Copyright © 2003 Pearson Education Canada Inc. Slide Chapter 21 Capital Budgeting and Cost Analysis

Copyright © 2003 Pearson Education Canada Inc. Slide Capital Budgeting Long-term planning for making and financing acquisitions Six stages of Capital Budgeting 1.identify potential investments 2.explore alternative investments 3.consider costs and consequences of alternatives 4.choose projects for implementation 5.obtain necessary funding 6.put project in motion and monitor performance Pages

Copyright © 2003 Pearson Education Canada Inc. Slide Discounted Cash Flow Methods Discounted cash flow (DCF) measures cash inflows and outflows of a project as if they occurred at a single point in time Focuses on cash inflows and outflows rather than net income Common methods are net present value (NPV) and internal rate of return (IRR) Net present value (NPV) Discount all expected future cash flows to the present using a minimum desired rate of return Accept project if NPV > 0 Internal rate of return (IRR) Determine the rate of return which will result in a NPV of zero Accept project if IRR > minimum desired rate of return Pages

Copyright © 2003 Pearson Education Canada Inc. Slide Using the Annuity Tables Net initial investment($379,100) Recurring cash flows($100,000 x 3.993)399,300 Net present value$20,200 Net Present Value Cash flows: annual savings.926$92,600$100, ,700$100, ,400$100, ,500$100, ,100$100,000 Present value of future inflows$399,300 Initial outlay1.000(379,100)(379,100) Net present value$20,200 PresentTotalEnd of Year Cash Flows Value of Present 8%Value Page 781

Copyright © 2003 Pearson Education Canada Inc. Slide Internal Rate of Return Cash flows: annual savings.909$90,900$100, ,600$100, ,100$100, ,300$100, ,100$100,000 Present value of future inflows$379,100 Initial outlay1.000(379,100)(379,100) Net present value$ 0 PresentTotalEnd of Year Cash Flows Value of Present 10%Value Using the Annuity Tables Net initial investment($379,100) Recurring cash flows($100,000 x 3.791)379,100 Net present value$ 0 Page 783

Copyright © 2003 Pearson Education Canada Inc. Slide Comparing NPV and IRR Models NPV calculates an amount in dollars rather than a percentage avoids problems inherent in comparing %s various NPVs can be added together NPV can also incorporate different required rates of return over the life of a project such as 8% for years 1-3 and 12% for years 4-5 Sensitivity Analysis in all cases, sensitivity analysis is useful to compare how the evaluation of the projects will change if the projected cash flows, timing of the cash flows, or required rates of return change Pages

Copyright © 2003 Pearson Education Canada Inc. Slide Relevant Cash Flows in DCF Analysis 1.Initial investment in capital assets and working capital 2.Current disposal price of existing capital assets 3.Recurring operating cash flows 4.Terminal disposal price of investment in capital assets and recovery of working capital Initial investment in machinery & working capital Current disposal values Terminal disposal values and recovery of working capital Recurring Operating Cash Flows Pages

Copyright © 2003 Pearson Education Canada Inc. Slide Payback Method Length of time required to recoup, in the form of cash flows from operations, the initial outlay Payback = Net initial investment time Uniform increase in annual cash flows Construct a table of cumulative cash inflows if the annual cash flows are nonuniform Problems with payback method fails to consider the "profitability" of the project ignores the time value of money ignores cash flows after the payback period Pages

Copyright © 2003 Pearson Education Canada Inc. Slide Accounting Rate-of-Return Model Annual rate of return including depreciation expenses Also known as accrual accounting rate-of-return model or the unadjusted rate-of-return model Increase in expected Accounting = average annual operating income rate of returnNet initial investment Can also use average book value of fixed assets as the denominator Major drawback is that it ignores the time value of money Pages

Copyright © 2003 Pearson Education Canada Inc. Slide Complexities in Capital Budgeting Predicting the full set of benefits and costs is a challenge and often difficult to quantify benefit of faster response time to market changes benefit of increased worker knowledge of automation Also, difficult to recognize the full time horizon of the project when benefits will occur over a long period of time when major benefits occur far in the future Use of accounting rate of return model may lead manager to reject profitable projects Pages

Copyright © 2003 Pearson Education Canada Inc. Slide Post-Investment Audits A post-investment audit compares the predictions of investment costs and outcomes made at the time a project was selected to the actual results achieved Point to areas requiring corrective action underestimation of time to implement a new project underestimation of capital investment requirements overestimation of savings from new investment Conduct the post-investment audit after the project outcomes have stabilized Capital Budgeting Promises Actual Results Achieved Pages