Capital Budgeting Decisions
Capital Budgeting Decisions
Capital Budgeting Decisions
Cost reduction
The capital
budgeting
techniques that best
recognize the time
value of money are
those that involve
discounted cash
flows.
Learning Objective 1
Working
capital
Initial
investment
Incremental
operating
costs
Release of
working
capital
Reduction
of costs
Incremental
revenues
Periods
1
2
3
4
5
Present Value of $1
10%
12%
0.909
0.893
1.736
1.690
2.487
2.402
3.170
3.037
3.791
3.605
14%
0.877
1.647
2.322
2.914
3.433
Present
Present value
value
of
of an
an annuity
annuity
of
of $1
$1 table
table
This implies that the cash inflows are sufficient to recover the $3,170
initial investment (therefore depreciation is unnecessary) and to
provide exactly a 10% return on the investment.
Present value of $1
factor for 5 years at 10%.
Quick Check
Denny Associates has been offered a four-year contract to
supply the computing requirements for a local bank.
Quick Check
What is the net present value of the contract with
the local bank?
a. $150,000
b. $ 28,230
c. $ 92,340
d. $132,916
Quick Check
What is the net present value of the contract with
the local bank?
a. $150,000
b. $ 28,230
c. $ 92,340
d. $132,916
Learning Objective 2
Acceptable.
Rejected.
Investment required
Annual net cash flows
10%
0.909
1.736
. . .
5.759
6.145
12%
0.893
1.690
. . .
5.328
5.650
14%
0.877
1.647
. . .
4.946
5.216
Quick Check
The expected annual net cash inflow from a project
is $22,000 over the next 5 years. The required
investment now in the project is $79,310. What is
the internal rate of return on the project?
a. 10%
b. 12%
c. 14%
d. Cannot be determined
Quick Check
The expected annual net cash inflow from a project
is $22,000 over the next 5 years. The required
investment now in the project is $79,310. What is
the internal rate of return on the project?
a. 10%
b. 12%
$79,310/$22,000
=
3.605,
c. 14%
which is the present value factor
d. Cannot be determined
$175,000
80,000
Incremental investment
Incremental cost of brushes
Increased net cash inflows
Salvage of old equipment
Salvage of new equipment
Net present value
Year
Now
6
1-10
Now
10
Cash
Flows
$(125,000)
$ 30,000
15,000
40,000
7,000
10%
Factor
1.000
0.564
6.145
1.000
0.386
Present
Value
$(125,000)
16,920
92,175
40,000
2,702
$ 26,797
Quick Check
Consider the following alternative projects. Each
project would last for five years.
Project A
Project B
Initial investment
$80,000
$60,000
Annual net cash inflows
20,000
16,000
Salvage value
10,000
8,000
The company uses a discount rate of 14% to evaluate
projects. Which of the following statements is true?
a. NPV of Project A > NPV of Project B by $5,230
b. NPV of Project B > NPV of Project A by $5,230
c. NPV of Project A > NPV of Project B by $2,000
d. NPV of Project B > NPV of Project A by $2,000
Quick Check
Consider the following alternative projects. Each
project would last for five years.
Project A
Project B
Initial investment
$80,000
$60,000
Annual net cash inflows
20,000
16,000
Salvage value
10,000
8,000
The company uses a discount rate of 14% to evaluate
projects. Which of the following statements is true?
a. NPV of Project A > NPV of Project B by $5,230
b. NPV of Project B > NPV of Project A by $5,230
c. NPV of Project A > NPV of Project B by $2,000
d. NPV of Project B > NPV of Project A by $2,000
$ 4,500
10,000
250
9,000
10%
Factor
1.000
3.791
1.000
0.621
10%
Factor
1.000
3.791
0.621
Present
Value
$ (21,000)
(22,746)
9,000
1,863
(32,883)
Present
Value
$ (4,500)
(37,910)
155
(42,255)
Quick Check
Bay Architects is considering a drafting
machine that would cost $100,000, last
four years, provide annual cash savings
of $10,000, and considerable intangible
benefits each year. How large (in cash
terms) would the intangible benefits
have to be per year to justify investing in
the machine if the discount rate is 14%?
a. $15,000
b. $90,000
c. $24,317
d. $60,000
Quick Check
Bay Architects is considering a drafting
machine that would cost $100,000, , last
four years, provide annual cash savings
$70,860/2.914
= $24,317intangible
of $10,000,
and considerable
benefits each year. How large (in cash
terms) would the intangible benefits
have to be per year to justify investing in
the machine if the discount rate is 14%?
a. $15,000
b. $90,000
c. $24,317
d. $60,000
Learning Objective 3
Evaluate an investment
project that has uncertain
cash flows.
Real Options
Delay the start of
a project
Expand a project
if conditions are
favorable
Cut losses if
conditions are
unfavorable
The ability to consider these real options adds value to
many investments. The value of these options can be
quantified using what is called real options analysis, which
is beyond the scope of the book.
Learning Objective 4
Preference Decisions
Pertain to whether or
not some proposed
investment is
acceptable; these
decisions come first.
Attempt to rank
acceptable
alternatives from the
most to least
appealing.
The
The higher
higher the
the profitability
profitability index,
index, the
the
more
more desirable
desirable the
the project.
project.
Other Approaches to
Capital Budgeting Decisions
Other methods of making capital budgeting
decisions include . . .
1. The Payback Method.
2. Simple Rate of Return.
Learning Objective 5
Investment required
Annual net cash inflow
Costs
Costs $140,000
$140,000 and
and has
has aa 10-year
10-year life.
life.
Will
Will generate
generate annual
annual net
net cash
cash inflows
inflows of
of $35,000.
$35,000.
Management
Management requires
requires aa payback
payback period
period of
of 55
years
years or
or less
less on
on all
all investments.
investments.
What
What is
is the
the payback
payback period
period for
for the
the espresso
espresso bar?
bar?
Investment required
Annual net cash inflow
Payback period =
$140,000
$35,000
Payback period =
4.0 years
According
According to
to the
the companys
companys criterion,
criterion,
management
management would
would invest
invest in
in the
the espresso
espresso bar
bar
because
because its
its payback
payback period
period is
is less
less than
than 55 years.
years.
Quick Check
Consider the following two investments:
Project X Project Y
Initial investment
$100,000
$100,000
Year 1 cash inflow
$60,000
$60,000
Year 2 cash inflow
$40,000
$35,000
Year 14-10 cash inflows
$0
$25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined
Quick Check
Consider the following two investments:
Project X Project Y
Initial investment
$100,000
$100,000
Year 1 cash inflow
$60,000
$60,000
Year 2 cash inflow
$40,000
$35,000
Year 14-10 cash inflows
$0
$25,000
Which project has the shortest payback period?
a. Project X
b. Project
Project
X has aYpayback period of 2 years.
c. Cannot
determined
Project
Y has abe
payback
period of slightly more than 2 years.
Which project do you think is better?
Ignores cash
flows after
the payback
period.
Identifies
investments that
recoup cash
investments
quickly.
Identifies
products that
recoup initial
investment
quickly.
$0
$2,000 $1,000
$500
$1,000
$0
$2,000 $1,000
$500
Learning Objective 6
*Should be reduced by any salvage from the sale of the old equipment
Simple rate
of return
$35,000
$140,000
= 25%
Learning Objective 7
(Appendix 14A)
Understand present value
concepts and the use of
present value tables.
Fn = P(1 + r)
Fn = P(1 + r)
F1 = $100(1 + .08)1
F1 = $108.00
Fn = P(1 + r)
F2 = $100(1 + .08)
F2 = $116.64
The interest that is paid in the second year on
the interest earned in the first year is known as
compound interest.
Future
Value
Fn
P=
n
(1 + r)
F = the balance at the end of the period n.
P = the amount invested now.
r = the rate of interest per period.
n = the number of periods.
$100
P=
(1 + .12)2
P = $79.72
This process is called discounting. We have
discounted the $100 to its present value of
$79.72. The interest rate used to find the
present value is called the discount rate.
IfIf $79.72
$79.72 is
is put
put in
in the
the bank
bank today
today and
and earns
earns
12%,
12%, itit will
will be
be worth
worth $100
$100 in
in two
two years.
years.
10%
10%
0.909
0.909
0.826
0.826
0.751
0.751
0.683
0.683
0.621
0.621
Rate
Rate
12%
12%
0.893
0.893
0.797
0.797
0.712
0.712
0.636
0.636
0.567
0.567
14%
14%
0.877
0.877
0.769
0.769
0.675
0.675
0.592
0.592
0.519
0.519
Quick Check
How much would you have to put in the bank
today to have $100 at the end of five years if the
interest rate is 10%?
a. $62.10
b. $56.70
c. $90.90
d. $51.90
Quick Check
How much would you have to put in the bank
today to have $100 at the end of five years if the
interest rate is 10%?
a. $62.10
$100 0.621 = $62.10
b. $56.70
c. $90.90
d. $51.90
$100
$100
$100
$100
$100
Value of an Annuity
10%
12%
0.909
0.893
1.736
1.690
2.487
2.402
3.170
3.037
3.791
3.605
of $1
14%
0.877
1.647
2.322
2.914
3.433
Quick Check
If the interest rate is 14%, how much would you
have to put in the bank today so as to be able to
withdraw $100 at the end of each of the next five
years?
a. $34.33
b. $500.00
c. $343.30
d. $360.50
Quick Check
If the interest rate is 14%, how much would you
have to put in the bank today so as to be able to
withdraw $100 at the end of each of the next five
years?
a. $34.33
b. $500.00
c. $343.30
$100 3.433 = $343.30
d. $360.50
Learning Objective 8
(Appendix 14C)
Include income taxes in a
capital budgeting analysis.
Simplifying Assumptions
Taxable income
equals net income as
computed for
financial reports.
The tax rate is a
flat percentage of
taxable income.
$
$
250,000
170,000
80,000
End of Chapter 14