Capital Budgeting Decisions UAA – ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee.

Capital Budgeting DecisionsCapital Budgeting Decisions

UAA – ACCT 202 Principles of Managerial Accounting

Dr. Fred Barbee

Introduction to Capital BudgetingIntroduction to Capital Budgeting

Capital Budgeting is . . .Capital Budgeting is . . .

. . . The making of long-term planning decisions for investments.


Should we purchase new labor-saving equipment to perform operations presently performed manually

A Cost-Reduction Decision


Should we replace existing equipment with more efficient, newer equipment.

A Cost-Reduction Decision


Should we enter a new market with a new product or purchase an existing business already in that market

A Profit-Expansion Decision

The Process of Capital BudgetingThe Process of Capital Budgeting

Process of Capital BudgetingProcess of Capital Budgeting

Identification Stage

Search Stage

Information-Acquisition Stage

Selection Stage

Financing Stage

Implementation and Control Stage

Project Selection . . .Project Selection . . .

Selection in capital budgeting comes in two phases:

Screening, and

Preference

Screening . . .Screening . . .

A specific criterion is used to eliminate unprofitable and/or high-risk investment proposals.

Projects meeting criteria

Projects not meeting criteria

Preference SelectionPreference Selection

The surviving projects are subjected to a ranking criterion.

Outcome: The most favorable projects are selected for any given amount of capital to be invested.

We interrupt this regularly scheduled program to bring you a special bulletin

on the characteristics of business investments.

We interrupt this regularly scheduled program to bring you a special bulletin

on the characteristics of business investments.

Characteristics of Business InvestmentsCharacteristics of Business Investments

Business InvestmentsBusiness Investments

Most business investments involve depreciable assets; and

The returns on business investments extend over long periods of time.

Depreciable AssetsDepreciable Assets

Time

Consumed as Depreciation Expense

To Illustrate . . .To Illustrate . . .

A firm purchases land (a non-depreciable asset) for $5,000; and

Rents it out at $750.00 per year for ten years.

What is the return?

Since the asset will still be intact at the end of the 10-year period, each year’s $750 inflow is a return on the original $5,000 investment. The rate of return is therefore:

%15000,5$

750$

What is the Return?What is the Return?

Return on Assets MustReturn on Assets Must

Provide a return on the original investment.

A return of the original investment itself.

To Illustrate . . .To Illustrate . . .

A firm purchases land (a non-depreciable asset) for $5,000; and

Rents it out at $750.00 per year for ten years.Assume the $5,000 investment is in

equipment and will reduce operating

costs by $750 each year for 10 years.

Hmmm. What now?

%15000,5$

750$

What is the Return?What is the Return?

Why?Why?

Because part of the yearly $750 inflow from the equipment must go to recoup the original $5,000 investment itself, since the equipment will be worthless at the end of its 10-year life.

Long Periods of Time

Long Periods of Time

In approaching capital budgeting decisions, it is necessary to employ techniques that recognize the time value of money.

Long Periods of TimeLong Periods of Time

Discounted Cash Flow Models (DCF)

DCF Models . . .DCF Models . . .

Focus on . . .

Cash inflows; and

Cash outflows

Rather than on net income

DCF Models . . .DCF Models . . .

There are two main variations of the discounted cash flow model . . .

Net Present Value (NPV); and

Internal Rate of Return (IRR)

Net Present ValueNet Present Value

Cash Inflows

Cash Outflows

PV$

(PV$)

Usually Future

Future and/or PresentNPV

Discount

Discount

Net Present Value MethodNet Present Value Method

Cash Inflows

Cash Outflows

PV$

(PV$)

Usually Future


Discount

Discount

Net Present Value MethodNet Present Value MethodIf the result is positive, the investment promises more than the interest rate used to evaluate the proposal.

Cash Inflows

Cash Outflows

PV$

(PV$)

Usually Future


Discount

Discount


If the result is zero, the investment yields exactly the interest rate used to evaluate the proposal.

Cash Inflows

Cash Outflows

PV$

(PV$)

Usually Future


Discount

Discount

Net Present Value MethodNet Present Value MethodIf the result is negative, the investment should be rejected because the required rate of return will not be earned.

(NPV)

Typical Cash OutflowsTypical Cash Outflows

The initial investment

Additional amount of working capital

Repairs and maintenance

Additional operating costs

Typical Cash InflowsTypical Cash Inflows

Incremental revenues

Reduction in costs

Salvage value

Release of working capital

PDQ Company – NPV Example

•PDQ company requires a minimum return of 18% on all investments.

•The company can purchase a new machine at a cost of $40,350. The new machine would generate cash inflows of $15,000 per year and have a four-year life with no salvage value.

•What is the net present value of this project?

Initial Inv.

Annual CF

Net Present Value

Now

1-4

(40,350)

15,000

1.000

2.690

Item Yr(s)Amt of Cash Flow

18% Factor

Present Value of

CF

(40,350)

40,350

-0-

PDQ Company – NPV Example

Each $15,000 Inflow . . .Each $15,000 Inflow . . .

Provides for a recovery of a portion of the original $40,350 investment; and

Also provides a return of 18% on this investment.

$15,000 $7,263 $7,737 $32,6131

2

3

4

$40,350

(2)

Cash Inflow

(3)

ROI (1)* 18%

(4)

Rec of Inv.

(2)-(3)

PV of Cash Flow

(1)-(4)

Year

(1)Inv O/S

during Year

$40,350 x 18% = $7,263

$15,000 - $7,263 = $7,737

$40,350 - $7,737 = $32,613

$15,000

15,000

$7,263

5,870

$7,737

9,130

$32,613

23,483

1

2

3

4

$40,350

32,613

(2)

Cash Inflow

(3)

ROI (1)* 18%

(4)

Rec of Inv.

(2)-(3)

PV of Cash Flow

(1)-(4)

Year

(1)Inv O/S

during Year

15,000 4,227 10,773 12,71023,483

15,000 2,290 12,710 -0-12,710

Practice Exercise 1Practice Exercise 1

Calculate Net Present Value (NPV)

An investment that costs $10,000 will return $4,000 per year for four years.

Determine the net present value of the investment if the required rate of return is 12 percent. Ignore income taxes.

Should the investment be undertaken?


Initial Inv.

Annual CF

Net Present Value

Now

1-4

(10,000)

4,000

1.000

3.037


12% Factor

Present Value of CF

($10,000)

12,148

$2,148

Practice Exercise 1


Calculate Net Present Value (NPV)

Magnolia Florist is considering replacing an old refrigeration unit with a larger unit to store flowers.

Because the new refrigeration unit has a larger capacity, Magnolia estimates that they can sell an additional $6,000 of flowers a year (the cost of the flowers is $3,500).


In addition, the new unit is energy efficient and should save $950 in electricity each year.

It will cost an extra $150 per month for maintenance.

The new refrigeration unit costs $20,000 and has an expected life of 10 years.


The old unit is fully depreciated and can be sold for an amount equal to disposal cost.

At the end of 10 years, the new unit has an expected residual value of $5,000

Determine the NPV of the investment if the RRR is 14% (ignore taxes).

Should the investment be made.


Determine the net cash flow for the life of the equipment.


Item Cash Flow

Additional Sales $6,000

Cost of Sales (3,500)

Savings in Electricity 950

Maintenance (1,800)

Total $1,650

Initial Inv.

Annual CF

Net Present Value

Now

1-10

(20,000)

1,650

1.000

5.216


14% Factor

Present Value of CF

($20,000)

8,606

Practice Exercise 2

Salvage 10 5,000 .270 1,350

($10,044)

Limiting Assumptions . . .Limiting Assumptions . . .

All cash flows occur at the end of the period.

All cash flows generated by an investment are immediately reinvested in another project which yields a return at least as large as the discount rate used in the first project.

Discount Rate . . .Discount Rate . . .

The rate generally viewed as being the most appropriate is a firm’s cost of capital.

This rate is also known as . . .

Hurdle Rate

Cutoff Rate

Required Rate of Return

Internal Rate of ReturnInternal Rate of Return

Cash Inflows

Cash Outflows

PV$

(PV$)

Usually Future


Discount

Discount


$-0-

The internal rate of return (IRR) is that rate of interest which will exactly equate the PV of the cash inflows with the PV of

the cash outflows.

Resulting in $0 NPV

Internal Rate of ReturnInternal Rate of Return

When the annual cash flows are even, the IRR formula is simply . . .

df = I / CF, or

Investment/Annual Cash Flow

Cost of Capital as a Screening Tool

Cost of Capital as a Screening Tool

Using the IRR MethodUsing the IRR Method

The cost of capital takes the form of a hurdle rate that a project must clear for acceptance.

If the IRR on a project is not great enough to clear the cost of capital hurdle, then the project is rejected.

Using the NPV MethodUsing the NPV Method

The cost of capital becomes the actual discount rate used to compute the NPV of a proposed project.

Projects yielding negative NPVs are rejected unless nonquantitative factors, such as social responsibility, employee morale, etc., intervene.

CompareNet Present Value andInternal Rate of Return

CompareNet Present Value andInternal Rate of Return

Compare IRR & NPV . . .Compare IRR & NPV . . .

The NPV method is simpler to use.

Using the NPV method makes it easier to adjust for risk.

The NPV method provides more usable information than does the IRR method.

Simplified Approaches to Capital Budgeting


The Payback Period . . .The Payback Period . . .

This method involves a span of time known as the payback period.

The payback period is the length of time it takes for an investment project to recoup its own initial cost out of the cash receipts that it generates.


The basic premise of this method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment.


The payback period is expressed in years. The basic formula is . . .

Investment Req --------------------------- = Payback Period Net Annual CF


Calculate the Payback period

The Lower Valley Wheat Cooperative is considering the construction of a new silo.

It will cost $41,000 to construct the silo.

Determine the payback period if the expected cash inflows are $5,000 per year.



$41,000 --------------------------- = 8.2 Years $5,000



AKA: Accounting Rate of Return

The Simple Rate of ReturnThe Simple Rate of Return

The Simple Rate of Return is equal to Incremental income from the project

divided by the initial investment in the project.

Simple Rate of Return (SRR)

=Inc. NOI

Initial Investment*

*Less Salvage Value if any

The Simple Rate of ReturnThe Simple Rate of Return

If a cost reduction project is involved, the formula becomes:

SRR =Cost Savings - Depreciation

Initial Investment*

*Less Salvage Value if any


Calculate the Simple Rate of Return


Martin Company is considering the purchase of a new piece of equipment. Relevant information concerning the equipment follows:

Compute the Simple Rate of Return.

Purchase Cost $180,000

Annual cost savings 37,500

Useful Life 12 Years


Capital Budgeting Decisions UAA – ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee.

Documents

preference slide

control stage slide

depreciable assets slide

net income slide

fred barbee slide

depreciation expense

long periods of time

costreduction decision