CAPITAL BUDGETING
WHY DIDN’T I THINK OF THAT?
What does every baseball player need to
complete the uniform?
A cap.
What a business opportunity for C&C Sports!
Or is it?
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© Tomwang112 / iStockphoto
CAPITAL BUDGETING
DECISIONS
Unit 9.1 Unit 9.2 Unit 9.3 Unit 9.4
91
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CAPITAL BUDGETING IS…
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A systematic approach to evaluating an
investment in a capital asset
A process for evaluating long-range investment
proposals for the purpose of allocating limited
resources
Different from cash budgeting because of the time
horizon involved
WHAT ARE CAPITAL ASSETS?
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Equipment or facilities that provide productive
services to the organization for more than one
accounting period
Also called depreciable assets or long-lived assets
WHY DO YOU INVEST?
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For expected future returns
• Return of investment
• Return on investment
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RETURN OF INVESTMENT VS. RETURN ON INVESTMENT
Suppose you buy
a share of a
company’s stock
today at $26 and
sell it in one
month for $32.50
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$26.00
Return OF
investment
$6.50
Return ON
investment
SCREENING VS. PREFERENCE DECISIONS
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Screening Decisions
• Which projects meet the hurdle rate?
• Which of the projects are acceptable for the
organization in light of its goals?
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Preference Decisions
• Of the acceptable projects, which ones should be
implemented?
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SCREENING VS. PREFERENCE
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IDENTIFYING PROJECT CASH FLOWS
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Cash receipts
• Additional sales revenue
• Salvage value of equipment
• Cost savings
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Cash disbursements
• Purchase price
• Additional operating costs (DM, DL, MOH, SG&A)
• DO NOT include interest from financing the
acquisition of the asset
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Identify when the cash flows occur
CASH FLOWS OF THE TOPCAP SYSTEM
Cash Flow
Amount
Timing
$625,000
Years 1 – 10
Purchase and installation of TopCap system
$ 50,265
Year 0
Purchase of direct materials (250,000 caps ×$2.00 per cap)
$500,000
Years 1 – 10
Direct labor (3 employees×8 hours/day×$9.60/hour×5
days/week×50 weeks per year)
$ 57,600
Years 1 – 10
Variable overhead (250,000 caps ×$0.15 per cap)
$ 37,500
Years 1 – 10
Variable selling expense (250,000 caps ×$0.05 per cap)
$ 12,500
Years 1 – 10
Fixed expenses
$ 7,000
Years 1 – 10
Cash Inflows
Sales revenue (250,000 caps ×$2.50 per cap)
Cash Outflows
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© Tomwang112 / iStockphoto
TIME VALUE
OF MONEY
Unit 9.1 Unit 9.2 Unit 9.3 Unit 9.4
9.2
WHICH SHOULD YOU CHOOSE?
$20,000
TODAY
$22,000
A YEAR FROM NOW
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WHY?
WHICH SHOULD YOU CHOOSE?
$20,000
TODAY
$22,000
A YEAR FROM NOW
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IT DEPENDS.
PRESENT VALUE
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What you pay today to receive $22,000 five years
from now?
You can calculate this amount by “discounting” the
future amount based on the expected interest rate
you would earn over the 5-year period
PV(n,i) = Future amount ×
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1
(1 + i)n
PRESENT VALUE
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What you are willing to pay today to receive
$22,000 five years from now is the present value
You can calculate this amount by “discounting” the
future amount based on the expected interest rate
you would earn over the 5-year period
PV(n,i) = Future amount ×
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1
(1 + i)n
USING A PRESENT VALUE TABLE
Periods
4%
5%
6%
7%
8%
9%
10%
11%
12%
1
0.9615
0.9524
0.9434
0.9346
0.9259
0.9174
0.9091
0.9009
0.8928
2
0.9246
0.9070
0.8900
0.8734
0.8573
0.8417
0.8264
0.8116
0.7972
3
0.8890
0.8638
0.8399
0.8163
0.7938
0.7722
0.7513
0.7312
0.7118
4
0.8548
0.8227
0.7921
0.7629
0.7350
0.7084
0.6830
0.6587
0.6355
5
0.8219
0.7005
0.7473
0.7438
0.6806
0.6499
0.6209
0.5935
0.5674
$22,000 × 0.6209 = $13,659.80
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ANNUITIES
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A stream of cash flows (either receipts or
disbursements) over a period of time
For the TopCap System, the $625,000 additional
revenue and the $500,000 spent for direct
materials in each year are annuities
PRESENT VALUE OF AN ANNUITY
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What are you willing to pay today to receive
$625,000 per year for the next 10 years?
Can calculate the present value of each individual
amount and then add them all together
Or use the formula:
1
1(1 + i)n
PVA(n,i) = Annual amount x
i
Or use the present value of annuity table
PRESENT VALUE OF AN ANNUITY TABLE
Periods
4%
5%
6%
7%
8%
9%
10%
11%
12%
1
0.9615
0.9504
0.9434
0.9346
0.9259
0.9174
0.9091
0.9009
0.8929
2
1.8861
1.8594
1.8334
1.8080
1.7833
1.7591
1.7355
1.7125
1.6901
3
2.7751
2.7232
2.6730
2.6243
2.5771
2.5313
2.4868
2.4437
2.4018
4
3.6299
3.5460
3.4651
3.3872
3.3121
3.2397
3.1698
3.1024
3.0373
5
4.4518
4.3295
4.2124
4.1002
3.9927
3.8897
3.7907
3.6959
3.6048
6
5.2421
5.0757
4.9173
4.7665
4.6229
4.4859
4.3553
4.2305
4.1114
7
6.0021
5.7864
5.5824
5.3893
5.2064
5.0330
4.8684
4.7122
4.5638
8
6.7327
6.4632
6.2098
5.9713
5.7466
5.5348
5.3349
5.1461
4.9676
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7.4353
7.1078
6.8017
6.5152
6.2469
5.9952
5.7590
5.5370
5.3282
10
8.1109
7.7217
7.3601
7.0236
6.7101
6.4177
6.1446
5.8892
5.6502
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$625,000 × 6.1446 = $3,840,375
© Tomwang112 / iStockphoto
DISCOUNTED CASH FLOW
TECHNIQUES
Unit 9.1 Unit 9.2 Unit 9.3 Unit 9.4
9.3
FOUR STEPS TO CALCULATE NET PRESENT VALUE (NPV)
1. Identify the amount and timing of each cash flow
2. Determine the appropriate discount rate (cost of
capital, hurdle rate, etc.)
3. Calculate the present value of each cash flow
4. Calculate the NPV of the project
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TOPCAP SYSTEM CASH FLOWS
Cash Flow
Purchase and installation of TopCap system
Year 0
Years 1-10
($50,265)
Sales revenue
$625,000
Purchase of direct materials
($500,000)
Direct labor
($ 57,600)
Variable overhead
($ 37,500)
Variable selling expense
($ 12,500)
Fixed expenses
($ 7,000)
Annual net cash flow
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$(50,265)
$ 10,400
NPV OF THE TOPCAP SYSTEM
Cash Flow
Present
Value
PV
Factor
Year 0
Purchase and installation of TopCap system
($50,265.00)
1.0
($50,265)
58,762.08
5.6502
Annual net cash flow
Net present value
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$ 8,497.08
Years
1-10
$ 10,400
HOW DO YOU KNOW IF A PROJECT IS ACCEPTABLE USING NPV?
NPV Value
What it means
Project Acceptable?
>0
Return on proposed project exceeds
the discount rate
YES
=0
Return on proposed project equals
the discount rate
YES
<0
Return on proposed project is less
than the discount rate
NO
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ASSUMPTIONS OF THE NPV APPROACH
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Timing and amount of all cash flows are known
with certainty
There is no inflation
Cash flows occur at the end of each year
All cash inflows are reinvested at the discount rate
USING EXCEL TO CALCULATE NPV
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THINGS TO REMEMBER ABOUT NPV
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Changing the discount rate affects NPV (How so?)
Changing the timing and size of cash flows affects
the NPV (How so?)
NPV is a good preference ranking tool for projects
designed to perform the same function
The higher the risk, the higher the discount rate to
use
INTERNAL RATE OF RETURN
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Internal rate of return calculations for projects with
even annual cash flows
• Find the PVFA using the formula below
• Use PVA table to find the IRR
• Or do trial and error NPV calculations until you get
NPV = 0
PVF =
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Initial Investment
Net Annual Cash Flow
IRR OF TOPCAP SYSTEM
(Annual cash flow ×PVA10,i ) – Net initial investment = $0
($10,400×PVA10,i ) – $50,265 = $0
PVA10,i
$50,265
=
$10,400
PVA10,i = 4.8332
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IRR OF TOPCAP SYSTEM
Periods
6%
7%
8%
9%
10%
11%
12%
14%
16%
1
0.9434
0.9346
0.9259
0.9174
0.9091
0.9009
0.8929
0.8772
0.8621
2
1.8334
1.8080
1.7833
1.7591
1.7355
1.7125
1.6901
1.6467
1.6052
3
2.6730
2.6243
2.5771
2.5313
2.4868
2.4437
2.4018
2.3216
2.2459
4
3.4651
3.3872
3.3121
3.2397
3.1698
3.1024
3.0373
2.9137
2.7982
5
4.2124
4.1002
3.9927
3.8897
3.7907
3.6959
3.6048
3.4331
3.2743
6
4.9173
4.7665
4.6229
4.4859
4.3553
4.2305
4.1114
3.8887
3.6647
7
5.5824
5.3893
5.2064
5.0330
4.8684
4.7122
4.5638
4.2883
4.0386
8
6.2098
5.9713
5.7466
5.5348
5.3349
5.1461
4.9676
4.6389
4.3436
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6.8017
6.5152
6.2469
5.9952
5.7590
5.5370
5.3282
4.9464
4.6065
10
7.3601
7.0236
6.7101
6.4177
6.1446
5.8892
5.6502
5.2161
4.8332
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USING EXCEL TO CALCULATE IRR
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USING IRR TO EVALUATE PROJECT ACCEPTABILITY
IRR Value
Compared to NPV
Project Acceptable?
> Discount Rate
NPV > 0
YES
= Discount Rate
NPV = 0
YES
< Discount Rate
NPV < 0
NO
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INTERNAL RATE OF RETURN
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This is the rate that returns a NPV = 0
Assumes that cash flows can be reinvested at the
IRR
May give you different ranking from NPV
calculation
NPV is a magnitude return measure, IRR is a
relative return measure
PROFITABILITY INDEX
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Facilitates evaluation of projects requiring different
levels of investment
Higher profitability index is preferred
Profitability Index =
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Present Value of Annual Cash Flows
Required Initial Investment
© Tomwang112 / iStockphoto
OTHER CAPTIAL BUDGETING
TECHNIQUES
Unit 9.1 Unit 9.2 Unit 9.3 Unit 9.4
94
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PAYBACK PERIOD
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How long it will take to get back the return of
investment for a particular project
The amount of time it takes a project’s cash
inflows to equal the original investment
HOW IS PAYBACK PERIOD CALCULATED
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For even annual cash flows
Payback Period =
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Initial Investment
Net Annual Cash Flow
For unequal annual cash flows, calculate
cumulative cash flow until you reach the initial
investment amount
PAYBACK PERIOD LIMITATIONS
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Ignores the time value of money
Ignores cash outflows after initial acquisition and
cash inflows after the payback period
The longer the payback period, the greater the
project’s risk
Best used as a screening tool rather than
preference ordering tool
LET’S PRACTICE
John Dallas has been following the mortgage interest rate
movement over the last several weeks and is trying to
decide if he should refinance his house. The mortgage
company has estimated that the cash needed at closing
on the refinancing will be $5,000. The new interest rate on
the refinanced mortgage will lower John’s monthly
payments by $150.
What is the payback period for the refinancing?
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LET’S PRACTICE
John Dallas has been following the mortgage interest rate
movement over the last several weeks and is trying to
decide if he should refinance his house. The mortgage
company has estimated that the cash needed at closing
on the refinancing will be $5,000. The new interest rate on
the refinanced mortgage will lower John’s monthly
payments by $150.
What is the payback period for the refinancing?
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$5,000
= 33.3 months
$150/month
ACCOUNTING RATE OF RETURN
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This method uses net operating income, not cash
flows
This typically means to remember to consider
depreciation expenses
Also called simple rate of return or unadjusted rate
of return
Focus on additional net operating income
generated by the project
ACCOUNTING RATE OF RETURN
Project revenues – project operating expenses
Initial investment – salvage value of old equipment
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ACCOUNTING RATE OF RETURN LIMITATIONS
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Influenced by the choice of accounting methods
(income differences)
Ignores the time value of money
Relies on accounting measures rather than cash
flows
Useful screening tool, but limited use for
preference ranking (compared to hurdle rate)