1. Chapter 3 – Opportunity Cost of Capital and Capital Budgeting
Accounting 6310
Chapter 3 – Opportunity Cost of Capital and Capital Budgeting

2. Opportunity Cost of Capital
Accounting profits do not include the time value of money
Economic profits are adjusted for the time value of money
Capital budgeting generally should involve the use of time value of money

3. Time Value of Money
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Present value Future value
Present value = current value of a sum in the future
Future value = worth of a sum in the future
Future value always > than present value due to the interest it can earn
Annuities – series of equal payments

4. Capital Budgeting Long-term commitments of large amounts of money
Stages:
Selection stage
Capital budgeting methods used
Qualitative factors considered
Financing stage
Done by treasurer
Implementation and control stage
Get projects underway
Monitor performance
Perform postinvestment audits

5. Capital Budgeting Methods
Discounted cash flows (Net present value)
Payback
Accounting rate of return
Internal rate of return

6. Capital Budgeting Methods
Discounted cash-flow methods
All cash flows included
Time value of money considered
Expects cash amount to be greater in the future than the cash invested now
Required rate of return
Minimum acceptable rate of return
Also called discount or hurdle rate

7. Discounted Cash Flow (Net Present Value) Method
1 - Using present value tables at a chosen discount rate, compute the present value of net cash flows
2 - Compare (1) to investment
3 - Value in (2) should be positive in order to consider investment further
Problems - NPV varies based on discount rate chosen; the higher the discount rate, the lower the net present value of cash flows
Theoretically best to choose the weighted average cost of capital.

8. Net Present Value NPV index: NPV/Initial investment
Allows different size projects to be compared
Highest NPV index would be chosen

9. Payback Method Time it takes to recover cash investment
Based exclusively on cash flows
Cash flows = net income + depreciation +amort.
Initial investment
Annual cash flows/savings = Payback period
Ex.: $300,000/ $100,000 = 3 years
Pros: simple, highlights liquidity
Cons: ignores time value of money, disregards cash flows after payback, may produce short-lived projects

10. Accounting Rate of Return
Average Return on project investment
Net Income/ Average investment = ROI
Average investment = (Cost + Salvage value) / 2
Ex.: $25,000/(($300, )/2)
$25,000/150,000 = 16.7%
Simple to use
Problems: Ignores time value of money

11. Internal Rate of Return
Interest rate computed such that the net present value of the investment is zero.
IRR assumes that the cash flows will be reinvested at the internal rate of return.
Often not as reliable as net present value
End product is a percentage that can be compared to minimum rate of return.
Widely used but hard to calculate if cash flows are not equal
When an annuity, you can calculate as such:
Investment/Annual cash flows = factor
Look up factor in the PV of annuity table to determine IRR.

12. Relevant Cash Flows Net initial investment Cash flows from operations
Purchase of project
Working capital changes
Salvage value of old investment (if sold)
Tax effects of sale of old investment
Cash flows from operations
Cash savings or payments after taxes
Cash flows from tax advantages of depreciation

13. Depreciation Savings
Depreciation is a non-cash expense; however depreciation expenses reduce the amount of taxes paid
Thus tax savings from depreciation is a cash flow
Example: 10,000 asset (3 yrs.), 40% tax rate
MACRS – 1- 33%, 2- 45%, 3 – 14%, 4-8%
1 – 10,000 x .33 = 3300 tax deduction yields x .40 = $1,320 cash flows from taxes

14. Relevant Cash Flows Cash flows from disposal of investment
Proceeds from sale
Tax savings (payments) from sale based on sales price – book value

15. Other Considerations Managers and goal-congruence issues
Managers may be rewarded on short-term income
Thus they may want to invest in short-term quick return assets that may not be in the best long-term interest of the company

16. Postinvestment Audit
Compares actual results for a project to the costs and benefits expected at the time the project is selected
Provides feedback about performance
Original estimates may have been overly optimistic
There may have been problems in implementing the project

17. Estimates All future cash flows/savings are based on estimates
Initial cash flows are real
Be careful with estimates

18. Analyzing Proposed New Programs
Can be proactive (take advantage of an opportunity) or reactive (reaction to perceived threat)
Opportunities emerge from several sources:
New technologies
New markets
Upgrading of equipment
New or existing regulations
Asset allocation system – set of formal routines and procedures designed to process and evaluate requests to acquire new assets or start a new program; often called capital budget plan.

19. Capital Acquisitions Managers need to define
Procedures for capital proposal
Process by which proposals will be gathered and reviewed by management
Time period for submission
Strategic acquisitions often must be approved by top managers
Investments to enhance existing operations often approved by lower-level managers

20. Capital Acquisitions Assets to meet safety/health regulatory needs
These projects often must be implemented.
Ex: Environmental protection or pollution-controls.
No need to do cost/benefit analyses or capital budgeting techniques since the projects must be implemented
Evaluation: engineering studies
Lower-level managers often can approve these projects

21. Capital Acquisitions
Assets to enhance operating efficiency and/or increase revenue
New technologies
Better equipment
New plants
Evaluation: cost/benefit, capital budgeting techniques often employed
Lower-level managers often can approve these projects up to a certain amount

22. Capital Acquisitions Assets to enhance competitive effectiveness
Funds strategy of business
Must make sure these proposals are in line with the strategy of the business
New product lines, acquire existing companies, acquire suppliers, new markets
Approval reserved for highest levels of management
Can use traditional capital budgeting techniques but must be very careful due to estimates being very uncertain

23. Additional Influencing Factors
Alignment of proposal with existing strategy
Risks in acquiring the assets/programs
Risks in deciding not to acquire the asset/programs
Quality of information supporting proposal
Track record and ability of people involved
Feasibility and cost of reversing decision

24. Problems P 3-7 Northern Sun, Inc. P 3-26 Electric Generator
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