© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Capital Budgeting
Chapter
25
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Capital budgeting:
Analyzing alternative long-
term investments a...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
?
?
?
Limited
Investment
Funds
Plant
Expansion
New
Equipment
Offi...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Initial
investment
Repairs and
maintenance
Incremental
operating
...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Cost
savings
Salvage
value
Incremental
revenues
Capital Investmen...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Employee morale
Environmental concerns Corporate image
Employee w...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Let’s look at
methods used
to make capital
investment
decisions.
...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Stars’ Stadium is considering purchasing
vending machines with a ...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Most capital budgeting techniques use
annual net cash flow.
Depre...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
The payback period of an investment
is the time expected to recov...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
The payback period of an investment
is the time expected to recov...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Ignores the
time value
of money.
Ignores cash
flows after
the pay...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Consider two projects, each with a five-year life
and each costin...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
ROI =
Average estimated net income
Average investment
ROI focuses...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
ROI = = 25%
$10,000
$40,000
ROI focuses on annual income
instead ...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Income may vary
from year to year.
Time value of
money is ignor...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Now let’s look at a capital budgeting
model that considers the ti...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
A comparison of the present value of cash
inflows with the presen...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Chose a discount rate – the
minimum required rate of return.
Ca...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
General decision rule . . .
If the Net Present
Value is . . . The...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Savak Company can buy a new machine for
$96,000 that will save $2...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Savak Company can buy a new machine for
$96,000 that will save $2...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Calculate the NPV if Savak Company’s required
return is 15 percen...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Now that you have mastered the basic
concept of net present value...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Stars’ Stadium is considering purchasing
vending machines with a ...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Most capital budgeting techniques use
annual net cash flow.
Depre...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Star’s Stadium Net Present Value Analysis
Year(s) Cash Flow PV fa...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Year(s) Cash Flow PV factor PV
Vending mach. Now (75,000)$ 1.000 ...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Year(s) Cash Flow PV factor PV
Vending mach. Now (75,000)$ 1.000 ...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Since the NPV is positive, we know the rate of return is
greater ...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Let’s use NPV
concepts with
an asset
replacement
decision.
Net Pr...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
The Maine LobStars are considering replacing an old bus
with a ne...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Depreciation is not a cash outflow.
Annual net income 2,400$
Add ...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Year(s) Cash Flow PV factor PV
New bus Now (65,000)$ 1.000 (65,00...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Year(s) Cash Flow PV factor PV
New bus Now (65,000)$ 1.000 (65,00...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Year(s) Cash Flow PV factor PV
New bus Now (65,000)$ 1.000 (65,00...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Since the NPV is negative, we know the rate of return
is less tha...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Capital budgeting involves many estimates.
 Estimates may be pes...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
Conflicts may exist between short-run
performance measures and lo...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
A follow-up after the project has been
approved to see whether or...
© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin
I told you that’s the end. You
can’t work any more accounting
pro...
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    1. 1. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Capital Budgeting Chapter 25
    2. 2. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Capital budgeting: Analyzing alternative long- term investments and deciding which assets to acquire or sell. Outcome is uncertain. Large amounts of money are usually involved. Investment involves a long-term commitment. Decision may be difficult or impossible to reverse. Capital Investment DecisionsCapital Investment Decisions
    3. 3. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin ? ? ? Limited Investment Funds Plant Expansion New Equipment Office Renovation I will choose the project with the most profitable return on available funds. Capital Investment DecisionsCapital Investment Decisions
    4. 4. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Initial investment Repairs and maintenance Incremental operating costs Capital Investment Decisions: Typical Cash Outflows Capital Investment Decisions: Typical Cash Outflows
    5. 5. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Cost savings Salvage value Incremental revenues Capital Investment Decisions: Typical Cash Inflows Capital Investment Decisions: Typical Cash Inflows
    6. 6. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Employee morale Environmental concerns Corporate image Employee working conditions Product quality Capital Investment Decisions: Nonfinancial Considerations Capital Investment Decisions: Nonfinancial Considerations
    7. 7. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Let’s look at methods used to make capital investment decisions. Evaluating Capital Investment Proposals: An Illustration Evaluating Capital Investment Proposals: An Illustration
    8. 8. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Stars’ Stadium is considering purchasing vending machines with a 5-year life. Cost and revenue information Cost of vending machines $ 75,000 Revenue 84,375$ Cost of goods sold 50,625 Gross profit 33,750$ Cash operating costs 3,350$ Depreciation 14,000 17,350 Pretax income 16,400$ Income tax 6,400 After-tax income 10,000$ ($75,000 - $5,000) ÷ 5 years Evaluating Capital Investment Proposals: An Illustration Evaluating Capital Investment Proposals: An Illustration
    9. 9. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Most capital budgeting techniques use annual net cash flow. Depreciation is not a cash outflow. Annual net income 10,000$ Add annual depreciation 14,000 Annual net cash flow 24,000$ Evaluating Capital Investment Proposals: An Illustration Evaluating Capital Investment Proposals: An Illustration
    10. 10. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin The payback period of an investment is the time expected to recover the initial investment amount. The payback period of an investment is the time expected to recover the initial investment amount. Payback period = Cost of Investment Annual Net Cash Flow Managers prefer investing in projects with shorter payback periods. Payback PeriodPayback Period
    11. 11. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin The payback period of an investment is the time expected to recover the initial investment amount. The payback period of an investment is the time expected to recover the initial investment amount. Payback period = Cost of Investment Annual Net Cash Flow Payback period = $75,000 $24,000 = 3.125 years Payback PeriodPayback Period
    12. 12. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Ignores the time value of money. Ignores cash flows after the payback period. Payback PeriodPayback Period
    13. 13. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Consider two projects, each with a five-year life and each costing $6,000. Project One Project Two Net Cash Net Cash Year Inflows Inflows 1 2,000$ 1,000$ 2 2,000 1,000 3 2,000 1,000 4 2,000 1,000 5 2,000 1,000,000 Would you invest in Project One just because it has a shorter payback period? Payback PeriodPayback Period
    14. 14. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin ROI = Average estimated net income Average investment ROI focuses on annual income instead of cash flows. Original cost + Salvage value 2 Return on Average Investment (ROI) Return on Average Investment (ROI)
    15. 15. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin ROI = = 25% $10,000 $40,000 ROI focuses on annual income instead of cash flows. $75,000 + $5,000 2 Return on Average Investment (ROI) Return on Average Investment (ROI)
    16. 16. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Income may vary from year to year. Time value of money is ignored. So why would I ever want to use this method anyway? Return on Average Investment (ROI) Return on Average Investment (ROI)
    17. 17. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Now let’s look at a capital budgeting model that considers the time value of cash flows. Now let’s look at a capital budgeting model that considers the time value of cash flows. Discounting Future Cash FlowsDiscounting Future Cash Flows
    18. 18. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin A comparison of the present value of cash inflows with the present value of cash outflows A comparison of the present value of cash inflows with the present value of cash outflows Net Present Value (NPV)Net Present Value (NPV)
    19. 19. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Chose a discount rate – the minimum required rate of return. Calculate the present value of cash inflows. Calculate the present value of cash outflows. NPV = – Net Present Value (NPV)Net Present Value (NPV)
    20. 20. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin General decision rule . . . If the Net Present Value is . . . Then the Project is . . . Positive . . . Acceptable, since it promises a return greater than the required rate of return. Zero . . . Acceptable, since it promises a return equal to the required rate of return. Negative . . . Not acceptable, since it promises a return less than the required rate of return. Net Present Value (NPV)Net Present Value (NPV)
    21. 21. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a. $ 4,300 b. $12,700 c. $11,000 d. $17,000 Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a. $ 4,300 b. $12,700 c. $11,000 d. $17,000 Net Present Value (NPV) Question Net Present Value (NPV) Question
    22. 22. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a. $ 4,300 b. $12,700 c. $11,000 d. $17,000 Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a. $ 4,300 b. $12,700 c. $11,000 d. $17,000 Using the present value of an annuity (table 2) PV of inflows = $20,000 × 5.650 = $113,000 NPV = $113,000 - $96,000 = $17,000 Net Present Value (NPV) Question Net Present Value (NPV) Question
    23. 23. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Calculate the NPV if Savak Company’s required return is 15 percent instead of 12 percent. Calculate the NPV if Savak Company’s required return is 15 percent instead of 12 percent. Note that the NPV is smaller using the larger interest rate. Using the present value of an annuity (table 2) PV of inflows = $20,000 × 5.019 = $100,380 NPV = $100,380 - $96,000 = $4,380 Net Present Value (NPV) Question Net Present Value (NPV) Question
    24. 24. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Now that you have mastered the basic concept of net present value, it’s time for a more sophisticated checkup! Let’s return to Stars’ Stadium. Net Present Value (NPV)Net Present Value (NPV)
    25. 25. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Stars’ Stadium is considering purchasing vending machines with a 5-year life. Cost and revenue information Cost of vending machines $ 75,000 Revenue 84,375$ Cost of goods sold 50,625 Gross profit 33,750$ Cash operating costs 3,350$ Depreciation 14,000 17,350 Pretax income 16,400$ Income tax 6,400 After-tax income 10,000$ ($75,000 - $5,000) ÷ 5 years Evaluating Capital Investment Proposals: An Illustration Evaluating Capital Investment Proposals: An Illustration
    26. 26. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Most capital budgeting techniques use annual net cash flow. Depreciation is not a cash outflow. Annual net income 10,000$ Add annual depreciation 14,000 Annual net cash flow 24,000$ Evaluating Capital Investment Proposals: An Illustration Evaluating Capital Investment Proposals: An Illustration
    27. 27. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Star’s Stadium Net Present Value Analysis Year(s) Cash Flow PV factor PV Vending mach. Now (75,000)$ 1.000 (75,000)$ Stars uses a 15% discount rate. Net Present Value (NPV)Net Present Value (NPV)
    28. 28. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Year(s) Cash Flow PV factor PV Vending mach. Now (75,000)$ 1.000 (75,000)$ Annual inflow 1 - 5 24,000 3.352 80,448 Present value of an annuity of $1 factor for 5 years at 15%. Star’s Stadium Net Present Value Analysis $24,000 × 3.352 = $80,448 Net Present Value (NPV)Net Present Value (NPV)
    29. 29. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Year(s) Cash Flow PV factor PV Vending mach. Now (75,000)$ 1.000 (75,000)$ Annual inflow 1 - 5 24,000 3.352 80,448 Salvage 5 5,000 0.497 2,485 Present value of $1 factor for 5 years at 15%. Star’s Stadium Net Present Value Analysis Net Present Value (NPV)Net Present Value (NPV)
    30. 30. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Since the NPV is positive, we know the rate of return is greater than the 15 percent discount rate. Year(s) Cash Flow PV factor PV Vending mach. Now (75,000)$ 1.000 (75,000)$ Annual inflow 1 - 5 24,000 3.352 80,448 Salvage 5 5,000 0.497 2,485 NPV Now 7,933 Star’s Stadium Net Present Value Analysis Net Present Value (NPV)Net Present Value (NPV)
    31. 31. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Let’s use NPV concepts with an asset replacement decision. Net Present Value (NPV) Replacing Assets Net Present Value (NPV) Replacing Assets
    32. 32. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin The Maine LobStars are considering replacing an old bus with a new bus, each with a 5-year life and zero salvage. Cost and savings information Cost of new bus $ 65,000 Book value of old bus $ 25,000 Current value of old bus 10,000 Loss if old bus sold $ 15,000 Annual savings of new bus 12,000$ Depreciation - new bus 13,000$ old bus 5,000 8,000 Increase in taxable income 4,000$ Tax @ 40% 1,600 After-tax income 2,400$ Evaluating Capital Investment Proposals: An Illustration Evaluating Capital Investment Proposals: An Illustration
    33. 33. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Depreciation is not a cash outflow. Annual net income 2,400$ Add increased depreciation 8,000 Annual net cash flow 10,400$ Tax savings from loss on disposal of old bus: $15,000 × 40% = $6,000 Evaluating Capital Investment Proposals: An Illustration Evaluating Capital Investment Proposals: An Illustration
    34. 34. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Year(s) Cash Flow PV factor PV New bus Now (65,000)$ 1.000 (65,000)$ LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate. Net Present Value (NPV)Net Present Value (NPV)
    35. 35. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Year(s) Cash Flow PV factor PV New bus Now (65,000)$ 1.000 (65,000)$ Annual inflow 1 - 5 10,400 3.352 34,861 LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate. Net Present Value (NPV)Net Present Value (NPV)
    36. 36. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Year(s) Cash Flow PV factor PV New bus Now (65,000)$ 1.000 (65,000)$ Annual inflow 1 - 5 10,400 3.352 34,861 Old bus sale Now 10,000 1.000 10,000 LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate. Net Present Value (NPV)Net Present Value (NPV)
    37. 37. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Since the NPV is negative, we know the rate of return is less than the 15 percent discount rate. Year(s) Cash Flow PV factor PV New bus Now (65,000)$ 1.000 (65,000)$ Annual inflow 1 - 5 10,400 3.352 34,861 Old bus sale Now 10,000 1.000 10,000 Tax savings 1 6,000 0.870 5,220 NPV Now (14,919)$ LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate. Net Present Value (NPV)Net Present Value (NPV)
    38. 38. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Capital budgeting involves many estimates.  Estimates may be pessimistic or optimistic.  Uncertainty about the future may impact estimates. Behavioral Issues in Capital Budgeting Behavioral Issues in Capital Budgeting
    39. 39. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin Conflicts may exist between short-run performance measures and long-run capital budgeting criteria. Behavioral Issues in Capital Budgeting Behavioral Issues in Capital Budgeting
    40. 40. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin A follow-up after the project has been approved to see whether or not expected results are actually realized. Capital Budget AuditCapital Budget Audit
    41. 41. © The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin I told you that’s the end. You can’t work any more accounting problems in my class! THE ENDTHE END
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