Capital Budgeting Capital Budgeting: How managers plan significant outlays on projects that have long-term implications (such as the purchase of new equipment or introduction of new products). Next Page Click Here

Methods for Capital Budgeting Decisions Methods which do not consider the time value of money: * Payback Method * Simple Rate of Return Method that does consider the time value of money: * Net Present Value (NPV) Method covered here Next Page Click Here

Time Value of Money Business investments extend over long periods of time. Investments that promise returns earlier in time are preferable to those that promise returns later in time. As such, the time value of money must be considered. A dollar today is worth more than a dollar a year from now since a dollar received today can be invested - yielding more than a dollar a year from now. Next Page Click Here

Typical Cash Outflows Repairs and maintenance Incremental operating costs Initial investment Working capital Next Page Click Here

Typical Cash Inflows Reduction of costs Salvage value Incremental revenues Release of working capital Next Page Click Here

The Net Present Value Method To determine net present value: * Calculate the present value of cash inflows, * Calculate the present value of cash outflows, * Subtract the present value of the outflows from the present value of the inflows. * Apply the general decision rule. Next Page Click Here

The Net Present Value Method General decision rule... Next Page Click Here

Choosing a Discount (or Hurdle)Rate The firms cost of capital is usually regarded as the most appropriate choice for the discount (or hurdle) rate. 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. Next Page Click Here

Simple Illustration of the NPV Method Carver Hospital is considering the purchase of an attachment for its X-ray machine. No investments are made unless they have an annual return of at least 10%. Next Page Click Here

Present Value of Initial Investment Since the initial investment takes place immediately, the present value of the initial investment equals the outflow. Start with the present value of the initial investment(s): Next Page Click Here

Present Value of Cash Inflows Present value of an annuity of $1 table Present value of an annuity of $1 table An annuity Calculate the present value(s) of the other cash flows: x = Discount (or Hurdle) Rate Next Page Click Here

Illustration of the NPV Method Because the net present value is equal to zero, the investment provides exactly a 10% return. Determine the NPV of the cash flows (subtract the present value(s) of the cash outflow(s) from the present value(s) of the cash inflow(s)): Next Page Click Here Apply general decision rule:

Another Illustration Lester Company has been offered a five year contract to provide component parts for a large manufacturer: At the end of year 5, the working capital will be released for use elsewhere. Lester Company uses a discount (or hurdle) rate of 10%. Next Page Click Here

Present Value of Initial Investments Start with the present value of the initial investment(s): Since the initial investments (the investment in the equipment and the working capital needed) take place immediately, the present values equal those outflows. Next Page Click Here

Present Values of Other Cash Flows Present value of an annuity of $1 factor for 5 years at 10%. Annual net cash inflows from operations: Calculate the present value of the other cash flows: Next Page Click Here An annuity x =

Present Value of Other Cash Flows Present value of $1 factor for 3 years at 10%. Calculate the present value of the other cash flows, continued: Cash outflow to reline equipment at end of year 3 Next Page Click Here A single payment x =

Present Value of Other Cash Flows Present value of $1 factor for 5 years at 10%. Calculate the present value of the other cash flows, continued: Cash inflows from sale of equipment and release of working capital at end of year 5 Next Page Click Here Single payments x = x =

Apply General Decision Rule The project has a positive net present value (that is, its return is greater than 10%); accept the project. Determine the NPV of the cash flows (subtract the present value(s) of the cash outflow(s) from the present value(s) of the cash inflows)): Next Page Click Here Apply general decision rule: