Chapter 14

Capital Investments Long Term in nature covering many years Large amounts of capital Investments are not easily or quickly disposed Critical to long-term profitability Affect human resources needs and composition

Prior to sending out requests 1. Determination of dollars available for capital investments 2.Determine the cost of capital (minimum rate of return)

Cost of Capital Also called Desired Rate of Return TypeLoan $%Interest % Time Share 30, %.9 Auto20, %.2 Rental200, %2.7 Residence200, %2.2 TOTAL450,000100%6.0

Steps in choosing a proposal Step 1: Identification of capital investment needs Step 2: Formal requests for capital investments Step 3: Preliminary screening (remove those that are not appropriate for the project) Step 4: Evaluate the proposal based on Acceptance – rejection standards previously determined Step 5: Rank the proposals Step 6: Choose the best proposal (s).

Capital Investment Analysis Methods Net Present Value Internal Rate of Return Payback Period Method Simple (Acctg) Rate of Return

Terms Cash InFlows Increase in Net cash inflows Cost Savings Reduce Costs

Undiscounted Cash Inflows Rate of Return X Cash Inflows Discounted Cash Inflows Adjusted for the loss of value over time Present Value Multiplier X Cash Inflows

NET PRESENT VALUE METHOD Uses PRESENT VALUE Table Columns: % Return Rows: Number of Period Multiplier or factor is where the rate intersects the period.

Periods (Not just years) Can be Semi Annual, Quarterly, Monthly % - estimate return rate Based on the number of periods 10% for yearly 5% for seimannual 2.5% for quarterly Present Value of Cash InFlows ( How much is the money received in following years worth today)

What Present Value Table Present Value of $1 Received at the end of a period of time Uneven cash inflows Present Value of a Ordinary Annuity of $1 Received the same amount every period Even Cash Inflows

PRACTICE READING TABLE 1. What multiplier do you use if you receive $100,000 at the end of 10 years assuming a return of 7%? What is its present value?.508 $100,000 *.508 = $50, What multiplier do you use if you receive $10,000 every year for 10 years assuming a return of 7%. What is it’s present value? $10,000* = $70,240

Application Exercise 14-1 Compare discounted cash flow with undiscounted cash flow Exercise 14-9 Evaluating projects based on PV concept Is 16% reasonable?

Project Profitability Index Net Present Value of Project Investment required Helpful to decide what project to select. The higher the better Amount of cash inflow generated for each dollar of investment

Internal Rate of Return Investment Required Annual Cash inflow Rate that causes the PV of the project’s cash inflows to equal the PV of the investment How much interest you need to receive to pay it back Do not know the rate of return %. Divide Investment required by Annual Cash Inflows Gives you the multiplier factor. Go to the number of periods and find this multiplier Go to the top of the column to get the % = IRR

Excercise 14-2 Only 1 and 2

Apply NPV and IRR Exercise 14-11

Payback Method Investment Required Net Annual Cash Inflows Time it takes for the investment to pay for itself. In years. Same as IRR Use formula only if even cash inflows

Payback Period con’t Uneven cash inflows – Use following table YearInvestmentCash InflowsUnrecovered 14,0001,0003, ,000 32,0001,000 42,0001,0002, ,500 63, ,0000

Application Exercise 14-5 EVEN OR UNEVEN?

Simple Rate of Return Annual Incremental Net Income Initial Investment Not Cash Inflow Includes depreciation Annual Revenue-Annual expenses/Invest. Easier than Acctg rate of return but not accurate No present value considered

Exercise 14-6 Both Payback period and SRR Exercise 14-13

Ranking of investments Problem pg 672 Rank based on NPV (inferior to PPI) 1,2,4,3 Rank based on PPI (most dependable) 3,2,1,4 Rank based on IRR (payback) 4,3,2,1

Application of NPV Concept Problem pg 672

SRR, IRR and payback methods Problem 14-28