Capital Budgeting

Revision Question 1
A travel company is planning a wine tour of Western Australias wine growing region. The costs associated with the tour are estimated to be as follows: Bus $1,035, wine tasting at a winery, $10 per person, Wine Appreciation Course $25 per person, insurance $500, $500 lunch $20 per person person. Required What is the variable cost of each wine tour?

What are the fixed costs of conducting the wine tour?

Solution 1
Variable Cost Wine Tasting Wine Course Lunch 10 25 20 55 Fixed Costs Bus Hire Insurance 1,035 500 1,535

Revision Question 2

A travel company p y is p planning g a wine tour of Western Australias wine growing region. The costs associated with the tour are estimated to be as follows: Bus $1 $1,035, 035 wine tasting at a winery, $10 per person, Wine Appreciation Course $25 p per p person, , insurance $500, , lunch $20 per person.

Required If it is estimated that 44 people will attend, what is the break even selling price?
4

Solution 2
Profit = SP(X) - VC(X) - FC 0 = SP(44) 55 (44) 1,535 0 = 44SP 2,420 2 420 1,535 1 535 3,955 = 44SP 3,955/44 = SP $89.89 = SP

Revision Question 3
A travel company p y is p planning g a wine tour of Western Australias wine growing region. The costs associated with the tour are estimated to be as follows: Bus $1 $1,035, 035 wine tasting at a winery, $10 per person, Wine Appreciation Course $25 p per p person, , insurance $500, , lunch $20 per person. Required If it is estimated that 30 people will attend and a profit of $300 is desired, what price would need to be set for tickets?

Solution 3
Profit = SP(X) - VC(X) - FC 300 = SP(30) 55 (30) 1,535 0 = 30SP 1,650 1 650 1,535 1 535 3,485 = 30SP 3,485/30 = SP $116.17 = SP

Revision Question 4

A travel company p y is p planning g a wine tour of Western Australias wine growing region. The costs associated with the tour are estimated to be as follows: Bus $1 $1,035, 035 wine tasting at a winery, $10 per person, Wine Appreciation Course $25 p per p person, , insurance $500, , lunch $20 per person.

Required If ticket price is $70 each, how many people need to attend to break break-even? even?
8

Solution 4
Profit = SP(X) - VC(X) - FC 0 = 70(X) 55(X) 1,535 0 = 70X 55X 1,535 1 535 1,535 = 15X 1,535/15 = X 102.33 = X 103 people are required to break-even

Revision Question 5

A business currently makes calculators. The variable cost of making each calculator is $22. $ The fixed cost per calculator is $9. The business is currently producing 16,000 calculators. The selling price per calculator is $45. The maximum capacity of the business is 19,500. 19 500 A large electronic retail store has offered to buy 5,000 calculators for $30 each each.

Required 1. Calculate C l l t what h t gain i or l loss will ill b be made d if th the offer ff i is accepted. t d

10

Solution 5
Current Production + Special Order 16,000 16 000 5,000 21 000 21,000 19,500 1,500

Maximum Capacity Opportunity Cost

11

Solution 5
Selling Price (5,000 x $30) - Variable Costs (5 (5,000 000 x $22) 150,000 (110 000) (110,000)

- Opportunity Cost (1 (1,500 500 x $23) (34,500) (34 500) - Additional Fixed Cost Gain 0 5 500 5,500
12

Revision Question 6

A business currently y makes calculators. The variable cost of making each calculator is $22. The fixed cost per calculator is $9. The business is currently producing gp price p per calculator is 16,000 calculators. The selling $45. The maximum capacity of the business is 19,500. A large electronic retail store has offered to buy 5 5,000 000 calculators for $30 each.

Required What is the gain or loss if the order is for 6,000 products.

13

Solution 6
Current Production + Special Order 16,000 16 000 6,000 22 000 22,000 19,500 2,500

Maximum Capacity Opportunity Cost

14

Solution 6
Selling Price (6,000 x $30) - Variable Costs (6 (6,000 000 x $22) 180,000 132 000 132,000

- Opportunity Cost (2 (2,500 500 x $23) 57,500 57 500 - Additional Fixed Cost Gain 0 (9 500) (9,500)
15

Lecture Outline

Discuss the time time value of money money concept. concept Define and explain the importance of Capital Budgeting. Budgeting Use quantitative analysis to determine the viability of a proposed capital expenditure expenditure.

Time Value of Money

Would you rather have $5,000 today or $5,000 in five years time?

Answer: $5 $5,000 000 Today $5,000 can be invested today and if it earns 6% interest e es eac each yea year for o the e next e 5 yea years s it will accumulate to $6,691.

$5,000 today will also buy more than $ $ $5,000 in five years time.

Time Value of Money

$1 today is worth more than $1 in the future because of two main factors:
1. Interest Rates 2. Inflation

Time Value of Money

(45,000) )

20,000

20,000

20,000

1 (years)

Would you invest $45,000 now if you were to receive a return of $20,000 every year for the next three years

Time Value of Money

We cannot simply say:
Cash Inflow L Less C Cost t Gain

60,000 45 000 45,000 15,000

Money has a time value. $20,000 in one years time is worth more than $20 $20,000 000 in three years time time.

Time Value of Money

If you have the following amounts: $A100 $SG100 $HK100 Is the value of these amounts $300?

Time Value of Money

To determine how much you have you would convert them into a common scale as shown below: $AUD100 = $AUD 100 $SGD100 = $AUD 80 $HKD100 = $AUD 20

$AUD 200

Time Value of Money

Present Value The value, in todays dollars, of a future amount. amount The common scale used in accounting and finance to enable cash flows from different periods to be added together.

Time Value of Money

Present Value

(45,000)

20,000

20,000

20,000

In calculating present value we convert (discount) all the annual cash flows into todays dollars (i.e. what is $20,000 in one year worth in todays dollars, what is $20,000 in two years worth in todays today s dollars and so on) on).

Time Value of Money

Lump Sum

Al lumps sum refers f t to a one off ff amount. t P Present t Value V l = Future F t Value V l
(1 + i)n

Where;

i: Required rate of return n: Number N b of f years th the amount t needs d t to b be di discounted t d back

Present Value
Lump Sum

If the required rate of return is 10% 10%, what is the PV of $161 received in five years time? ?
0 1 2 3 4
$161

Solution
Present Value = Future Value (1 + i)n Present Value = 161 (1.10) ( )5

Present Value = $99.97

Practice Question 1

If the required rate of return is 8% 8%, how much would need to be invested today in order to have $ $15,000 , in seven y years?
$15 000 $15,000

?
0 1 2 3 4 5 6

Solution to Practice Question 1

Present Value = Future Value (1 + i)n Present Value = 15,000 (1.08) ( )7

Present Value = $8,752.36

Practice Question 2

What is the Present Value of receiving $500 in two years and $680 in four years. Assume a required q rate of return of 12%. % 500 680

Solution to Practice Question 2

Present Value = 500 + (1.12)2 680 (1.12)4

Present Value = $398.60 + 432.15

Present Value = $830.75

Present Value
Annuity

Constant stream of cash flows (i (i.e. e cash flow received or paid throughout a projects life). PV = FV1 +
(1 + i)

FV2 +
(1 +i)2

FV3
(1 + i)3

Practice Question 3

If the required rate of return is 10% 10%, how much would the government need to invest today y to fund a road safety y program p g costing g $5m every year for the next three years?
PV = FV1 + FV2 + FV3

(1 + i)

(1 +i)2

(1 + i)3

Solution to Practice Question 3

PV = 5,000,000 + 5,000,000 + 5,000,000 (1.10) (1.10)2 (1.10)3 PV = 4,545,454 + 4,132,231 + 3,756,574

PV = $12,434,259

Govt. will invest $12.4m of its own money today and this will earn $2.6m in interest over three years.

Practice Question 4

Would you invest $45 $45,000 000 now if you were to receive a return of $20,000 every year for the next three y years. Assume a required q rate of return of 8%.

Solution to Practice Question 4

PV = 20,000 + (1.08) 20,000 + (1.08)2 20,000 (1.08)3

PV =

18,518 + 17,146 + 15,877

PV =

$51,541

Gain = Gain =

51,541 45,000 $6,541

A $15,000 gain over three years is equivalent to a gain of $6,541 in y dollars. todays

Present Value of an Annuity

Equal Annual Cash Flows

If the th cash h flows fl are the th same each h year: PV = NCFi]n

NCF: Net Annual Cash Flow i: Required rate of return n: Useful life of project/asset

Practice Question 5

A machine is estimated to provide annual cash flows of $40,000 for the next five years. If the required q rate of return is 12%, %, what is the present value of these cash flows?

Solution to Practice Question 5

PV = NCFi]n i] PV = 40,000 40 00012%]5 PV = 40,000 x 3.6048 (from annuity table) PV = $144,192

A business should not pay more than $144,192 for the machine (assuming payment is made immediately).

Practice Question 6

An organisation buys a new machine at a cost of $100,000. The machine is estimated to have a useful life of 7 y years and to p produce estimated annual cash flows of $25,000 per year. The required y q rate of return is 8%. What is the present value of the cash flows produced by the machine?

Solution to Practice Question 6

PV = NCFi]n i] PV = 25,000 25 0008%]7 PV = 25,000 x 5.2063 PV = $130,157 $130 157

Capital Budgeting

A process that is undertaken to minimise the risk associated with capital expenditures such as:
1. 2. 3. 4 4. Purchasing new equipment Opening a new retail store Buying new premises E Expanding di production d ti f facilities iliti

Importance of Capital Budgeting

Capital expenditures usually have the following characteristics.

High Cost (relative to the size of the entity) Decision will extend well into the future. Diffi lt to Difficult t reverse decision. d i i

The risk associated with capital expenditures is therefore very high.

Capital Budgeting Process

1 1. 2.

3. 4.

Planning and Feasibility Assessment Quantitative Analysis and Choice of Projects Implementation A dit Audit

Quantitative Analysis
Step One Calculate the net annual cash flows.

See Lecture Illustration I

Step Two

A l one (or Apply ( more) ) of f the th four f evaluation l ti techniques t h i

Payback Method Net et Present ese t Value a ue Internal Rate of Return (not required in Acc100) Accounting Rate of Return (not required in Acc100)

Analysis Techniques
Payback Method

Measures the time it will take the net annual cash flows generated by a project to recover the cost of the original amount invested invested. The project is acceptable if the payback period is less than the pre-determined period of time set by the business.

Analysis Techniques
Payback Method

Curtin Ltd will not invest in projects with a payback period greater than 4 years.
Potential Project A B C Payback Period (Years) 2 5 3.6 Outcome Acceptable Unacceptable Acceptable

Calculating Payback Period

New robotic equipment costing $32 $32,000 000 is expected to produce net annual cash flows of $12,000 $ , for the next 5 y years. What is the payback period?

Calculating Payback Period

Year Annual Net Cash Flow 12,000 12,000 12,000 Investment Recovered 12,000 24,000 36,000

1 2 3

Calculating Payback Period

After 2 years: $24,000 $24 000 recovered After 3 years: $36,000 recovered Therefore payback period is 2 years and ?? months. th

= 2 years + (8,000/12,000 x 12 months) = 2 years 8 months

Practice Question 7

A machine costing $26 $26,000 000 is estimated to have a useful life of three years and to produce net annual cash flows of $ p $9,000, , , in the first year, $11,000 in the second and $14,000 in the third. What is the payback period?

Solution to Practice Question 7

Year Annual Net Cash Flow 9,000 11,000 14,000 Investment Recovered 9,000 20,000 34,000

1 2 3

Solution to Practice Question 7

After 2 y years: $ $20,000 , recovered After 3 years: $34,000 recovered Therefore payback period is 2 years and ?? months.

= 2 years + (6 (6,000/14,000 000/14 000 x 12 months) th ) = 2 years 5.14 months = 2 years 6 months

Practice Question 8

A machine costing $95 $95,700 700 is expected to produce the following cash flows:
1 32 600 32,600 2 33 400 33,400 3 35 200 35,200 4 38 000 38,000 5 39 500 39,500

What is the payback period?

Solution to Practice Question 8

Year Annual Net Cash Flow 32,600 33,400 35,200 Investment Recovered 32,600 66,000 101,200

1 2 3

Solution to Practice Question 8

After 2 years: $66,000 recovered After 3 years: $101,200 recovered Therefore payback period is 2 years and ?? months.

= 2 years + ((29,700/35,200) x 12 months) = 2 years 10.125 months = 2 years 11 months

Analysis Techniques
Payback Method - Benefits

Simple to use and understand. Provides a rough estimate of risk (i (i.e. e earlier cash flows are less risky than later ones). Firms experiencing cash shortages may need to recover investments quickly.

Analysis Techniques
Payback Method - Limitations

Ignores the time value of money. Payback method ignores cash flows after the point at which the initial cash outlay has been received.
(60)
0

20
1

20
2

20
3

100
4

120
5

150
6

180
7

(years)

Analysis Techniques
Net Present Value (NPV)
Step 1

Calculate the present value of the net annual cash flows. Calculate the p present value of the cost of the project/asset. NPV = Answer to Step 1 Answer to Step 2

Step 2

Step 3

Analysis Techniques
Net Present Value

If NPV

0 : Project is acceptable

The amount of any positive NPV represents the increase in the entitys wealth, expressed in present value terms terms, that will result from accepting the project.

Practice Question 9

An organisation buys a new machine at a cost of $85,000. The machine is estimated to have a useful life of 6 y years and to produce p estimated net cash flows of $21,000 per year. The organisation g has a required q rate of return equal to 10%. What is the net present value of the machine?

Solution to Practice Question 9

NPV = NPV = NPV = NPV = NPV = NPV = PV of NCF PV Cost of Project NCFi]n 85,000 21,00010%]6 - 85,000 (21,000 x 4.3552) - 85,000 $91,459 - 85,000 6,459

Practice Question 10

A machine costing $45 $45,000 000 is expected to produce a net annual cash flow of $17,000 per y p year. The life of the machine is estimated to be four years and it is will be sold for an estimated $5,000. The required q rate of return for the business is 12%.

Solution to Practice Question 10

NPV = NPV = NPV = NPV = NPV = NPV = PV of NCF PV Cost of Project NCFi]n 45,000 17,00012%]4 + 5,000/(1.12)4 - 45,000 (17,000 x 3.0373) + 3,178 - 45,000 $51,634 + 3,178 - 45,000 9,812

Analysis Techniques
Net Present Value - Benefits

The time-value of money is considered. The entire life of the project is included in the analysis.

Required Rate of Return

Cost of Capital

The required rate of return is the minimum return a business needs to achieve from a capital investment. In many cases the required rate of return is equal to the weighted average cost of obtaining finance (i.e. the cost of capital) Refer to the Accounting in Practice 2011 text for further information. information

Cost of Capital - Example

Source of Finance A Amount Interest Rate

90,000

8.5

10 000 10,000

10 2 10.2

Cost of Capital - Solution

Source of Finance A Amount Interest Weighting Cost of Capital 7 65 7.65

90 000 90,000

85 8.5

0 90 0.90

10,000

10.2

0.10

1.02

100,000

1.00

8.67%

Practice Question 10
What is the Cost of Capital?
Source of Finance A Amount Interest

160 000 160,000

8 75 8.75

95,000

9.6

35,000

11.3

Solution to Practice Question 10

Source of Finance A B C Amount 160,000 95,000 35,000 290,000 Interest 8.75 9.6 11.3 Weighting 0.55 0.33 0.12 1.00 Cost of Capital 4.81 3.17 1.36

9.34%

Practice Question 11
What is the cost of capital?
Source of Finance A B C D Amount 350,000 175,000 45,000 15,000 Interest Rate 8.25% 8.60% 9.40% 11.3%

Solution to Practice Question 11

Source A B C D Amount 350,000 175,000 45,000 15 000 15,000 585,000 Interest Rate Weighting 8.25% 8.60% 9.40% 11 30% 11.30% 0.598 0.299 0.077 0 026 0.026 1.00 Cost of Capital 4.93 2.57 0.72 0 29 0.29 8.51%

NPV and Cost of Capital

A project has a cost of capital = 14% NPV > 0 Return on the project > 14% If NPV < 0 Return on the project < 14%

Qualitative Considerations

Qualitative factors must also be taken into consideration before a capital investment is made. Examples of qualitative factors i l d include:

Impact on brand or reputation Impact on staff (i (i.e e introd introduction ction of labo labour r sa saving ing machinery may be deferred due to potentially adverse impact on staff morale and in-turn productivity Project may be resource intensive and distract business from its core activities activities.