Chapter 11
Capital Budgeting
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Capital Budgeting Process
Plant expansion
Equipment selection
Equipment replacement
Capital budgeting is a decision-making approach
aimed at helping managers make decisions about
investments in major capital assets, such as new
facilities, equipment, new products, and research and
development projects.
Lease or buy
Cost reduction
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Capital Budgeting Methods
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Accounting Rate of Return
Annual
Net
Income
$108,000
÷
Initial
Investment
=
Accounting
Rate of
Return
÷
$1,000,000
=
10.8%
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Payback Period
Initial
Investment
÷
Annual
Net Cash
Flow
=
Payback
Period
=
3.25 years
Net Income + Depreciation
$1,000,000
÷
$308,000
$108,000 + $200,000
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Time Value of Money
One dollar received today is worth more than one
dollar received a year from now because the dollar can
be invested to earn interest.
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Time Value of Money
Discounting is exactly the opposite of compounding.
Just as interest builds up over time through
compounding, discounting involves backing out the
interest to determine the equivalent value in today’s
present value dollars.
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Net Present Value (NPV)
The net present value (NPV) method compares the
present value (PV) of a project’s future cash inflows
to the PV of the cash outflows.
The reason is that
accounting net income is
based on accruals that
ignore the timing of cash
flows into and out of an
organization.
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Net Present Value (NPV)
Chose a discount rate – the
minimum required rate of return.
Calculate the present
value of cash inflows.
Calculate the present
value of cash outflows.
NPV = –
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Net Present Value (NPV)
Relationship Between NPV and
the Required Rate of Return
If the Net Present
Value is . . .
Then the Project is . . .
Positive . . .
Acceptable, since it promises a
return greater than the required
rate of return (discount rate).
Zero . . .
Acceptable, since it promises a
return equal to the required rate of
return (discount rate).
Negative . . .
Not acceptable, since it promises
a return less than the required rate
of return (discount rate).
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Internal Rate of Return (IRR)
The internal rate of return is the interest
rate that makes . . .
 Present
value of
cash inflows
=
Present
value of
cash outflows
 The net present value equal zero.
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Internal Rate of Return (IRR)
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Profitability Index
The profitability index is the ratio of a project’s benefits
(measured by the present value of the future cash flows) to
its costs (or required investment).
Profitability Index > 1 = Project Acceptable
Profitability Index < 1 = Project Unacceptable
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Comparing Capital Budgeting Methods
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Prioritizing Independent Projects
The profitability index is used to prioritize
capital investment projects.
Profitability
Index
=
Present Value of
Future Cash flows
÷
Initial
Investment
When using the profitability index to prioritize
projects, the preference rule is: the higher the
profitability index, the more desirable the project.
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Time Value of Money
Future
Value of
a Single
Payment
Present
Value of
a Single
Payment
Future
Value of
an
Annuity
Present
Value of
an
Annuity
Present and future value
problems may involve two
types of cash flow: a single
payment or an annuity (a
fancy word for a series of
equal cash payments)
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Future Value of a Single Amount
To solve a future value problem,
you need to know three things:
1.Amount to be invested.
2.Interest rate (i) the amount will
earn.
3.Number of periods (n) in which
the amount will earn interest.
Using Table 11.1A.: $1,000 × 1.3310 = $1,331
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Present Value of a Single Amount
The present value of a single
amount is the value to you today of
receiving some amount of money
in the future. To compute the
present value of an amount to be
received in the future, we must
discount (a procedure that is the
opposite of compounding) at i
interest rate for n periods.
Assume that today is January 1, 2013, and you have the opportunity to receive
$1,000 cash on December 31, 2015 (three years from today). At an interest rate
of 10 percent per year, how much is the $1,000 payment worth to you on January
1, 2013 (today)? You could discount the amount year by year, but it is easier to use
Table 11.2A , Present Value of $1.
Using Table 11.2A.: $1,000 × 0.7513 = $751.30
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Future Value of an Annuity
The future value of an annuity
includes compound interest on
each payment from the date of
payment to the end of the term of
the annuity. Each new payment
accumulates less interest than
prior payments because the
number of periods in which to
accumulate interest decreases.
Assume that each year for three years, you deposit $1,000 cash into a savings
account that earns 10 percent interest per year. You make the first $1,000
deposit on December 31, 2013, the second one on December 31, 2014, and the
third and last one on December 31, 2015. To calculate the future value of this
annuity, use Table 11.3A , Future Value of an Annuity of $1.
Using Table 11.3A.: $1,000 × 3.3100 = $3,310
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Present Value of an Annuity
The present value of an annuity is
the value now of a series of equal
amounts to be received (or paid
out) for some specified number of
periods in the future.
Assume you are to receive $1,000 cash on each December 31 for three years:
2013, 2014, and 2015. How much would the sum of these three $1,000 future
amounts be worth on January 1, 2013, assuming an interest rate of 10 percent per
year? To calculate the present value of this annuity, use Table 11.4A , Present
Value of an Annuity of $1.
Using Table 11.4A.: $1,000 × 2.4869 = $2,487 (rounded)
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End of Chapter 11
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