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Chapter 26

Capital Budgeting

Budgeting for the acquisition of capital assets Capital budgeting techniques (a) Payback period (b) Accounting Rate of Return (c) Net Present Value (d) Internal Rate of Return

Capital Budgeting

Outcome is uncertain. Large amounts of money involved.

Analyzing alternative longterm investments and deciding which assets to acquire or sell.

Decision may be difficult or impossible to reverse.

Example

Casey Co. is considering an investment of $130,000 in new equipment. The new equipment is expected to last 10 years. It will have zero salvage value at the end of its useful life. The straight-line method of depreciation is used for accounting purposes. The expected annual revenues and costs of the new product that will be produced from the investment are: Sales Cost of goods sold Depreciation expense Selling & Admin expense Income before income tax Income tax expense Net Income $200,000 $145,000 13,000 22,000 180,000 $20,000 7,000 $13,000

Payback Period

Time period required to recover the cost of the investment from the annual cash inflow produced by the investment.

Amount invested Expected annual net cash inflow

Expected annual net cash inflow = Net income $13,000 Depreciation expense 13,000 $26,000

$130,000

$26,000

5 years

Casey Co. wants to install a machine that costs $16,000 and has an 8-year useful life with zero salvage value. Annual net cash flows are:

Year 0 1 2 3 4 5 6 7 8 Annual Net Cash Flows $ (16,000) 3,000 4,000 4,000 4,000 5,000 3,000 2,000 2,000 Cumulative Net Cash Flows $ (16,000) (13,000) (9,000) (5,000) (1,000)

We recover the $16,000 purchase price between years 4 and 5, about 4.2 years for the payback period.

Year 0 1 2 3 4 4.2 5 6 7 8 Annual Net Cash Flows $ (16,000) 3,000 4,000 4,000 4,000 5,000 3,000 2,000 2,000 Cumulative Net Cash Flows $ (16,000) (13,000) (9,000) (5,000) (1,000)

Payback = 5 years

Payback = 3 years

Consider two projects, each with a 5-year life and each costing $6,000.

Project One Net Cash Inflows $ 2,000 2,000 2,000 2,000 2,000 Project Two Net Cash Inflows $ 1,000 1,000 1,000 1,000 1,000,000

Year 1 2 3 4 5

Would you invest in Project One just because it has a shorter payback period?

Average annual operating income from asset Average amount invested in asset

Compare accounting rate of return to companys required minimum rate of return for investments of similar risk. The minimum return is based on the companys cost of capital.

Average Investment =

Average annual operating income from asset Average amount invested in asset

$13,000 / $65,000 = 20%

The decision rule is: A project is acceptable if its rate of return is greater than managements minimum rate of return. The higher the rate of return for a given risk, the more attractive the investment.

Considers both the estimated total cash inflows and the time value of money. Two methods 1) net present value 2) internal rate of return

Find PV of future cash flows and compare with capital outlay Interest rate used = required minimum rate of return Proposal is acceptable when NPV is zero or positive. The higher the positive NPV, the more attractive the investment.

We will assume that Casey Cos annual cash inflows of $26,000 are uniform over the assets useful life. The present value of the annual cash inflows can be computed by using the present value of an annuity of 1 for 10 periods. Assume the company requires a minimum return of 12%.

Cash Flow When? Type of cash flow Present value factor 5.650 Present value of cash flows ($130,000) 146,900

NPV

$16,900

is acceptable at a required rate of return of 12% because the net present value is positive

When annual cash inflows are unequal, use present value of one tables.

Cash Flow (130,000) 36,000 32,000 29,000 27,000 26,000 24,000 23,000 22,000 21,000 20,000 NPV

When?

1 2 3 4 5 6 7 8 9 10 Lump sum ,, .893 .797 .712 .636 .567 .507 .452 .404 .361 .322

PV factor

Present value ($130,000) 32,148 25,504 20,648 17,172 14,742 12,168 10,396 8,888 7,581 6,440 $25,687

Interest yield of the potential investment The interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows.

STEP 1.Compute the internal rate of return factor using this formula:

Capital Investment Annual Cash Inflows

$130,000 /

$26,000

5.0

STEP 2. Use the factor and the present value of an annuity of 1 table to find the internal rate of return. Locate the discount factor that is closest to 5.0 on the line for 10 periods.

(N) Periods 10 6% 7.360 PRESENT VALUE OF AN ANNUITY OF 1 7% 8% 9% 10% 12% 7.024 6.710 6.418 6.145 5.650 14% 5.216 15% 5.019

The decision rule is: Accept when internal rate of return is equal to or greater than the required rate of return Reject when internal rate of return is less than required rate

If cash inflows are unequal, trial and error solution will result if present value tables are used. Use business calculators and electronic spreadsheets

Comparing Methods

Basis of measurement Measure expressed as Payback period Cash flow s Number of years Easy to Understand Accounting rate of return Accrual income Percent Easy to Understand Net present Internal rate value of return Cash flow s Cash flow s Profitability Profitability Dollar Percent Amount Considers time Considers time value of money value of money

Strengths

Limitations

Allow s Allow s Accommodates Allow s comparison comparison different risk comparisons across projects across projects levels over of dissimilar a project's life projects Doesn't Doesn't Difficult to Doesn't reflect consider time consider time compare varying risk value of money value of money dissimilar levels over the projects project's life Doesn't consider cash flow s after payback period Doesn't give annual rates over the life of a project

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