CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Capital Budgeting

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Capital Budgeting

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Capital Budgeting Is... The process of making capital expenditure decisions in business. Choosing among many capital projects to find the one(s) that will MAXIMIZE a company’s return on its financial investment.

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Capital Budgeting Authorization

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Capital Budgeting Uses estimated Cash Inflows and Outflows- not accrual-based income statement numbers.

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Capital Budgeting Cash Outflows: Initial investment Repairs and investment Increased operating cost Overhaul of equipment Cash Inflows Sale of old equipment Increased cash received from customers Reduced cash outflows related to operating costs Salvage value of equipment when project is completed. Illustration 10-2

Illustration 10-3 Data To Be Used In Following Examples Initial investment$130,000 Estimated useful life 10 years Estimated salvage value Estimated annual cash flows Cash inflow from customers$200,000 Cash outflows for operating costs 176,000 Net annual cash inflow$ 24,000

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Cash Payback Technique A capital budgeting technique that identifies the time period required to recover the cost of a capital investment from the annual cash inflow produced by the investment. Cost of Capital Investment  = Net Annual Cash Inflow Cash Payback Period Illustration 10-4 The shorter the payback period, the better.

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Cash Payback Technique Cost of Capital Investment  = Net Annual Cash Inflow Cash Payback Period Illustration 10-4 $130,000  $24,000 = 5.42 years Illustration 10-4

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Cash Payback Advantages: éMay be critical factor if company needs a fast turnaround of money. éEasy to compute and understand. Disadvantages: éIgnores profitability of project. éIgnore time value of money.

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Net Present Value The difference that results when the original capital outlay is subtracted from the discounted cash inflows.

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Net Present Value Method A method used in capital budgeting in which cash inflows are discounted to their present value and then compared to the capital outlay required by the investment.

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Discounted Cash Flow Technique A capital budgeting technique that considers both the estimated total cash inflows from the investment and the time value of money.

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Illustration 10-5 Net Present Value Criteria

Net Present Value Annual cash inflows are $24,000 for all ten years. PV at 12% Discount factor for annuity of $1 for 10 periods Present value of cash flows: $24,000 x $135,605 Illustration 10-6 The analysis of the proposal by the Net Present Value method is: 12% Present value of cash flows:$135,605 Capital investment 130,000 Net present value$ 5,605 Illustration 10-7 The proposed capital expenditure is acceptable at the 12% required rate of return because the NPV is positive.

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Choosing A Discount Rate A company uses a discount rate that is equal to its cost of capital. The cost of capital is a weighted average of the rates paid on borrowed funds and funds from investors in the company’s stock. A discount rate has two elements: a cost of capital element a risk element. Companies often assume the risk element is zero.

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Cost of Capital The average rate of return that the firm must pay to obtain borrowed and equity funds.

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Net Present Value Assumptions All cash flows come at the end of each year. All cash flows are immediately reinvested in another project that has a similar return. All cash flows can be predicted with certainty.

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Intangible Benefits Increased quality Safety Employee loyalty To avoid rejecting projects that should be accepted, two possible approaches are suggested: –Calculate NPV ignoring intangible benefits and if NPV is negative, ask if intangible benefits are worth at least the negative NPV. –Project rough, conservative estimates of the value of the intangible benefits and include those in NPV calculation.

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Mutually Exclusive Projects Project AProject B Initial investment$40,000$90,000 Net annual cash inflows10,00019,000 Salvage value5,00010,000 Net present value18,11220,574 Illustration year life 12% discount rate

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Mutually Exclusive Projects Revised investment information for the two projects is: Project AProject B Initial investment$40,000$90,000 Net annual cash inflows10,00019,000 Salvage value5,00010,000 Present value of cash flows: ($10,000 x ) + ($5,000 x.32197)58,112 ($19,000 x ) + ($10,000 x.32197)110,574 Illustration 10-18

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Profitability Index A method of comparing alternative projects that takes into account: the size of the investment its discounted future cash flows. Present Value of Cash Flows  = Initial Investment Profitability Index Illustration 10-17

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Profitability Index Revised investment information for the two projects is: Project AProject B Initial investment$40,000$90,000 Net annual cash inflows10,00019,000 Salvage value5,00010,000 Present value of cash flows: ($10,000 x ) + ($5,000 x.32197)58,112 ($19,000 x ) + ($10,000 x.32197)110,574 Illustration Illustration Profitability Index = Present Value of Cash Flows Initial Investment Project A Project B $58,112 = 1.45$110,574 = 1.23 $40,000 $90,000 Project A is better because it has the higher profitability index.

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Post-audit A thorough evaluation of how well a project’s actual performance matches the projections made when the project was proposed.

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Internal Rate of Return Illustration 10-21

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Internal Rate of Return The rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows.

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Internal Rate of Return Method A method used in capital budgeting that results in finding the interest yield of the potential investment.

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Annual Rate of Return Method The determination of the profitability of a capital expenditure by dividing expected annual net income by the average investment

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show Illustration Illustration Sales$200,000 Less: Cost and expenses Manufacturing costs $132,000 Depreciation expense ($130,000  5) 26,000 Selling and administrative expenses 22, ,000 Income before income taxes20,000 Income tax expense 7,000 Net income$ 13,000 Annual Rate of Return Method Illustration Average Investment Original Investment + Value at end of usefu1 life 2 $13,000  $65,000 = 20%

CapitalCapital Budgeting CashCash PaybackPayback NetNet Present ValuePresent IntangibleIntangible Benefits in Capital Budgeting ProfitabilityProfitability Index PostPost Audits InternalInternal Rate of Return Method AnnualAnnual Rate of Return Method Next Slide Previous Slide End Show