1. Chapter 10 Adelman & Marks
Capital budgeting
Chapter 10
Adelman & Marks

2. Key terms Capital budgeting Capital goods
The method used to justify the acquisition of capital goods
Capital goods
Assets that have a useful life greater than 1 year

3. Why capital budgeting?
A company should make the decision to enter into a specific project, acquire another company, or purchase a specific long-term asset if the present value of the benefits exceeds the the present value of the costs.
Remember that assets are tools your business uses to help generate revenues
Example: Capital budgeting helps a business to make the most profitable decisions regarding purchase of delivery vehicles.

4. Factors Affecting Capital Budgeting
Changes in regulations (CFC banned in air conditioning)
Research and Development investments (half of all new products fail)
Changes in business strategy (when economy changes or opportunities/threats arise

5. Five Steps in Capital Budgeting
Write a proposal that identifies projected costs and benefits
Evaluate the data with respect to expected benefits and costs
Make a decision that provides greatest value while minimizing costs
Follow up on decision through post-audit to compare costs to benefits
Take corrective action if post-audit indicates benefits are not meeting expectations

6. Costs in capital budgeting
Start-up costs – total $ spent to start a project (equipment, training costs, maintenance, service agreements, hiring new people, storage space, etc)
Working capital costs – cash, investments, A/R, and inventory to show bank you can make monthly payments ($ is legally committed to lender, so it’s an opportunity cost)
Tax factor costs – additional taxes that have to be paid

7. Benefits in capital budgeting
Investments in capital equipment should increase cash flows
Capital equipment investments can be written off and provide reduced tax liability
MACRS! (see MACRS worksheet)

8. Techniques Payback Net present value (NPV) Profitability index (PI)
Internal rate of return (IRR)
Accounting rate of return (ARR)
Lowest total cost (LTC)

9. Payback
# of years it takes to get back the money it invested in project or asset
Payback = C / ATB
C = cost of project
ATB = annual after-tax benefit of project
Example – invest in $25,000 project that creates $3,000 in ATB
Payback occurs in $25,000/$3,000 = 8.33 yrs

10. Net present value
Uses time value of $ by discounting future costs and benefits to present
Combines:
PV of stream of payments for even cash flows and
PV of future lump sum of unequal yearly cash flows
Important considerations – (1) interest rate of lender and (2) interest rate you could make by investing in some other project or asset

11. Weighted Average Cost of Capital
Multiplies cost of debt by its proportion of total funds raised and multiplies cost of equity (opportunity cost to owner) by its proportion of total funds raised
Key terms:
Real rate of return (return received after factoring out inflation)
Inflation premium (expected average inflation for term of investment)
Risk premium (rate added to interest rate to account for risk of investment) (see Techniques)

12. Getting to NPV NPV = PVB - PVC NPV is net present value of investment
PVB is present value of the benefit
PVC is present value of the cost of the investment
If NPV is negative, do not make the investment (see example)

13. Profitability Index PI = PVB / PVC
From example: $170,394/$100,000 = 1.70
This project returns $1.70 for every $1 invested

14. Accounting rate of return
ARR = (average annual income)/(average cost of investment over its life)
Does not incorporate time value of $
Example: spend $10,000 on software that will help you earn $3,000/yr for 4 yrs
ARR = $3,000/$10,000 = 30%

15. Lowest total cost
Include all costs associated with two or more competing investments
Calculate PVs of these costs
Add the present value of any residual benefits (salvage value) that investment can provide
Select investment with lowest total cost

16. Recommendations Use NPV for new projects or assets
For existing operations (replacing equipment and service contracts) use LTC