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McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12 Capital Budgeting Decisions

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12-2 Typical Capital Budgeting Decisions Plant expansion Equipment selection Equipment replacement Lease or buy Cost reduction Capital budgeting analysis can be used for any decision that involves an outlay now in order to obtain some future return. Typical capital budgeting decisions include:

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12-3 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. 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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12-4 Time Value of Money A dollar today is worth more than a dollar a year from now. Therefore, investments that promise earlier returns are preferable to those that promise later returns.

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12-5 discounted cash flows The capital budgeting techniques that best recognize the time value of money are those that involve discounted cash flows. Time Value of Money

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12-6 Learning Objective 1 Evaluate the acceptability of an investment project using the net present value method.

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12-7 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. 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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12-8 The Net Present Value Method General decision rule...

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12-9 Net present value analysis emphasizes cash flows and not accounting net income. The reason is that accounting net income is based on accruals that ignore the timing of cash flows into and out of an organization. The Net Present Value Method

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12-10 Repairs and maintenance Incrementaloperatingcosts InitialinvestmentWorkingcapital Typical Cash Outflows

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12-11Reduction of costs Salvagevalue Incrementalrevenues Release of workingcapital Typical Cash Inflows

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12-12 Two simplifying assumptions are usually made in net present value analysis: end of periods All cash flows other than the initial investment occur at the end of periods. immediately reinvested All cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate. Two Simplifying Assumptions

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12-13 Choosing a 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. 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. The firm’s cost of capital is usually regarded as the minimum required rate of return. The firm’s cost of capital is usually regarded as the minimum required rate of return. 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. 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. The firm’s cost of capital is usually regarded as the minimum required rate of return. The firm’s cost of capital is usually regarded as the minimum required rate of return.

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12-14 The Net Present Value Method Let’s look at how we use the net present value method to make business decisions.

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12-15 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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12-16 The Net Present Value Method At the end of five years, the working capital will be released and may be used elsewhere by Lester. 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? Lester Company uses a discount rate of 10%. Should the contract be accepted? At the end of five years, the working capital will be released and may be used elsewhere by Lester. 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? Lester Company uses a discount rate of 10%. Should the contract be accepted?

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12-17 The Net Present Value Method Annual net cash inflows from operations

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12-18 The Net Present Value Method

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12-19 annuity Present value of an annuity of $1 factor for 5 years at 10%. annuity Present value of an annuity of $1 factor for 5 years at 10%. The Net Present Value Method

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12-20 Present value of $1 factor for 3 years at 10%. Present value of $1 factor for 3 years at 10%. The Net Present Value Method

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12-21 Present value of $1 factor for 5 years at 10%. Present value of $1 factor for 5 years at 10%. The Net Present Value Method

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12-22 positive Accept the contract because the project has a positive net present value. The Net Present Value Method

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12-23 Quick Check Denny Associates has been offered a four-year contract to supply the computing requirements for a local bank. The working capital is released at the end of the contract. Denny Associates requires a 14% return.

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12-24 Quick Check What is the net present value of the contract with the local bank? a. $150,000 b. $ 28,230 c. $ 92,340 d. $132,916 What is the net present value of the contract with the local bank? a. $150,000 b. $ 28,230 c. $ 92,340 d. $132,916

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12-25 What is the net present value of the contract with the local bank? a. $150,000 b. $ 28,230 c. $ 92,340 d. $132,916 What is the net present value of the contract with the local bank? a. $150,000 b. $ 28,230 c. $ 92,340 d. $132,916 Quick Check

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12-26 Expanding the Net Present Value Method To compare competing investment projects, we can use the following net present value approaches: Total-cost Total-cost Incremental cost Incremental cost To compare competing investment projects, we can use the following net present value approaches: Total-cost Total-cost Incremental cost Incremental cost

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12-27 The Total-Cost Approach White Co. has two alternatives: (1) remodel an old car wash or, (2) remove it and install a new one. The company uses a discount rate of 10%. White Co. has two alternatives: (1) remodel an old car wash or, (2) remove it and install a new one. The company uses a discount rate of 10%.

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12-28 The Total-Cost Approach If White installs a new washer... Let’s look at the net present value of this alternative.

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12-29 If we install the new washer, the investment will yield a positive net present value of $83,202. The Total-Cost Approach

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12-30 The Total-Cost Approach If White remodels the existing washer... Let’s look at the present value of this second alternative.

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12-31 If we remodel the existing washer, we will produce a positive net present value of $56,405. The Total-Cost Approach

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12-32 Both projects yield a positive net present value. However, investing in the new washer will produce a higher net present value than remodeling the old washer. The Total-Cost Approach

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12-33 The Incremental-Cost Approach Under the incremental-cost approach, only those cash flows that differ between the two alternatives are considered. Let’s look at an analysis of the White Co. decision using the incremental-cost approach. Under the incremental-cost approach, only those cash flows that differ between the two alternatives are considered. Let’s look at an analysis of the White Co. decision using the incremental-cost approach.

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12-34 We get the same answer using either the total-cost or incremental-cost approach. The Incremental-Cost Approach

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12-35 Quick Check Consider the following alternative projects. Each project would last for five years. Project AProject B Initial investment$80,000$60,000 Annual net cash inflows20,00016,000 Salvage value10,0008,000 The company uses a discount rate of 14% to evaluate projects. Which of the following statements is true? a. NPV of Project A > NPV of Project B by $5,230 b. NPV of Project B > NPV of Project A by $5,230 c. NPV of Project A > NPV of Project B by $2,000 d. NPV of Project B > NPV of Project A by $2,000

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12-36 Consider the following alternative projects. Each project would last for five years. Project AProject B Initial investment$80,000$60,000 Annual net cash inflows20,00016,000 Salvage value10,0008,000 The company uses a discount rate of 14% to evaluate projects. Which of the following statements is true? a. NPV of Project A > NPV of Project B by $5,230 b. NPV of Project B > NPV of Project A by $5,230 c. NPV of Project A > NPV of Project B by $2,000 d. NPV of Project B > NPV of Project A by $2,000 Quick Check

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12-37 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. Let’s look at the Home Furniture Company. In decisions where revenues are not directly involved, managers should choose the alternative that has the least total cost from a present value perspective. Let’s look at the Home Furniture Company.

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12-38 Least Cost Decisions Home Furniture Company is trying to decide whether to overhaul an old delivery truck now or purchase a new one. The company uses a discount rate of 10%. Home Furniture Company is trying to decide whether to overhaul an old delivery truck now or purchase a new one. The company uses a discount rate of 10%.

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12-39 Here is information about the trucks... Least Cost Decisions

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12-40 Least Cost Decisions

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12-41 Least Cost Decisions new Home Furniture should purchase the new truck.

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12-42 Quick Check Bay Architects is considering a drafting machine that would cost $100,000, last four years, and provide annual cash savings of $10,000 and considerable intangible benefits each year. How large (in cash terms) would the intangible benefits have to be per year to justify investing in the machine if the discount rate is 14%? Bay Architects is considering a drafting machine that would cost $100,000, last four years, and provide annual cash savings of $10,000 and considerable intangible benefits each year. How large (in cash terms) would the intangible benefits have to be per year to justify investing in the machine if the discount rate is 14%? a. $15,000 b. $90,000 c. $24,317 d. $60,000 Bay Architects is considering a drafting machine that would cost $100,000, last four years, and provide annual cash savings of $10,000 and considerable intangible benefits each year. How large (in cash terms) would the intangible benefits have to be per year to justify investing in the machine if the discount rate is 14%? Bay Architects is considering a drafting machine that would cost $100,000, last four years, and provide annual cash savings of $10,000 and considerable intangible benefits each year. How large (in cash terms) would the intangible benefits have to be per year to justify investing in the machine if the discount rate is 14%? a. $15,000 b. $90,000 c. $24,317 d. $60,000

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12-43 Bay Architects is considering a drafting machine that would cost $100,000, last four years, and provide annual cash savings of $10,000 and considerable intangible benefits each year. How large (in cash terms) would the intangible benefits have to be per year to justify investing in the machine if the discount rate is 14%? Bay Architects is considering a drafting machine that would cost $100,000, last four years, and provide annual cash savings of $10,000 and considerable intangible benefits each year. How large (in cash terms) would the intangible benefits have to be per year to justify investing in the machine if the discount rate is 14%? a. $15,000 b. $90,000 c. $24,317 d. $60,000 Bay Architects is considering a drafting machine that would cost $100,000, last four years, and provide annual cash savings of $10,000 and considerable intangible benefits each year. How large (in cash terms) would the intangible benefits have to be per year to justify investing in the machine if the discount rate is 14%? Bay Architects is considering a drafting machine that would cost $100,000, last four years, and provide annual cash savings of $10,000 and considerable intangible benefits each year. How large (in cash terms) would the intangible benefits have to be per year to justify investing in the machine if the discount rate is 14%? a. $15,000 b. $90,000 c. $24,317 d. $60,000 Quick Check $70,860/2.914 = $24,317

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12-44 Learning Objective 2 Rank investment projects in order of preference.

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12-45 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. Preference Decision – The Ranking of Investment Projects

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12-46 The net present value of one project cannot be directly compared to the net present value of another project unless the investments are equal. Net Present Value Method

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12-47 Ranking Investment Projects Profitability Net present value of the project index Investment required = The higher the profitability index, the more desirable the project. Therefore, investment B is more desirable than investment A. The higher the profitability index, the more desirable the project. Therefore, investment B is more desirable than investment A.

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12-48 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: Internal Rate of Return Method

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12-49 Other Approaches to Capital Budgeting Decisions Other methods of making capital budgeting decisions include... The Payback Method. Simple Rate of Return. Other methods of making capital budgeting decisions include... The Payback Method. Simple Rate of Return.

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12-50 Learning Objective 3 Determine the payback period for an investment.

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12-51 The Payback Method 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: When the net annual cash inflow is the same each year, this formula can be used to compute the 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: 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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12-52 The Payback Method The management at the Daily Grind wants to install an espresso bar in its restaurant. The management at the Daily Grind wants to install an espresso bar in its restaurant. The espresso bar: The espresso bar: 1. Costs $140,000 and has a 10-year life. 2. Will generate net annual cash inflows of $35,000. Management requires a payback period of 5 years or less on all investments. Management requires a payback period of 5 years or less on all investments. What is the payback period for the espresso bar? The management at the Daily Grind wants to install an espresso bar in its restaurant. The management at the Daily Grind wants to install an espresso bar in its restaurant. The espresso bar: The espresso bar: 1. Costs $140,000 and has a 10-year life. 2. Will generate net annual cash inflows of $35,000. Management requires a payback period of 5 years or less on all investments. 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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12-53 Payback period = Investment required Investment required Net annual cash inflow Payback period = $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. The Payback Method

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12-54 Quick Check Consider the following two investments: Project XProject Y Initial investment$100,000$100,000 Year 1 cash inflow$60,000$60,000 Year 2 cash inflow$40,000$35,000 Year 3-10 cash inflows$0$25,000 Which project has the shortest payback period? a. Project X b. Project Y c. Cannot be determined Consider the following two investments: Project XProject Y Initial investment$100,000$100,000 Year 1 cash inflow$60,000$60,000 Year 2 cash inflow$40,000$35,000 Year 3-10 cash inflows$0$25,000 Which project has the shortest payback period? a. Project X b. Project Y c. Cannot be determined

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12-55 Consider the following two investments: Project XProject Y Initial investment$100,000$100,000 Year 1 cash inflow$60,000$60,000 Year 2 cash inflow$40,000$35,000 Year 3-10 cash inflows$0$25,000 Which project has the shortest payback period? a. Project X b. Project Y c. Cannot be determined Consider the following two investments: Project XProject Y Initial investment$100,000$100,000 Year 1 cash inflow$60,000$60,000 Year 2 cash inflow$40,000$35,000 Year 3-10 cash inflows$0$25,000 Which project has the shortest payback period? a. Project X b. Project Y c. Cannot be determined Quick Check Project X has a payback period of 2 years.Project X has a payback period of 2 years. Project Y has a payback period of slightly more than 2 years.Project Y has a payback period of slightly more than 2 years. Which project do you think is better?Which project do you think is better?

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12-56 Ignores the time value of money. Ignores cash flows after the payback period. Criticisms of the payback period. Evaluation of the Payback Method

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12-57 Serves as screening tool. Identifies investments that recoup cash investments quickly. Identifies products that recoup initial investment quickly. Strengths of the payback period. Evaluation of the Payback Method

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12-5812345$1,000$0$2,000$1,000$500 When the cash flows associated with an investment project change from year to year, the payback formula introduced earlier cannot be used. Instead, the un-recovered investment must be tracked year by year. When the cash flows associated with an investment project change from year to year, the payback formula introduced earlier cannot be used. Instead, the un-recovered investment must be tracked year by year. Payback and Uneven Cash Flows

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12-5912345$1,000$0$2,000$1,000$500 For example, if a project requires an initial investment of $4,000 and provides uneven net cash inflows in years 1-5, as shown, the investment would be fully recovered in year 4. Payback and Uneven Cash Flows

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12-60 Learning Objective 4 Compute the simple rate of return for an investment.

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12-61 Simple Rate of Return Method accounting net operating income Does not focus on cash flows -- rather it focuses on accounting net operating income. The following formula is used to calculate the simple rate of return: Simple rate of return = Annual Incremental Net Operating Income Initial investment* * * Should be reduced by any salvage from the sale of the old equipment

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12-62 Simple Rate of Return Method The Management of the Daily Grind wants to install an espresso bar in its restaurant. The Management of the Daily Grind wants to install an espresso bar in its restaurant. The espresso bar: The espresso bar: 1. Cost $140,000 and has a 10-year life. 2. 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? The Management of the Daily Grind wants to install an espresso bar in its restaurant. The Management of the Daily Grind wants to install an espresso bar in its restaurant. The espresso bar: The espresso bar: 1. Cost $140,000 and has a 10-year life. 2. 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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12-63 Simple rate of return $100,000 - $65,000 $100,000 - $65,000 $140,000 $140,000 = 25% = 25%= Criticisms of the simple rate of return include that this method ignores the time value of money and it can fluctuate from year to year. Simple Rate of Return Method

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12-64 Postaudit of Investment Projects A postaudit is a follow-up after the project has been completed to see whether or not expected results were actually realized.

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12-65 The Concept of Present Value Appendix 12A

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12-66 Learning Objective 5 Understand present value concepts and the use of present value tables.

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12-67 A dollar received today is worth more than a dollar received a year from now because you can put it in the bank today and have more than a dollar a year from now. The Mathematics of Interest

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12-68 Assume a bank pays 8% interest on a $100 deposit made today. How much will the $100 be worth in one year? F n = P(1 + r) n The Mathematics of Interest

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12-69 Assume a bank pays 8% interest on a $100 deposit made today. How much will the $100 be worth in one year? F n = P(1 + r) n F 1 = $100(1 +.08) 1 F 1 = $108.00 The Mathematics of Interest

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12-70 Compound Interest F n = P(1 + r) n What if the $108 was left in the bank for a second year? How much would the original $100 be worth at the end of the second year?

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12-71 Compound Interest The interest that is paid in the second year on the interest earned in the first year is known as compound interest. F 2 = $100(1 +.08) 2 F 2 = $116.64

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12-72 Present Value Future Value An investment can be viewed in two ways—its future value or its present value. Let’s look at a situation where the future value is known and the present value is the unknown. Computation of Present Value

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12-73 Present Value If a bond will pay $100 in two years, what is the present value of the $100 if an investor can earn a return of 12% on investments? (1 + r) n P = FnFnFnFn

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12-74 Present Value This process is called discounting. We have discounted the $100 to its present value of $79.72. The interest rate used to find the present value is called the discount rate. (1 +.12) 2 P = $100 $79.72

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12-75 Present Value Let’s verify that if we put $79.72 in the bank today at 12% interest that it would grow to $100 at the end of two years. Let’s verify that if we put $79.72 in the bank today at 12% interest that it would grow to $100 at the end of two years. If $79.72 is put in the bank today and earns 12%, it will be worth $100 in two years.

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12-76 $100 × 0.797 = $79.72 present value (rounded) Present value factor of $1 for 2 periods at 12%. Present Value – An Example

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12-77 Quick Check How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62.10 b. $56.70 c. $90.90 d. $51.90 How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62.10 b. $56.70 c. $90.90 d. $51.90

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12-78 How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62.10 b. $56.70 c. $90.90 d. $51.90 How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62.10 b. $56.70 c. $90.90 d. $51.90 Quick Check $100 0.621 = $62.10

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12-79123456$100$100$100$100$100$100 Present Value of a Series of Cash Flows annuity An investment that involves a series of identical cash flows at the end of each year is called an annuity.

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12-80 Present Value of a Series of Cash Flows Lacey Inc. 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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12-81 Present Value of a Series of Cash Flows We could solve the problem like this... $60,000 × 3.605 = $216,300

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12-82 Quick Check If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? a. $34.33 b. $500.00 c. $343.30 d. $360.50 If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? a. $34.33 b. $500.00 c. $343.30 d. $360.50

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12-83 If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? a. $34.33 b. $500.00 c. $343.30 d. $360.50 If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? a. $34.33 b. $500.00 c. $343.30 d. $360.50 Quick Check $100 3.433 = $343.30

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12-84 Quick Check If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? a. $866.90 b. $178.60 c. $ 86.90 d. $300.00 If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? a. $866.90 b. $178.60 c. $ 86.90 d. $300.00

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12-85 If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? a. $866.90 b. $178.60 c. $ 86.90 d. $300.00 If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years? a. $866.90 b. $178.60 c. $ 86.90 d. $300.00 Quick Check $100 (3.433 - 1.647) = $100 1.786 = $178.60 or $100 (0.675 + 0.592 + 0.519) = $100 1.786 = $178.60

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12-86 End of Chapter 12

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Capital Budgeting Decisions

Capital Budgeting Decisions

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