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Chapter 20 Capital budgeting Decisions

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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!

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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

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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.

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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.

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

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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.

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Present Value (pages 711- 716) 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) + 100 = 106 n Yr2: (106 x.06) + 106 = 112.36 n yr3: (112.36 x.06) + 112.36 = 119.10 n $119.10 is the future value & $100 is the present value.

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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 $119.10 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 $119.10 = $99.996 (or $100 rounded)

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

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

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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

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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.

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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.

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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 $

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Be sure to read through the examples in the text!

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The End

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