2. WHY DIDN’T I THINK OF THAT? What does every baseball player need to complete the uniform? A cap. What a business opportunity for C&C Sports! Or is it?

4. CAPITAL BUDGETING IS… A systematic approach to evaluating an investment in a capital asset A process for evaluating long-range investment proposals for the purpose of allocating limited resources Different from cash budgeting because of the time horizon involved

5. WHAT ARE CAPITAL ASSETS? Equipment or facilities that provide productive services to the organization for more than one accounting period Also called depreciable assets or long-lived assets

6. WHY DO YOU INVEST? For expected future returns Return of investment Return on investment

7. RETURN OF INVESTMENT VS. RETURN ON INVESTMENT Recovery of original investment Return OF investment Income for each investment period (interest or earnings) Return ON investment

8. RETURN OF INVESTMENT VS. RETURN ON INVESTMENT Suppose you buy a share of a company’s stock today at $26 and sell it in one month for $32.50 Return ON investment $6.50 Return OF investment $26.00

9. SCREENING VS. PREFERENCE DECISIONS Screening Decisions Which projects meet the hurdle rate? Which of the projects are acceptable for the organization in light of its goals? Preference Decisions Of the acceptable projects, which ones should be implemented?

10. SCREENING VS. PREFERENCE

11. IDENTIFYING PROJECT CASH FLOWS Cash receipts Additional sales revenue Salvage value of equipment Cost savings Cash disbursements Purchase price Additional operating costs (DM, DL, MOH, SG&A) DO NOT include interest from financing the acquisition of the asset Identify when the cash flows occur

12. CASH FLOWS OF THE TOPCAP SYSTEM Cash FlowAmountTiming Cash Inflows Sales revenue (250,000 caps ×$2.50 per cap)$625,000Years 1 – 10 Cash Outflows Purchase and installation of TopCap system$ 50,265Year 0 Purchase of direct materials (250,000 caps ×$2.00 per cap)$500,000Years 1 – 10 Direct labor (3 employees×8 hours/day×$9.60/hour×5 days/week×50 weeks per year) $ 57,600Years 1 – 10 Variable overhead (250,000 caps ×$0.15 per cap)$ 37,500Years 1 – 10 Variable selling expense (250,000 caps ×$0.05 per cap)$ 12,500Years 1 – 10 Fixed expenses$ 7,000Years 1 – 10

13. FIND THE CASH Exercise 9-1 © Alexey Dudoladov/iStockphoto

14. E 9-1 SOLUTION Cash FlowTimingAmount Purchase of new equipmentYear 0($1,200,000) Salvage of old equipmentYear 0 180,000 Sales revenue (30,000 × $20)Years 1-4 600,000 Variable costs (30,000 × $12)Years 1-4 (360,000) Additional fixed costsYears 1-4 (90,000) Salvage of new equipmentYear 4 200,000

16. WHICH WOULD YOU CHOOSE? $20,000 TODAY $22,000 A YEAR FROM NOW WHY? © Kyu Oh/iStockphoto

17. WHICH WOULD YOU CHOOSE? $20,000 TODAY $22,000 A YEAR FROM NOW IT DEPENDS. © Kyu Oh/iStockphoto

18. PRESENT VALUE What would you pay today to receive $22,000 five years from now? We can calculate this amount by using what is called “discounting” based on the expected interest rate we would earn over the 5-year period PV (n,i) = Future amount × 1 (1 + i) n

19. USING A PRESENT VALUE TABLE $22,000 × 0.6209 = $13,659.80 Periods4%5%6%7%8%9%10%11%12% 10.96150.95240.94340.93460.92590.91740.90910.90090.8928 20.92460.90700.89000.87340.85730.84170.82640.81160.7972 30.88900.86380.83990.81630.79380.77220.75130.73120.7118 40.85480.82270.79210.76290.73500.70840.68300.65870.6355 50.82190.70050.74730.74380.68060.64990.62090.59350.5674

20. ANNUITIES A stream of cash flows (either receipts or disbursements) over a period of time For the TopCap System, the $625,000 additional revenue in each year would be an annuity

21. PRESENT VALUE OF AN ANNUITY What are you willing to pay today to receive $625,000 per year for the next 10 years? Can calculate the present value of each individual amount and then add them all together Or use the formula: Or use the present value of annuity table PVA (n,i) = Annual amount x 1 (1 + i) n i 1 -

22. PRESENT VALUE OF AN ANNUITY TABLE Periods4%5%6%7%8%9%10%11%12% 10.96150.95040.94340.93460.92590.91740.90910.90090.8929 21.88611.85941.83341.80801.78331.75911.73551.71251.6901 32.77512.72322.67302.62432.57712.53132.48682.44372.4018 43.62993.54603.46513.38723.31213.23973.16983.10243.0373 54.45184.32954.21244.10023.99273.88973.79073.69593.6048 65.24215.07574.91734.76654.62294.48594.35534.23054.1114 76.00215.78645.58245.38935.20645.03304.86844.71224.5638 86.73276.46326.20985.97135.74665.53485.33495.14614.9676 97.43537.10786.80176.51526.24695.99525.75905.53705.3282 108.11097.72177.36017.02366.71016.41776.14465.88925.6502 $625,000 × 6.1446 = $3,840,375

23. GIVE ME SOME PRESENTS Exercise 9-4 © Alexey Dudoladov/iStockphoto

24. E 9-4 SOLUTION Cash FlowTimingAmount 8% PV Factor Present Value Purchase of new equipmentYear 0($1,200,000)1.0000($1,200,000) Salvage of old equipmentYear 0 180,0001.0000 180,000 Sales revenueYears 1-4 600,0003.3121 1,987,260 Variable costsYears 1-4 (360,000)3.3121 (1,192,356) Additional fixed costsYears 1-4 (90,000)3.3121 (298,089) Salvage of new equipmentYear 4 200,000.7350 147,000

26. FOUR STEPS TO CALCULATE NET PRESENT VALUE (NPV) 1.Identify the amount and timing of each cash flow 2.Determine the appropriate discount rate (cost of capital, hurdle rate, etc.) 3.Calculate the present value of each cash flow 4.Calculate the NPV of the project

27. TOPCAP SYSTEM CASH FLOWS Cash FlowYear 0Years 1-10 Purchase and installation of TopCap system($50,265) Sales revenue$625,000 Purchase of direct materials($500,000) Direct labor($ 57,600) Variable overhead($ 37,500) Variable selling expense($ 12,500) Fixed expenses ($ 7,000) Annual net cash flow$(50,265)$ 10,400

28. NPV OF THE TOPCAP SYSTEM Cash FlowPresent Value PV Factor Year 0Years 1-10 Purchase and installation of TopCap system($50,265.00)1.0($50,265) Annual net cash flow 58,762.085.6502$ 10,400 Net present value$ 8,497.08

29. HOW DO YOU KNOW IF A PROJECT IS ACCEPTABLE USING NPV? NPV ValueWhat it meansProject Acceptable? > 0 Return on proposed project exceeds the discount rate YES = 0 Return on proposed project equals the discount rate YES < 0 Return on proposed project is less than the discount rate NO

30. ASSUMPTIONS OF THE NPV APPROACH Timing and amount of all cash flows are known with certainty There is no inflation Cash flows occur at the end of each year All cash inflows are reinvested at the discount rate

31. USING EXCEL TO CALCULATE NPV

32. THINGS TO REMEMBER ABOUT NPV Changing the discount rate affects NPV (How so?) Changing the timing and size of cash flows affects the NPV (How so?) NPV is a good preference ranking tool for projects designed to perform the same function The higher the risk, the higher the discount rate to use

33. INTERNAL RATE OF RETURN Use internal rate of return calculations for projects with even annual cash flows Find the PVF A using the formula below Use PVA table to find the IRR Or do trial and error NPV calculations until you get NPV = 0 PVF = Initial Investment Net Annual Cash Flow

34. IRR OF TOPCAP SYSTEM (Annual cash flow ×PVA 10,i ) – Net initial investment = $0 ($10,400×PVA 10,i ) – $50,265 = $0 PVA 10,i = PVA 10,i = 4.8332

35. IRR OF TOPCAP SYSTEM Periods6%7%8%9%10%11%12%14%16% 10.94340.93460.92590.91740.90910.90090.89290.87720.8621 21.83341.80801.78331.75911.73551.71251.69011.64671.6052 32.67302.62432.57712.53132.48682.44372.40182.32162.2459 43.46513.38723.31213.23973.16983.10243.03732.91372.7982 54.21244.10023.99273.88973.79073.69593.60483.43313.2743 64.91734.76654.62294.48594.35534.23054.11143.88873.6647 75.58245.38935.20645.03304.86844.71224.56384.28834.0386 86.20985.97135.74665.53485.33495.14614.96764.63894.3436 96.80176.51526.24695.99525.75905.53705.32824.94644.6065 107.36017.02366.71016.41776.14465.88925.65025.21614.8332

36. USING EXCEL TO CALCULATE IRR

37. USING IRR TO EVALUATE PROJECT ACCEPTABILITY IRR ValueCompared to NPVProject Acceptable? > Discount RateNPV > 0YES = Discount RateNPV = 0YES < Discount RateNPV < 0NO

38. INTERNAL RATE OF RETURN This is the rate that returns a NPV = 0 Assumes that cash flows can be reinvested at the IRR May give you different ranking from NPV calculation NPV is a magnitude return measure, IRR is a relative return measure

39. PROFITABILITY INDEX Facilitates evaluation of projects requiring different levels of investment Higher profitability index is preferred Profitability Index = Present Value of Annual Cash Flows Required Initial Investment

40. NOW YOU TRY IT… Exercise 9-9 © sellingpix/iStockphoto

41. E 9-9 SOLUTION a. Looking in the present value of an annuity table row for 14 periods, this factor is found in the 13% column. Therefore, the internal rate of return is 13%. b.Harrison should invest in the machine since the 13% internal rate of return exceeds the 12% hurdle rate. = 6.3025

43. PAYBACK PERIOD How long it will take to get back the return of investment for a particular project The amount of time it takes a project’s cash inflows to equal the original investment

44. HOW IS PAYBACK PERIOD CALCULATED For even annual cash flows For uneven annual cash flows, calculate cumulative cash flow until you reach the initial investment amount Payback Period = Initial Investment Net Annual Cash Flow

45. PAYBACK PERIOD LIMITATIONS Ignores the time value of money Ignores cash outflows after initial acquisition and cash inflows after the payback period The longer the payback period, the greater the project’s risk Best used as a screening tool rather than preference ordering tool

46. LET’S PRACTICE John Dallas has been following the mortgage interest rate movement over the last several weeks and is trying to decide if he should refinance his house. The mortgage company has estimated that the cash needed at closing on the refinancing will be $5,000. The new interest rate on the refinanced mortgage will lower John’s monthly payments by $150. What is the payback period for the refinancing? = 33.3 months

47. ACCOUNTING RATE OF RETURN This method uses net operating income, not cash flows This typically means to remember to consider depreciation expenses Also called simple rate of return or unadjusted rate of return Focus on additional net operating income generated by the project

48. ACCOUNTING RATE OF RETURN Project revenues – project operating expenses Initial investment – salvage value of old equipment

49. ACCOUNTING RATE OF RETURN LIMITATIONS Influenced by the choice of accounting methods (income differences) Ignores the time value of money Relies on accounting measures rather than cash flows Useful screening tool, but limited use for preference ranking (compared to hurdle rate)