Chapter 10 Adelman & Marks Capital budgeting Chapter 10 Adelman & Marks

Key terms Capital budgeting Capital goods The method used to justify the acquisition of capital goods Capital goods Assets that have a useful life greater than 1 year

Why capital budgeting? A company should make the decision to enter into a specific project, acquire another company, or purchase a specific long-term asset if the present value of the benefits exceeds the the present value of the costs. Remember that assets are tools your business uses to help generate revenues Example: Capital budgeting helps a business to make the most profitable decisions regarding purchase of delivery vehicles.

Factors Affecting Capital Budgeting Changes in regulations (CFC banned in air conditioning) Research and Development investments (half of all new products fail) Changes in business strategy (when economy changes or opportunities/threats arise

Five Steps in Capital Budgeting Write a proposal that identifies projected costs and benefits Evaluate the data with respect to expected benefits and costs Make a decision that provides greatest value while minimizing costs Follow up on decision through post-audit to compare costs to benefits Take corrective action if post-audit indicates benefits are not meeting expectations

Costs in capital budgeting Start-up costs – total $ spent to start a project (equipment, training costs, maintenance, service agreements, hiring new people, storage space, etc) Working capital costs – cash, investments, A/R, and inventory to show bank you can make monthly payments ($ is legally committed to lender, so it’s an opportunity cost) Tax factor costs – additional taxes that have to be paid

Benefits in capital budgeting Investments in capital equipment should increase cash flows Capital equipment investments can be written off and provide reduced tax liability MACRS! (see MACRS worksheet)

Techniques Payback Net present value (NPV) Profitability index (PI) Internal rate of return (IRR) Accounting rate of return (ARR) Lowest total cost (LTC)

Payback # of years it takes to get back the money it invested in project or asset Payback = C / ATB C = cost of project ATB = annual after-tax benefit of project Example – invest in $25,000 project that creates $3,000 in ATB Payback occurs in $25,000/$3,000 = 8.33 yrs

Net present value Uses time value of $ by discounting future costs and benefits to present Combines: PV of stream of payments for even cash flows and PV of future lump sum of unequal yearly cash flows Important considerations – (1) interest rate of lender and (2) interest rate you could make by investing in some other project or asset

Weighted Average Cost of Capital Multiplies cost of debt by its proportion of total funds raised and multiplies cost of equity (opportunity cost to owner) by its proportion of total funds raised Key terms: Real rate of return (return received after factoring out inflation) Inflation premium (expected average inflation for term of investment) Risk premium (rate added to interest rate to account for risk of investment) (see Techniques)

Getting to NPV NPV = PVB - PVC NPV is net present value of investment PVB is present value of the benefit PVC is present value of the cost of the investment If NPV is negative, do not make the investment (see example)

Profitability Index PI = PVB / PVC From example: $170,394/$100,000 = 1.70 This project returns $1.70 for every $1 invested

Accounting rate of return ARR = (average annual income)/(average cost of investment over its life) Does not incorporate time value of $ Example: spend $10,000 on software that will help you earn $3,000/yr for 4 yrs ARR = $3,000/$10,000 = 30%

Lowest total cost Include all costs associated with two or more competing investments Calculate PVs of these costs Add the present value of any residual benefits (salvage value) that investment can provide Select investment with lowest total cost

Recommendations Use NPV for new projects or assets For existing operations (replacing equipment and service contracts) use LTC