Capital Budgeting Decisions Chapter 26

Capital Budgeting Budgeting for the acquisition of “capital assets” Capital budgeting techniques (a) Payback period (b) Accounting Rate of Return (c) Net Present Value (d) Internal Rate of Return

Capital Budgeting Outcome is uncertain. Large amounts of money involved. Investment involves long-term commitment. Decision may be difficult or impossible to reverse. Analyzing alternative long- term investments and deciding which assets to acquire or sell.

Example Casey Co. is considering an investment of $130,000 in new equipment. The new equipment is expected to last 10 years. It will have zero salvage value at the end of its useful life. The straight-line method of depreciation is used for accounting purposes. The expected annual revenues and costs of the new product that will be produced from the investment are: Sales $200,000 Cost of goods sold $145,000 Depreciation expense 13,000 Selling & Admin expense 22,000 180,000 Income before income tax $20,000 Income tax expense 7,000 Net Income $13,000

Expected annual net cash inflow Payback Period Time period required to recover the cost of the investment from the annual cash inflow produced by the investment. Amount invested Expected annual net cash inflow

Computation of Annual Cash Inflow Expected annual net cash inflow = Net income $13,000 Depreciation expense 13,000 $26,000

Cash Payback Period / 5 years $130,000 $26,000 =

Payback Period – Uneven Cash Flows Casey Co. wants to install a machine that costs $16,000 and has an 8-year useful life with zero salvage value. Annual net cash flows are:

Payback Period – Uneven Cash Flows We recover the $16,000 purchase price between years 4 and 5, about 4.2 years for the payback period. 4.2

Using the Payback Period Payback = 5 years Payback = 3 years Consider two projects, each with a 5-year life and each costing $6,000. Would you invest in Project One just because it has a shorter payback period?

Accounting Rate of Return Average annual operating income from asset Average amount invested in asset Compare accounting rate of return to company’s required minimum rate of return for investments of similar risk. The minimum return is based on the company’s cost of capital. Cost of Capital - rate of return that management expects to pay on all borrowed and equity funds.

Accounting Rate of Return Average Investment = Original Investment + Residual Value 2 For Casey, average investment = ($130,000 + $0)/ 2 = $65,000

Solution to Accounting Rate of Return Problem Average annual operating income from asset Average amount invested in asset $13,000 / $65,000 = 20%

Accounting Rate of Return The decision rule is: A project is acceptable if its rate of return is greater than management’s minimum rate of return. The higher the rate of return for a given risk, the more attractive the investment.

Discounted Cash Flows Considers both the estimated total cash inflows and the time value of money. Two methods 1) net present value 2) internal rate of return The discounted cash flows technique is generally recognized as the best conceptual approach to making capital budgeting decisions.

Net Present Value Method Find PV of future cash flows and compare with capital outlay Interest rate used = required minimum rate of return Proposal is acceptable when NPV is zero or positive. The higher the positive NPV, the more attractive the investment.

Net Present Value We will assume that Casey Co’s annual cash inflows of $26,000 are uniform over the asset’s useful life. The present value of the annual cash inflows can be computed by using the present value of an annuity of 1 for 10 periods. Assume the company requires a minimum return of 12%.

Present value of cash flows Net Present Value Cash Flow When? Type of cash flow Present value factor Present value of cash flows (130,000) Now ($130,000) NPV 26,000 Yrs 1-10 Annuity 5.650 146,900 $16,900 Analysis of the proposal: The proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive

Net Present Value When annual cash inflows are unequal, use present value of one tables.

Net Present Value Cash Flow When? Type of cash flow PV factor (130,000) Now ($130,000) 36,000 1 Lump sum .893 32,148 32,000 2 “ .797 25,504 29,000 3 .712 20,648 27,000 4 .636 17,172 26,000 5 .567 14,742 24,000 6 .507 12,168 23,000 7 .452 10,396 22,000 8 .404 8,888 21,000 9 .361 7,581 20,000 10 .322 6,440 NPV $25,687 ,,

Internal Rate of Return Interest yield of the potential investment The interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows.

Internal Rate of Return STEP 1.Compute the internal rate of return factor using this formula: Capital Investment Annual Cash Inflows $130,000 / $26,000 = 5.0

Internal Rate of Return Method STEP 2. Use the factor and the present value of an annuity of 1 table to find the internal rate of return. Locate the discount factor that is closest to 5.0 on the line for 10 periods.

Internal Rate of Return Decision Criteria The decision rule is: Accept when internal rate of return is equal to or greater than the required rate of return Reject when internal rate of return is less than required rate

Internal Rate of Return – Uneven Cash Flows If cash inflows are unequal, trial and error solution will result if present value tables are used. Use business calculators and electronic spreadsheets

Comparing Methods