 27,187 2 $ 31,000 0.769 23,839 3 $ 19,000 0.675 12,825 4 $ 31,000 0.592 18,352 5 $ 37,000 0.519 19,203 Net present value $ 1,406 NPV Example

  35. Profitability Index Example Project A has future cash inflows with a present value of $105,000 and an initial investment of $100,000. Project B has future cash inflows with a present value of $206,000 and an initial investment of $200,000.

  36. Profitability Index Example PI for Project A: $105,000 ÷ $100,000 = 1.05 PI for Project B: $206,600 ÷ $200,000 = 1.03 Using this measure, Project A is the preferable project.

  37. Internal Rate of Return The internal rate of return (IRR) is the expected percentage return promised by a capital project. It is also known as the real rate of return or the time-adjusted rate of return.

  38. IRR Example Project C requires an initial investment of $300,000 and will provide annual cash inflows of $56,232 for eight years. Project D requires an initial investment of $330,000 and will provide annual cash inflows of $64,900 for eight years. What is the internal rate of return for each project?

  39. IRR Example Step #1: Calculate the present value factor. Initial investment ÷ Annual net cash inflow = Present value factor Step #2: Find the PV factor on the appropriate row of the present value of an annuity of $1 table.

  40. IRR Example Project C: $300,000 ÷ $56,232 = 5.335 For 8 years, the factor 5.335 equals a 10% rate of return. Project D: $330,000 ÷ $64,900 = 5.085For 8 years, the factor 5.085 is very close to the factor for the 11% rate of return.

  41. Nondiscounted Cash Flow Methods Nondiscounted cash flow methods do not factor the time value of money into the analysis.

  42. Payback Period Method The payback period method measures the length of time a capital project must generate positive net cash flows that equal, or “pay back,” the original investment.

  43. Payback Period Method Assume that a project’s estimated initial outlay is $40,000. It is expected to generate $12,500 per year. What is the payback period?

  44. Payback Period Method $40,000 ÷ $12,500= 3.2 years If a project has uneven cash flows, the payback period can be determined by adding the cash inflows year by year until the total equals the required initial investment.

  45. Accounting Rate of Return Method This capital budgeting method uses accrual accounting information rather than cash flows. Whitewater Company’s computer upgrade of $100,000 would reduce operating expenses by $31,000 per year for five years. The computer’s useful life is five years.

  46. Accounting Rate of Return Method What is the accounting rate of return? Depreciation: $100,000 ÷ 5 = $20,000 ($31,000 – $20,000) ÷ $100,000 = $11,000 ÷ $100,000 = 11%

  47. Factors Leading to Poor Capital Project Selection Natural optimism Capital budgeting games

  48. Learning Objective 7 Determine present and future values using present value tables and future value tables.

  49. Time Value of Money If you have a dollar in hand today, you can invest it and earn a return on it in the future. This is the concept of interest and is the basis for the time value of money. To properly understand the time value of money, you first must be able to distinguish between simple interest and compound interest.

  50. Simple Interest Calculation 10% Simple Interest Year 1Year 2Year 3 Principal 2,000 2,000 2,000 Interest 200 200 200 Amount to be received = $2,600 Interest each year equals principal amount times 10%.

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