1. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Chapter 21 1

2. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 2 Describe the importance of capital investments and the capital budgeting process Use the payback period and rate of return methods to make capital investment decisions Use the time value of money to compute the present and future values of single lump sums and annuities Use discounted cash flow models to make capital investment decisions

3. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Describe the importance of capital investments and the capital budgeting process 1 1 3

4. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Planning to invest in long-term assets in a way that returns the most profitability Making capital investments is acquiring capital assets Affects operations for many years Requires large sums of money Examples include: Purchasing new equipment Building new facilities Automating production Developing Web sites 4

5. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. How do managers decide whether expansion in plant and equipment will be good investments? Four methods of analyzing potential capital investments: 1. Payback period 2. Rate of return (ROR) 3. Net present value (NPV) 4. Internal rate of return (IRR) Not an exact science 5 Quick and easy and work well for investments that have a relatively short life span Factors in the time value of money

6. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Operating income based on accrual accounting Contains noncash expenses Capital investment’s net cash inflows will differ from its operating income Cash inflows: Future cash revenue generated Future savings in ongoing cash operating costs Future residual value Cash outflows: Initial investment Ongoing operating costs, maintenance, repairs 6

7. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 7 Identify potential investmentsEstimate net cash inflowsAnalyze investment using method(s)Capital rationing to choose optionsPost-audits to compare outcomes

8. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use the payback and rate of return methods to make capital investment decisions 2 2 8

9. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Used to screen capital investment choices Length of time it takes to recover the cost of the capital outlay Measures how quickly managers expect to recover their investment dollars The shorter the payback period, the more attractive the asset 9

10. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Equal annual net cash inflows Return in savings or cash flows are equal from year to year 10

11. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 11 Unequal annual net cash inflows Total net cash inflows until the amount invested is recovered

12. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Focuses only on time, not profitability Ignores cash flows after the payback period Decision rule – Investments with shorter payback period are more desirable, all else being equal 12

13. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. ROR measures the average accounting rate of return over the asset’s entire life One measure of profitability Focuses on the operating income Formula Average annual operating income The asset’s total operating income over the course of its operating life divided by its lifespan Average amount invested Net book value at the beginning of the asset’s useful life plus the net book value at the end of the asset’s useful life divided by 2 13

14. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Calculating average annual operating income from asset 14

15. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Calculating rate of return If the company required a ROR of at least 20%, this project would be rejected 15

16. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 16

17. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Consider how Smith Valley Snow Park Lodge could use capital budgeting to decide whether the $13,500,000 Snow Park Lodge expansion would be a good investment. Assume Smith Valley’s managers developed the following estimates concerning the expansion: Assume that Smith Valley uses the straight-line depreciation method and expects the lodge expansion to have a residual value of $1,000,000 at the end of its 10-year life. 17

18. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 1. Compute the average annual net cash inflow from the expansion. Average cash received from each skier per day $ 236 Average variable cost of serving each skier per day (76) Average net cash inflow per skier per day $ 160 Number of additional skiers per day × 117 Average net cash inflow per day $ 18,720 Number of ski days per year × 142 Average annual net cash inflow per year $2,658,240 2. Compute the average annual operating income from the expansion. = Average annual net cash inflow − depreciation = $2,658,240 − $1,250,000 = $1,408,240 18

19. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Refer to the Smith Valley Snow Park Lodge expansion project in S21-2 1.Compute the payback period for the expansion project. Payback period = Amount invested / Expected annual net cash inflow = $13,500,000 / $ 2,658,240 = 5.1 years (Rounded to one decimal place) 19

20. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Refer to the Smith Valley Snow Park Lodge expansion project in S21-2. 1. Calculate the ROR. 20 Accounting rate of return= Average annual operating income from investment Average amount invested = $2,658,240 − $1,250,000 [$13,500,000 + $1,000,000] / 2 = 1,408,240 $ 7,250,000 =19.42% (Round to nearest hundredths)

21. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use the time value of money to compute the present and future values of single lump sums and annuities 3 3 21

22. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Invested money earns income over time Timing of capital investments’ net cash inflows is important Two methods of capital investment using TVM The net present value (NPV) Internal rate of return (IRR) 22

23. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Principal (p)–amount of the investment Lump sum Single quantity of money Annuity Stream of equal installments at equal time intervals Number of periods (n) From the beginning of the investment until termination Interest rate (i)–annual percentage Simple interest Compound interest 23

24. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Simple interest Interest calculated only on the principal amount Compound interest Interest is calculated on the principal and on all previously earned interest Assumes that all interest earned will remain invested and earn additional interest at the same interest rate Capital investments yield compound interest Assume compounding interest for rest of this chapter 24

25. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The value of an investment at different points in time 25

26. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 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 26

27. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Lump sum Multiply amount by the factor number found in table Table based on interest rate and number of periods $10,000 invested for 5 periods at 6% 27 $10,000 X 1.3382 = $13,382 Differences due to table decimal places

28. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Annuity tables are derived from the lump-sum tables Annuity PV factors are the sums of the PV factors found in the Present Value of $1 tables Investing $2,000 at 6%, the end of each year for 5 years 28 $2,000 X 5.6371 11,274.20

29. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Lump sum Multiply amount by the factor found in table Table based on interest rate and number of periods $13,383 to be received in 5 periods at 6% 29 $13,382 X 0.7473 = $10,000 Differences due to table decimal places

30. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Assume you win the lottery Option #1: $1,000,000 now Option #2: $150,000 the end of each year for next ten years Option #3: $2,000,000 ten years from now Which option is the best? Use PV factors for single sum and annuities to find out Option #1 is $1,000,000 in your hand today Option #2 is an annuity, 10 payments Using PV annuity tables, assuming 8% 30 $150,000 x 6.7101 = $1,006,515 10 payments yield a present value of $1,006,515 and more than $1,000,000

31. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Assume you win the lottery Option #1: $1,000,000 now Option #2: $150,000 the end of each year for next ten years Option #3: $2,000,000 ten years from now Use PV factors for single sum to find out what option #3 is worth today 31 Option #3 $2,000,000 x.4632 = $ 926,400 Option #1 = $1,000,000 Option #2 = $1,006,515 Option #3 = $ 926,400 Option #2 is the highest of the three

32. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Your grandfather would like to share some of his fortune with you. He offers to give you money under one of the following scenarios (you get to choose): 1.$8,750 a year at the end of each of the next seven years. 2.$50,050 (lump sum) now. 3.$100,250 (lump sum) seven years from now. Calculate the present value of each scenario using a 6% discount rate. Which scenario yields the highest present value? Would your preference change if you used a 12% discount rate? 32

33. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Calculate the present value of each scenario using a 6% discount rate. Which scenario yields the highest present value? Would your preference change if you used a 12% discount rate? 33 Scenario #1 Present value=$ 8,750 × (Annuity PV factor, i = 6%, n = 7) =$ 8,750 × 5.582 =$ 48,843 Scenario #2 Present value=$50,050 (since it would be received now) Scenario #3 Present value=$100,250 × (PV factor, i = 6%, n = 7) =$100,250 ×.665 =$ 66,666 Scenario #3 appears to be the best option. Based on a 6% interest rate, its present value is the highest.

34. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Would your preference change if you used a 12% discount rate? 34 Scenario #1 Present value=$ 8,750 × (Annuity PV factor, i = 12%, n = 7) =$ 8,750 × 4.564 =$ 39,935 Scenario #2 Present value=$50,050 (since it would be received now) Scenario #3 Present value=$100,250 × (PV factor, i = 12%, n = 7) =$100,250 ×. 452 =$ 45,313 Scenario #2 appears to be the best option. Based on a 12% interest rate, its present value is the highest.

35. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use discounted cash flow models to make capital investment decisions 4 4 35

36. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Payback and ROR do not recognize time value of money Net present value (NPV) and internal rate of return (IRR) do recognize time value of money Both 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 investment comparison, not future value 36

37. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. NPV—the net difference between the present value of the investment’s net cash inflows and the investment’s cost (cash outflows) Discount rate—the interest rate that discounts or reduces future amounts to their lesser value in the present (today). Discount rate uses the firms desired rate of return Higher the risk – higher the rate If present value of the investment’s net cash inflows exceeds the initial cost of the investment, then it is a good investment 37

38. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Choose between two alternatives by comparing NPVs Consider these two projects: CD players generates higher total cash inflows DVRs generate cash flows sooner 38

39. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. CD players project generates equal cash flows Using Present Value of Annuity of $1, the NPV is: 39

40. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. DVR project has unequal net cash flows PV each inflow to find Net Present Value DVR project will generate net present value of $78,910 40

41. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Both projects, CD player and DVRs, had a positive NPV Both require the same investment amount Resources are limited, which project will be selected? To choose among the projects, compute the profitability index (present value index) 41

42. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Computes the number of dollars returned for every dollar invested Present value of net cash inflows Investment 42 Profitability index =

43. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 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 43

44. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Residual Values Cash inflows at the end of their useful lives Its present value is added to determine the total present value of the project(s) Discounted as a single lump sum 44

45. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Another discounted cash flow model for capital budgeting 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 45 Present value of the investment’s net cash inflows – Investment’s cost (Present value of cash outflows) $ 0

46. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Steps for computing the IRR of an investment with equal periodic cash flows: 1.IRR is the interest rate that makes the cost of the investment equal to the present value of the investment’s net cash inflows 2.Plug into the equation any information we do know 3.Rearrange the equation and solve for the Annuity PV factor (i = ?, n = 5) 4.Find the interest rate that corresponds to this Annuity PV factor 46

47. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Consider Greg’s CD-player project, which would cost $1,000,000 and result in five equal yearly cash inflows of $305,450 47 1.Investment’s cost = Amount of each equal net cash inflow X Annuity PV factor 2.$1,000,000 = $305,450 X Annuity PV factor (i = ?, n = 5) 3.$1,000,000 ÷ $305,450 = Annuity PV factor (i = ?, n = 5) $1,000,000 ÷ $305,450 = 3.273858 rounded to 4.3.274 = Annuity PV factor (i = ?, n = 5)

48. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Many times, the exact factor will not appear in the table Find the closest two factors IRR is between the two factors 48

49. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 49 Methods that Ignore the Time Value of Money

50. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 50 Methods that Incorporate the Time Value of Money

51. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Consider how Smith Valley Snow Park Lodge could use capital budgeting to decide whether the $13,500,000 Snow Park Lodge expansion would be a good investment. Assume Smith Valley’s managers developed the following estimates concerning the expansion: Assume that Smith Valley uses the straight-line depreciation method and expects the lodge expansion to have a residual value of $1,000,000 at the end of its 10-year life. 51

52. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Refer to the Smith Valley Snow Park Lodge expansion project in S21-2. 1. What is the project’s NPV? Is the investment attractive? Why? 52 The expansion is attractive project because its NPV is positive. PV factor at 10% Net Cash Inflow Total Present Value Present value of annuity of equal annual net cash inflows for 10 years at 10%6.145 × $2,658,240$16,334,885 Present value of residual value.386 × $1,000,000 386,000 Total present value$16,720,885 Investment (13,500,000) Net present value of expansion$ 3,220,885

53. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Refer to S21-2. Assume the expansion has no residual value. 1. What is the project’s NPV? Is the investment attractive? Why? 53 Without a residual value, the expansion is still attractive project because it’s NPV is positive Annuity PV factor at i=12%, n= 12 Net Cash Inflow Total Present Value Present value of annuity of equal annual net cash inflows for 12 years at 12% 6.145 × $2,658,240$16,334,885 Investment (13,500,000) Net present value of expansion$ 2,834,885

54. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Refer to S21-12. Continue to assume that the expansion has no residual value. 1. What is the project’s IRR? Is the investment attractive? Why? 54 Investment cost = Expected annual net cash inflows × Annuity PV factor (n=10, i = ?) $13,500,000=$2,658,240× Annuity PV factor (n = 10, i = ?) $13,500,000 = Annuity PV factor (n = 10, i = ?) $2,658,240 5.079= Annuity PV factor (n = 10, i = ?) The IRR is somewhere between 14 - 16%. The project attractive since it will earn a higher return than the company’s 10% hurdle rate.

55. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Capital budgeting is planning to invest in long-term assets in a way that returns the greatest profitability to the company. Capital rationing occurs when the company has limited assets available to invest in long- term assets. The four most popular capital budgeting techniques used are payback period, rate of return (ROR), net present value (NPV), and internal rate of return (IRR). 55

56. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The payback period focuses on the time it takes for the company to recoup its cash investment, but ignores all cash flows occurring after the payback period. Because it ignores any additional cash flows (including any residual value), the method does not consider the profitability of the project. The ROR, however, measures the profitability of the asset over its entire life using accrual accounting figures. It is the only method that uses accrual accounting rather than net cash inflows in its computations. The payback period and ROR methods are simple and quick to compute, so managers often use them to screen out undesirable investments. However, both methods ignore the time value of money. 56

57. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Invested money earns income over time. This is called the time value of money, and it explains why we would prefer to receive cash sooner rather than later. The time value of money means that the timing of capital investments’ net cash inflows is important. The cash inflows and outflows are either single amounts or annuities. An annuity is equal cash flows over equal time periods at the same interest rate. Time value of money tables in Appendix B help us to adjust the cash flows to the same time period (i.e., today or the present value, or a future date or the future value). 57

58. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The NPV is the net difference between the present value of the investment’s net cash inflows and the investment’s cost (cash outflows), discounted at the company’s required rate of return (hurdle) rate. The investment must meet or exceed the hurdle rate to be acceptable. The IRR is the interest rate that makes the cost of the investment equal to the present value of the investment’s net cash inflows. Capital investment (budgeting) methods that consider the time value of money (like NPV and IRR) are best for decision making. 58

59. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 59

60. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 60 Copyright All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.