# Capital Budgeting

Revision Question 1
A travel company is planning a wine tour of Western Australia’s 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?
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What are the fixed costs of conducting the wine tour?

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

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what is the break even selling price? 4 .Revision Question 2  A travel company p y is p planning g a wine tour of Western Australia’s wine growing region. The costs associated with the tour are estimated to be as follows: Bus \$1 \$1. \$10 per person. 035 wine tasting at a winery. Wine Appreciation Course \$25 p per p person. . lunch \$20 per person. . Required  If it is estimated that 44 people will attend. insurance \$500.035.

535 0 = 44SP – 2.Solution 2 Profit = SP(X) .955 = 44SP 3.420 2 420 – 1.535 1 535 3.89 = SP 5 .FC 0 = SP(44) – 55 (44) – 1.955/44 = SP \$89.VC(X) .

what price would need to be set for tickets?  6 .Revision Question 3 A travel company p y is p planning g a wine tour of Western Australia’s wine growing region. . Required  If it is estimated that 30 people will attend and a profit of \$300 is desired. The costs associated with the tour are estimated to be as follows: Bus \$1 \$1. 035 wine tasting at a winery. Wine Appreciation Course \$25 p per p person. insurance \$500. .035. lunch \$20 per person. \$10 per person.

Solution 3 Profit = SP(X) .485/30 = SP \$116.650 1 650 – 1.17 = SP 7 .485 = 30SP 3.535 0 = 30SP – 1.VC(X) .FC 300 = SP(30) – 55 (30) – 1.535 1 535 3.

035 wine tasting at a winery. lunch \$20 per person.Revision Question 4  A travel company p y is p planning g a wine tour of Western Australia’s wine growing region. how many people need to attend to break break-even? even? 8 . insurance \$500. . \$10 per person. Required  If ticket price is \$70 each. The costs associated with the tour are estimated to be as follows: Bus \$1 \$1.035. . Wine Appreciation Course \$25 p per p person.

535 0 = 70X – 55X – 1.33 = X 103 people are required to break-even 9 .535/15 = X 102.VC(X) .FC 0 = 70(X) – 55(X) – 1.535 1 535 1.Solution 4 Profit = SP(X) .535 = 15X 1.

t d 10 . The business is currently producing 16.000 calculators. The variable cost of making each calculator is \$22. \$ The fixed cost per calculator is \$9.000 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. 19 500 A large electronic retail store has offered to buy 5. The maximum capacity of the business is 19. The selling price per calculator is \$45.500.Revision Question 5  A business currently makes calculators.

500 Maximum Capacity Opportunity Cost 11 .500 1.000 21 000 21.Solution 5 Current Production + Special Order 16.000 16 000 5.000 19.

Solution 5 Selling Price (5.Opportunity Cost (1 (1.500 12 .000 (110 000) (110.000) .Variable Costs (5 (5.000 x \$30) .000 000 x \$22) 150.Additional Fixed Cost Gain 0 5 500 5.500 500 x \$23) (34.500) (34 500) .

000 calculators. Required  What is the gain or loss if the order is for 6. 13 . The business is currently producing gp price p per calculator is 16. The selling \$45. The fixed cost per calculator is \$9. The maximum capacity of the business is 19. The variable cost of making each calculator is \$22.Revision Question 6  A business currently y makes calculators.500.000 000 calculators for \$30 each. A large electronic retail store has offered to buy 5 5.000 products.

000 19.500 2.Solution 6 Current Production + Special Order 16.000 22 000 22.500 Maximum Capacity Opportunity Cost 14 .000 16 000 6.

000 132 000 132.000 .500 57 500 .Variable Costs (6 (6.000 x \$30) .500 500 x \$23) 57.000 000 x \$22) 180.500) 15 .Additional Fixed Cost Gain 0 (9 500) (9.Solution 6 Selling Price (6.Opportunity Cost (2 (2.

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

000 in five years time? Answer: \$5 \$5.000 in five years time.691.000 today will also buy more than \$ \$ \$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 \$6.000 000 Today  \$5.000 today or \$5.  \$5. .Time Value of Money  Would you rather have \$5.

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

000 now if you were to receive a return of \$20.000 every year for the next three years .000 0 1 (years) 2 3  Would you invest \$45.Time Value of Money (45.000 20.000) ) 20.000 20.

\$20.000 in one years time is worth more than \$20 \$20. .000 15.Time Value of Money We cannot simply say: Cash Inflow L Less C Cost t Gain  60.000 45 000 45.000 000 in three years time time.000 Money has a time value.

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. . amount  The common scale used in accounting and finance to enable cash flows from different periods to be added together. of a future amount. in today’s dollars.

e. what is \$20.000 in two years worth in today’s today s dollars and so on) on).000 0 1 2 3  In calculating present value we convert (discount) all the annual cash flows into today’s dollars (i. .000 in one year worth in today’s dollars. what is \$20.000 20.000) 20.000 20.Time Value of Money Present Value (45.

  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 .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.

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 5 .

10) ( )5 Present Value = \$99.Solution Present Value = Future Value (1 + i)n Present Value = 161 (1.97 .

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 ? 0 1 2 3 4 5 6 7 .000 . in seven y years? \$15 000 \$15.

Solution to Practice Question 1 Present Value = Future Value (1 + i)n Present Value = 15.36 .000 (1.08) ( )7 Present Value = \$8.752.

% 500 680 0 1 2 3 4 .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%.

12)4 Present Value = \$398.60 + 432.Solution to Practice Question 2 Present Value = 500 + (1.12)2 680 (1.75 .15 Present Value = \$830.

e cash flow received or paid throughout a projects life).e. PV = FV1 + (1 + i) FV2 + (1 +i)2 FV3 (1 + i)3 .Present Value Annuity  Constant stream of cash flows (i (i.

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

Practice Question 4
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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 =
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51,541 – 45,000 \$6,541

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

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? . %.

192 for the machine (assuming payment is made immediately).000 x 3.000 40 00012%]5 PV = 40.Solution to Practice Question 5 PV = NCFi]n i] PV = 40.6048 (from annuity table) PV = \$144. .192  A business should not pay more than \$144.

What is the present value of the cash flows produced by the machine?  .000.000 per year.Practice Question 6  An organisation buys a new machine at a cost of \$100. The machine is estimated to have a useful life of 7 y years and to p produce estimated annual cash flows of \$25. The required y q rate of return is 8%.

000 x 5.2063 PV = \$130.157 \$130 157 .Solution to Practice Question 6 PV = NCFi]n i] PV = 25.000 25 0008%]7 PV = 25.

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

. Diffi lt to Difficult t reverse decision. d i i  The risk associated with capital expenditures is therefore very high.    High Cost (relative to the size of the entity) Decision will extend well into the future.Importance of Capital Budgeting  Capital expenditures usually have the following characteristics.

3. 2. Planning and Feasibility Assessment Quantitative Analysis and Choice of Projects Implementation A dit Audit . 4.Capital Budgeting Process 1 1.

 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) .Quantitative Analysis Step One  Calculate the net annual cash flows.

 . 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  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.

6 Outcome Acceptable Unacceptable Acceptable .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.

000 000 is expected to produce net annual cash flows of \$12.000 \$ . for the next 5 y years.Calculating Payback Period  New robotic equipment costing \$32 \$32. What is the payback period?  .

000 1 2 3 .000 12.000 24.000 36.000 12.000 Investment Recovered 12.Calculating Payback Period Year Annual Net Cash Flow 12.

th  = 2 years + (8.000 \$24 000 recovered After 3 years: \$36.000/12.000 recovered Therefore payback period is 2 years and ?? months.000 x 12 months) = 2 years 8 months .Calculating Payback Period   After 2 years: \$24.

.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 second and \$14.000.Practice Question 7  A machine costing \$26 \$26.000 in the third. What is the payback period?  . in the first year. . \$11.

000 1 2 3 .000 11.000 Investment Recovered 9.000 14.000 34.Solution to Practice Question 7 Year Annual Net Cash Flow 9.000 20.

 = 2 years + (6 (6.14 months = 2 years 6 months .000/14.000 .000 recovered Therefore payback period is 2 years and ?? months.Solution to Practice Question 7   After 2 y years: \$ \$20. recovered After 3 years: \$34.000 000/14 000 x 12 months) th ) = 2 years 5.

400 3 35 200 35.700 700 is expected to produce the following cash flows: 1 32 600 32.600 2 33 400 33.200 4 38 000 38.Practice Question 8  A machine costing \$95 \$95.000 5 39 500 39.500  What is the payback period? .

000 101.400 35.600 66.600 33.200 1 2 3 .Solution to Practice Question 8 Year Annual Net Cash Flow 32.200 Investment Recovered 32.

200 recovered Therefore payback period is 2 years and ?? months.700/35.200) x 12 months) = 2 years 10.000 recovered After 3 years: \$101.Solution to Practice Question 8   After 2 years: \$66.125 months = 2 years 11 months .  = 2 years + ((29.

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

(60) 0 20 1 20 2 20 3 100 4 120 5 150 6 180 7 (years) .Limitations   Ignores the time value of money.Analysis Techniques Payback Method . Payback method ignores cash flows after the point at which the initial cash outlay has been received.

NPV = Answer to Step 1 – Answer to Step 2 Step 2  Step 3  . Calculate the p present value of the cost of the project/asset.Analysis Techniques Net Present Value (NPV) Step 1  Calculate the present value of the net annual cash flows.

. expressed in present value terms terms.Analysis Techniques Net Present Value  If NPV 0 : Project is acceptable  The amount of any positive NPV represents the increase in the entity’s wealth. that will result from accepting the project.

000 per year.000.Practice Question 9  An organisation buys a new machine at a cost of \$85. The machine is estimated to have a useful life of 6 y years and to produce p estimated net cash flows of \$21. The organisation g has a required q rate of return equal to 10%. What is the net present value of the machine?  .

3552) .000 21.00010%]6 .Solution to Practice Question 9 NPV = NPV = NPV = NPV = NPV = NPV = PV of NCF – PV Cost of Project NCFi]n – 85.000 \$91.000 (21.85.459 .85.000 x 4.459 .000 6.85.

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. .000 000 is expected to produce a net annual cash flow of \$17.000.Practice Question 10  A machine costing \$45 \$45. The required q rate of return for the business is 12%.

178 .000 17.000 x 3.000/(1.178 .000 \$51.45.000 9.12)4 .000 (17.634 + 3.0373) + 3.45.45.Solution to Practice Question 10 NPV = NPV = NPV = NPV = NPV = NPV = PV of NCF – PV Cost of Project NCFi]n – 45.812 .00012%]4 + 5.

.Analysis Techniques Net Present Value .Benefits   The time-value of money is considered. The entire life of the project is included in the analysis.

e. the cost of capital) Refer to the ‘Accounting in Practice 2011” text for further information. In many cases the required rate of return is equal to the weighted average cost of obtaining finance (i. information   .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.

Cost of Capital .000 10 2 10.000 8.Example Source of Finance A Amount Interest Rate 90.5 B 10 000 10.2 .

65 90 000 90.000 10.00 8.02 100.5 0 90 0.Cost of Capital .000 85 8.90 B 10.Solution Source of Finance A Amount Interest Weighting Cost of Capital 7 65 7.2 0.10 1.67% .000 1.

000 8 75 8.000 11.3 .000 9.Practice Question 10 What is the Cost of Capital? Source of Finance A Amount Interest 160 000 160.6 C 35.75 B 95.

6 11.000 95.75 9.3 Weighting 0.000 Interest 8.36 9.17 1.Solution to Practice Question 10 Source of Finance A B C Amount 160.33 0.000 35.00 Cost of Capital 4.12 1.81 3.55 0.34% .000 290.

3% .000 15.000 Interest Rate 8.40% 11.000 45.60% 9.Practice Question 11 What is the cost of capital? Source of Finance A B C D Amount 350.25% 8.000 175.

299 0.026 1.000 175.000 15 000 15.598 0.077 0 026 0.Solution to Practice Question 11 Source A B C D Amount 350.57 0.29 8.25% 8.00 Cost of Capital 4.000 Interest Rate Weighting 8.000 585.60% 9.40% 11 30% 11.93 2.000 45.30% 0.72 0 29 0.51% .

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% .

.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.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.