Chapter 20 Capital budgeting Decisions

What is a Capital Expenditure? n A long-term decision of whether or not to make an investment today which will bring future returns. n Those “future returns” must be greater than the initial cost of the investment. n This creates a complication - the time value of money!

Cash Flows n The initial cash outlay is compared to the future cash “inflows” n These future inflows can include n cash receipts n cash receipts less cash payments n savings of cash payments

Cost of Capital n In order to make a capital expenditure, a Co. must have cash. n Obtaining financing from creditors and investors costs $. n This is called the cost of capital. n An investment S/B made as long as the C of C is < or = the return on investment.

The Cost of Capital represents the minimum required rate of return needed before a capital expenditure should be made. n In other words, it is the cuttoff rate.

Time Value of Money n “A dollar today is worth more than a dollar tomorrow.” Why?

Since the initial capital expenditure is made in “todays dollars”, we must convert future cash flows to todays dollars in order to determine whether to make the investment.

Present Value (pages ) n Assume the following: You made a $100 investment in a savings account which earns 6% interest compounded annually. After three years you have the following: n Yr1: (100 x.06) = 106 n Yr2: (106 x.06) = n yr3: ( x.06) = n $ is the future value & $100 is the present value.

Think of the present value as the amount of the future value with the interest taken out! n What if we know the future value is $ and want to “convert” it to present value? n Use the table on page 732: 6% for 3 periods = factor of.8396 n.8396 x $ = $ (or $100 rounded)

Above Example - single amount was used. A series of equal payments is an annuity. n Use table on page 733!

Firms use a variety of “Tools” to make capital budgeting decisions: n NPV n Payback n Aver. Rate of Return

NPV - steps: n 1. Calculate, using PV tables, the PV of future cash flows n Use the cost of capital (ie, the required rate of return) n 2. Calculate the amount of the initial cash outlay for the investment n This is already the PV! n 3. #1-#2 = the NPV

How to evaluate the NPV: n if zero or positive, accept investment because the return if > or = the cost of capital. n If negative - don’t accept the project because the return is < required rate.

Payback n evaluates how long it will take to “recap” your initial investment. n Ignores the time value of money & the return on investment. n Only takes return of investment into consideration.

Average rate of return n Usually expressed as a % ARR = Total Cash Receipts-Total cash payment Years X Investment If ARR < C of C, don’t invest. n Also ignores the time value of $

Be sure to read through the examples in the text!

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