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Capital Budgeting Decisions Chapter 13 ACTG 202 – Principles of Managerial Accounting

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13-2 Typical Capital Budgeting Decisions Plant expansion Equipment selection Equipment replacement Lease or buy Cost reduction

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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.

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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.

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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.

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13-6 Present Value and Future Value

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13-7 Learning Objective 1 Determine the payback period for an investment.

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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

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13-9 Evaluation of the Payback Method Ignores the time value of. of money. Ignores cash flows after the payback period. Short-comings of the payback method. Shorter payback period does not always mean a more desirable investment.

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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. Strengths of the payback period.

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13-11 Learning Objective 2 Evaluate the acceptability of an investment project using the net present value method.

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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.

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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.

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13-14 The Net Present Value Method Two Simplifying Assumptions All cash flows other than the initial investment occur at the end of periods. All cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate.

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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.

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13-16 The Net Present Value Method

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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.

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13-18 Learning Objective 3 Evaluate the acceptability of an investment project using the internal rate of return method.

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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.

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13-20 Internal Rate of Return Method General decision rule... When using the internal rate of return, the cost of capital acts as a hurdle rate that a project must clear for acceptance.

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13-21 Comparing the Net Present Value and Internal 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.

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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.

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13-23 Learning Objective 4 Evaluate an investment project that has uncertain cash flows.

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13-24 Uncertain Cash Flows – An Example Assume that all of the cash flows related to an investment in a supertanker have been estimated, except for its salvage value in 20 years.Assume that all of the cash flows related to an investment in a supertanker have been estimated, except for its salvage value in 20 years. Using a discount rate of 12%, management has determined that the net present value of all the cash flows, except the salvage value is a negative $1.04 million.Using a discount rate of 12%, management has determined that the net present value of all the cash flows, except the salvage value is a negative $1.04 million. Assume that all of the cash flows related to an investment in a supertanker have been estimated, except for its salvage value in 20 years.Assume that all of the cash flows related to an investment in a supertanker have been estimated, except for its salvage value in 20 years. Using a discount rate of 12%, management has determined that the net present value of all the cash flows, except the salvage value is a negative $1.04 million.Using a discount rate of 12%, management has determined that the net present value of all the cash flows, except the salvage value is a negative $1.04 million. How large would the salvage value need to be to make this investment attractive?

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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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13-26 Learning Objective 5 Rank investment projects in order of preference.

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13-27 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.

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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:

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13-29 Net Present Value Method The net present value of one project cannot be directly compared to the net present value of another project unless the investments are equal.

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13-30 Ranking Investment Projects Project Net present value of the project profitability Investment required index = The higher the profitability index, the more desirable the project. The higher the profitability index, the more desirable the project.

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13-31 Time Value of Money Calculations There 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?

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