11-1 Lecture 8: Capital Budgeting Decisions Chapter 12 in Brewer

11-2 Typical Capital Budgeting Decisions Plant expansion Equipment selection Equipment replacement Lease or buy Cost reduction

11-3 Typical Capital Budgeting Decisions Capital budgeting tends to fall into two broad categories. 1.Screening decisions. Does a proposed project meet some preset standard of acceptance? 2.Preference decisions. Selecting from among several competing courses of action.

11-4 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.

11-5 Time Value of Money The capital budgeting techniques that best recognize the time value of money are those that involve discounted cash flows.

11-6 Compunding If I invest $100 at 10%, interest, how much will it be worth in 3 years time? After 1 year: $1 x 1.1= $110 After 2 years: $1.10 x 1.1 = $121 After 3 years: $1.21 x $133.10c

11-7 Discounting is the OPPOSITE of compounding! E.G. If I know I am going to receive $100 in three years time, what is that worth to me at todays prices if the discount rate is 10%? (It is easiest to think of the discount rate as the inflaation rate) The answer is: (1/ ) x $100 = (approx.) 0.75 x $100 = $75

11-8 Present value The $75 is known as the PRESENT VALUE of a FUTURE CASH INFLOW

11-9 The Net Present Value Method To determine net present value (of a proposed project), 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.

11-10 Net present value method Now read page 434 example A The factor of (on page 435) is known as an ANNUITY FACTOR It is the total of the DISCOUNT FACTORS for 20% for years 1-5 The twenty percent is the required rate of return this company needs to satisfy its shareholders

11-11 The discount factor for year 1 is: 1 / (1.2) = __________ The discount factor for year 2 is ________________ Year 3: _________________

11-12 Annuity factors and discount factors The annuity factor is the cumulative total of discount factors We can only use this when the case inflows are the same every year If the case inflows are different, we need to use discount factors Now read example on page 439 – example C

11-13 The Net Present Value Method

11-14 The Net Present Value Method Net present value analysis emphasizes cash flows and not accounting net income. The reason is that accounting net income is based on accruals that ignore the timing of cash flows into and out of an organization.

11-15 Choosing a Discount Rate The firm’s cost of capital is usually regarded as the minimum required rate of return. The cost of capital is the average rate of return the company must pay to its long- term creditors and stockholders for the use of their funds. The cost of capital is usually regarded as the minimum required rate of return. When the cost of capital is used as the discount rate, it serves as a screening device in net present value analysis.

11-16 Preference Decision – The Ranking of Investment Projects Screening Decisions Pertain to whether or not some proposed investment is acceptable; these decisions come first. Preference Decisions Attempt to rank acceptable alternatives from the most to least appealing.

11-17 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.

11-18 The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates. When the annual net cash inflow is the same each year, this formula can be used to compute the payback period: The Payback Method Payback period = Investment required Annual net cash inflow

11-19 Payback method See example on blackboard