1. Prepared by Debby Bloom-Hill CMA, CFM

2. Other Long-Run Decisions
CHAPTER 9
Capital Budgeting
and
Other Long-Run Decisions

3. Capital Budgeting Decisions
Most firms carefully analyze the potential projects in which they may invest.
The process of evaluating the investment opportunities is referred to as capital budgeting.
The final list of approved projects is referred to as the capital budget.

4. The Time Value of Money
In evaluating an investment opportunity, a company must not only know how much but also when cash is received or paid.
Time value of money recognizes that it is better to receive a dollar today than in the future.
This is because a dollar received today can be invested so that it amounts to more than a dollar.

5. Evaluating Opportunities: Time Value of Money Approaches
Companies invest money today hoping to receive more money in the future.
Money in the future is not equivalent to money today.
A company needs to convert future dollars into their equivalent current, or present value.

6. Basic Time Value of Money Calculations
Formula to convert future value to present value
𝐏= 𝐅 (𝟏+𝒓) 𝒏
Where: P = Present value
F = Future amount
r = Required rate of return
n = Number of years

7. Basic Time Value of Money Calculations - Example
At an interest rate of 10%, how much is $121 received two years from now worth today?
𝑷= $𝟏𝟐𝟏 (𝟏+ .𝟏𝟎) 𝟐
𝑷= $𝟏𝟐𝟏 𝟏.𝟐𝟏 =$𝟏𝟎𝟎

8. Present Value Tables
Managers can use present value tables to look up present value factors.
Present value factors are simply calculations of
Turn to Table 1 in Appendix B of this chapter.
To find the factor for r = 12% and n = 5.
Go across the top of the table to a discount rate of 12 percent and down five rows.

9. The Net Present Value Method
The only relevant cash flows are those that are incremental.
The cash flows that will be incurred if the project is undertaken.
Cash flows that have already been incurred are sunk.
They have no bearing on a current investment decision.

10. 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. Discount the cash flows to their present values using a required rate of return.
3. Evaluate the net present value, which is the sum of the present value of all cash inflows and outflows.

11. The Net Present Value Method
Evaluate the investment opportunity.
If the NPV is zero, the investment earns the required rate of return.
The investment should be undertaken.
If the NPV is positive:
It should also be undertaken because it earns more than the required rate of return.
Investments that have a negative NPV are not accepted because they earn less than the required rate of return.

12. Net Present Value Example
An auto repair shop is considering the purchase of an automated paint spraying machine. The machine will last five years.
Following information is available:
Each year $2,000 will be saved on 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%.

13. Net Present Value Example
Since the NPV > 0, the company should buy the equipment

14. The Internal Rate of Return (IRR) Method
The internal rate of return is that rate of return that equates the present value of the future cash flows to the investment outlay:
The rate of return that makes the net present value equal to zero.
If the IRR of a potential investment is equal to or greater than the required rate of return (hurdle rate), the investment should be undertaken.

15. The Internal Rate of Return with Equal Cash Flows
Equal cash flows are called an annuity
For an annuity,
PV = PV factor x Annuity
Therefore:
Use Table B9-2 in Appendix B to find the closest PV factor for the appropriate number of years. 15

16. Internal Rate of Return Example
Investment = $100.
Cash flow $60 per year for two years.
PV factor = 100 / 60 =
Check Table B9-2 in Appendix B, row 2.
Closest factor is in 13% column. 16

17. Internal Rate of Return With Unequal Cash Flows
Utilized when annual cash flows are not equal amounts.
Use trial and error.
Must estimate IRR.
Use estimated IRR to calculate the NPV of the project.
If NPV > 0, increase estimated IRR.
If NPV < 0, decrease estimated IRR.
Recalculate until NPV is equal to or close to zero.

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

19. 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.
In some cases, the required rate of return should equal cost of capital.
The cost of capital is the weighted average of debt and equity financing used.

20. Additional Cash Flow Considerations
Both NPV and IRR consider cash inflows and outflows, not revenues and expenses.
Only cash inflows and outflows are discounted back to present value:
Must consider the timing of collection of revenues and disbursement of cash for expenses.

21. Cash Flows, Taxes, and the Depreciation Tax Shield
In the previous examples we ignored the effect of taxes on cash flow.
Tax considerations play a major role:
If a project generates taxable income, cash inflows will be reduced by taxes paid on the revenue.
If a project generates a tax deductible loss, cash inflows will be increased by the tax savings generated.
Depreciation is a tax deductible expense but does not require a cash outflow.

22. Adjusting Cash Flows for Inflation
It may be important to consider inflation when estimating the cash flows associated with investment opportunities.
Inflation can be taken into account by multiplying the current cash flows by the expected rate of inflation.

23. Adjusting Cash Flows for Inflation
If inflation is ignored in net present value analysis, worthwhile opportunities might be rejected.
Current rates of return for debt and equity financing already include estimates of future inflation.
Cash flows will be low relative to the required rates of return.

24. Simplified Approaches to Capital Budgeting
Many companies continue to use simpler approaches.
Two of these are:
Payback period method.
Accounting rate of return.
Both methods have significant limitations in comparison to NPV and IRR.

25. Payback Period Method
The payback period is the length of time it takes to recover the initial cost of an investment.
An investment which costs $1,000 and yields cash flows of $500 per year has a payback period of 2 years ($1,000 / $500).
If an investment costs $1,000 and yields cash flows of $300 per year it has a payback period of 3 1/3 years. 25

26. Payback Period Method
One approach is to accept projects that have a payback period less than some specified requirement.
This method can lead to poor decisions:
It only considers the stream of cash flows up until the investment is repaid.
It does not consider the time value of money. 26

27. Accounting Rate of Return (ARR)
Accounting Rate of Return Formula:
ARR = Average Net Income
Average Investment
Average investment is the initial investment divided by 2.
Can lead to poor decisions:
Ignores the time value of money.
Based on revenues and expenses, not cash flows.

28. Conflict Between Performance Evaluation and Capital Budgeting
Managers may be discouraged from using PV techniques for evaluating investments depending on how their performance is evaluated.
An investment may have high depreciation in the early years, or revenue may be low.
Managers need to be assured that if they approve projects with long run positive NPV their compensation will take the expected benefits into account.

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