Internal Allocation of Scarce Resources

1. Internal Allocationof Scarce Resources Chapter 11

2. Learning Objective 1 • Explain the process • of capital budgeting.

3. The Capital Budget The capital budget is the budget that outlines how a firm intends to allocate its scarce resources over a time period. Capital assets are long-lived assets. The firm only uses capital budgeting techniques for large dollar amounts of long-lived expenditures.

4. Learning Objective 2 • Delineate the four shared • characteristics of all • capital projects.

5. Characteristics ofCapital Projects Characteristics: Long lives High cost Sunk costs High degree of risk

6. Learning Objective 3 • Describe the cost of • capital and the concept • of scarce resources.

7. Required rate of return Hurdle rate Cost of Capital It is the cost of obtaining financing from all available financial sources.

8. Financing % of Total Blended cost of capital Cost Rate Weighted Debt Equity 60% 40% × × 7.5% 20.0% = = 4.5% 8.0% 12.5% Blended Cost of Capital It is the combined cost of debt and equity financing.

9. Scarce Resources This means that a company has a limited amount of funding available to spend on capital projects.

10. Learning Objective 4 • Determine the information • relevant to a capital • budgeting decision.

11. Evaluating PotentialCapital Projects 1. Identify possible capital projects. 2. Determine the relevant cash flows for alternative projects. 3. Select a method of evaluating the alternatives. 4. Evaluate the alternatives and select the capital projects to be funded.

12. Learning Objective 5 • Evaluate potential capital investments using three capital budgeting decision models: payback method, • net present value, and the internal rate of return.

13. Net present value Internal rate of return Capital BudgetingDecision Methods Payback period method Discounted cash flow methods

14. 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.

15. 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? $40,000 ÷ $12,500 = 3.2 years

16. Payback Period withUneven Cash Flows Cash received in prior years 0 $12,000 $27,000 $45,000 $60,000 Year 1 2 3 4 5 + + + + + Cash received in current year $12,000 $15,000 $18,000 $15,000 $12,000 = = = = = Accumulated cash received $12,000 $27,000 $45,000 $60,000 $72,000 It will take about 1/3 of the fourth year ($5,000/$15,000) to collect the final $5,000.

17. Discounted Cash Flow Methods The time value of money is the increase in the value of cash over time due to the accumulation of investment income. Discounting cash flows is determining the present value of cash to be received in future periods. The net present value (NPV) of a proposed capital project is the present value of cash inflows minus the present value of cash outflows.

18. Net Present Value Example Elevation Sports, Inc., considers purchasing new equipment that will require an investment of $100,000. The new equipment will save $31,000 annually in production salaries. The blended cost of capital is equal to 14%. Therefore, 14% is the discount rate used.

19. Net Present Value Example Time Period 0 1 2 3 4 5 $(100,000) 106,423 $ 6,423 $31,000 $31,000 $31,000 $31,000 $31,000 $31,000 × 3.433 = $106,423 NPV = $106,423 – $100,000 = $6,423

20. Net Present Value Example Assume that the equipment will require $12,000 in maintenance fees in year 3. Also that the equipment can be sold at the end of year 5 for $6,000. What is the NPV?

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

22. Year 0 1 2 3 4 5 Net cash flow $(100,000) $ 31,000 $ 31,000 $ 19,000 $ 31,000 $ 37,000 PV of $1, factor at 14% 0.8772 0.7695 0.6750 0.5921 0.5194 Present value $(100,000) $ 27,193 $ 23,855 $ 12,825 $ 18,355 $ 19,218 Net Present Value Example Net present value $ 1,446

23. Profitability Index Example Project A present value of cash inflows was $105,000 and present value of cash outflow was $100,000. Project B present value of cash inflows was $206,000 and present value of cash outflow was $200,000. What is the profitability index?

24. Profitability Index Example Profitability index (PI) = PV of cash inflows ÷ PV of cash outflows PI for Project A: $105,000 ÷ $100,000 = 1.05 PI for Project B: $206,000 ÷ $200,000 = 1.03 Project A ranks higher than Project B.

25. Internal Rate of Return Example The internal rate of return (IRR) of a proposed capital project is the expected percentage return promised by the project. Assume that Project C requires an initial investment of $300,000 and will provide cash inflows of $56,232 for eight years. What is the IRR?

26. Internal Rate of Return Example PV = annual payments × Present value interest factor of an annuity Initial Investment = Annual payments ×PVIFA Project C: $300,000 ÷ $56,232 = 5.335 For 8 periods, the factor 5.335 equals a 10% rate of return.

27. Internal Rate of Return Example Project D requires an initial investment of $330,000 and will generate estimated annual returns of $64,900 for eight years. What is the IRR? $330,000 ÷ $64,900 = 5.0857 For 8 periods, the factor 5.0857 is between the factor for the 10% column and the 12% column.

28. PV initial investment = $330,000 FV future value = 0 n number of years = 8 PMT annual return = $64,900 CPT compute %i interest rate = 11.33762% Financial Calculator

29. They are based on cash flows, not accounting income. 1st Both methods consider the time value of money. 2nd Comparing the NPVand IRR Methods Both methods are well-respected techniques for determining the acceptability of a proposed capital project.

30. Comparing the NPVand IRR Methods A drawback of the NPV method is that the calculated net present value is stated in dollars rather than percentages. The IRR calculates a proposed capital project’s actual expected rate of return.

31. Learning Objective 6 • Explain the concept of simple • interest and compound • interest and describe • the concept of an annuity.

32. The Concept of Interest A dollar received today can be invested and earn a return as time passes. Future value is the value of a payment, or series of payments, at a future point in time. P x R x T = Interest $2,000 x 10% x 1 = $200

33. Simple Interest Simple interest is calculated only on the original principal. What is the amount of interest earned at 10 percent per year for three years on a $2,000 principal? P x R x T = Interest $2,000 x 10% x 3 = $600

34. Compound Interest It is interest calculated on the investment principal plus all previously earned interest at the end of each compounding period. 10% Compound Interest Year 1Year 2Year 3Total Principal $2,000 $2,200 $2,420 Interest 200 220 242$662 $2,200 $2,420 $2,662

35. Annuity An annuity is a stream of cash flows where the dollar amount of each payment and the time interval between each payment are uniform. Assume Trevor intends to deposit $2,000 in an account at the end of each year for 40 years at 10% compound annually. $2,000 x 442.5926 = $885,185.20

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

37. Present Value Determining the present value of an amount of cash to be received in the future is called discounting. What is the present value of $1,000 to be received a year from now at 6%? PV = $1,000 × 0.9434 = $943.40

38. Future Value What is the future value of $2,000 in 40 years at 10% interest compounded annually? $90,518.51 What is the future value of annual payments of $2,000 at the end of the next 40 years at 10% interest compounded annually? $885,185.11

39. End of Chapter 11