Capital Budgeting Evaluating Capital Expenditures Proposed

2 What is a “capital” expenditure? From Chapter 10, page 470: “Additions and improvements are costs incurred to increase the operating efficiency, productive capacity, or useful life of the plant asset. These expenditures are usually material in amount and occur infrequently. Additions and improvements increase the company’s investment in productive facilities and are generally debited to the plant asset affected. They are often referred to as capital expenditures.”

3 What is a “capital” expenditure? From Chapter 26, page 1205 capital budgeting

4 What is a “capital” expenditure? From Chapter 26, page 1205

5 What is a “capital” expenditure? “So you bought a new ________?”

6 What is a “capital” expenditure? “So you bought a new ________?” Date Account Title RefDebitCredit Asset? or Expense?6,900 Cash 14 debiting an ASSET is a CAPITAL expenditure

7 Annual Rate of Return measure of anticipated profitability of investment alternative average annual net income average cost * Book Value Average Cost

8 Annual Rate of Return measure of anticipated profitability of investment alternative average annual net income average cost * * (beg. bal. + end. bal.) 2 * 1/2 org. cost

9 Annual Rate of Return measure of anticipated profitability of investment alternative average annual net income average cost * LIMITATIONS: timing of recovery of investment timing of income

10 Annual Rate of Return LIMITATIONS $200,000 $18,000 $100,000 = 18%

11 Annual Rate of Return LIMITATIONS $200,000 $40,000$30,000$10,000 $5,000 $90,000 / 5 yrs $100,000 = 18%

12 Annual Rate of Return measure of anticipated profitability of investment alternative average annual net income average cost * LIMITATIONS: timing of recovery of investment timing of income

13 Cash Payback Period time required to recover cash spent Cash coming in (rev) – Cash flowing out (exp) Net Cash Flow Revenue – Expense Net Income + Depreciation Net Cash Flow

14 Cash Payback Period time required to recover cash spent Even “streams”: proposed expenditure annual NCF Uneven “streams”: sum annual NCFs until cumulative sum = investment LIMITATIONS: ignores... overall profitability, cash flow timing, and cash flow beyond payback period

15 Cash Payback Period LIMITATIONS $200,000 $18,000 Net Income NCF

16 Cash Payback Period LIMITATIONS

17 Cash Payback Period LIMITATIONS

18 Cash Payback Period LIMITATIONS

19 Cash Payback Period LIMITATIONS $200,000 $40,000$30,000$10,000 $5,000 Net Income NCF

20 Cash Payback Period LIMITATIONS

21 Cash Payback Period LIMITATIONS

22 Cash Payback Period time required to recover cash spent Even “streams”: proposed expenditure annual NCF Uneven “streams”: sum annual NCFs until cumulative sum = investment LIMITATIONS: ignores overall profitability, cash flow timing, and cash flow beyond payback period

23 Discounted Cash Flow: Net Present Value Method compares present value of future NCF with proposed outlay (already in today’s dollars) Profitability built into computation. When there is an excess of future NCF over the expenditure, it IS an acceptable alternative. NCF x PV factor = PV of NCF – PV of expenditure acceptable + or 0 not acceptable —

24 Capital Investment Analysis Victory Company is considering the acquisition of machinery at a cost of $750,000. The machinery has an estimated life of 5 years and no residual value. It is expected to provide yearly income of $37,500 and yearly net cash flows of $187,500. The company’s minimum desired rate of return for discounted cash flow analysis is 6%. Compute the following: (a)The annual rate of return. (b)The cash payback period. (c)The excess (deficiency) of present value over the amount to be invested, as determined by the net present value method. Use the table of present value of 1 in the textbook appendix.

25 Annual Rate of Return average annual net income average cost * $37,500 $375,000 = 10%

26 Cash Payback Period time required to recover cash spent Even “streams”: proposed expenditure annual NCF Uneven “streams”: sum annual NCFs until cumulative sum = investment EVEN Streams

27 Cash Payback Period time required to recover cash spent Even “streams”: proposed expenditure annual NCF $750,000 $187,500 = 4 yrs

28 Discounted Cash Flow: Net Present Value Method NCF x PV factor = PV of NCF – PV of expenditure acceptable + or 0 not acceptable —

29 Discounted Cash Flow: Net Present Value Method

30 Discounted Cash Flow: Net Present Value Method

31 Discounted Cash Flow: Net Present Value Method

32 Discounted Cash Flow: Net Present Value Method

33 Discounted Cash Flow: Net Present Value Method

34 Discounted Cash Flow: Net Present Value Method

35 Discounted Cash Flow: Net Present Value Method

36 Discounted Cash Flow: Net Present Value Method

37 Discounted Cash Flow: Net Present Value Method

38 Discounted Cash Flow: Net Present Value Method

39 8 Finally, brothers [and sisters], whatever is true, whatever is noble, whatever is right, whatever is pure, whatever is lovely, whatever is admirable – if anything is excellent or praise-worthy – think about such things 9 Whatever you have learned or received or heard from me, or seen in me – put it into practice. And the God of peace will be with you. Philippians 4:8-9

40 Have a great life!