1. Accounting 4310 Appendix Capital Investment Decisions

2. Capital Budgeting Long-term commitments Large amounts of money Challenge to managers to balance long-run and short-run issues Asset allocation system – set of formal routines and procedures designed to process and evaluate requests to acquire new assets; called capital budget plan.

3. Stages of Capital Budgeting Identification stage –Assets to meet safety/health regulatory needs These projects often must be implemented. Ex: Environmental protection or pollution-controls. –Assets to enhance operating efficiency and/or increase revenue New technologies Better equipment New plants

4. Stages of Capital Budgeting Identification stage (continued) –Assets to enhance competitive effectiveness Funds strategy of business Must make sure these proposals are in line with the strategy of the business New product lines, acquire existing companies, acquire suppliers, new markets Search stage Information-acquisition stage –Cost-benefit analysis –Financial and nonfinancial benefits identified

5. Stages of Capital Budgeting Selection stage –Capital budgeting methods used –Qualitative factors considered Financing stage –Done by treasurer Implementation and control stage –Get projects underway –Monitor performance –Perform postinvestment audits

6. Capital Budgeting Methods Discounted cash-flow methods –All cash flows included –Time value of money considered –Expects cash amount to be greater in the future than the cash invested now –Required rate of return Minimum acceptable rate of return Also called discount or hurdle rate

7. Net Present Value Method 1 - Using present value tables at a chosen discount rate, compute the present value of net cash flows 2 - Compare (1) to investment 3 - Value in (2) should be positive in order to consider investment further Problems - NPV varies based on discount rate chosen; the higher the discount rate, the lower the net present value of cash flows Theoretically best to choose the weighted average cost of capital.

8. Internal Rate of Return n  Periodic cash flow for period t t=0(1 + internal rate of return) Interest rate computed such that the net present value of the investment is zero. IRR assumes that the cash flows will be reinvested at the internal rate of return. Often not as reliable as net present value End product is a percentage that can be compared to minimum rate of return.

9. Payback Method Time it takes to recover cash investment Based exclusively on cash flows Cash flows = net income + depreciation +amort. Initial investment Annual cash flows/savings = Payback period Ex.: $300,000/ $100,000 = 3 years Pros: simple, highlights liquidity Cons: ignores time value of money, disregards cash flows after payback, may produce short-lived projects

10. Relevant Cash Flows Net initial investment –Purchase of project –Working capital changes –Salvage value of old investment (if sold) –Tax effects of sale of old investment Cash flows from operations –Cash savings or payments after taxes –Cash flows from tax advantages of depreciation –Investment tax credits

11. Depreciation Savings Depreciation is a non-cash expense; however depreciation expenses reduce the amount of taxes paid Thus tax savings from depreciation is a cash flow Example: 10,000 asset (3 yrs.), 40% tax rate MACRS – 1- 33%, 2- 45%, 3 – 14%, 4-8% 1 – 10,000 x.33 = 3,300 tax deduction yields x.40 = $1,320 cash flows from taxes

12. Relevant Cash Flows Cash flows from disposal of investment –Proceeds from sale –Tax savings (payments) from sale based on sales price – book value

13. Other Considerations Managers and goal-congruence issues –Managers may be rewarded on short-term income –Thus they may want to invest in short-term quick return assets that may not be in the best long-term interest of the company

14. Postinvestment Audit Compares actual results for a project to the costs and benefits expected at time project selected Provides feedback about performance –Original estimates may have been overly optimistic –There may have been problems in implementing the project

15. Estimates All future cash flows/savings are based on estimates Initial cash flows are real Be careful with estimates