McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12 Planning Investments: Capital Budgeting

12-2 What are the Steps in the Capital Budgeting Process? Identify the opportunity—departments may submit requests, a unique opportunity may arise, the company may need to expand Select appropriate investments—use the net present value or other methods to discount cash flows Determine how to finance the investments—(chapter 13 and 14) Accept or reject the opportunity

12-3 Selecting Appropriate Investments Cost of Capital if often calculated as the weighted average cost of its debt and equity financing. It represents the amount of return that the assets of the company must generate to satisfy both creditors and owners. The cost of debt financing is the rate of interest the creditors receive for the use of their money, and the cost of equity financing is the rate on their investment, and if they are not satisfied, they can dispose of their holdings in the company or vote to replace the management of the company.

Cost of Capital

12-5 Calculating the amount of return Benchmark Corporation is financed with $1,000,000 of debt and $3,000,000 of shareholder’s equity. If the debt has an interest rate of 12 percent, and the shareholders demand a 16 percent rate of return, what is the cost of capital?

Exercise 1 and 2 Owner’s equity = $5,000,000 - $2,000,000 =  $3,000,000 Weighted average cost of capital =  ($2,000,000/$5,000,000 * 0.09) +  ($3,000,000/$5,000,000 * 0.16) = 13.2% (2,000,000/5,000,000 * 0.11) + (3,000,000/5,000,000 * 0.16) = 14%

Planning Purposes—compare return to the weighted average cost of capital. Return on investment is calculated as:  Profit before interest and tax/asset investment Benchmark plans to invest $700,000 in assets for one year and these assets are expected to generate a profit of $98,000 before interest or taxes. This investment has an expected return of 14 percent.  98,000/700,000 = 14%

Special Notations 1.We will assume that all cash flows will occur at the end of the period. 2.We assume that compounding will occur annually. 3.We assume that all items are taxed at the same rate. Note– gains and losses are not taxed differently than revenue and expenses.

Net Present Value Analysis Next Section

12-10 What are the Steps in the Net Present Value Method of Capital Budgeting? Identify (estimate) the timing and amount of all relevant cash inflows and cash outflows Calculate the present value of the future cash flows using the company’s cost of capital as the discount rate. Compute the net present value by subtracting the initial cash outflows necessary to acquire the asset from the present value of the future cash flows. Accept or reject the proposal. If the net present value is zero or positive, the proposed investment is acceptable. If the NPV is negative, the company should reject the project.

Apple makes a decision See handout

Rationale Why does a positive NPV indicate that the rate of return is greater than the cost of capital? You have to understand step 2. If Apple invested $792,466 in an asset and received $250,000 each year for four years, it would recover its original investment and receive a 10 percent return on its investment.

Exercise 12-4 Ann=2,850, n=5, c=1, r=14, FV=0,  PV=9, The maximum amount the United Way should pay is $9, NPV=$9, – 9,000 = $  Since the NPV is positive, they should acquire the machine.

Exercise 12-5 Ann=$192,850, n=8, c=1, r=12, FV=0  PV = $958, NPV = $958, ,000 = 9.33  According to a strict NPV analysis, they should buy the machine; however, since the positive number is so small, they should consider how likely the cash flows might be lower than forecasted.

12-15 What are the Sources of Cash Inflows? Cash receipts from using the asset (net of tax) Decrease in working capital requirements Sale of old assets (net of tax) Sale of new assets at the end of the project (net of tax) Tax savings due to tax shield

12-16 What are the Sources of Cash Outflows? Increase in working capital requirements Cash expenditures from using the asset (net of tax)

12-17 What Costs are Included in the Initial Investment Amount? All costs necessary to obtain and get the asset ready for its intended use. Cost of the asset itself Cost to receive the asset (freight, etc.) Cost to setup the asset (installation, etc.)

12-18 How is the NPV Determined? (Sum of the present value of cash inflows and outflows) less the initial investment