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## Capital Budgeting

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**Chapter25**Capital Budgeting**Investment involves along-term commitment.**Outcomeis uncertain. Decision may bedifficult or impossibleto reverse. Large amounts ofmoney are usuallyinvolved. Capital Investment Decisions Capital budgeting:Analyzing alternative long-term investments and deciding which assets to acquire or sell.**I will choose theproject with the mostprofitable return**onavailable funds. Capital Investment Decisions PlantExpansion ? LimitedInvestmentFunds NewEquipment ? ? OfficeRenovation**Initial**investment Repairs and maintenance Incremental operating costs Capital Investment Decisions: Typical Cash Outflows**Capital Investment Decisions: Typical Cash Inflows**Salvage value Cost savings Incremental revenues**Capital Investment Decisions:Nonfinancial Considerations**Employee working conditions Environmental concerns Corporate image Employee morale Product quality**Evaluating Capital Investment Proposals: An Illustration**Let’s look at methods used to make capitalinvestmentdecisions.**Stars’ Stadium is considering purchasingvending machines**with a 5-year life. Evaluating Capital Investment Proposals: An Illustration ($75,000 - $5,000) ÷ 5 years**Most capital budgeting techniques useannual net cash flow.**Depreciation is not a cash outflow. Evaluating Capital Investment Proposals: An Illustration**Payback**period Cost of Investment Annual Net Cash Flow = Payback Period The payback period of an investmentis the time expected to recoverthe initial investment amount. Managers prefer investing in projects with shorter payback periods.**Payback**period Cost of Investment Annual Net Cash Flow = Payback Period The payback period of an investmentis the time expected to recoverthe initial investment amount. Payback period $75,000 $24,000 = = 3.125 years**Ignores the**time value of money. Ignores cash flows after the payback period. Payback Period**Consider two projects, each with a five-year life and each**costing $6,000. Payback Period Would you invest in Project One just because it has a shorter payback period?**ROI focuses on annual incomeinstead of cash flows.**Average estimated net income Average investment ROI = Return on Average Investment (ROI) Original cost + Salvage value2**ROI focuses on annual incomeinstead of cash flows.**$10,000$40,000 ROI = = 25% Return on Average Investment (ROI) $75,000 + $5,0002**Income may vary from year to year.**Time value ofmoney is ignored. Return on Average Investment (ROI) So why would I ever want to use this method anyway?**Now let’s look at a capital budgeting model that**considers the time value of cash flows. Discounting Future Cash Flows**A comparison of the present value of cash inflows with the**present value of cash outflows Net Present Value (NPV)**Chose a discount rate – the minimum required rate of**return. • Calculate the presentvalue of cash inflows. • Calculate the presentvalue of cash outflows. NPV = – Net Present Value (NPV)**General decision rule . . .**Net Present Value (NPV)**Net Present Value (NPV)Question**Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a. $ 4,300 b. $12,700 c. $11,000 d. $17,000**Net Present Value (NPV)Question**Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a. $ 4,300 b. $12,700 c. $11,000 d. $17,000 Using the present value of an annuity (table 2) PV of inflows = $20,000 × 5.650 = $113,000 NPV = $113,000 - $96,000 = $17,000**Net Present Value (NPV)Question**Calculate the NPV if Savak Company’s required return is 15 percent instead of 12 percent. Using the present value of an annuity (table 2) PV of inflows = $20,000 × 5.019 = $100,380 NPV = $100,380 - $96,000 = $4,380 Note that the NPV is smallerusing the larger interest rate.**Net Present Value (NPV)**Now that you have mastered the basic concept of net present value, it’s time for a more sophisticated checkup! Let’s return to Stars’ Stadium.**Stars’ Stadium is considering purchasingvending machines**with a 5-year life. Evaluating Capital Investment Proposals: An Illustration ($75,000 - $5,000) ÷ 5 years**Most capital budgeting techniques use annual net cash flow.**Depreciation is not a cash outflow. Evaluating Capital Investment Proposals: An Illustration**Net Present Value (NPV)**Star’s Stadium Net Present Value Analysis Stars uses a 15% discount rate.**Net Present Value (NPV)**Star’s Stadium Net Present Value Analysis Present value of an annuity of $1 factor for 5 years at 15%. $24,000 × 3.352 = $80,448**Net Present Value (NPV)**Star’s Stadium Net Present Value Analysis Present value of $1 factor for 5 years at 15%.**Net Present Value (NPV)**Star’s Stadium Net Present Value Analysis Since the NPV is positive, we know the rate of return is greater than the 15 percent discount rate.**Net Present Value (NPV)Replacing Assets**Let’s use NPVconcepts withan asset replacement decision.**The Maine LobStars are considering replacing an old bus with**a new bus, each with a 5-year life and zero salvage. Evaluating Capital Investment Proposals: An Illustration**Depreciation is not a cash outflow.**Evaluating Capital Investment Proposals: An Illustration Tax savings from loss ondisposal of old bus: $15,000 × 40% = $6,000**Net Present Value (NPV)**LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.**Net Present Value (NPV)**LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.**Net Present Value (NPV)**LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.**Net Present Value (NPV)**LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate. Since the NPV is negative, we know the rate of return is less than the 15 percent discount rate.**Capital budgeting involves many estimates.**Estimates may be pessimistic or optimistic. Uncertainty about the future may impact estimates. Behavioral Issuesin Capital Budgeting**Conflicts may exist between short-run performance measures**and long-run capital budgeting criteria. Behavioral Issuesin Capital Budgeting**A follow-up after the project has been approved to see**whether or not expected results are actually realized. Capital Budget Audit**THE END**I told you that’s the end. You can’t work any more accounting problems in my class!