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Capital Budgeting Decisions
Chapter 13
ACTG 202 – Principles of
Managerial Accounting
13-2
Typical Capital Budgeting Decisions
Plant expansion
Equipment selection Equipment replacement
Lease or buy Cost reduction
13-3
Typical Capital Budgeting Decisions
Capital budgeting tends to fall into two broad
categories.
1. Screening decisions. Does a proposed
project meet some preset standard of
acceptance?
2. Preference decisions. Selecting from
among several competing courses of action.
13-4
Time Value of Money
The discussion of capital
budgeting begins with a
discussion of the time value of
money.
A dollar today is worth more than
a dollar a year from now.
Therefore, projects that promise
earlier returns are preferable to
those that promise later returns.
13-5
Time Value of Money
The capital
budgeting
techniques that best
recognize the time
value of money are
those that involve
discounted cash
flows.
13-6
Present Value and Future Value
13-7
Learning Objective 1
Determine the payback
period for an
investment.
13-8
The payback method
focuses on the
payback period,
which is the length of
time that it takes for
a project to recoup
its initial cost out of
the cash receipts
that it generates.
The Payback Method
13-9
Evaluation of the Payback Method
Ignores the
time value
of money.
Ignores cash
flows after
the payback
period.
Short-comings
of the payback
method.
Shorter payback
period does not
always mean a
more desirable
investment.
13-10
Evaluation of the Payback Method
Serves as
screening
tool.
Identifies
investments that
recoup cash
investments
quickly.
Identifies
products that
recoup initial
investment
quickly.
Strengths
of the payback
period.
13-11
Learning Objective 2
Evaluate the
acceptability of an
investment project using
the net present value
method.
13-12
The Net Present Value Method
The net present value method compares the
present value of a project’s cash inflows
with the present value of its cash outflows.
The difference between these two streams
of cash flows is called the net present
value.
13-13
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.
13-14
The Net Present Value Method
Two Simplifying Assumptions
• All cash flows other than the initial
investment occur at the end of
periods.
• All cash flows generated by an
investment project are immediately
reinvested at a rate of return equal
to the discount rate.
13-15
iClicker Quick Check 
Cash flow information
Cost of computer equipment $ 250,000
Working capital required 20,000
Upgrading of equipment in 2 years 90,000
Salvage value of equipment in 4 years 10,000
Annual net cash inflow 120,000
• The working capital would be released at the end of the
contract.
• Denny Associates requires a 14% return.
Denny Associates has been offered a four-year contract to
supply the computing requirements for a local bank.
13-16
If the Net Present
Value is . . . Then the Project is . . .
Positive . . .
Acceptable because it promises
a return greater than the
required rate of return.
Zero . . .
Acceptable because it promises
a return equal to the required
rate of return.
Negative . . .
Not acceptable because it
promises a return less than the
required rate of return.
The Net Present Value Method
13-17
Choosing a Discount Rate
• The company’s cost of
capital is usually regarded
as the minimum required
rate of return.
• The cost of capital is the
average return the
company must pay to its
long-term creditors and
stockholders.
13-18
Learning Objective 3
Evaluate the
acceptability of an
investment project using
the internal rate of return
method.
13-19
Internal Rate of Return Method
• The internal rate of return is the rate of return
promised by an investment project over its
useful life. It is computed by finding the
discount rate that will cause the net present
value of a project to be zero.
• It works very well if a project’s cash flows are
identical every year. If the annual cash flows
are not identical software, such as Excel,
must be used for the calculation.
13-20
Internal Rate of Return Method
General decision rule . . .
If the Internal Rate of Return is . . . Then the Project is . . .
Equal to or greater than the minimum
required rate of return . . .
Acceptable.
Less than the minimum required rate
of return . . .
Rejected.
When using the internal rate of return, the cost
of capital acts as a hurdle rate that a project
must clear for acceptance.
13-21
Comparing the Net Present Value and
Internal Rate of Return Methods
• NPV is often simpler to
use.
• Questionable assumption:
▫ Internal rate of return
method assumes cash
inflows are reinvested at the
internal rate of return.
13-22
Least Cost Decisions
In decisions where
revenues are not
directly involved,
managers should
choose the
alternative that has
the least total cost
from a present
value perspective.
13-23
Learning Objective 4
Evaluate an investment
project that has
uncertain cash flows.
13-24
Uncertain Cash Flows – An Example
• Assume that all of the cash flows related to an
investment in a supertanker have been
estimated, except for its salvage value in 20
years.
• Using a discount rate of 12%, management has
determined that the net present value of all the
cash flows, except the salvage value is a
negative $1.04 million.
How large would the salvage value need to be to
make this investment attractive?
13-25
Uncertain Cash Flows – An Example
If the salvage value of the supertanker is at
least $10,000,000, the net present value of the
investment would be positive and therefore
acceptable.
13-26
Learning Objective 5
Rank investment
projects in order of
preference.
13-27
Preference Decision – The Ranking of
Investment Projects
Screening Decisions
Pertain to whether or
not some proposed
investment is
acceptable; these
decisions come first.
Preference Decisions
Attempt to rank
acceptable
alternatives from the
most to least
appealing.
13-28
Internal Rate of Return Method
The higher the internal
rate of return, the
more desirable the
project.
When using the internal rate of return
method to rank competing investment
projects, the preference rule is:
13-29
Net Present Value Method
The net present value of one project cannot
be directly compared to the net present
value of another project unless the
investments are equal.
13-30
Ranking Investment Projects
Project Net present value of the project
profitability Investment required
index
=
Project A Project B
Net present value (a) 1,000
$ 1,000
$
Investment required (b) $ 10,000 $ 5,000
Profitability index (a) ÷ (b) 0.10 0.20
The higher the profitability index, the
more desirable the project.
13-31
Time Value of Money Calculations
There are a variety of resources for doing
time value of money calculations:
▫ Financial Calculator (such as your TI)
▫ Excel
 Excel contains a number of functions for doing time
value of money calculations
 These functions include:
 PV function
 IRR function
 FV function
 PMT function
 RATE function
▫ Tables and factors?

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3824283.ppt

  • 1. Capital Budgeting Decisions Chapter 13 ACTG 202 – Principles of Managerial Accounting
  • 2. 13-2 Typical Capital Budgeting Decisions Plant expansion Equipment selection Equipment replacement Lease or buy Cost reduction
  • 3. 13-3 Typical Capital Budgeting Decisions Capital budgeting tends to fall into two broad categories. 1. Screening decisions. Does a proposed project meet some preset standard of acceptance? 2. Preference decisions. Selecting from among several competing courses of action.
  • 4. 13-4 Time Value of Money The discussion of capital budgeting begins with a discussion of the time value of money. A dollar today is worth more than a dollar a year from now. Therefore, projects that promise earlier returns are preferable to those that promise later returns.
  • 5. 13-5 Time Value of Money The capital budgeting techniques that best recognize the time value of money are those that involve discounted cash flows.
  • 6. 13-6 Present Value and Future Value
  • 7. 13-7 Learning Objective 1 Determine the payback period for an investment.
  • 8. 13-8 The payback method focuses on the payback period, which is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates. The Payback Method
  • 9. 13-9 Evaluation of the Payback Method Ignores the time value of money. Ignores cash flows after the payback period. Short-comings of the payback method. Shorter payback period does not always mean a more desirable investment.
  • 10. 13-10 Evaluation of the Payback Method Serves as screening tool. Identifies investments that recoup cash investments quickly. Identifies products that recoup initial investment quickly. Strengths of the payback period.
  • 11. 13-11 Learning Objective 2 Evaluate the acceptability of an investment project using the net present value method.
  • 12. 13-12 The Net Present Value Method The net present value method compares the present value of a project’s cash inflows with the present value of its cash outflows. The difference between these two streams of cash flows is called the net present value.
  • 13. 13-13 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.
  • 14. 13-14 The Net Present Value Method Two Simplifying Assumptions • All cash flows other than the initial investment occur at the end of periods. • All cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate.
  • 15. 13-15 iClicker Quick Check  Cash flow information Cost of computer equipment $ 250,000 Working capital required 20,000 Upgrading of equipment in 2 years 90,000 Salvage value of equipment in 4 years 10,000 Annual net cash inflow 120,000 • The working capital would be released at the end of the contract. • Denny Associates requires a 14% return. Denny Associates has been offered a four-year contract to supply the computing requirements for a local bank.
  • 16. 13-16 If the Net Present Value is . . . Then the Project is . . . Positive . . . Acceptable because it promises a return greater than the required rate of return. Zero . . . Acceptable because it promises a return equal to the required rate of return. Negative . . . Not acceptable because it promises a return less than the required rate of return. The Net Present Value Method
  • 17. 13-17 Choosing a Discount Rate • The company’s cost of capital is usually regarded as the minimum required rate of return. • The cost of capital is the average return the company must pay to its long-term creditors and stockholders.
  • 18. 13-18 Learning Objective 3 Evaluate the acceptability of an investment project using the internal rate of return method.
  • 19. 13-19 Internal Rate of Return Method • The internal rate of return is the rate of return promised by an investment project over its useful life. It is computed by finding the discount rate that will cause the net present value of a project to be zero. • It works very well if a project’s cash flows are identical every year. If the annual cash flows are not identical software, such as Excel, must be used for the calculation.
  • 20. 13-20 Internal Rate of Return Method General decision rule . . . If the Internal Rate of Return is . . . Then the Project is . . . Equal to or greater than the minimum required rate of return . . . Acceptable. Less than the minimum required rate of return . . . Rejected. When using the internal rate of return, the cost of capital acts as a hurdle rate that a project must clear for acceptance.
  • 21. 13-21 Comparing the Net Present Value and Internal Rate of Return Methods • NPV is often simpler to use. • Questionable assumption: ▫ Internal rate of return method assumes cash inflows are reinvested at the internal rate of return.
  • 22. 13-22 Least Cost Decisions In decisions where revenues are not directly involved, managers should choose the alternative that has the least total cost from a present value perspective.
  • 23. 13-23 Learning Objective 4 Evaluate an investment project that has uncertain cash flows.
  • 24. 13-24 Uncertain Cash Flows – An Example • Assume that all of the cash flows related to an investment in a supertanker have been estimated, except for its salvage value in 20 years. • Using a discount rate of 12%, management has determined that the net present value of all the cash flows, except the salvage value is a negative $1.04 million. How large would the salvage value need to be to make this investment attractive?
  • 25. 13-25 Uncertain Cash Flows – An Example If the salvage value of the supertanker is at least $10,000,000, the net present value of the investment would be positive and therefore acceptable.
  • 26. 13-26 Learning Objective 5 Rank investment projects in order of preference.
  • 27. 13-27 Preference Decision – The Ranking of Investment Projects Screening Decisions Pertain to whether or not some proposed investment is acceptable; these decisions come first. Preference Decisions Attempt to rank acceptable alternatives from the most to least appealing.
  • 28. 13-28 Internal Rate of Return Method The higher the internal rate of return, the more desirable the project. When using the internal rate of return method to rank competing investment projects, the preference rule is:
  • 29. 13-29 Net Present Value Method The net present value of one project cannot be directly compared to the net present value of another project unless the investments are equal.
  • 30. 13-30 Ranking Investment Projects Project Net present value of the project profitability Investment required index = Project A Project B Net present value (a) 1,000 $ 1,000 $ Investment required (b) $ 10,000 $ 5,000 Profitability index (a) ÷ (b) 0.10 0.20 The higher the profitability index, the more desirable the project.
  • 31. 13-31 Time Value of Money Calculations There are a variety of resources for doing time value of money calculations: ▫ Financial Calculator (such as your TI) ▫ Excel  Excel contains a number of functions for doing time value of money calculations  These functions include:  PV function  IRR function  FV function  PMT function  RATE function ▫ Tables and factors?

Editor's Notes

  1. Time Value of Money Assignment 5 icqs
  2. Need to introduce use of TI calculator!!!! Setting decimal places – 2ND FORMAT 9 ENTER TVM line of functions Clearing TVM 2nd QUIT; 2nd CLR TVM If your rich uncle offered you $10,000 today or $10,000 at in 3 years, which would you take? What about $11,000, $15,000? FV of $10,000 compounded annually at 5%. (CALCULATE MANUALLY AND WITH CALCULATOR) PV of $11,576/25 over 3 years at 5% = $10,000 (PV) Annuity – stream of equal cash flows PV of $200 per year for 3 years Do by year – then calculate – PV is $545
  3. Ex. 13-1 (page 609)
  4. The idea is to bring EVERYTHING back to its value at time zero. An interest rate needs to be selected and used in the calculation. Ex. 13-2 (page 609) Ex. 13-7 (page 610) Ex. 13-10 (page 611)
  5. Why do we focus on PV rather than FV?
  6. Ex. 13-3 (page 609) Ex. 13-15 (page 612)
  7. Ex. 13-4 (page 609)
  8. Ex. 13-5 (page 610)
  9. Show Excel spreadsheet Show some other types of calculations that can be done with time value of money concepts. Loan payment - $250,000; 4.25%/year; 30 years, paid monthly = $1,229.85 Future value - $20,000 today; 6% per year, compounded quarterly; 20 years = $65,813 (annual compounding is $64,143) Calculate interest rate – buy $50,000 car with $5,000 down; payment is $1,217 over 60 months; no residual = I = 20.98%