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Capital Investments Chapter 12

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Capital Budgeting How managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment and introduction of new products.

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Typical Capital Budgeting Decisions Cost reduction Plant expansion Equipment selection Lease or buy Equipment replacement Lease or buyCost reduction

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Typical Capital Budgeting Decisions Capital budgeting tends to fall into two broad categories... Screening decisions. Does a proposed project meet some present standard of acceptance? Preference decisions. Selecting from among several competing courses of action.

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Time Value of Money Business investments extend over long periods of time, so we must recognize the time value of money. Investments that promise returns earlier in time are preferable to those that promise returns later in time.

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Can you compare cash flows in different time periods? Yes! Using the market interest rate, you can discount each value to find its present value. Remember, you CANNOT compare cash flows in different time periods without first adjusting them to the present using an interest rate.

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Economic equivalence is when we are indifferent between a future payment, or series of future payments, and a present sum of money. That is, the present value of the cash inflows exactly equals the present value of the cash outflows. Economic equivalence

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Time Value of Money Lacey Company purchased a tract of land on which a $60,000 payment will be due each year for the next five years. What is the present value of this stream of cash payments when the discount rate is 12%?

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Time Value of Money We could solve the problem like this... $60,000 × 3.605 = $216,300

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Present Value of Annual Cash Inflows-Unequal Annual Cash Flows When annual cash inflows are unequal, we cannot use annuity tables to calculate their present value. Instead tables showing the present value of a single future amount must be applied to each annual cash inflow. $260,000 $155,667 $140,061

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Typical Cash Outflows Initialinvestment Repairs and maintenance Incrementaloperatingcosts Workingcapital

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Typical Cash Inflows Reduction of costs Salvagevalue Incrementalrevenues Release of workingcapital

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Recovery of the Original Investment Carver Hospital is considering the purchase of an attachment for its X-ray machine. No investments are to be made unless they can earn at least 10% return on their investment. Will we be allowed to invest in the attachment?

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Recovery of the Original Investment Present value of an annuity of $1 table Present value of an annuity of $1 table

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Recovery of the Original Investment Because the net present value is equal to zero, the attachment investment provides exactly a 10% return. Because the net present value is equal to zero, the attachment investment provides exactly a 10% return.

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Recovery of the Original Investment Depreciation is not deducted in computing the present value of a project because... It is not a current cash outflow. Discounted cash flow methods automatically provide for return of the original investment.

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Choosing a Discount Rate The firm’s cost of capital is usually regarded as the most appropriate choice for the discount rate. The cost of capital is the average rate of return the company must pay to its long- term creditors and stockholders for the use of their funds.

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Net Present Value Method Under the net present value method, cash inflows are discounted to their present value and then compared with the capital outlay required by the investment. The interest rate used in discounting the future cash inflows is the required minimum rate of return. A proposal is acceptable when NPV is zero or positive. The higher the positive NPV, the more attractive the investment.

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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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The Net Present Value Method General decision rule...

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The Net Present Value Method Let’s look at how we use present value to make business decisions.

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The Net Present Value Method Lester Company has been offered a five year contract to provide component parts for a large manufacturer.

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The Net Present Value Method At the end of five years the working capital will be released and may be used elsewhere by Lester. Lester Company uses a discount rate of 10%. Should the contract be accepted?

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The Net Present Value Method Annual net cash inflows from operations

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The Net Present Value Method

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Present value of an annuity of $1 factor for 5 years at 10%.

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The Net Present Value Method Present value of $1 factor for 3 years at 10%.

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The Net Present Value Method Present value of $1 factor for 5 years at 10%.

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The Net Present Value Method positive Accept the contract because the project has a positive net present value.

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The Internal Rate of Return Method The internal rate of return is the interest yield promised by an investment project over its useful life. The internal rate of return is computed by finding the discount rate that will cause the net present value of a project to be zero.

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The Internal Rate of Return Method Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life.

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The Internal Rate of Return Method Future cash flows are the same every year in this example, so we can calculate the internal rate of return as follows: Investment required Net annual cash flows PV factor for the internal rate of return = $104, 320 $20,000 = 5.216

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The Internal Rate of Return Method 14% Find the 10-period row, move across until you find the factor 5.216. Look at the top of the column and you find a rate of 14%. Using the present value of an annuity of $1 table...

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The Internal Rate of Return Method Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life. internal rate of return The internal rate of return on this project is 14%. If the internal rate of return is equal to or greater than the company’s required rate of return, the project is acceptable.

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Net Present Value vs. Internal Rate of Return Net Present Value v Easier to use. v Assumes cash inflows will be reinvested at the discount rate. This is a realistic assumption.

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Investments in Automated Equipment Investments in automated equipment tend to be very large in dollar amount. The benefits received are often indirect and intangible.

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Ranking Investment Projects Profitability Present value of cash inflows index Investment required = The higher the profitability index, the more desirable the project. The higher the profitability index, the more desirable the project.

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Other Approaches to Capital Budgeting Decisions Other methods of making capital budgeting decisions include... The Payback Method. Simple Rate of Return.

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The Payback Method payback period The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates. When the net annual cash inflow is the same each year, this formula can be used to compute the payback period: Payback period = Investment required Net annual cash inflow

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The Payback Method Management at The Daily Grind wants to install an espresso bar in its restaurant. The espresso bar: Costs $140,000 and has a 10-year life. Will generate net annual cash inflows of $35,000. Management requires a payback period of 5 years or less on all investments. What is the payback period for the espresso bar?

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The Payback Method Payback period = Investment required Investment required Net annual cash inflow Net annual cash inflow Payback period = $140,000 $140,000 $35,000 $35,000 Payback period = 4.0 years According to the company’s criterion, management would invest in the espresso bar because its payback period is less than 5 years.

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Evaluation of the Payback Method Ignores the time value of money. Ignores cash flows after the payback period. Short-comings of the Payback Period.

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The Annual Rate of Return Method (Simple) accounting income Does not focus on cash flows -- rather it focuses on accounting income. The following formula is used to calculate the simple rate of return: Annual rate of return = Incremental Incremental expenses, Incremental Incremental expenses, revenues including depreciation revenues including depreciation - Average Investment

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The Annual Rate of Return Method Management of The Daily Grind wants to install an espresso bar in its restaurant. The espresso bar: Cost $140,000 with a 10-year life, no salvage. Will generate incremental revenues of $100,000 and incremental expenses of $65,000 including depreciation. What is the simple rate of return on the investment project?

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The Annual Rate of Return Method Annual rate of return $100,000 - $65,000 $100,000 - $65,000 $140,000 $140,000 = 25% = 25%= The simple rate of return method is not recommended for a variety of reasons, the most important of being that it ignores the time value of money.

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Postaudit of Investment Projects A postaudit is a follow-up after the project has been approved to see whether or not expected results are actually realized.

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End of Chapter 12

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