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Capital Budgeting DecisionsChapter 13
ACTG 202 – Principles of Managerial Accounting
13-2
Typical Capital Budgeting Decisions
Plant expansionPlant expansion
Equipment selectionEquipment selection
Lease or buyLease or buy Cost reductionCost reduction
13-3
Typical Capital Budgeting Decisions
Capital budgeting tends to fall into two broad categories.
1. Screening decisions. Does a proposed project meet some preset standard of acceptance?
2. Preference decisions. Selecting from among several competing courses of action.
13-4
Time Value of Money
The discussion of capital budgeting begins with a discussion of the 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.
13-5
Time Value of Money
The capital budgeting
techniques that best recognize the time value of money are those that involve discounted cash
flows.
13-6
Present Value and Future Value
13-7
Learning Objective 1
Determine the payback period for an investment.
13-8
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.
The Payback Method
13-9
Evaluation of the Payback Method
Ignores the Ignores the time valuetime valueof of money..
Ignores cashflows after the payback
period.
Short-comingsof the payback
method.
Shorter payback Shorter payback period does not period does not always mean a always mean a more desirable more desirable
investment.investment.
13-10
Evaluation of the Payback Method
Serves as screening
tool.Identifies
investments that recoup cash investments
quickly.Identifies
products that recoup initial investment
quickly.
Strengthsof the payback
period.
13-11
Learning Objective 2
Evaluate the acceptability of an
investment project using the net present value
method.
13-12
The Net Present Value Method
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.
13-13
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.
13-14
The Net Present Value Method
13-15
iClicker Quick Check
• The working capital would be released at the end of the contract.
• Denny Associates requires a 14% return.
Denny Associates has been offered a four-year contract to supply the computing requirements for a local bank.
13-16
The Net Present Value Method
13-17
Choosing a Discount Rate
•The company’s cost of capital is usually regarded as the minimum required rate of return.
•The cost of capital is the average return the company must pay to its long-term creditors and stockholders.
13-18
Learning Objective 3
Evaluate the acceptability of an
investment project using the internal rate of return
method.
13-19
Internal Rate of Return Method•The internal rate of return is the rate of return
promised by an investment project over its useful life. It is computed by finding the discount rate that will cause the net present value of a project to be zero.
•It works very well if a project’s cash flows are identical every year. If the annual cash flows are not identical software, such as Excel, must be used for the calculation.
13-20
Internal Rate of Return MethodGeneral decision rule . . .
If the Internal Rate of Return is . . . Then the Project is . . .
Equal to or greater than the minimum required rate of return . . .
Acceptable.
Less than the minimum required rate of return . . .
Rejected.
When using the internal rate of return, the cost of capital acts as a hurdle rate that a project
must clear for acceptance.
13-21
Comparing the Net Present Value andInternal Rate of Return Methods
•NPV is often simpler to use.
•Questionable assumption:▫Internal rate of return
method assumes cash inflows are reinvested at the internal rate of return.
13-22
Least Cost Decisions
In decisions where revenues are not directly involved, managers should
choose the alternative that has the least total cost
from a present value perspective.
13-23
Learning Objective 4
Evaluate an investment project that has
uncertain cash flows.
13-24
Uncertain Cash Flows – An Example• Assume that all of the cash flows related to an Assume that all of the cash flows related to an
investment in a supertanker have been investment in a supertanker have been estimated, except for its salvage value in 20 estimated, except for its salvage value in 20 years.years.
• Using a discount rate of 12%, management has Using a discount rate of 12%, management has determined that the net present value of all the determined that the net present value of all the cash flows, except the salvage value is a cash flows, except the salvage value is a negative $1.04 million.negative $1.04 million.
• Assume that all of the cash flows related to an Assume that all of the cash flows related to an investment in a supertanker have been investment in a supertanker have been estimated, except for its salvage value in 20 estimated, except for its salvage value in 20 years.years.
• Using a discount rate of 12%, management has Using a discount rate of 12%, management has determined that the net present value of all the determined that the net present value of all the cash flows, except the salvage value is a cash flows, except the salvage value is a negative $1.04 million.negative $1.04 million.
How large would the salvage value need to be to make this investment attractive?
13-25
Uncertain Cash Flows – An Example
If the salvage value of the supertanker is at least $10,000,000, the net present value of the investment would be positive and therefore
acceptable.
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Learning Objective 5
Rank investment projects in order of
preference.
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Preference Decision – The Ranking of Investment Projects
Screening Decisions
Pertain to whether or not some proposed
investment is acceptable; these
decisions come first.
Preference Decisions
Attempt to rank acceptable
alternatives from the most to least
appealing.
13-28
Internal Rate of Return Method
The higher the internal rate of return, the more desirable the project.
When using the internal rate of return method to rank competing investment
projects, the preference rule is:
13-29
Net Present Value MethodThe net present value of one project cannot
be directly compared to the net present value of another project unless the
investments are equal.
13-30
Ranking Investment Projects Project Net present value of the project profitability Investment required index
=
Project A Project B
Net present value (a) 1,000$ 1,000$
Investment required (b) $ 10,000 $ 5,000
Profitability index (a) ÷ (b) 0.10 0.20
The higher the profitability index, themore desirable the project.
The higher the profitability index, themore desirable the project.
13-31
Time Value of Money CalculationsThere are a variety of resources for doing time value of money calculations:▫Financial Calculator (such as your TI)▫Excel
Excel contains a number of functions for doing time value of money calculations
These functions include: PV function IRR function FV function PMT function RATE function
▫Tables and factors?