Chapter 11

PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIA

Cynthia J. Rooney, Ph.D., CPA

Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 11

Capital Budgeting

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Capital Budgeting Process

Capital budgeting is a decision-making approach aimed at helping managers make

decisions about investments in major capital assets, such as new facilities,

equipment, new products, and research and development projects.

Plant expansion

Equipment selection Equipment replacement

Lease or buy Cost reduction

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Capital Budgeting Methods

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Accounting Rate of Return

Accounting

Rate ofReturn

AnnualNet

Income

Initial Investme

nt÷ =

10.8%$108,000$1,000,00

0÷ =

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Payback Period

PaybackPeriod

InitialInvestme

nt

Annual Net Cash

Flow÷ =

Net Income + Depreciation

3.25 years

$1,000,000

$308,000÷ =

$108,000 + $200,000

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Time Value of Money

One dollar received today is worth more than one dollar received a year from now because the dollar can be invested to earn interest.

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Time Value of Money Discounting is exactly the opposite of

compounding. Just as interest builds up over time through compounding, discounting

involves backing out the interest to determine the equivalent value in today’s

present value dollars.

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The net present value (NPV) method compares the present value (PV) of a

project’s future cash inflows to the PV of the cash outflows.

The net present value (NPV) method compares the present value (PV) of a

project’s future cash inflows to the PV of the cash outflows.

The reason is that accounting net income

is based on accruals that ignore the timing of cash flows into and out of an organization.

The reason is that accounting net income

is based on accruals that ignore the timing of cash flows into and out of an organization.

Net Present Value (NPV)

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Chose a discount rate – the minimum required rate of return.

Calculate the presentvalue of cash inflows.

Calculate the presentvalue of cash outflows.

NPV = –

Net Present Value (NPV)

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If the Net Present Value is . . . Then the Project is . . .

Positive . . . Acceptable, since it promises a return greater than the required

rate of return (discount rate).

Zero . . . Acceptable, since it promises a

return equal to the required rate of return (discount rate).

Negative . . . Not acceptable, since it promises

a return less than the required rate of return (discount rate).

Net Present Value (NPV)

Relationship Between NPV and

the Required Rate of Return

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Internal Rate of Return (IRR)

Presentvalue of

cash inflows

Presentvalue of

cash outflows=

The net present value equal zero.

The internal rate of return is the interest rate that makes . . .

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Internal Rate of Return (IRR)

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Profitability IndexThe profitability index is the ratio of a project’s benefits (measured by the present value of the

future cash flows) to its costs (or required investment).

Profitability Index > 1 = Project Acceptable

Profitability Index < 1 = Project Unacceptable

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Comparing Capital Budgeting Methods

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Profitability

Index

Present Value of Future Cash

flows

Initial Investme

nt÷=

The profitability index is used to prioritize capital investment

projects.

When using the profitability index to prioritize projects, the preference rule is:

the higher the profitability index, the more desirable the project.

Prioritizing Independent Projects

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Time Value of Money

Future Value of a Single Payment

Present Value of a Single Payment

Future Value of

an Annuity

Present Value of

an Annuity

Present and future value problems may involve two types of cash flow: a single

payment or an annuity (a fancy word for a series of equal

cash payments)

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Future Value of a Single Amount

To solve a future value problem, you need to know three things:1.Amount to be invested.2.Interest rate (i) the

amount will earn.3.Number of periods (n) in

which the amount will earn interest.

Using Table 11.1A.: $1,000 × 1.3310 = $1,331

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Present Value of a Single AmountThe present value of a

single amount is the value to you today of receiving

some amount of money in the future. To compute the present value of an amount to be received in the future,

we must discount (a procedure that is the

opposite of compounding) at i interest rate for n

periods.

Using Table 11.2A.: $1,000 × 0.7513 = $751.30

Assume that today is January 1, 2013, and you have the opportunity to receive $1,000 cash on December 31, 2015 (three

years from today). At an interest rate of 10 percent per year, how much is the $1,000 payment worth to you on January 1,

2013 (today)? You could discount the amount year by year, but it is easier to use Table 11.2A , Present Value of $1.

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Future Value of an AnnuityThe future value of an

annuity includes compound interest on each payment

from the date of payment to the end of the term of the

annuity. Each new payment accumulates less interest

than prior payments because the number of

periods in which to accumulate interest

decreases.

Using Table 11.3A.: $1,000 × 3.3100 = $3,310

Assume that each year for three years, you deposit $1,000 cash into a savings account that earns 10 percent interest per year. You make the first $1,000 deposit on December 31, 2013, the

second one on December 31, 2014, and the third and last one on December 31, 2015. To calculate the future value of this annuity,

use Table 11.3A , Future Value of an Annuity of $1.

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Present Value of an Annuity

The present value of an annuity is the value now of

a series of equal amounts to be received (or paid out) for some specified number of

periods in the future.

Using Table 11.4A.: $1,000 × 2.4869 = $2,487 (rounded)

Assume you are to receive $1,000 cash on each December 31 for three years: 2013, 2014, and 2015. How much would the sum of these three $1,000 future amounts be worth on January 1, 2013, assuming an interest rate of 10 percent per year? To calculate

the present value of this annuity, use Table 11.4A , Present Value of an Annuity of $1.

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End of Chapter 11