McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. May 31 Capital Budgeting Decisions

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Today’s Agenda Capital Budgeting Time Value of Money Decision Making – Example Simple Return and Payback Methods

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Typical Capital Budgeting Decisions Plant expansion Equipment selection Equipment replacement Lease or buy Cost reduction Capital budgeting analysis is used to decide when to invest in capital (typically hard assets). Investment is tested against return requirements, or alternatives

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Time Value of Money Analysis of whether to invest capital requires the expectation of long term returns Therefore we need to identify the cash flows associated with the investment over years Time Value of Money methodologies are required to Compare one investment against an alternative See if an investment meets return requirements

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Time Value of Money Money now is worth more than money in the future How much more is determined by the discount rate Discounted Cash Flows The stating of cash inflows and outflows over time and discounted to a given point in time Internal Rate of Return (IRR) The discount rate that results from discounting the cash flows Net Present Value (NPV) Yields an absolute value after DCF of cash flows at a discount rate Note: Focus is on Cash Flows, not accounting income. Why?

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Typical Cash Flows Inflows Incremental revenue Cash from disposal of assets Reductions in working capital Incremental cost reduction Outflows Initial and on-going capital investment Incremental operating costs Increases in working capital

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Choosing a Discount Rate The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds. The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds. The firm’s cost of capital is usually regarded as the minimum required rate of return. The firm’s cost of capital is usually regarded as the minimum required rate of return. The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds. The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds. The firm’s cost of capital is usually regarded as the minimum required rate of return. The firm’s cost of capital is usually regarded as the minimum required rate of return.

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Two simplifying assumptions are usually made in net present value analysis: end of periods All cash flows other than the initial investment occur at the end of periods. immediately reinvested All cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate. Two Simplifying Assumptions

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. NPV - Example Capital Budget Decision - Should May Company buy new or refurbish old jet fleet New jets cost $30m, training will cost $2m, but they only require $1m/yr to maintain and $4m/yr to operate. Also, May can charge $3m/yr extra to her customers Refurbishing the old fleet would cost $10m, but maintenance would still be $3m/yr and operating costs $5m/yr At the end of 5 years, the new jets would be worth $10m and the refurbished jets, $2m What should May Co do?

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. NPV - Example

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. NPV – Evaluation of Alternatives Approach

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Ranking Investment Projects Profitability Net present value of the project index Investment required = The higher the profitability index, the more desirable the project. Therefore, investment B is more desirable than investment A. The higher the profitability index, the more desirable the project. Therefore, investment B is more desirable than investment A.

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. IRR Test – Evaluation of Alternatives

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Decision Time What should May Co do? NPV’s are not comparable if investments are not equivalent All other factors being equal, May Co should refurbish the old planes Achieves maximum profitability However, all other factors are never equal Potentially, market value may be maximized by employing more capital at 78% IRR than less at 127%

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Simple Rate of Return Method accounting net operating income Does not focus on cash flows -- rather it focuses on accounting net operating income. The following formula is used to calculate the simple rate of return: Simple rate of return = Annual Incremental Net Operating Income Initial investment* * * Should be reduced by any salvage from the sale of the old equipment

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. The Payback Method The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates. When the net annual cash inflow is the same each year, this formula can be used to compute the payback period: When the net annual cash inflow is the same each year, this formula can be used to compute the payback period: The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates. When the net annual cash inflow is the same each year, this formula can be used to compute the payback period: When the net annual cash inflow is the same each year, this formula can be used to compute the payback period: Payback period = Investment required Net annual cash inflow

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Tutorial Assignment Review Build versus Buy Decisions Study Review Problems Interim Progress Reports on Group Projects Tutorial session on Group Projects Bring laptops and financial statements

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. A dollar received today is worth more than a dollar received a year from now because you can put it in the bank today and have more than a dollar a year from now. The Mathematics of Interest

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Assume a bank pays 8% interest on a $100 deposit made today. How much will the $100 be worth in one year? F n = P(1 + r) n The Mathematics of Interest

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Assume a bank pays 8% interest on a $100 deposit made today. How much will the $100 be worth in one year? F n = P(1 + r) n F 1 = $100(1 +.08) 1 F 1 = $ The Mathematics of Interest

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Compound Interest F n = P(1 + r) n What if the $108 was left in the bank for a second year? How much would the original $100 be worth at the end of the second year?

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Compound Interest The interest that is paid in the second year on the interest earned in the first year is known as compound interest. F 2 = $100(1 +.08) 2 F 2 = $116.64

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Present Value Future Value An investment can be viewed in two ways—its future value or its present value. Let’s look at a situation where the future value is known and the present value is the unknown. Computation of Present Value

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Present Value If a bond will pay $100 in two years, what is the present value of the $100 if an investor can earn a return of 12% on investments? (1 + r) n P = FnFnFnFn

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Present Value This process is called discounting. We have discounted the $100 to its present value of $ The interest rate used to find the present value is called the discount rate. (1 +.12) 2 P = $100 $79.72

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Present Value Let’s verify that if we put $79.72 in the bank today at 12% interest that it would grow to $100 at the end of two years. Let’s verify that if we put $79.72 in the bank today at 12% interest that it would grow to $100 at the end of two years. If $79.72 is put in the bank today and earns 12%, it will be worth $100 in two years.

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. $100 × = $79.72 present value (rounded) Present value factor of $1 for 2 periods at 12%. Present Value – An Example

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Quick Check How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62.10 b. $56.70 c. $90.90 d. $51.90 How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62.10 b. $56.70 c. $90.90 d. $51.90

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62.10 b. $56.70 c. $90.90 d. $51.90 How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62.10 b. $56.70 c. $90.90 d. $51.90 Quick Check $100  = $62.10

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved $100$100$100$100$100$100 Present Value of a Series of Cash Flows annuity An investment that involves a series of identical cash flows at the end of each year is called an annuity.

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Present Value of a Series of Cash Flows Lacey Inc. purchased a tract of land on which a $60,000 payment will be due each year for the next five years. What is the present value of this stream of cash payments when the discount rate is 12%?

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Present Value of a Series of Cash Flows We could solve the problem like this... $60,000 × = $216,300

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Quick Check If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? a. $34.33 b. $ c. $ d. $ If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? a. $34.33 b. $ c. $ d. $360.50

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? a. $34.33 b. $ c. $ d. $ If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? a. $34.33 b. $ c. $ d. $ Quick Check $100  = $343.30

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Quick Check If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? a. $ b. $ c. $ d. $ If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? a. $ b. $ c. $ d. $300.00

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? a. $ b. $ c. $ d. $ If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? a. $ b. $ c. $ d. $ Quick Check $100  ( ) = $100  = $ or $100  ( ) = $100  = $178.60