CHAPTER 9 Capital Budgeting and Other Long-Run Decisions

Capital Budgeting Decisions  Capital Expenditure Decisions  Decisions involving the acquisition of long- lived assets  Capital Budgeting  Process of evaluating investment opportunities  The final list of approved projects is referred to as the capital budget

Capital Budgeting Decision Examples

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Evaluating Opportunities: Time Value of Money Approaches Time Value of Money  A dollar today is worth more than a dollar tomorrow!  Must convert future dollars into their equivalent present value

Basic Time Value of Money Calculations `Formula to convert future value to present value P = ___F___ (1 + i) n Where:P = Present Value F = Future Value i = Interest Rate (rate of return) n = Number of units of time

Basic Time Value of Money Calculations - Example What is the present value of $1,000 receive five years from now if your required rate of return is 12%? P = __$1,000__ (1 +.12) 5 = __$1,000__ = $567.43

Evaluating Opportunities: Time Value of Money Approaches Two Methods  Net Present Value Method  Internal Rate of Return Method

The Net Present Value Method Steps in the NPV Method 1.Identify the amount and time period of each cash flow associated with a potential investment 2.Identify required rate of return and calculate the present values of the cash flows 3.Evaluate the net present value

Net Present Value Approach

Net Present Value Example An auto repair shop considering the purchase of an automated paint spraying machine. The machine will last five years and the following information is available:  Each year $2,000 will be saved on wasted paint  It will reduce labor costs by $20,000 each year  It will require maintenance costs of $1,000 each year  The machine costs $70,000  The expected residual value is $5,000  The required rate of return is 12%

Net Present Value Example Since the Net Present Value is positive, the company should purchase the equipment.

Example Exercise #1 An investment that costs $50,000 will return $22,000 per year for five years. Determine the net present value of the investment if the required rate of return is 14%. Ignore taxes. Should the investment be undertaken?

Example Exercise #1 Solution Net Present Value Calculation  PV of Return (Table 2, PV of Annuity where n=5 and i = 14%) =  So, $22,000 x $75, ($50,000) x 1.000_($50,000) $25, Should it be undertaken?  Yes, NPV is positive

The Internal Rate of Return Method  IRR Method  An alternative to the net present value method  Takes into account the time value of money  Rate of return that equates the present value of future cash flows to the investment outlay

The Internal Rate of Return Method

Internal Rate of Return Example A company invests $100 to yield $60 at the end of year one and $60 at the end of year two. What rate of return equates the two-year, $60 annuity to $100?  Calculate Present Value Factor =__Initial Outlay_ Annuity Amount

Internal Rate of Return Example  Present Value Factor = $100 $60 =  Compare with PV of Annuity table for two periods  very close to  IRR is approximately 13%

Example Exercise #2 An investment that costs $79,100 will reduce operating costs by $14,000 per year for ten years. Determine the internal rate of return of the investment (ignore taxes). Should the investment be undertaken if the required rate of return is 18%?

Example Exercise #2 Solution  IRR Calculation =Initial Outlay / Annuity Amount =$79,100 / $14,000 =  PV of Annuity Identification  10 years is approximately  So, IRR = 12%  Should the project be undertaken?  No, IRR is less than required rate of return

Study Break #1 Which of the following is not a capital expenditure decision? a.Building a new factory b.Purchasing a new piece of equipment c.Purchasing a new computer system d.All are capital expenditure decisions

Study Break #1 Which of the following is not a capital expenditure decision? a.Building a new factory b.Purchasing a new piece of equipment c.Purchasing a new computer system d.All are capital expenditure decisions

Study Break #2 If the net present value of a project is zero, the project is earning a return equal to: a.Zero b.The rate of inflation c.The accounting rate of return d.The required rate of return

Study Break #2 If the net present value of a project is zero, the project is earning a return equal to: a.Zero b.The rate of inflation c.The accounting rate of return d.The required rate of return

Study Break #3 An investment should be made if: a.The IRR is equal to or greater than the required rate of return b.The IRR is equal to or greater than zero c.The IRR is greater than the accounting rate of return d.The IRR is greater than the present value factor

Study Break #3 An investment should be made if: a.The IRR is equal to or greater than the required rate of return b.The IRR is equal to or greater than zero c.The IRR is greater than the accounting rate of return d.The IRR is greater than the present value factor

Internal Rate of Return With Unequal Cash Flows  Utilized when yearly cash flows are not equal amounts  Must estimate the IRR and calculate the NPV of the project  If NPV > Zero, then IRR should be increased  If NPV < Zero, then IRR should be decreased

Internal Rate of Return With Unequal Cash Flows Example The IRR is approximately 16%

CFO use of NPV and IRR

Considering “Soft” Benefits in Investment Decisions  NPV and IRR allow for a quantitative analysis of a situation  “Soft” benefits include a project’s impact on  Future Sales  Firm’s Reputation  “Soft” benefits are difficult to quantify

Calculating the Value of “Soft” Benefits Managers should make a reasonable attempt to quantify the value of soft benefits  A high-tech wheelchair project has a NPV of negative $80,000. The finance department used a required rate of return of 15% with a 10-year life. What must be the value of the soft benefits each year?

Calculating the Value of “Soft” Benefits  This implies that as long as the soft benefits are worth at least $15,959 per year, the project should be funded

Estimating the Required Rate of Return  In previous examples the required rate of return was simply stated  In practice, management must estimate the required rate of return  Typically, the required rate of return must equal the cost of capital for the firm

Cost of Capital  Weighted average of the costs of debt and equity financing used to generate the capital for investments  Cost of Debt Financing  Interest paid to individuals, banks, or other companies that lend money to the firm  Cost of Equity Financing  Return demanded by shareholders

Cost of Capital Examples

Additional Cash Flow Considerations  Both NPV and IRR consider cash flows, but not revenues and expenses  Two Special Topics  Depreciation  Inflation

Cash Flows, Taxes, and the Depreciation Tax Shield  Depreciation indirectly affects cash flows  Depreciation reduces the amount of tax a company must pay  Referred to as the Depreciation Tax Shield

Adjusting Cash Flow for Inflation It is important to consider the rate of inflation for investment decisions  Typically, inflation is factored into the cost of capital  If inflation is not factored into expected cash flows, suitable projects may appear to have a negative NPV –The cash inflows will be relatively low, although the required rate of return will be relatively high

Other Long-Run Decisions  Decisions that affect cash flows for a number of future periods  Utilize NPV and IRR to analyze  Examples include

Simplified Approaches to Capital Budgeting  Payback Period Method  Calculating the length of time it takes to recover the initial cost of an investment; does not consider the  Time value of money  Total stream of cash flows  Accounting Rate of Return  Used to evaluate investment opportunities by comparing the accounting rates of return with a required accounting rate of return

Payback Period Method Examples  If an investment opportunity costs $1,000 and yields cash flows of $500 per year, it has a payback period of 2 years.  If an investment opportunity costs $1,000 and yields cash flows of $300 per year, it has a payback period of 3-1/3 years.

Example Exercise #3  The Sunny Valley Wheat Cooperative is considering the construction of a new silo. It will cost $55,000 to construct the silo. Determine the payback period if the expected cash inflows are $10,000 per year.

Example Exercise #3 Solution  Payback Period = $55,000 / $10,000 = 5.5 The payback period is 5.5 years

Accounting Rate of Return  Formula  Average Net Income Average Investment  Example

Conflict Between Performance Evaluation and Capital Budgeting  Managers may be discouraged from using present value techniques for evaluating investments because of the way in which their own performance is evaluated  Manager’s performance could be evaluated based on short-term outcomes  Managers who wish to maximize shareholder wealth should use present value techniques to evaluate investments

Study Break #4 Which of the following methods equates future dollars to current dollars? a.Net present value method b.Internal rate of return method c.Payback period method d.Both a and b

Study Break #4 Which of the following methods equates future dollars to current dollars? a.Net present value method b.Internal rate of return method c.Payback period method d.Both a and b

Study Break #5 The cost of capital is: a.The cost of debt financing b.The cost of equity financing c.The weighted average of the costs of debt and equity financing d.The internal rate of return

Study Break #5 The cost of capital is: a.The cost of debt financing b.The cost of equity financing c.The weighted average of the costs of debt and equity financing d.The internal rate of return

NPV and IRR

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