1. Capital Budgeting Decisions Chapter 14

2. Capital Budgeting How managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment and introduction of new products.

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

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

5. Time Value of Money Business investments extend over long periods of time, so we must recognize the time value of money. Investments that promise returns earlier in time are preferable to those that promise returns later in time.

6. Time Value of Money A dollar today is worth more than a dollar a year from now since a dollar received today can be invested, yielding more than a dollar a year from now.

7. If $100 is invested today at 8% interest, how much will you have in two years? At the end of one year: $100 + 0.08  $100 = (1.08)  $100 = $108 At the end of two years: $116.64 (1.08)  $108 = $116.64 or (1.08) 2 × $100 = $116.64 Interest and the Time Value of Money

8. The present value of any sum to be received in the future can be computed by turning the interest formula around and solving for P: (1 + r) n P = F n 1 Interest and the Time Value of Money

9. A bond will pay $100 in two years. What is the present value of the $100 if an investor can earn a return of 12% on investments? Interest and the Time Value of Money (1 +.12) 2 P = 100 1 P = $100 (0.797) P = $79.70

10. What does this mean? If $79.70 is put in the bank today, it will be worth $100 in two years. In that sense, $79.70 today is equivalent to $100 in two years. What does this mean? If $79.70 is put in the bank today, it will be worth $100 in two years. In that sense, $79.70 today is equivalent to $100 in two years. Interest and the Time Value of Money Present Value = $79.70 A bond will pay $100 in two years. What is the present value of the $100 if an investor can earn a return of 12% on investments?

11. Time Value of Money $100 × 0.797 = $79.70 present value Present value factor of $1 for 2 periods at 12%.

12. Quick Check Quick Check How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62.10 b. $56.70 c. $90.90 d. $51.90 How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62.10 b. $56.70 c. $90.90 d. $51.90

13. How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62.10 b. $56.70 c. $90.90 d. $51.90 How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62.10 b. $56.70 c. $90.90 d. $51.90 Quick Check Quick Check $100  0.621 = $62.10

14. Time Value of Money 123456$100$100$100$100$100$100 An investment that involves a series of identical cash flows at the end of each year is called an annuity.

15. Time Value of Money Lacey Inc. purchased a tract of land on which a $60,000 payment will be due each year for the next five years. What is the present value of this stream of cash payments when the discount rate is 12%? Lacey Inc. purchased a tract of land on which a $60,000 payment will be due each year for the next five years. What is the present value of this stream of cash payments when the discount rate is 12%?

16. Time Value of Money We could solve the problem like this... Look in Appendix C of this Chapter for the Present Value of an Annuity of $1 Table

17. Time Value of Money We could solve the problem like this... $60,000 × 3.605 = $216,300

18. Quick Check Quick Check If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? a. $34.33 b. $500.00 c. $343.30 d. $360.50 If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? a. $34.33 b. $500.00 c. $343.30 d. $360.50

19. If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? a. $34.33 b. $500.00 c. $343.30 d. $360.50 If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? a. $34.33 b. $500.00 c. $343.30 d. $360.50 Quick Check Quick Check $100  3.433 = $343.30

20. Typical Cash Outflows Repairs and maintenance Incrementaloperatingcosts InitialinvestmentWorkingcapital

21. Typical Cash Inflows Reduction of costs Salvagevalue Incrementalrevenues Release of workingcapital

22. Recovery of the Original Investment Carver Hospital is considering the purchase of an attachment for its X-ray machine. No investments are to be made unless they have an annual return of at least 10%. Will we be allowed to invest in the attachment?

23. Present value of an annuity of $1 table Present value of an annuity of $1 table Recovery of the Original Investment

24. Quick Check Quick Check Suppose that the investment in the attachment for the X-ray machine had cost $4,000 and generated an increase in annual cash inflows of $1,200. What is the net present value of the investment? Suppose that the investment in the attachment for the X-ray machine had cost $4,000 and generated an increase in annual cash inflows of $1,200. What is the net present value of the investment? a. $ 800 b. $ 196 c. $(196) d. $(800) Suppose that the investment in the attachment for the X-ray machine had cost $4,000 and generated an increase in annual cash inflows of $1,200. What is the net present value of the investment? Suppose that the investment in the attachment for the X-ray machine had cost $4,000 and generated an increase in annual cash inflows of $1,200. What is the net present value of the investment? a. $ 800 b. $ 196 c. $(196) d. $(800)

25. Recovery of the Original Investment Depreciation is not deducted in computing the present value of a project because...  It is not a current cash outflow.  Discounted cash flow methods automatically provide for return of the original investment. Depreciation is not deducted in computing the present value of a project because...  It is not a current cash outflow.  Discounted cash flow methods automatically provide for return of the original investment.

26. Choosing a Discount Rate The firm’s cost of capital is usually regarded as the most appropriate choice for the discount rate. 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.

27. 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.

28. General decision rule... The Net Present Value Method

29. Lester Company has been offered a five year contract to provide component parts for a large manufacturer. The Net Present Value Method

30. At the end of five years the working capital will be released and may be used elsewhere by Lester. Lester Company uses a discount rate of 10%. Should the contract be accepted? At the end of five years the working capital will be released and may be used elsewhere by Lester. Lester Company uses a discount rate of 10%. Should the contract be accepted? The Net Present Value Method

31. Annual net cash inflows from operations The Net Present Value Method

33. Present value of an annuity of $1 factor for 5 years at 10%. Present value of an annuity of $1 factor for 5 years at 10%.

34. Present value of $1 factor for 3 years at 10%. Present value of $1 factor for 3 years at 10%. The Net Present Value Method

35. Present value of $1 factor for 5 years at 10%. Present value of $1 factor for 5 years at 10%. The Net Present Value Method

36. positive Accept the contract because the project has a positive net present value. The Net Present Value Method

37. Internal Rate of Return Method The internal rate of return is the rate of return promised by an investment project over its useful life. The internal rate of return is computed by finding the discount rate that will cause the net present value of a project to be zero.

38. Internal Rate of Return Method Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life. Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life.

39. Internal Rate of Return Method Future cash flows are the same every year in this example, so we can calculate the internal rate of return as follows: Investment required Net annual cash flows PV factor for the internal rate of return = $104, 320 $20,000 = 5.216

40. Internal Rate of Return Method 14% Find the 10-period row, move across until you find the factor 5.216. Look at the top of the column and you find a rate of 14%. Using the present value of an annuity of $1 table...

41. Internal Rate of Return Method Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life. internal rate of return The internal rate of return on this project is 14%. If the internal rate of return is equal to or greater than the company’s required rate of return, the project is acceptable.

42. Quick Check Quick Check The expected annual net cash inflow from a project is $22,000 over the next 5 years. The required investment now in the project is $79,310. What is the internal rate of return on the project? The expected annual net cash inflow from a project is $22,000 over the next 5 years. The required investment now in the project is $79,310. What is the internal rate of return on the project? a. 10% b. 12% c. 14% d. Cannot be determined The expected annual net cash inflow from a project is $22,000 over the next 5 years. The required investment now in the project is $79,310. What is the internal rate of return on the project? The expected annual net cash inflow from a project is $22,000 over the next 5 years. The required investment now in the project is $79,310. What is the internal rate of return on the project? a. 10% b. 12% c. 14% d. Cannot be determined

43. Net Present Value vs. Internal Rate of Return v NPV is easier to use. v Assumptions vNPV assumes cash inflows will be reinvested at the discount rate. vInternal rate of return method assumes cash inflows are reinvested at the internal rate of return.

44. Ranking Investment Projects Profitability Present value of cash inflows index Investment required = The higher the profitability index, the more desirable the project. The higher the profitability index, the more desirable the project.