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Capital Budgeting Decisions

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Capital Budgeting

Budgeting for the acquisition ofcapital assets Capital budgeting techniques(a) Payback period(b) Accounting Rate of Return(c) Net Present Value(d) Internal Rate of Return

MFRD

BDM

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Analyzing alternative long-term investments and decidingwhich assets to acquire or sell.

Outcomeis uncertain.

Large amounts ofmoney involved.

Investment involveslong-term commitment.

Decision may bedifficult or impossible

to reverse.

Capital Budgeting

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ExampleCasey Co. is considering an investment of $130,000

in new equipment. The new equipment is expectedto last 10 years . It will have zero s alvage value atthe end of its useful life. The s t ra igh t-l ine m ethodof depreciat ion is used for accounting purposes.The expected annual revenues and costs of the

new product that will be produced from theinvestment are:

Sales $200,000Cost of goods sold $145,000Depreciation expense 13,000Selling & Admin expense 22,000 180,000Income before income tax $20,000Income tax expense 7,000Net Income $13,000

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Payback Period

Time period required to recover thecost of the investment from theannual cash inflow produced by theinvestment.

Amount investedExpected annual net cash inflow

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Computation of Annual CashInflow

Expected annual net cash inflow =Net income $13,000Depreciation expense 13,000

$26,000

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Cash Payback Period

$130,000 $26,000 5 years / =

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Casey Co. wantsto install amachine that costs$16,000 and has an8-year useful lifewith zero salvagevalue. Annual netcash flows are:

Year Annual NetCash Flows

CumulativeNet Cash

Flows

0 (16,000)$ (16,000)$1 3,000 (13,000) 2 4,000 (9,000) 3 4,000 (5,000)

4 4,000 (1,000) 5 5,000 6 3,000 7 2,000 8 2,000

Payback Period Uneven Cash Flows

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Year Annual NetCash Flows

CumulativeNet Cash

Flows

0 (16,000)$ (16,000)$1 3,000 (13,000) 2 4,000 (9,000) 3 4,000 (5,000) 4 4,000 (1,000) 5 5,000 6 3,000 7 2,000 8 2,000

4.2

Payback Period Uneven Cash Flows

We recover the $16,000purchase price between

years 4 and 5, about4.2 years for thepayback period.

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Consider two projects, each with a 5-yearlife and each costing $6,000.

Project One Project Two

Net Cash Net Cash Year Inflows Inflows

1 2,000$ 1,000$2 2,000 1,000 3 2,000 1,000 4 2,000 1,000 5 2,000 1,000,000

Would you invest in Project One just becauseit has a shorter payback period?

Using the Payback PeriodPayback = 3 years

Payback = 5 years

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Accounting Rate of Return

Compare accounting rate of return tocompanys required minimum rate ofreturn for investments of similar risk.The minimum return is based on thecompanys co s t o f cap i tal .

Average annual operating income from assetAverage amount invested in asset

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Accounting Rate of Return

For Casey, average investment =($130,000 + $0)/ 2 = $65,000

Average Investment =

Original Investment + Residual Value2

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Solution to Accounting Rate ofReturn Problem

$13,000 / $65,000 = 20%

Average annual operating income from assetAverage amount invested in asset

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Accounting Rate of Return

The decision rule is: A project is acceptable if its rate of return is

greater than managements minimum rateof return.

The higher the rate of return for a given risk,the more attractive the investment.

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Discounted Cash Flows

Considers both the estimated totalcash inflows and the time value ofmoney.Two methods1) net present value2) internal rate of return

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Net Present Value Method

Find PV of future cash flows andcompare with capital outlay

Interest rate used = requiredminimum rate of returnProposal is acceptable when NPV is

zero or positive.The higher the positive NPV, themore attractive the investment.

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Net Present Value

We will assume that Casey Cosannual cash inflows of $26,000 are

uniform over the assets useful life.The present value of the annual cashinflows can be computed by usingthe present value of an annuity of 1for 10 periods. Assume thecompany requires a minimum returnof 12%.

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Net Present Value

CashFlow

When? Type ofcash flow

Presentvaluefactor

Presentvalue of

cash flows

(130,000) Now ($130,000)

NPV

26,000 Yrs 1-10 Annuity 5.650 146,900

$16,900

Analysis of the proposal: The proposed capital expenditureis acceptable at a required rate of return of 12% because the net

present value is positive

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Net Present Value

When annual cash inflows areunequal, use present value of one

tables.

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Net Present ValueCashFlow

When? Type ofcash flow

PV factor Presentvalue

(130,000) Now ($130,000)

36,000 1 Lump sum .893 32,14832,000 2 .797 25,50429,000 3 .712 20,648

27,000 4 .636 17,17226,000 5 .567 14,74224,000 6 .507 12,16823,000 7 .452 10,396

22,000 8 .404 8,88821,000 9 .361 7,58120,000 10 .322 6,440

NPV $25,687

,,

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Internal Rate of Return

Interest yield of the potentialinvestmentThe interest rate that will cause thepresent value of the proposedcapital expenditure to equal thepresent value of the expected annualcash inflows.

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Internal Rate of Return

STEP 1.Compute the internal rate ofreturn factor using this formula:

Capital InvestmentAnnual Cash Inflows

$130,000 / $26,000 = 5.0

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Internal Rate of Return Method

STEP 2. Use the factor and thepresent value of an annuity of 1table to find the internal rate of

return.Locate the discount factor that isclosest to 5.0 on the line for 10

periods.PRESENT VALUE OF AN ANNUITY OF 1

(N)Periods

6% 7% 8% 9% 10% 12% 14% 15%

10 7.360 7.024 6.710 6.418 6.145 5.650 5.2165.019

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Internal Rate of ReturnDecision Criteria

The decision rule is: Accept when internal rate of return is

equal to or greater than the requiredrate of return

Reject when internal rate of return is lessthan required rate

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Internal Rate of Return Uneven Cash Flows

If cash inflows are unequal, trialand error solution will result ifpresent value tablesare used.Use business calculators andelectronic spreadsheets

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Payback Accounting Net present Internal rate

period rate of return value of returnBasis of Cash Accrual Cash flows Cash flowsmeasurement flows income Profitability Profitability

Measure Number Percent Dollar Percentexpressed as of years Amount

Easy to Easy to Considers time Considers time

Unde rsta nd Unde rsta nd va lue of mone y va lue of m one yStrengths Allows Allows Accommodates Allows

comparison comparison different risk comparisonsacross projects across projects leve ls over of dissimila r

a project's life projectsDoesn't Doesn't Difficult to Doesn't reflect

consider time consider time compare varying riskvalue of money value of money dissimilar levels over the

Limitations projects project's life

Doesn't Doesn't giveconsider cash annual ra tes

flows after over the lifeb k i d f j

Comparing Methods