Capital Budgeting Decisions Chapter 13 ACTG 202 – Principles of Managerial Accounting Time Value of Money Assignment 5 icqs

Typical Capital Budgeting Decisions Plant expansion Equipment selection Equipment replacement Lease or buy Cost reduction

Typical Capital Budgeting Decisions Capital budgeting tends to fall into two broad categories. Screening decisions. Does a proposed project meet some preset standard of acceptance? Preference decisions. Selecting from among several competing courses of action.

Time Value of Money The discussion of capital budgeting begins with a discussion of the time value of money. A dollar today is worth more than a dollar a year from now. Therefore, projects that promise earlier returns are preferable to those that promise later returns.

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

Present Value and Future Value Need to introduce use of TI calculator!!!! Setting decimal places – 2ND FORMAT 9 ENTER TVM line of functions Clearing TVM 2nd QUIT; 2nd CLR TVM If your rich uncle offered you $10,000 today or $10,000 at in 3 years, which would you take? What about $11,000, $15,000? FV of $10,000 compounded annually at 5%. (CALCULATE MANUALLY AND WITH CALCULATOR) PV of $11,576/25 over 3 years at 5% = $10,000 (PV) Annuity – stream of equal cash flows PV of $200 per year for 3 years Do by year – then calculate – PV is $545

Determine the payback period for an investment. Learning Objective 1 Determine the payback period for an investment.

The Payback Method The payback method focuses on the payback period, which is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates. Ex. 13-1 (page 609)

Evaluation of the Payback Method Ignores the time value of money. Short-comings of the payback method. Shorter payback period does not always mean a more desirable investment. Ignores cash flows after the payback period.

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

Learning Objective 2 Evaluate the acceptability of an investment project using the net present value method.

The Net Present Value Method The net present value method compares the present value of a project’s cash inflows with the present value of its cash outflows. The difference between these two streams of cash flows is called the net present value.

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. The idea is to bring EVERYTHING back to its value at time zero. An interest rate needs to be selected and used in the calculation. Ex. 13-2 (page 609) Ex. 13-7 (page 610) Ex. 13-10 (page 611)

The Net Present Value Method Two Simplifying Assumptions All cash flows other than the initial investment occur at the end of periods. All cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate.

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

The Net Present Value Method Why do we focus on PV rather than FV?

Choosing a Discount Rate The company’s cost of capital is usually regarded as the minimum required rate of return. The cost of capital is the average return the company must pay to its long-term creditors and stockholders.

Learning Objective 3 Evaluate the acceptability of an investment project using the internal rate of return method.

Internal Rate of Return Method The internal rate of return is the rate of return promised by an investment project over its useful life. It is computed by finding the discount rate that will cause the net present value of a project to be zero. It works very well if a project’s cash flows are identical every year. If the annual cash flows are not identical software, such as Excel, must be used for the calculation.

Internal Rate of Return Method General decision rule . . . Ex. 13-3 (page 609) Ex. 13-15 (page 612) When using the internal rate of return, the cost of capital acts as a hurdle rate that a project must clear for acceptance.

Comparing the Net Present Value and Internal Rate of Return Methods NPV is often simpler to use. Questionable assumption: Internal rate of return method assumes cash inflows are reinvested at the internal rate of return.

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.

Evaluate an investment project that has uncertain cash flows. Learning Objective 4 Evaluate an investment project that has uncertain cash flows.

Uncertain Cash Flows – An Example Assume that all of the cash flows related to an investment in a supertanker have been estimated, except for its salvage value in 20 years. Using a discount rate of 12%, management has determined that the net present value of all the cash flows, except the salvage value is a negative $1.04 million. How large would the salvage value need to be to make this investment attractive?

Uncertain Cash Flows – An Example If the salvage value of the supertanker is at least $10,000,000, the net present value of the investment would be positive and therefore acceptable. Ex. 13-4 (page 609)

Rank investment projects in order of preference. Learning Objective 5 Rank investment projects in order of preference.

Preference Decision – The Ranking of Investment Projects Screening Decisions Preference Decisions Pertain to whether or not some proposed investment is acceptable; these decisions come first. Attempt to rank acceptable alternatives from the most to least appealing.

Internal Rate of Return Method When using the internal rate of return method to rank competing investment projects, the preference rule is: The higher the internal rate of return, the more desirable the project.

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

Ranking Investment Projects Project Net present value of the project profitability Investment required index = Ex. 13-5 (page 610) The higher the profitability index, the more desirable the project.

Time Value of Money Calculations There are a variety of resources for doing time value of money calculations: Financial Calculator (such as your TI) Excel Excel contains a number of functions for doing time value of money calculations These functions include: PV function IRR function FV function PMT function RATE function Tables and factors? Show Excel spreadsheet Show some other types of calculations that can be done with time value of money concepts. Loan payment - $250,000; 4.25%/year; 30 years, paid monthly = $1,229.85 Future value - $20,000 today; 6% per year, compounded quarterly; 20 years = $65,813 (annual compounding is $64,143) Calculate interest rate – buy $50,000 car with $5,000 down; payment is $1,217 over 60 months; no residual = I = 20.98%