PLANNING FOR CAPITAL INVESTMENTS CHAPTER 1212 PLANNING FOR CAPITAL INVESTMENTS Chapter 12-1

Study Study Objectives Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting. Describe the cash payback technique. Explain the net present value method. Identify the challenges presented by intangible benefits in capital budgeting. Describe the profitability index. Indicate the benefits of performing a post- audit. Explain the internal rate of return method. Describe the annual rate of return method. Chapter 12-2

Capital Budgeting Evaluation Process Many companies follow a carefully prescribed process in capital budgeting. At least once a year: 1) Proposals for projects are requested from each department. 2) The proposals are screened by a capital budgeting committee, which submits its finding to officers of the company. 3) Officers select projects and submit a list of projects to the board of directors. LO 1 Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting. Chapter 12-3

Capital Budgeting Evaluation Process The capital budgeting decision depends on a variety of considerations: 1) The availability of funds. 2) Relationships among proposed projects. 3) The company’s basic decision-making approach. 4) The risk associated with a particular project. LO 1 Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting. Chapter 12-4

Cash Payback Formula The cash payback technique identifies the time period required to recover the cost of the capital investment from the annual cash inflow produced by the investment. The formula for computing the cash payback period is: Chapter 12-5 LO 2 Describe the cash payback technique.

Estimated Annual Net Income from Capital Expenditure Assume that Reno Co. is considering an investment of $130,000 in new equipment. The new equipment is expected to last 5 years. It will have zero salvage value at the end of its useful life. The straight-line method of depreciation is used for accounting purposes. The expected annual revenues and costs of the new product that will be produced from the investment are: Sales $200,000 Less: Costs and expenses $132,000 Depreciation expense ($130,000/5) 26,000 Selling and administrative expenses 22,000 180,000 Income before income taxes 20,000 Income tax expense 7,000 Net income $ 13,000 Chapter 12-6 LO 2 Describe the cash payback technique.

Computation of Annual Cash Inflow Cash income per year equals net income plus depreciation expense. Annual (or net) cash inflow is approximated by taking net income and adding back depreciation expense. Depreciation expense is added back because depreciation on the capital expenditure does not involve an annual outflow of cash. Net income $13,000 Add: Depreciation expense 26,000 Cash income $39,000 LO 2 Describe the cash payback technique. Chapter 12-7

Cash Payback Period $130,000 ÷ $39,000 = 3.33 years The cash payback period in this example is therefore 3.33 years, computed as follows: $130,000 ÷ $39,000 = 3.33 years When the payback technique is used to decide among acceptable alternative projects, the shorter the payback period, the more attractive the investment. This is true for two reasons: 1) the earlier the investment is recovered, the sooner the cash funds can be used for other purposes, and 2) the risk of loss from obsolescence and changed economic conditions is less in a shorter payback period. LO 2 Describe the cash payback technique. Chapter 12-8

8.00 years. 3.08 years. 5.00 years. 13.33 years. Review Question A $100,000 investment with a zero scrap value has an 8-year life. Compute the payback period if straight-line depreciation is used and net income is determined to be $20,000. 8.00 years. 3.08 years. 5.00 years. 13.33 years. LO 2 Describe the cash payback technique. Chapter 12-9

8.00 years. 3.08 years. 5.00 years. 13.33 years. Review Question A $100,000 investment with a zero scrap value has an 8-year life. Compute the payback period if straight-line depreciation is used and net income is determined to be $20,000. 8.00 years. 3.08 years. 5.00 years. 13.33 years. LO 2 Describe the cash payback technique. Chapter 12-10

Net Present Value Method S The discounted cash flow technique is generally recognized as the best conceptual approach to making capital budgeting decisions. This technique considers both the estimated total cash inflows and the time value of money. Two methods are used with the discounted cash flow technique: 1) net present value and 2) internal rate of return Chapter 12-11 LO 3 Explain the net present value method.

Net Present Value Method Under the net present value method, cash inflows are discounted to their present value and then compared with the capital outlay required by the investment. The interest rate used in discounting the future cash inflows is the required minimum rate of return. A proposal is acceptable when NPV is zero or positive. The higher the positive NPV, the more attractive the investment. LO 3 Explain the net present value method. Chapter 12-12

Net Present Value Decision Criteria LO 3 Explain the net present value method. Chapter 12-13

Present Value of Annual Cash Inflows-Equal Annual Cash Flows Stewart Soup Company’s annual cash inflows are $24,000. If we assume this amount is uniform over the asset’s useful life, the present value of the annual cash inflows can be computed by using the present value of an annuity of 1 for 10 periods. The computations at rates of return of 12% and 15%, respectively are: LO 3 Explain the net present value method. Chapter 12-14

Computation of Net Present Values The analysis of the proposal by the net present value method is as follows: The proposed capital expenditure is acceptable at a required rate of return of 12% (not 15%) because the net present value is positive. LO 3 Explain the net present value method. Chapter 12-15

Present Value of Annual Cash Inflows-Unequal Annual Cash Flows When annual cash inflows are unequal, we cannot use annuity tables to calculate their present value. Instead tables showing the present value of a single future amount must be applied to each annual cash inflow. $260,000 $155,667 $140,061 LO 3 Explain the net present value method. Chapter 12-16

Analysis of Proposal Using Net Present Value Method Therefore, the analysis of the proposal by the net present value method is as follows: Positive (negative) net present value $ 25,667 $10,061 In this example, the present values of the cash inflows are greater than the $130,000 capital investment. Thus, the project is acceptable at both a 12% and 15% required rate of return. LO 3 Explain the net present value method. Chapter 12-17

Review Question $(9,062). $22,511. $9,062. $(22,511). Compute the net present value of a $260,000 investment with a 10-year life, annual cash inflows of $50,000 and a discount rate of 12%. $(9,062). $22,511. $9,062. $(22,511). LO 3 Explain the net present value method. Chapter 12-18

Review Question $(9,062). $22,511. $9,062. $(22,511). Compute the net present value of a $260,000 investment with a 10-year life, annual cash inflows of $50,000 and a discount rate of 12%. $(9,062). $22,511. $9,062. $(22,511). LO 3 Explain the net present value method. Chapter 12-19

Additional Considerations The previous NPV example relied on tangible costs and benefits that can be relatively easily quantified. By ignoring intangible benefits, such as increased quality, improved safety, etc. capital budgeting techniques might incorrectly eliminate projects that could be financially beneficial to the company. LO 4 Identify the challenges presented by intangible benefits in capital budgeting. Chapter 12-20

Additional Considerations To avoid rejecting projects thatactually should be accepted, two possible approaches are suggested: 1. Calculate net present value ignoring intangible benefits. Then, if the NPV is negative, ask whether the intangible benefits are worth at least the amount of the negative NPV. 2. Project rough, conservative estimates of the value of the intangible benefits, and incorporate these values into the NPV calculation. LO 4 Identify the challenges presented by intangible benefits in capital budgeting. Chapter 12-21

The Profitability Index Present Value of Net Cash Flows ÷ Initial Investment = Profitability Index Project A Project B Present Value of Net Cash Flows $58,112 $110,574 Initial Investment $40,000 $90,000 Profitability Index 1.45 1.23 LO 5 Describe the profitability index. Chapter 12-22

Thus, Project A is more desirable. Profitability Index In the previous slide, the profitability index of Project A exceeds that of Project B. Thus, Project A is more desirable. If the projects are not mutually exclusive, and if resources are not limited, then the company should invest in both projects, since both have positive NPVs. LO 5 Describe the profitability index. Chapter 12-23

Review Question Project B. Project A or B. Project A. Assume Project A has a present value of net cash inflows of $79,600 and an initial investment of $60,000. Project B has a present value of net cash inflows of $82,500 and an initial investment of $75,000. Assuming the projects are mutually exclusive, which project should management select? Project B. Project A or B. Project A. There is not enough data to answer the question. LO 5 Describe the profitability index. Chapter 12-24

Review Question Project B. Project A or B. Project A. Assume Project A has a present value of net cash inflows of $79,600 and an initial investment of $60,000. Project B has a present value of net cash inflows of $82,500 and an initial investment of $75,000. Assuming the projects are mutually exclusive, which project should management select? Project B. Project A or B. Project A. There is not enough data to answer the question. LO 5 Describe the profitability index. Chapter 12-25

Post-Audit of Investment Projects Performing a post-audit is important for a variety of reasons. If managers know that their estimates will be compared to actual results they will be more likely to submit reasonable and accurate data when making investment proposals. A post-audit provides a formal mechanism by which the company can determine whether existing projects should be supported or terminated. Post-audits improve future investment proposals because by evaluating past successes and failures, managers improve their estimation techniques. LO 6 Indicate the benefits of performing a post-audit. Chapter 12-26

Formula for Internal Rate of Return Factor Internal Rate of Return Method Formula for Internal Rate of Return Factor The internal rate of return method finds the interest yield of the potential investment. This is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows. Determining the true interest rate involves two steps: STEP 1.Compute the internal rate of return factor using this formula: LO 7 Explain the internal rate of return method. Chapter 12-27

Internal Rate of Return Method The computation for the Stewart Soup Company, assuming equal annual cash inflows is: $244,371 ÷ $1000,000 = 2.44371 LO 7 Explain the internal rate of return method. Chapter 12-28

Internal Rate of Return Method STEP 2. Use the factor and the present value of an annuity of 1 table to find the internal rate of return. The internal rate of return is found by locating the discount factor that is closest to the internal rate of return factor for the time period covered by the annual cash flows. For Stewart Soup, the annual cash flows are expected to continue for 3 years. In the table below, the discount factor of 2.44371 represents an interest rate of 11%. LO 7 Explain the internal rate of return method. Chapter 12-29

Internal Rate of Return Decision Criteria The decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return. Reject the project when the internal rate of return is less than the required rate. LO 7 Explain the internal rate of return method. Chapter 12-30

Comparison of Discounted Cash Flow Methods In practice, the internal rate of return and cash payback methods are most widely used. A comparative summary of the two discounted cash flow methods-net present value and internal rate of return- is presented below: LO 7 Explain the internal rate of return method. Chapter 12-31

Review Question A $60,000 project has net cash inflows for 10 years of $9,349. Compute the internal rate of return from this investment. 8%. 10%. 9%. 11%. LO 7 Explain the internal rate of return method. Chapter 12-32

Review Question A $60,000 project has net cash inflows for 10 years of $9,349. Compute the internal rate of return from this investment. 8%. 10%. 9%. 11%. LO 7 Explain the internal rate of return method. Chapter 12-33

Annual Rate of Return Formula The annual rate of return technique is based on accounting data. It indicates the profitability of a capital expenditure. The formula is: The annual rate of return is compared with its required minimum rate of return for investments of similar risk. This minimum return is based on the company’s cost of capital, which is the rate of return that management expects to pay on all borrowed and equity funds. LO 8 Describe the annual rate of return method. Chapter 12-34

Formula for Computing Average Investment Expected annual net income ($13,000) is obtained from the projected income statement. Average investment is derived from the following formula: For Reno, average investment is $65,000: [($130,000 + $0)/2] LO 8 Describe the annual rate of return method. Chapter 12-35

Solution to Annual Rate of Return Problem The expected annual rate of return for Reno Company’s investment in new equipment is therefore 20%, computed as follows: $13,000 ÷ $65,000 = 20% The decision rule is: A project is acceptable if its rate of return is greater than management’s minimum rate of return. It is unacceptable when the reverse is true. When choosing among several acceptable projects, the higher the rate of return for a given risk, the more attractive the investment. Chapter 12-36 LO 8 Describe the annual rate of return method.

Review Question Bear Company computes an expected annual net income from an investment of $30,000. The investment has an initial cost of $200,000 and a terminal value of $20,000. Compute the annual rate of return. 15%. 30%. 25%. 27.3%. LO 8 Describe the annual rate of return method. Chapter 12-37

Review Question Bear Company computes an expected annual net income from an investment of $30,000. The investment has an initial cost of $200,000 and a terminal value of $20,000. Compute the annual rate of return. 15%. 30%. 25%. 27.3%. LO 8 Describe the annual rate of return method. Chapter 12-38

All About You: The Risks of Adjustable Rates Chapter 12-39

All About You: The Risks of Adjustable Rates

All About You: The Risks of Adjustable Rates

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