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

3. Long Run Decisions Capital expenditure decisions
Decisions related to investments in property, plant and equipment
Proper analysis requires taking into account the time value of money
Capital expenditure decisions affect cash flows across multiple years

4. Capital Budgeting Decisions
Investment decisions are important because they have a long run impact
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
Learning objective 1: Define capital expenditure decisions and capital budgets

5. Capital Budgeting Decision Examples
Learning objective 1: Define capital expenditure decisions and capital budgets

6. Review 1 Which of the following is not a capital expenditure decision?
Building a new factory
Purchasing a new piece of equipment
Purchasing inventory
Purchasing another company
Answer: c
Learning objective 1: Define capital expenditure decisions and capital budgets

7. Equipment Investment
Learning objective 1: Define capital expenditure decisions and capital budgets

8. Evaluating Opportunities: Time Value of Money Approaches
In evaluating an investment opportunity, a company must know
- how much cash it pays or receives
- when cash is received or paid
It is better to receive a dollar today than any time in the future
- A dollar received today can be invested and grow to more than a dollar
Learning objective 1: Define capital expenditure decisions and capital budgets

9. Evaluating Opportunities: Time Value of Money Approaches
Companies invest money today hoping to receive more money in the future
By how much must the future cash flows exceed the cost of the investment?
- Need to convert future dollars into their equivalent current , or present value
Learning objective 1: Define capital expenditure decisions and capital budgets

10. 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
Learning objective 1: Define capital expenditure decisions and capital budgets

11. Basic Time Value of Money Calculations - Example
What is the present value of $1,000 received five years from now if your required rate of return is 12%?
P = __$1,000__
( )5
= __$1,000__
= $567.43
Learning objective 1: Define capital expenditure decisions and capital budgets

12. 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
Learning objective 2: Evaluate investment opportunities using the net present value approach

13. The Net Present Value Method
Amount and time period of each cash flow
- Cash outflows are negative
- Cash inflows are positive
Only incremental cash flows are relevant to the decision
- Cash flows already incurred (sunk costs) are not relevant
Learning objective 2: Evaluate investment opportunities using the net present value approach

14. The Net Present Value Method
Required rate of return (i.e. hurdle rate)
Evaluate the investment opportunity
- If NPV = 0, the investment earns the
hurdle rate
- If NPV > 0, the investment earns
more than the hurdle rate
- If NPV < 0, the investment earns
less than the hurdle rate
Learning objective 2: Evaluate investment opportunities using the net present value approach

15. Review 2
If the net present value of a project is zero, the project is earning a return equal to:
Zero
The rate of inflation
The accounting rate of return
The required rate of return
Answer: d
Learning objective 2: Evaluate investment opportunities using the net present value approach

16. Net Present Value Approach
Learning objective 2: Evaluate investment opportunities using the net present value approach

17. 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%
Learning objective 2: Evaluate investment opportunities using the net present value approach

18. Net Present Value Example
Since the NPV > 0, the company should buy the equipment.
Learning objective 2: Evaluate investment opportunities using the net present value approach

19. Exercise 1 Four year investment opportunity - Cost $50,000
- Annual incremental cash flow $22,000
- Residual value $8,000
- Required rate of return 14%
Calculate the net present value
Learning objective 2: Evaluate investment opportunities using the net present value approach

20. Comparing Alternatives with NPV
Calculate the NPV of each alternative
and choose the alternative with the
highest NPV
Another method to evaluate alternatives:
- Calculate incremental cash flows
- Calculate NPV of incremental cash flows
Slide 9-20
Learning objective 2: Evaluate investment opportunities using the net present value approach 20

21. Comparing Alternatives with NPV
Slide 9-21
Learning objective 2: Evaluate investment opportunities using the net present value approach 21

22. The Internal Rate of Return (IRR) Method
An alternative to the NPV method
Rate of return that equates PV of future cash flows to investment outlay, i.e. NPV = 0
If IRR of potential investment is equal to or greater than IRR, the investment should be undertaken
Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

23. The Internal Rate of Return Method
Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

24. Review 3 An investment should be made if:
The IRR is equal to or greater than the required rate of return
The IRR is equal to or greater than zero
The IRR is greater than the accounting rate of return
The IRR is greater than the present value factor
Answer: a
Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

25. 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 to find closest PV factor for the same number of years
Slide 9-25
Learning objective 3: Evaluate investment opportunities using the internal rate of return approach 25

26. Internal Rate of Return Example
Investment = $100
Cash flow $60 per year for two years
PV factor = 100 / 60 = 1.667
Check PV annuity table, row 2
Closest factor is in 13% column
Slide 9-26
Learning objective 3: Evaluate investment opportunities using the internal rate of return approach 26

27. Exercise 2 Investment costs = $79,100
Returns $14,000 a year for 10 years
Required return is 18%
Calculate IRR and evaluate
PV Factor = 79,100 / 14,000 = 5.65
Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

28. Internal Rate of Return
Slide 9-28
Learning objective 3: Evaluate investment opportunities using the internal rate of return approach 28

29. Internal Rate of Return With Unequal Cash Flows
Utilized when annual cash flows are not equal amounts
- 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
Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

30. Internal Rate of Return With Unequal Cash Flows
The IRR is approximately 16%
Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

31. Use of NPV and IRR
Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

32. Considering “Soft” Benefits in Investment Decisions
NPV and IRR allow for a quantitative analysis of a situation
“Soft” benefits are difficult to quantify
“Soft” benefits include a project’s impact on:
- Future sales
- Firm’s reputation
- New production techniques
Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

33. “Soft” Benefits Slide 9-33 33
Learning objective 3: Evaluate investment opportunities using the internal rate of return approach 33

34. Calculating the Value of “Soft” Benefits
Example
A high-tech wheelchair project
-NPV of negative $80,000
-Required rate of return 15%, 10-year life
Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

35. 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
- Cost of capital is the weighted average of debt and equity financing used
Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

36. Review 4 The cost of capital is: The cost of debt financing
The cost of equity financing
The weighted average of the costs of debt and equity financing
The internal rate of return
Answer: c
Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

37. Cost of Capital Examples
Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

38. Additional Cash Flow Considerations
Both NPV and IRR consider cash inflows and outflows
Only cash inflows and outflows are discounted back to present value:
- Timing of collection of revenues
- Depreciation does not require cash outflow
Two special topics related to cash flows
- Depreciation and its effect on taxes
- Effect of inflation on cash flows
Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

39. Cash Flows, Taxes, and the Depreciation Tax Shield
Depreciation does not directly affect cash flows
Depreciation affects cash flows indirectly
- Depreciation reduces the amount of tax a company must pay
- Referred to as the depreciation tax shield
Learning objective 4: Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes

40. Example of the Depreciation Tax Shield
Slide 9-40
Learning objective 4: Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes 40

41. Cash Flows, Taxes, and the Depreciation Tax Shield
Slide 9-41
Learning objective 4: Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes 41

42. 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
- Inflation can be taken into account by
multiplying the cash flow by the expected rate
of inflation
Learning objective 4: Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes

43. Adjusting Cash Flow for Inflation
If inflation is not factored into expected cash flows, suitable projects may appear to have a negative NPV
Current rates of return already include estimates of inflation
- Cash inflows will be relatively low
- Required rate of return will be relatively high
Slide 9-43
Learning objective 4: Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes 43

44. Other Long-Run Decisions
Evaluation of decision to sponsor a golf tournament
Learning objective 5: Evaluate long-run decisions, other than investment decisions, using time value of money techniques

45. Other Long-Run Decisions
Slide 9-45
Learning objective 5: Evaluate long-run decisions, other than investment decisions, using time value of money techniques 45

46. Simplified Approaches to Capital Budgeting
Many companies use simpler approaches
- Payback period method
- Accounting rate of return
Both methods have significant limitations as compared to NPV and IRR
Learning objective 6: Use the payback period and the accounting rate of return methods to evaluate investment opportunities

47. Payback Period Method
Length of time it takes to recover the initial cost of an investment
An investment which costs $1,000 andyields cash flows of $500 per year has payback $1,000 / $500 = 2 years
- Does not consider total stream of cash
- Does not consider time value of money
Slide 9-47
Learning objective 6: Use the payback period and the accounting rate of return methods to evaluate investment opportunities 47

48. Review 5
Which of the following methods ignores the time value of money (present and future values) in its calculation?
Net present value
Internal rate of return
Payback period
External rate of return
Answer: c
Learning objective 6: Use the payback period and the accounting rate of return methods to evaluate investment opportunities

49. Exercise 3 New construction costs $55,000
Cash flows are $10,000 per year for 10 years
Calculate the payback period
Payback period = $55,000 / $10,000 =
5.5 years
Learning objective 6: Use the payback period and the accounting rate of return methods to evaluate investment opportunities

50. 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
Learning objective 6: Use the payback period and the accounting rate of return methods to evaluate investment opportunities

51. Conflict Between Performance Evaluation and Capital Budgeting
Managers may not use PV techniques for evaluating investments depending on how their performance is evaluated:
- Manager’s performance may be evaluated based on short-term outcomes
- Managers must be confident that their performance will be evaluated based on long-run profitability of the firm
Learning objective 7: Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values

52. Short-Run Accounting Profit
Learning objective 7: Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values

53. Copyright
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