© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 26-1 CAPITAL BUDGETING Chapter 26

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 26-2 Capital budgeting: Analyzing alternative long- term investments and deciding which assets to acquire or sell. Outcome is uncertain. Large amounts of money are usually involved. Investment involves a long-term commitment. Decision may be difficult or impossible to reverse. Capital Investment Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 26-3 ? ? ? Plant Expansion New Equipment Office Renovation I will choose the project with the most profitable return on available funds. Capital Investment Decisions Limited Investment Funds

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 26-4 Incremental operating costs Initial investment Repairs and maintenance Capital Investment Decisions: Typical Cash Outflows

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 26-5 Cost savings Salvage value Incremental revenues Capital Investment Decisions: Typical Cash Inflows

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 26-6 Employee morale Environmental concernsCorporate image Employee working conditions Product quality Capital Investment Decisions: Nonfinancial Considerations

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 26-7 Let’s look at methods used to make capital investment decisions. Evaluating Capital Investment Proposals: An Illustration

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 26-8 Stars’ Stadium is considering purchasing vending machines with a 5-year life. ($75,000 - $5,000) ÷ 5 years Evaluating Capital Investment Proposals: An Illustration

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 26-9 Most capital budgeting techniques use annual net cash flow. Depreciation is not a cash outflow. Evaluating Capital Investment Proposals: An Illustration

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin The payback period of an investment is the time expected to recover the initial investment amount. Payback period = Cost of Investment Annual Net Cash Flow Managers prefer investing in projects with shorter payback periods. Payback Period

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin The payback period of an investment is the time expected to recover the initial investment amount. Payback period = Cost of Investment Annual Net Cash Flow Payback period = $75,000 $24,000 = years Payback Period

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Ignores the time value of money. Ignores cash flows after the payback period. Payback Period

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Consider two projects, each with a five-year life and each costing $6,000. Would you invest in Project One just because it has a shorter payback period? Payback Period

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin ROI = Average estimated net income Average investment Original cost + Salvage value 2 Return on Average Investment (ROI) ROI focuses on annual income instead of cash flows.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin ROI = = 25% $10,000 $40,000 ROI focuses on annual income instead of cash flows. $75,000 + $5,000 2 Return on Average Investment (ROI)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Income may vary from year to year. Time value of money is ignored. Income may vary from year to year. Time value of money is ignored. So why would I ever want to use this method anyway? Return on Average Investment (ROI)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Now let’s look at a capital budgeting model that considers the time value of cash flows. Discounting Future Cash Flows

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin A comparison of the present value of cash inflows with the present value of cash outflows Net Present Value (NPV)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin  Chose a discount rate – the minimum required rate of return.  Calculate the present value of cash inflows.  Calculate the present value of cash outflows. NPV =  –  Net Present Value (NPV)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin General decision rule... Net Present Value (NPV)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a.$ 4,300 b.$12,700 c. $11,000 d. $17,000 Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a.$ 4,300 b.$12,700 c. $11,000 d. $17,000 Net Present Value (NPV) Question

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a.$ 4,300 b.$12,700 c. $11,000 d. $17,000 Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a.$ 4,300 b.$12,700 c. $11,000 d. $17,000 Using the present value of an annuity (table 2) PV of inflows = $20,000 × = $113,000 NPV = $113,000 - $96,000 = $17,000 Net Present Value (NPV) Question

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Calculate the NPV if Savak Company’s required return is 15 percent instead of 12 percent. Note that the NPV is smaller using the larger interest rate. Using the present value of an annuity (table 2) PV of inflows = $20,000 × = $100,380 NPV = $100,380 - $96,000 = $4,380 Net Present Value (NPV) Question

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Now that you have mastered the basic concept of net present value, it’s time for a more sophisticated checkup! Let’s return to Stars’ Stadium. Net Present Value (NPV)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Stars’ Stadium is considering purchasing vending machines with a 5-year life. ($75,000 - $5,000) ÷ 5 years Evaluating Capital Investment Proposals: An Illustration

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Most capital budgeting techniques use annual net cash flow. Depreciation is not a cash outflow. Evaluating Capital Investment Proposals: An Illustration

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Stars’ Stadium Net Present Value Analysis Stars uses a 15% discount rate. Net Present Value (NPV)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Present value of an annuity of $1 factor for 5 years at 15%. Stars’ Stadium Net Present Value Analysis $24,000 × = $80,448 Net Present Value (NPV)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Present value of $1 factor for 5 years at 15%. Stars’ Stadium Net Present Value Analysis Net Present Value (NPV)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Since the NPV is positive, we know the rate of return is greater than the 15 percent discount rate. Stars’ Stadium Net Present Value Analysis Net Present Value (NPV)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Let’s use NPV concepts with an asset replacement decision. Net Present Value (NPV) Replacing Assets

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin The Maine LobStars are considering replacing an old bus with a new bus, each with a 5-year life and zero salvage. Evaluating Capital Investment Proposals: An Illustration

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Depreciation is not a cash outflow. Tax savings from loss on disposal of old bus: $15,000 × 40% = $6,000 Evaluating Capital Investment Proposals: An Illustration

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate. Net Present Value (NPV)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate. Net Present Value (NPV)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate. Net Present Value (NPV)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Since the NPV is negative, we know the rate of return is less than the 15 percent discount rate. LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate. Net Present Value (NPV)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Capital budgeting involves many estimates. Estimates may be pessimistic or optimistic. Uncertainty about the future may impact estimates. Capital budgeting involves many estimates. Estimates may be pessimistic or optimistic. Uncertainty about the future may impact estimates. Behavioral Issues in Capital Budgeting

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Conflicts may exist between short-run performance measures and long-run capital budgeting criteria. Behavioral Issues in Capital Budgeting

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin A follow-up after the project has been approved to see whether or not expected results are actually realized. Capital Budget Audit

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin End of Chapter 26