PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 11 Capital Budgeting

11- 3 Capital Budgeting Process Capital budgeting is a decision-making approach aimed at helping managers make decisions about investments in major capital assets, such as new facilities, equipment, new products, and research and development projects. Plant expansion Equipment selection Equipment replacement Lease or buy Cost reduction

11- 4 Capital Budgeting Methods

11- 5 Accounting Rate of Return Accounting Rate of Return Annual Net Income Initial Investment ÷ = 10.8%$108,000$1,000,000 ÷ =

11- 6 Payback Period Initial Investment Annual Net Cash Flow ÷ = Net Income + Depreciation 3.25 years$1,000,000$308,000 ÷ = $108,000 + $200,000

11- 7 Time Value of Money One dollar received today is worth more than one dollar received a year from now because the dollar can be invested to earn interest.

11- 8 Time Value of Money Discounting is exactly the opposite of compounding. Just as interest builds up over time through compounding, discounting involves backing out the interest to determine the equivalent value in today’s present value dollars.

11- 9 The net present value (NPV) method compares the present value (PV) of a project’s future cash inflows to the PV of the cash outflows. The reason is that accounting net income is based on accruals that ignore the timing of cash flows into and out of an organization. Net Present Value (NPV)

 Chose a discount rate – the minimum required rate of return.  Calculate the present value of cash inflows.  Calculate the present value of cash outflows. NPV =  –  Net Present Value (NPV)

Net Present Value (NPV) Relationship Between NPV and the Required Rate of Return

Internal Rate of Return (IRR) Present value of cash inflows Present value of cash outflows =   The net present value equal zero. The internal rate of return is the interest rate that makes...

Internal Rate of Return (IRR)

Profitability Index The profitability index is the ratio of a project’s benefits (measured by the present value of the future cash flows) to its costs (or required investment). Profitability Index > 1 = Project Acceptable Profitability Index < 1 = Project Unacceptable

Comparing Capital Budgeting Methods

Profitability Index Present Value of Future Cash flows Initial Investment ÷ = The profitability index is used to prioritize capital investment projects. When using the profitability index to prioritize projects, the preference rule is: the higher the profitability index, the more desirable the project. Prioritizing Independent Projects

Time Value of Money Future Value of a Single Payment Present Value of a Single Payment Future Value of an Annuity Present Value of an Annuity Present and future value problems may involve two types of cash flow: a single payment or an annuity (a fancy word for a series of equal cash payments)

Future Value of a Single Amount To solve a future value problem, you need to know three things: 1.Amount to be invested. 2.Interest rate (i) the amount will earn. 3.Number of periods (n) in which the amount will earn interest. Using Table 11.1A.: $1,000 × = $1,331

Present Value of a Single Amount The present value of a single amount is the value to you today of receiving some amount of money in the future. To compute the present value of an amount to be received in the future, we must discount (a procedure that is the opposite of compounding) at i interest rate for n periods. Using Table 11.2A.: $1,000 × = $ Assume that today is January 1, 2013, and you have the opportunity to receive $1,000 cash on December 31, 2015 (three years from today). At an interest rate of 10 percent per year, how much is the $1,000 payment worth to you on January 1, 2013 (today)? You could discount the amount year by year, but it is easier to use Table 11.2A, Present Value of $1.

Future Value of an Annuity The future value of an annuity includes compound interest on each payment from the date of payment to the end of the term of the annuity. Each new payment accumulates less interest than prior payments because the number of periods in which to accumulate interest decreases. Using Table 11.3A.: $1,000 × = $3,310 Assume that each year for three years, you deposit $1,000 cash into a savings account that earns 10 percent interest per year. You make the first $1,000 deposit on December 31, 2013, the second one on December 31, 2014, and the third and last one on December 31, To calculate the future value of this annuity, use Table 11.3A, Future Value of an Annuity of $1.

Present Value of an Annuity The present value of an annuity is the value now of a series of equal amounts to be received (or paid out) for some specified number of periods in the future. Using Table 11.4A.: $1,000 × = $2,487 (rounded) Assume you are to receive $1,000 cash on each December 31 for three years: 2013, 2014, and How much would the sum of these three $1,000 future amounts be worth on January 1, 2013, assuming an interest rate of 10 percent per year? To calculate the present value of this annuity, use Table 11.4A, Present Value of an Annuity of $1.

End of Chapter 11