1. Capital Budgeting Decisions
November 26-27, 2015
Capital Budgeting Decisions
Chapter 11: Capital Budgeting Decisions.
The term capital budgeting is used to describe how managers plan significant cash outlays on projects that have long-term implications such as the purchase of new equipment and the introduction of new products. This chapter describes several tools that can be used by managers to help make these types of investment decisions.

2. Today’s Agenda Capital Budgeting Time Value of Money
Decision Making – Example
Simple Return and Payback Methods

3. Typical Capital Budgeting Decisions
Capital budgeting analysis is used to decide when to invest in capital (typically hard assets).
Investment is tested against return requirements, or alternative investments
Plant expansion
Equipment selection
Equipment replacement
Capital budgeting analysis can be used for any decision that involves an outlay now in order to obtain some future return. Typical capital budgeting decisions include:
Cost reduction decisions. Should new equipment be purchased to reduce costs?
Expansion decisions. Should a new plant or warehouse be purchased to increase capacity and sales?
Equipment selection decisions. Which of several available machines should be purchased?
Lease or buy decisions. Should new equipment be leased or purchased?
Equipment replacement decisions. Should old equipment be replaced now or later?
Lease or buy
Cost reduction

4. Typical Capital Budgeting Decisions
Capital budgeting tends to fall into two broad categories.
Screening decisions. Does a proposed project meet some preset standard of acceptance?
Preference decisions. Selecting from among several competing courses of action.
There are two main types of capital budgeting decisions:
Screening decisions relate to whether a proposed project passes a preset hurdle. For example, a company may have a policy of accepting projects only if they promise a return of 20% on the investment.
Preference decisions relate to selecting among several competing courses of action. For example, a company may be considering several different machines to replace an existing machine on the assembly line.

5. A dollar today is worth more than a dollar a year from now.
Time Value of Money
A dollar today is worth more than a dollar a year from now.
Therefore, projects that promise earlier returns are preferable to those that promise later returns.
The time value of money concept recognizes that a dollar today is worth more than a dollar a year from now. Therefore, projects that promise earlier returns are preferable to those that promise later returns.

6. Time Value of Money
Analysis of whether to invest capital requires the expectation of long term returns
Therefore we need to identify the cash flows associated with the investment over years
Time Value of Money methodologies are required to
Compare one investment against an alternative
See if an investment meets return requirements

7. Time Value of Money Time Value of Money
Money now is worth more than money in the future
How much more is determined by the discount rate
Discounted Cash Flows
The stating of cash inflows and outflows over time and discounted to a given point in time
Internal Rate of Return (IRR)
The discount rate that results from discounting the cash flows
Net Present Value (NPV)
Yields an absolute value after DCF of cash flows at a discount rate
The capital budgeting techniques that best recognize the time value of money are those that involve discounted cash flows. The concepts of discounting cash flows and using present value tables are explained in greater detail in Appendix 12A.

8. Time Value of Money
Note: Focus is on Cash Flows, not accounting income. Why?
Accounting Net Income is based on accruals
Accruals ignore the timing of cash flows into and out of an organization
Examples?
Accounts Receivable – recognized as income, but cash not yet received
Payroll Payable – expensed on income statement, but cash not yet paid to employees
The capital budgeting techniques that best recognize the time value of money are those that involve discounted cash flows. The concepts of discounting cash flows and using present value tables are explained in greater detail in Appendix 12A.

9. The Net Present Value Method
To determine net present value we . . .
Calculate the present value of cash inflows,
Calculate the present value of cash outflows,
Subtract the present value of the outflows from the present value of the inflows.
The net present value method compares the present value of a project’s cash inflows with the present value of its cash outflows. The difference between these two streams of cash flows is called the net present value.

10. Typical Cash Flows Inflows Incremental revenue
Cash from disposal of assets
Reductions in working capital
Incremental cost reduction
Outflows
Initial and on-going capital investment
Incremental operating costs
Increases in working capital

11. The Net Present Value Method
The net present value is interpreted as follows:
If the net present value is positive, then the project is acceptable.
If the net present value is zero, then the project is acceptable.
If the net present value is negative, then the project is not acceptable.
The outcome is dependent upon the selected Discount Rate

12. Choosing a Discount Rate
The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds.
The firm’s cost of capital is usually regarded as the minimum required rate of return.
A company’s cost of capital, which is defined as the average rate of return a company must pay to its long-term creditors and shareholders for the use of their funds, is usually regarded as the minimum required rate of return. When the cost of capital is used as the discount rate, it serves as a screening device in net present value analysis.

13. Two Simplifying Assumptions
Two simplifying assumptions are usually made in net present value analysis:
More complex models can be built; eg, periods can be shrunk to quarterly, monthly, etc. to increase accuracy.
All cash flows other than the initial investment occur at the end of periods.
All cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate.
Two simplifying assumptions are usually made in net present value analysis:
The first assumption is that all cash flows other than the initial investment occur at the end of periods.
The second assumption is that all cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate.

14. Net Present Value Method
The net present value of one project cannot be directly compared to the net present value of another project unless the investments are equal.
The net present value of one project cannot be directly compared to the net present value of another project, unless the investments are equal.

15. Preference Decision – The Ranking of Investment Projects
Screening Decisions
Preference Decisions
Pertain to whether or not some proposed investment is acceptable; these decisions come first.
Attempt to rank acceptable alternatives from the most to least appealing.
Recall that when considering investment opportunities, managers must make two types of decisions – screening decisions and preference decisions.
Screening decisions, which come first, pertain to whether or not some proposed investment is acceptable.
Preference decisions, which come after screening decisions, attempt to rank acceptable alternatives from the most to least appealing.
Preference decisions need to be made because the number of acceptable investment alternatives usually exceeds the amount of available funds.

16. NPV - Example Capital Budget Decision -
Should May Company buy new or refurbish old jet fleet
New jets cost $30m, training will cost $2m, but they only require $1m/yr to maintain and $4m/yr to operate. Also, May can charge $3m/yr extra to customers
Refurbishing the old fleet would cost $10m, but maintenance would still be $3m/yr and operating costs $5m/yr
At the end of 5 years, the new jets would be worth $10m and the refurbished jets, $2m
What should May Co do?

17. NPV - Example

18. NPV – Evaluation of Alternatives Approach

19. Ranking Investment Projects
Profitability Net present value of the project index Investment required =
In the case of unequal investments, a profitability index can be computed as the net present value of the project divided by the investment required. Notice three things:
The profitability indexes for investments A and B are 0.01 and 0.20, respectively.
The higher the profitability index, the more desirable the project. Therefore, investment B is more desirable than investment A.
In this type of situation, the constrained resource is the limited funds available for investment, so the profitability index is similar to the contribution margin per unit of the constrained resource, as discussed in Chapter 11.
The higher the profitability index, the
more desirable the project. Therefore, investment B is
more desirable than investment A.
Another name for Return on Investment (ROI)

20. IRR Test – Evaluation of Alternatives

21. Decision Time What should May Co do?
NPV’s are not comparable if investments are not equivalent
All other factors being equal (including investment amount), May Co might refurbish the old planes
Achieves maximum profitability
However, all other factors are never equal
Potentially, market value may be maximized by employing more capital at 78% IRR than less at 127%

22. Decision Time
The ultimate decision requires knowledge of the following:
Is capital constrained? Can the company actually raise further capital at 20%?
What other alternative investments can the company deploy capital into, and at what rate of return.
If the company has the money, and the second best IRR is below 78%, then profit is maximized by making the new investment.

23. Net Present Value Method
The net present value of one project cannot be directly compared to the net present value of another project unless the investments are equal.
The net present value of one project cannot be directly compared to the net present value of another project, unless the investments are equal.

24. Simple Rate of Return Method
Does not focus on cash flows -- rather it focuses on accounting net operating income.
The following formula is used to calculate the simple rate of return:
Simple rate
of return =
Annual Incremental Net Operating Income
Initial investment*
The simple rate of return method (also known as the accounting rate of return or the unadjusted rate of return) does not focus on cash flows, rather it focuses on accounting net operating income.
The equation for computing the simple rate of return is as shown.
*Should be reduced by any salvage from the sale of the old equipment

25. The Payback Method
The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates.
When the net annual cash inflow is the same each year, this formula can be used to compute the payback period:
The payback method focuses on the payback period, which is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates.
When the net annual cash inflow is the same every year, the formula for computing the payback period is the investment required divided by the net annual cash inflow.
Payback period =
Investment required
Net annual cash inflow

26. Postaudit of Investment Projects
A postaudit is a follow-up after the project has been completed to see whether or not expected results were actually realized.
A postaudit is a follow-up after the project has been completed to see whether or not expected results were actually realized.
The data used in a postaudit analysis should be actual observed data rather than estimated data.

27. Tutorial Assignment Review Build versus Buy Decisions
Study Review Problems
Interim Progress Reports on Group Projects
Tutorial session on Group Projects
Bring laptops and financial statements

28. The Mathematics of Interest
Assume a bank pays 8% interest on a $100 deposit made today. How much will the $100 be worth in one year?
Fn = P(1 + r)n
Assume a bank pays 8 percent interest on a $100 deposit made today.
How much will the $100 be worth in one year?
The equation needed to answer this question is as shown, where:
Fn = the balance at the end of n periods, in our case n is equal to 1.
P = the amount invested now.
r = the rate of interest per period, in our case the interest rate is 8%.

29. The Mathematics of Interest
Assume a bank pays 8% interest on a $100 deposit made today. How much will the $100 be worth in one year?
Fn = P(1 + r)n
F1 = $100( )1
F1 = $108.00
Solving this equation, the answer is $108.
The $100 outlay is called the present value of the $108 amount to be received in one year. It is also known as the discounted value of the future $108 amount.

30. Fn = P(1 + r)n Compound Interest
What if the $108 was left in the bank for a second year? How much would the original $100 be worth at the end of the second year?
Fn = P(1 + r)n
What if the $108 were left in the bank for a second year? How much would the original $100 be worth at the end of the second year?
The equation needed to answer this question is as shown, where:
Fn = the balance at the end of n periods.
P = the amount invested now.
r = the rate of interest per period, in our case the interest rate is 8%.
n = the number of periods, in our case n is equal to 2.

31. F2 = $100(1 + .08)2 F2 = $116.64 Compound Interest
The interest that is paid in the second year on the interest earned in the first year is known as compound interest.
Solving this equation, the answer is $
The interest that is paid in the second year on the interest earned in the first year is known as compound interest.

32. Computation of Present Value
An investment can be viewed in two ways—its future value or its present value.
Present Value
Future Value
An investment can be viewed in two ways – its future value or its present value. In the example just completed, the present value was known and the future value was the unknown that we computed. Let’s look at the opposite situation, where the future value is known and the present value is the unknown amount that we must compute.
Let’s look at a situation where the future value is known and the present value is the unknown.

33. Present Value
If a bond will pay $100 in two years, what is the present value of the $100 if an investor can earn a return of 12% on investments?
(1 + r)n
P = Fn
Assume a bond will pay $100 in two years. If an investor can earn 12 percent on his or her investment, what is the present value of the bond?
The equation needed to answer this question is as shown, where:
F = the ending balance.
P = the amount invested now.
r = the rate of interest per period.
n = the number of periods.

34. $100 P = (1 + .12)2 P = $79.72 Present Value
This process is called discounting. We have discounted the $100 to its present value of $ The interest rate used to find the present value is called the discount rate.
Solving this equation, P is $79.72.
This process is called discounting. We have discounted the $100 to its present value of $ The interest rate used to find the present value is called the discount rate.

35. Present Value
Let’s verify that if we put $79.72 in the bank today at 12% interest that it would grow to $100 at the end of two years.
We can verify, as shown on the slide, that if we put $79.72 in the bank today at 12 percent interest, it would grow to $100 at the end of two years.
If $79.72 is put in the bank today and earns 12%, it will be worth $100 in two years.

36. Present Value – An Example
$100 × = $79.72 present value (rounded)
Present value factor of $1 for 2 periods at 12%.
We can also use the present value of $1.00 table from Appendix 12B-1 to verify the accuracy of the $79.72 figure.
An excerpt of the appropriate table is as shown.
The appropriate present value factor is and the present value is $79.72 (rounded).

37. Quick Check 
How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%?
a. $62.10
b. $56.70
c. $90.90
d. $51.90
How much would you have to put in the bank today to have $100 at the end of 5 years if the interest rate is 10 percent?

38. $100  0.621 = $62.10 Quick Check  a. $62.10 b. $56.70 c. $90.90
How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%?
a. $62.10
b. $56.70
c. $90.90
d. $51.90
$100  = $62.10
The answer is $ Take a minute to review the solution provided.

39. Present Value of a Series of Cash Flows
An investment that involves a series of identical cash flows at the end of each year is called an annuity. 1 2 3 4 5 6
$100
Although some investments involve a single sum to be received (or paid) at a single point in the future, other investments involve a series of identical cash flows known as an annuity.

40. Present Value of a Series of Cash Flows
Lacey Inc. purchased a tract of land on which a $60,000 payment will be due each year for the next five years. What is the present value of this stream of cash payments when the discount rate is 12%?
Assume Lacey Inc. purchased a tract of land on which a $60,000 payment will be due each year for the next 5 years.
What is the present value of this stream of cash payments when the discount rate is 12 percent?

41. Present Value of a Series of Cash Flows
We could solve the problem like this . . .
Appendix 12B-2 contains a present value of an annuity of $1.00 table.
An excerpt from this table is as shown.
The appropriate present value factor is The present value is $216,300.
$60,000 × = $216,300

42. Quick Check 
If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years?
a. $34.33
b. $500.00
c. $343.30
d. $360.50
If the interest rate is 14 percent, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years?

43. Quick Check  $100  3.433 = $343.30 a. $34.33 b. $500.00 c. $343.30
If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years?
a. $34.33
b. $500.00
c. $343.30
d. $360.50
The answer is $ Take a minute to review the solution provided.
$100  = $343.30

44. Quick Check 
If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years?
a. $866.90
b. $178.60
c. $
d. $300.00
If the interest rate is 14 percent, what is the present value of $100 to be received at the end of the third, fourth, and fifth years?

45. Quick Check 
If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years?
a. $866.90
b. $178.60
c. $
d. $300.00
The answer is $ Take a minute to review the solution provided.
$100  ( ) = $100  = $178.60 or
$100  ( ) = $100  = $178.60