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Chapter 20

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Describe the importance of capital investments and the capital budgeting process

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Making capital investment decisions Examples include: ◦ Purchasing new equipment ◦ Building new facilities ◦ Automating production ◦ Developing Web sites Affects operations for many years Requires large sums of money 3Copyright (c) 2009 Prentice Hall. All rights reserved.

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Payback period Accounting rate of return Net present value Internal rate of return Copyright (c) 2009 Prentice Hall. All rights reserved.4 Quick and easy; work well for investments with a shorter life span Use the time value of money; work well for investments with a longer life span

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Operating income differs from cash flows ◦ Cash flows do not include noncash expenses Cash inflows ◦ Future cash revenue generated ◦ Future savings in ongoing cash operating costs ◦ Future residual value Cash outflows ◦ Initial investment ◦ Operating costs, maintenance, repairs 5Copyright (c) 2009 Prentice Hall. All rights reserved.

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6 Identify potential investments Project net cash inflows Analyze using one or more of the methods Capital rationing Post-audits

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Use the payback and accounting rate of return methods to make capital investment decisions

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Length of time it takes to recover the cost of the capital outlay Measures how quickly the amount invested will be recovered The shorter the payback period, the more attractive the asset 8Copyright (c) 2009 Prentice Hall. All rights reserved.

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9 Amount invested Equal annual net cash inflows Expected annual net cash inflow Payback period Unequal annual net cash inflows Total net cash inflows until amount equals investment

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Focuses only on time, not profitability Ignores cash flows after the payback period Copyright (c) 2009 Prentice Hall. All rights reserved.10

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DECISION RULE: Payback Period Investments with shorter payback periods are more desirable, all else being equal. 11

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Copyright (c) 2009 Prentice Hall. All rights reserved.12 Payback period Amount invested Expected annual net cash inflow $314,000 $1,300,000 4.1 years

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13Copyright (c) 2009 Prentice Hall. All rights reserved. Average annual operating income from asset Average amount invested in asset Original investment + Residual value 2 2

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DECISION RULE: Invest in capital assets? If expected accounting rate of return exceeds the required rate of return? Invest If expected accounting rate of return is less than required rate of return? Do not invest 14

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Questions? Copyright (c) 2009 Prentice Hall. All rights reserved.15

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1. Which of the following decisions would NOT fall under capital budgeting? A. Purchasing new equipment B. Building a new facility C. Buying a short-term investment D. Automating production 16 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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1.Which of the following decisions would NOT fall under capital budgeting? A.Purchasing new equipment B.Building a new facility C.Buying a short-term investment D.Automating production 17 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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2. When estimating future cash inflows from a capital investment, which of the following are included? A. Future cash revenue generated B. Future savings in operating costs C. Future residual value D. All of the above 18 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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2.When estimating future cash inflows from a capital investment, which of the following are included? A.Future cash revenue generated B.Future savings in operating costs C.Future residual value D.All of the above 19 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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3. The decision rule regarding the payback period states that the: A. shorter the payback period, the more attractive the investment. B. longer the payback period, the more attractive the investment. C. payback period should exceed the asset’s life. D. payback period should be compared to the internal rate of return. 20 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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3.The decision rule regarding the payback period states that this: A.shorter the payback period, the more attractive the investment. B.longer the payback period, the more attractive the investment. C.payback period should exceed the asset’s life. D.payback period should be compared to the internal rate of return. 21 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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4. A criticism of the payback period is that it: A. uses operating income instead of cash flows. B. focuses only on the time value of money. C. de-emphasizes risk of assets with longer lives. D. ignores cash flows after the payback period. Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.22

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4.A criticism of the payback period is that it: A.uses operating income instead of cash flows. B.focuses only on the time value of money. C.de-emphasizes risk of assets with longer lives. D.ignores cash flows after the payback period. Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.23

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5. The unique element of the accounting rate of return method is: A. its focus on operating income instead of cash flows. B. its use of time value of money. C. that it ignores cash flows later in the asset’s life. D. that it generates a unique rate of return. 24 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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5.The unique element of the accounting rate of return method is: A.its focus of operating income instead of cash flows. B.its use of time value of money. C.that it ignores cash flows later in the asset’s life. D.that it generates a unique rate of return. 25 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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Use the time value of money to compute the present and future values of single lump sums and annuities

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Invested money earns income over time 27Copyright (c) 2009 Prentice Hall. All rights reserved.

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Principal (p) – amount of the investment ◦ Lump sum ◦ Annuity Stream of equal installments at regular time periods Number of periods (n) ◦ From the beginning of the investment until termination Interest rate (i) – annual percentage ◦ Simple interest Calculated only on principal ◦ Compound interest Interest earned is added to principal 28Copyright (c) 2009 Prentice Hall. All rights reserved.

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29 Present valueFuture value Time Future valuePresent value Interest earned Present valueFuture value Interest earned

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Mathematical formulas developed to compute present and future values These factors are programmed into business calculators and spreadsheet programs See Appendix B for present and future factor tables: ◦ Present Value of $1 & Future Value of $1 – for lump sum amounts (one-time investments) ◦ Present Value of Annuity & Future Value of Annuity – for a series of equal installments Copyright (c) 2009 Prentice Hall. All rights reserved.30

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Lump sum ◦ Multiply amount by factor found in table Table based on interest rate and number of periods Annuity ◦ Multiply one period’s installment by the factor found in the table Copyright (c) 2009 Prentice Hall. All rights reserved.31

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Use discounted cash flow models to make capital investment decisions

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Recognize time value of money Two methods: ◦ Net present value (NPV) ◦ Internal rate of return (IRR) Compare amount of investment with its expected net cash inflows ◦ Cash outflow for investment usually occurs now ◦ Cash inflows usually occur in the future Companies use present value to make the comparison 33Copyright (c) 2009 Prentice Hall. All rights reserved.

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34 Present value of net cash inflows Less: Investment cost Equals: Net present value Interest rate used is desired rate of return The higher the risk, the higher the rate Also called “discount rate ”

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DECISION RULE: Invest in capital assets? If NPV is positive Invest If NPV is negative Do not invest 35

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36Copyright (c) 2009 Prentice Hall. All rights reserved. If investment is expected to bring in even cash flows: ◦ Use Present Value of Annuity (PVA) table If amounts are unequal: ◦ Present value of each individual cash flow is computed ◦ Use Present Value of $1 (PV) table

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Project A Present value of net cash inflows $ 264,423 57,000 x 4.639 (PVA 14%, 8 periods) Investment cost (290,000) Net present value($25,557) Copyright (c) 2009 Prentice Hall. All rights reserved.37

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Copyright (c) 2009 Prentice Hall. All rights reserved.38 Project B Present value of net cash inflows $410,256 77,000 x 5.328 (PVA 12%, 9 periods) Investment cost (380,000) Net present value$30,256

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Number of dollars returned for every dollar invested 39Copyright (c) 2009 Prentice Hall. All rights reserved. Present value of net cash inflows Investment

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Rate of return a company can expect to earn by investing in the project The interest rate that will cause the present value to equal zero 40Copyright (c) 2009 Prentice Hall. All rights reserved. Investment’s costPresent value of net cash flows

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Copyright (c) 2009 Prentice Hall. All rights reserved.41 Investment’s cost Annual net cash inflow PVA Factor Locate PVA factor in table using the project’s life as the number of periods

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DECISION RULE: Invest in capital assets? If the IRR exceeds the required rate of return? Invest If the IRR is less than required rate of return? Do not invest 42

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Methods that Ignore the Time Value of Money Payback PeriodAccounting rate of return Simple to computeUses accrual accounting Focuses on time it takes to recover cost of asset Shows how investment will impact operating income, which is important to investors Ignores cash flows after the payback period Highlights risks of assets with longer cash recovery periods Measures the profitability over the asset’s life Ignores time value of money 43

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Methods that Incorporate the Time Value of Money Net present valueInternal rate of return Uses time value of money and asset’s cash flows over its entire life Indicates whether the asset will earn the minimum required rate of return Computes the project’s unique rate of return Shows excess or deficiency of asset’s present value of net cash flows over its initial cost Profitability index should be computed when assets have differing investment amounts No additional steps needed for capital rationing decisions 44

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Question? Copyright (c) 2009 Prentice Hall. All rights reserved.45

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6. You want to invest in an account today that earns 10% interest, so that you can have a $10,000 down payment on a home in five years. The formula used to compute the amount to invest is: A. PV factor (i = 10%, n = 5) x $10,000. B. Annuity PV factor (i = 10%, n = 5) x $10,000. C. FV factor (i = 10%, n = 5) x $10,000. D. Annuity FV factor (i = 10%, n = 5) x $10,000. 46 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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6.You want to invest in an account today that earns 10% interest, so that you can have a $10,000 down payment on a home in five years. The formula used to compute the amount to invest is: A. PV factor (i = 10%, n = 5) x $10,000. B. Annuity PV factor (i = 10%, n = 5) x $10,000. C. FV factor (i = 10%, n = 5) x $10,000. D. Annuity FV factor (i = 10%, n = 5) x $10,000. 47 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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7. What factor affects the time value of money? A. Principal – the amount of the invested B. Interest rate C. Time amount is invested D. All of the above 48 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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7.What factor affects the time value of money? A.Principal – the amount of the invested B.Interest rate C.Time amount is invested D.All of the above 49 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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8. Which of the following capital budgeting methods uses the time value of money? A. Payback period B. Accounting rate of return C. Internal rate of return D. All of the above 50 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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8.Which of the following capital budgeting methods uses the time value of money? A.Payback period B.Accounting rate of return C.Internal rate of return D.All of the above 51 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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9. The profitability index would most likely be used with which of the following capital budgeting methods? A. Payback period B. Accounting rate of return C. Internal rate of return D. Net present value method 52 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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9.The profitability index would most likely be used with which of the following capital budgeting methods? A.Payback period B.Accounting rate of return C.Internal rate of return D.Net present value method 53 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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10. Which of the following capital budgeting methods sets the cost of the investment to equal the present value of its expected cash inflows? A. Payback period B. Accounting rate of return C. Internal rate of return D. Net present value 54 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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10.Which of the following capital budgeting methods sets the cost of the investment to equal the present value of its expected cash inflows? A.Payback period B.Accounting rate of return C.Internal rate of return D.Net present value 55 Co pyr igh t (c) 20 09 Pr ent ice Ha ll. All rig hts res erv ed.

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