C H A P T E R 4 Capital Investment Decisions Capital Investment Decisions

Learning Objective 1 Understand the importance of capital budgeting and the concepts underlying strategic and capital investment decisions.

Define Capital Budgeting and Capital Capital Budgeting Capital

Capital Investment Decisions What three aspects of capital investment decisions are critical to long-run profitability?

Capital Budgeting Analysis Requires What Two Processes? Screening Ranking

What is the Time Value of Money?

Example: Discounting Cash Flows Project A $90,910 $100,000 Year 1 Discounted at 10% Year 1Year 2 $50,000 $41,320 45,455 $86,775 Discounted at 10% per year Discounted value at beginning of Year 1 Project B Discounted value at beginning of Year 1 Discounted at 10%

What are Cash Outflows? Investment opportunity Cash outflows

Example: Cash Outflows Cash PV PV of Cash OutflowsFactorOutflows Initial cash outlay $20, $20,000 Future cash outlay , ,151 Total present value of cash outflows $23,151

Example: Internal Rate of Return Method George’s Power Tools wants to purchase a wood lathe for $5,000. The machine will save $1,200 a year for the next 5 years. Determine the internal rate of return. Remember the 3 steps: 1. Calculate the present value factor by dividing the investment cost by annual net cash inflows. 2. Using applicable present value tables and the life of the investment, find the present value factor closest to the number derived in step Using interpolation, if necessary, find the exact internal rate of return represented by the present value factor in step Calculate the present value factor by dividing the investment cost by annual net cash inflows. 2. Using applicable present value tables and the life of the investment, find the present value factor closest to the number derived in step Using interpolation, if necessary, find the exact internal rate of return represented by the present value factor in step 1.

Example: Internal Rate of Return Method Present value factor = Investment cost Annual net cash inflows $5,000 $1,200 = : Steps =

Example: Internal Rate of Return Method Present value factor= Steps 1: Using the table, we find the yield for the machine is between 6 and 7 percent. 4% 5% 6% 7% 8% :

Example: Internal Rate of Return Method Steps Present value factor= : : 3: Find the exact rate of return. Rate Present Value Factors High factor 6% True factor Low factor 7% Difference 1% Internal rate of return x = =

What are Cash Inflows? Investment opportunity Cash outflows Cash inflows

Example: Cash Inflows Cash PV PV of Cash Inflows FactorInflows Revenues $3, $23,148 Salvage value , ,928 Total present value of cash inflows $25,076

Learning Objective 2 Describe and use two non-discounted capital budgeting techniques: the payback method and the unadjusted rate of return method.

Capital Budgeting Techniques Non-discounted capital budgeting techniques do not take into account the time value of money. What are two common techniques?

Define Payback Method and Provide the Formula

Example: Payback Method John wants to determine the payback period for an investment with an initial cost of $2,500. He estimates the net cash flows from the investment to be $800 per year. Estimate the payback period.

Define Unadjusted Rate of Return and Provide the Formula

Example: Unadjusted Rate of Return Method Paul’s new investment is estimated to increase net income by $25,000 each year. The initial investment is $150,000. Determine the unadjusted rate of return.

Learning Objective 3 Describe and use two discounted capital budgeting techniques: the net present value method and the internal rate of return method.

Define Capital Budgeting Techniques What are two common techniques?

Selecting a Discount Rate Define Cost of Capital In order to evaluate investments using discounted cash flows, a firm must first establish a cost of capital, or acceptable rate of return.

What are the Three Steps to Do the Net Present Value Method?

What is the Decision Rule for the Net Present Value Method? NPV $0

NPV $0 What is the Decision Rule for the Net Present Value Method?

George’s Power Tools wants to purchase a wood lathe for $5,000. The machine will save $1,200 a year for the next 5 years. The wood lathe can then be sold at the end of 5 years for $1,000. If the required rate of return is 12 percent, should the company invest in the new equipment? Example: Net Present Value Method PV Present Cash FlowsAmountFactor Value

What is a Least-Cost Decision?

What are the three steps? What are the three steps? Define the Internal Rate of Return Method

Internal Rate of Return The “true” discount rate that will produce a net present value of zero when applied to the cash flows of investment inventory goods held for resale. What is Interpolation? Internal Rate of Return Method

What is a Hurdle Rate?

What Is the Decision Rule for Internal Rate of Return Method? IRR Hurdle Rate

What Is the Decision Rule for Internal Rate of Return Method? IRR Hurdle Rate

Learning Objective 4 Understand the need for evaluating qualitative factors in strategic and capital investment decisions.

Qualitative Factors in Decisions u An investment’s effect on the quality of products and services offered. u An investment’s effect on the time with which products and services can be produced and delivered to customers. u Other qualitative factors: - Consumer safety - Government regulations - Pollution control and environmental protection - Worker safety - Company image and prestige - Preferences of owners and management - Community welfare

Expanded Material Learning Objective 5 Use sensitivity analysis to assess the potential effects of uncertainty in capital budgeting.

Define Sensitivity Analysis Sensitivity Analysis

Beatles Inc. wants to purchase a new belt buckle press for $9,000. The press will save $2,000 a year for the next 10 years. The press can then be sold at the end of 10 years for $1,000. Beatles Inc. has established a rate of 8 percent as the hurdle rate. Should the company invest in the new equipment? Example: Sensitivity Analysis PV Present Cash FlowsAmountFactor Value

Example: Sensitivity Analysis If expected cash flows are uncertain, what is the minimum cash flow needed to still meet the required 10 percent hurdle rate, which has a present value factor of ?

Example: Sensitivity Analysis If the expected useful life is uncertain, how long does the press need to last in order for the investment to still be acceptable? 10%

Example: Sensitivity Analysis According to the present value tables, the internal rate of return is between 18 and 20 percent. Internal Rate of Return Method Present value factor = $8,614 $2,000 = 4.307

Expanded Material Learning Objective 6 Explain how to use capital budgeting techniques in ranking capital investment projects.

What Is Capital Rationing?

Example: Capital Rationing The Ono Company needs to rank the following investment opportunities. The company requires a hurdle rate of 16 percent. Use the capital rationing techniques to determine the appropriate investments. Expected ProjectRate of Return A 16% B 13% C 22% D 18% Ranking OrderDecision

How Do You Rank by Net Present Value? Profitability index

Example: Ranking by Net Present Value The Ono Company has the following two possible investments. Rank them using a profitability index. A B Present value of cash inflows.... $6,000 $11,000 Investment cost ,000 10,000 Net present value Profitability index Rank

Expanded Material Learning Objective 7 Explain how income taxes affect capital budgeting decisions.

Income Tax Considerations Examples of income tax effects: A capital investment may allow a company to take an expense deduction for the cost of the asset and expense deductions for repairs and depreciation. The resulting income from operations and any gain on the eventual sale of an asset are affected by taxes. Such tax effects can be so significant that the net present value of the cash flows changes from positive to negative, or vice versa.

Income Tax Considerations Cash inflows and outflows of capital budgeting decisions must be converted to after-tax amounts before the present values are computed. They are converted to after-tax amounts by including such amounts as: Expense deduction for the cost of the asset. Expense deduction for repairs to the asset. Expense deduction for depreciation (MACRS). Income from operations. Gain on sale of disposal of asset.

Finished Chapter 4 Managerial Accounting