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Chapter 20 Capital budgeting Decisions What is a Capital Expenditure? n A long-term decision of whether or not to make an investment today which will.

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Presentation on theme: "Chapter 20 Capital budgeting Decisions What is a Capital Expenditure? n A long-term decision of whether or not to make an investment today which will."— Presentation transcript:

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2 Chapter 20 Capital budgeting Decisions

3 What is a Capital Expenditure? n A long-term decision of whether or not to make an investment today which will bring future returns. n Those “future returns” must be greater than the initial cost of the investment. n This creates a complication - the time value of money!

4 Cash Flows n The initial cash outlay is compared to the future cash “inflows” n These future inflows can include n cash receipts n cash receipts less cash payments n savings of cash payments

5 Cost of Capital n In order to make a capital expenditure, a Co. must have cash. n Obtaining financing from creditors and investors costs $. n This is called the cost of capital. n An investment S/B made as long as the C of C is < or = the return on investment.

6 The Cost of Capital represents the minimum required rate of return needed before a capital expenditure should be made. n In other words, it is the cuttoff rate.

7 Time Value of Money n “A dollar today is worth more than a dollar tomorrow.” Why?

8 Since the initial capital expenditure is made in “todays dollars”, we must convert future cash flows to todays dollars in order to determine whether to make the investment.

9 Present Value (pages ) n Assume the following: You made a $100 investment in a savings account which earns 6% interest compounded annually. After three years you have the following: n Yr1: (100 x.06) = 106 n Yr2: (106 x.06) = n yr3: ( x.06) = n $ is the future value & $100 is the present value.

10 Think of the present value as the amount of the future value with the interest taken out! n What if we know the future value is $ and want to “convert” it to present value? n Use the table on page 732: 6% for 3 periods = factor of.8396 n.8396 x $ = $ (or $100 rounded)

11 Above Example - single amount was used. A series of equal payments is an annuity. n Use table on page 733!

12 Firms use a variety of “Tools” to make capital budgeting decisions: n NPV n Payback n Aver. Rate of Return

13 NPV - steps: n 1. Calculate, using PV tables, the PV of future cash flows n Use the cost of capital (ie, the required rate of return) n 2. Calculate the amount of the initial cash outlay for the investment n This is already the PV! n 3. #1-#2 = the NPV

14 How to evaluate the NPV: n if zero or positive, accept investment because the return if > or = the cost of capital. n If negative - don’t accept the project because the return is < required rate.

15 Payback n evaluates how long it will take to “recap” your initial investment. n Ignores the time value of money & the return on investment. n Only takes return of investment into consideration.

16 Average rate of return n Usually expressed as a % ARR = Total Cash Receipts-Total cash payment Years X Investment If ARR < C of C, don’t invest. n Also ignores the time value of $

17 Be sure to read through the examples in the text!

18 The End


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