14th Meeting Chapter 14.ppt accountung mana

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1. Capital Budgeting Capital Budgeting
DecisionsDecisions
Chapter 14

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

3. Typical Capital Budgeting DecisionsTypical Capital Budgeting Decisions
Plant expansionPlant expansion
Equipment selectionEquipment selection Equipment replacementEquipment replacement
Lease or buyLease or buy Cost reductionCost reduction

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

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

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

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

8. The The present valuepresent value of any sum to be of any sum to be
received in the future can be computed by received in the future can be computed by
turning the interest formula around and turning the interest formula around and
solving for P:solving for P:
(1 + r)(1 + r)
nnP = FP = F
nn
11
Interest and the Time Value of MoneyInterest and the Time Value of Money

9. A bond will pay $100 in two years. What is A bond will pay $100 in two years. What is
the present value of the $100 if an investor the present value of the $100 if an investor
can earn a return of 12% on investments?can earn a return of 12% on investments?
Interest and the Time Value of MoneyInterest and the Time Value of Money
(1 + .12)(1 + .12)
22P = 100P = 100
11
P = $100 (0.797)P = $100 (0.797)
P = $79.70P = $79.70

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

11. Rate
Periods 10% 12% 14%
1 0.909 0.893 0.877
2 0.826 0.797 0.769
3 0.751 0.712 0.675
4 0.683 0.636 0.592
5 0.621 0.567 0.519
Time Value of MoneyTime Value of Money
$100 $100 ×× 0.797 = $79.70 present value 0.797 = $79.70 present value
Present value factor of $1 for 2 periods at 12%.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 How much would you have to put in the bank
today to have $100 at the end of five years if the today to have $100 at the end of five years if the
interest rate is 10%?interest rate is 10%?
a. $62.10a. $62.10
b. $56.70b. $56.70
c. $90.90c. $90.90
d. $51.90d. $51.90

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

14. Time Value of MoneyTime Value of Money
11 22 33 44 55 66
$100$100$100$100$100$100$100$100 $100$100 $100$100
An investment that involves a series An investment that involves a series
of identical cash flows at the end of of identical cash flows at the end of
each year is called an each year is called an annuityannuity..

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

16. Time Value of MoneyTime Value of Money
We could solve the problem like this . . .We could solve the problem like this . . .
Look in Appendix C of this Chapter for the
Present Value of an Annuity of $1 Table
Periods 10% 12% 14%
1 0.909 0.893 0.877
2 1.736 1.690 1.647
3 2.487 2.402 2.322
4 3.170 3.037 2.914
5 3.791 3.605 3.433

17. Time Value of MoneyTime Value of Money
We could solve the problem like this . . .We could solve the problem like this . . .
Periods 10% 12% 14%
1 0.909 0.893 0.877
2 1.736 1.690 1.647
3 2.487 2.402 2.322
4 3.170 3.037 2.914
5 3.791 3.605 3.433
$60,000 × 3.605 = $216,300$60,000 × 3.605 = $216,300

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

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

20. Typical Cash OutflowsTypical Cash Outflows
Repairs andRepairs and
maintenancemaintenance
IncrementalIncremental
operatingoperating
costscosts
InitialInitial
investmentinvestment
WorkingWorking
capitalcapital

21. Typical Cash InflowsTypical Cash Inflows
ReductionReduction
of costsof costs
SalvageSalvage
valuevalue
IncrementalIncremental
revenuesrevenues
Release ofRelease of
workingworking
capitalcapital

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

23. Periods 10% 12% 14%
1 0.909 0.893 0.877
2 1.736 1.690 1.647
3 2.487 2.402 2.322
4 3.170 3.037 2.914
5 3.791 3.605 3.433
Present valuePresent value
of an annuityof an annuity
of $1 tableof $1 table
Recovery of the Original Recovery of the Original InvestmentInvestment

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

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

26. Choosing a Discount RateChoosing a Discount Rate
The firm’sThe firm’s cost of capitalcost of capital is is
usually regarded as the most usually regarded as the most
appropriate choice for the appropriate choice for the
discount rate.discount rate.
The cost of capital is the The cost of capital is the
average rate of return the average rate of return the
company must pay to its long-company must pay to its long-
term creditors and term creditors and
stockholders for the use of stockholders for the use of
their funds.their funds.

27. The Net Present Value MethodThe Net Present Value Method
To determine net present value we . . .To determine net present value we . . .
Calculate the present value of cash inflows,Calculate the present value of cash inflows,
Calculate the present value of cash outflows,Calculate the present value of cash outflows,
Subtract the present value of the outflows Subtract the present value of the outflows
from the present value of the inflows.from the present value of the inflows.

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

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

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

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

32. The Net Present Value MethodThe Net Present Value Method

33. The Net Present Value MethodThe Net Present Value Method
Present value of an annuity of $1
factor for 5 years at 10%.

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

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

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

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

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

39. Internal Rate of Return MethodInternal Rate of Return Method
Future cash flows are the same every year in Future cash flows are the same every year in
this example, so we can calculate the internal this example, so we can calculate the internal
rate of return as follows: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 MethodInternal Rate of Return Method
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%14%.
Periods 10% 12% 14%
1 0.909 0.893 0.877
2 1.736 1.690 1.647
. . . . . . . . . . . .
9 5.759 5.328 4.946
10 6.145 5.650 5.216
Using the present value of an annuity of $1 table . . .

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

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

43. Net Present Value vs. Internal Rate of Net Present Value vs. Internal Rate of
ReturnReturn
NPV is easier to use.NPV is easier to use.
AssumptionsAssumptions
NPV assumes cash inflows NPV assumes cash inflows
will be reinvested at the will be reinvested at the
discount rate.discount rate.
Internal rate of return Internal rate of return
method assumes cash method assumes cash
inflows are reinvested at inflows are reinvested at
the internal rate of return. the internal rate of return.

44. Ranking Investment ProjectsRanking Investment Projects
Profitability Present value of cash inflows
index Investment required
=
A B
Present value of cash inflows$81,000 $6,000
Investment required 80,000 5,000
Profitability index 1.01 1.20
Investment
The higher the profitability index, theThe higher the profitability index, the
more desirable the project.more desirable the project.