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Capital Expenditure – an outlay of funds for a project that is expected to generate positive net cash inflows over an extended period of time. Capital Budgeting – the process of identifying, analyzing, and selecting projects which will allow management to implement and realize the firm’s profit strategy. Can involve very large financial outlays and last for extended periods of time, so can have a significant financial impact on a firm. Considerations Quantitative – (financial)
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What is the predicted rate of return generated by the project (Internal Rate of Return or IRR)? How does this rate compare with a minimum required rate of return (RRR)? What is the basis for measuring this return? Cash flows or accrual numbers? How does the time value of money affect the decision? What is the minimum acceptable time period for investment cost recovery? How are risk and uncertainty dealt with?
Since our time is limited, we shall study the basic analytical procedures in stand-alone investment decisions, not in comparative decisions as is demonstrated in the “Lifetime Care” example presented in the text. Additionally, we shall not consider tax effects.
Acctg 505 – Decision Analysis II, Capital Budgeting Basics, Chapter 21 – Widdison s.v
Examples include • Improved operating efficiency • Adding value to product or service leading to improved customer satisfaction • Improvement in environmental impact III.734 – 740. • release of working capital at end of project (Note: Depreciation is non-cash expense. we shall not discuss the “tax shield” afforded by depreciation.)2 2 Since we shall not consider the effect of income taxes in this course.(anticipated desirable outcomes not measurable in dollars). Qualitative -. Capital Budgeting Basics. Acctg 505 – Decision Analysis II. cost savings) • salvage (terminal) values o salvage value of any asset being sold upon acquisition of a new/replacement asset. Those of you interested in the impact of income taxes on capital budgeting cash flows are referred to text pp. Cash Flows -.Preferred evaluation models focus on after-tax cash flows. see Item 2b. o salvage value of asset being acquired is cash flow in terminal year of project.e. Chapter 21 – Widdison s. page 739.v 2 . Reduces investment cost. For depreciation impact.B. Potential Cash Outflows: • cost of initial investment • estimated repairs and maintenance during project life • incremental operating costs • increase in working capital at beginning of project Potential Cash Inflows: • incremental revenues • reduction in costs (i. Annual operating cash flows will always exceed accrual income at least by amount of this expense.
No separate instruction on present-value. Complete example analysis on next page. • Should take into consideration the opportunity value of the next best use of available funds. PV of inflows < PV of outflows. the net present value). Where NPV = $0.v 3 . the PVs of the cash flows are equal. Where NPV > $0. etc. you should see the TA or the instructor. Acctg 505 – Decision Analysis II.) required that you use a time value of money approach. Expected return > minimum required rate of return. Net Present Value (NPV) Model – uses a benchmark minimum required rate of return (RRR Procedure: Determine the difference between the total present value of the cash inflows and the total present value of the cash outflows. Chapter 21 – Widdison s.IV. Capital Budgeting Basics.e. bonds. 3 It is assumed that you are comfortable working with time value of money since you have just completed a sequence of modules in which certain topics (e.g. Expected return < minimum required rate of return. Project Evaluation Methods Discounted Cash Flow Models3 – Preferred. These examine the relationship between the present value of the cash inflows and the present value of the cash outflows over the life of the project. Issue: The discount rate involved in these time-value models. A. PV of inflows > PV of outflows. (i. will be included in this module If you are not comfortable with these procedures. therefore. Accept project. minimum required rate of return is expected. • Companies often use the WACC 1. Reject project. Where NPV < $0. Accept project. leases. asset impairment procedures.
Its estimated useful life is five years. Determine the present value of cash outflows. If Erudite’s required rate of return is 12% on projects of this type and level of risk. using either your calculator (preferred) or tables (requires two computations).000 at the end of its useful life. Annual operating cash savings from the use of the new machine will be $10. this requires no p. Determine the total present value of the cash inflows.000 at the beginning of its use.v. what is the net present value of this proposed investment? 1. Determine NPV and interpret result. computation. now). 3. Since all occur at “time zero” (i. Acctg 505 – Decision Analysis II. Chapter 21 – Widdison s. Capital Budgeting Basics. Recovery of working capital will be $4.500 and requires an increase in working capital of $4. The machine has a list price of $32. after which it is estimated to have a salvage value of $4.Illustrative Project: Erudite Bookstore wants to buy a new coding machine to help control book inventories. 2.000.000.v 4 .e.
Chapter 21 – Widdison s. Difficult to do where periodic cash flows are unequal or where there are several different lump-sum cash flows occurring at different points in time. we know that IRR is greater than 12%. page 729.2. Since this project has lump sum future cash inflows in addition to periodic equal cash inflows. It is not practical. From NPV analysis. 4 Interpret result. at what interest rate is the net present value equal to zero? The IRR is compared with the required rate of return. see your text. 4) 1. It is possible to estimate IRR fairly easily using the tables if the only cash inflows are periodic equal flows. time-consuming. project is acceptable. Acctg 505 – Decision Analysis II. Procedure: Determine the interest rate at which the total PVs of the cash inflows and outflows are equal. 2. Internal Rate of Return (IRR) Model – determines the actual rate of return expected to be generated by the project. In other words. section beginning “the step-by-step computations of internal rate of return…” You will not be asked to work with the trial-and-error approach. either a trial-and-error approach must be used OR a financial calculator approach. Where it exceeds or is equal to the RRR. Tedious. and not fun! Calculator. Capital Budgeting Basics.v 5 . Much easier! Recommended! Example: What is the IRR of the illustrative project? (see p. Methods: Trial-and-error approach. For an example of this.4 3.
e. Comparison of NPV and IRR Methods • NPV focuses on dollars. $12. therefore. e.v 6 . a less risky model. Suppose Erudite’s annual cash savings were expected to be $8. for longer projects. Payback Method – period of time to recover cost of investment in absolute dollars. $10.000.g.000. What is the payback period for the illustrative project? Interpret the result if Erudite requires a maximum payback period of 3 years.g.000 in Years 1 through 5 respectively. • NPV can be used when annual project returns differ among the years of the project’s life.000.000. Capital Budgeting Basics.3. $9. What if cash flows are not equal? Use sequential subtraction and then interpolation. there is not one overall RRR against which the IRR can be compared. Net investment cost/annual cash flows where the latter are equal. Chapter 21 – Widdison s. If IRR is used. IRR on comparative rates of return. How would this affect the payback computation? Acctg 505 – Decision Analysis II. B. and $11. Non-Discounted Methods – Not Preferred 1. • NPV is more conservative and.
Why used? 1.Concerns about the payback period approach: 1. Chapter 21 – Widdison s. Divide by net investment cost 3. Accrual Accounting Rate of Return (AARR) – the only approach which is not based on cash flows. For long projects.v 7 . Average Accrual Operating Income/Net Investment Cost Assume that Erudite requires a minimum AARR of 7%. 2. 3. Easy to understand and compute. Is the project acceptable? 1. Ignores cash flows beyond payback time. Ignores time-value of money. Primary reliance on it may result in suboptimal decisions. Acctg 505 – Decision Analysis II. it provides a measure of reassurance about cost recovery where payback period is relatively short. 2. Interpret result. Determine average accrual operating income. 2. Capital Budgeting Basics. 2.
Capital Budgeting Basics. 3. such as trading in an old asset for new at a loss. Is not based on cash flows. Chapter 21 – Widdison s. and/or AARR < ROI of an investment center. (More on this in Chapter 23. May lead to suboptimal decision-making because • Accrual income negatively impacted by items not affecting cash flows. 2. Does not take into account time value of money. How would you determine average accrual operating income if the annual cash flows were as reported on the bottom of Page 6? Concerns about the accrual accounting rate of return approach: 1.) • Acctg 505 – Decision Analysis II.Alternative assumption.v 8 .
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