Capital Budgeting Decisions teaching material.ppt

investment decision

1. Chapter 14

2. Capital Investments
Long Term in nature covering many
years
Large amounts of capital
Investments are not easily or quickly
disposed
Critical to long-term profitability
Affect human resources needs and
composition

3. Prior to sending out requests
1. Determination of dollars available for
capital investments
2.Determine the cost of capital (minimum
rate of return)

4. Cost of Capital
Also called Desired Rate of Return
Type Loan $ % Interest
%
%
Time
Share
30,000 6.613% .9
Auto 20,000 4.44% .2
Rental 200,00044.56% 2.7
Residenc
e
200,00044.55% 2.2
TOTAL 450,000100
%
6.0

5. Steps in choosing a proposal
Step 1: Identification of capital investment needs
Step 2: Formal requests for capital investments
Step 3: Preliminary screening (remove those that
are not appropriate for the project)
Step 4: Evaluate the proposal based on
Acceptance – rejection standards
previously determined
Step 5: Rank the proposals
Step 6: Choose the best proposal (s).

6. Capital Investment Analysis Methods
Net Present Value
Internal Rate of Return
Payback Period Method
Simple (Acctg) Rate of
Return

7. Terms
Cash InFlows
Increase in Net cash inflows
Cost Savings
Reduce Costs

8. Undiscounted Cash Inflows
Rate of Return X Cash Inflows
Discounted Cash Inflows
Adjusted for the loss of value over time
Present Value Multiplier X Cash Inflows

9. NET PRESENT VALUE
METHOD
Uses PRESENT VALUE Table
Columns: % Return
Rows: Number of Period
Multiplier or factor is where the
rate intersects the period.

10. Periods (Not just years) Can be Semi Annual,
Quarterly, Monthly
% - estimate return rate
Based on the number of periods
10% for yearly
5% for seimannual
2.5% for quarterly
Present Value of Cash InFlows ( How much is the
money received in following years worth today)

11. What Present Value Table
Present Value of $1
Received at the end of a period of time
Uneven cash inflows
Present Value of a Ordinary Annuity of $1
Received the same amount every period
Even Cash Inflows

12. PRACTICE READING TABLE
1. What multiplier do you use if you receive $100,000
at the end of 10 years assuming a return of 7%?
What is its present value?
 .508
 $100,000 * .508 = $50,800
2. What multiplier do you use if you receive $10,000
every year for 10 years assuming a return of 7%.
What is it’s present value?
 7.024
 $10,000* 7.024 = $70,240

13. Application
Exercise 14-1 Compare discounted cash flow
with undiscounted cash flow
Exercise 14-9 Evaluating projects based on PV
concept
Is 16% reasonable?

14. Project Profitability Index
Net Present Value of Project
Investment required
Helpful to decide what project to select.
The higher the better
Amount of cash inflow generated for
each dollar of investment

15. Internal Rate of Return
Investment Required
Annual Cash inflow
Rate that causes the PV of the project’s cash inflows to
equal the PV of the investment
How much interest you need to receive to pay it back
Do not know the rate of return %.
Divide Investment required by Annual Cash Inflows
Gives you the multiplier factor.
Go to the number of periods and find this multiplier
Go to the top of the column to get the % = IRR

16. Excercise 14-2
Only 1 and 2

17. Apply NPV and IRR
Exercise 14-11

18. Payback Method
Investment Required
Net Annual Cash Inflows
Time it takes for the investment to pay
for itself.
In years.
Same as IRR
Use formula only if even cash inflows

19. Payback Period con’t
Uneven cash inflows – Use following table
Year Investment Cash Inflows Unrecovered
1 4,000 1,000 3,000
2 -0- 3,000
3 2,000 1,000
4 2,000 1,000 2,000
5 500 1,500
6 3,000 0
7 2,000 0

20. Application
Exercise 14-5 EVEN OR UNEVEN?

21. Simple Rate of Return
Annual Incremental Net Income
Initial Investment
Not Cash Inflow
Includes depreciation
Annual Revenue-Annual expenses/Invest.
Easier than Acctg rate of return but not
accurate
No present value considered

22. Exercise 14-6
Both Payback period and SRR
Exercise 14-13

23. Ranking of investments
Problem 14-26 pg 672
Rank based on NPV (inferior to PPI)
 1,2,4,3
Rank based on PPI (most dependable)
 3,2,1,4
Rank based on IRR (payback)
 4,3,2,1

24. Application of NPV Concept
Problem 14-27 pg 672

25. SRR, IRR and payback methods
Problem 14-28