Chapter 12 Capital Investment Decisions and the Time Value of Money 1 What is Capital Budgeting a The process of making capital investment decisions companies make such decisions when they acquire capital assets that are used for a long period of time i Buying new equipment building new plants automatic production etc b Four Popular Methods of Capital Budgeting Analysis i Payback Period easy to calculate and works well for capital investments with short life span 1 How fast will the cash invested be recouped ii Accounting Rate of Return ARR easy to calculate and work well for capital investments with short life span 1 Shows the effect of the investment on the company s accrual based income iii Net Present Value NPV considers time value of money iv Internal Rate of Return IRR considers time value of money c Focus on Cash Flows The desirability of a capital asset depends on its ability to generate net cash inflows over the asset s useful life i Payback period NPV and IRR use the investment s projected cash flows ii Net Cash Inflows Future cash revenue generated from the investment future savings in ongoing cash operating costs resulting from the investment and any future residual value of the asset iii The amount of the investment is separate from all other cash flows related to the investment d Capital Budgeting Process i Identify Potential Investments ii Project net cash inflows from the investment iii Analyze potential investment using one or more of the capital budgeting analysis methods 1 Screen out undesirable investments using payback and or ARR a Not considering the time value of 2 Further analyze investments using NPV and or ARR 3 Some companies may use capital rationing choose among alternative capital investments 2 How do Managers Calculate the Payback Period and ARR a Payback Period The length of time it takes to recover in cash inflows the cost of the capital outlay the quicker the period the more attractive the asset less risky i Payback with Equal Annual Net Cash Inflows 1 Amount Invested Expected Annual Net Cash Inflow ii Payback with Unequal Net Cash Inflows 1 When periodic cash flows are unequal you must accumulate net cash inflows until the amount invested is recovered iii Only use this method to weed out investments that will take too long to recoup the investment with the shortest payback period is only best when all other factors are the same iv Ignores all cash flows after payback period so it does not consider the profitability of b Accounting Rate of Return ARR Measures the average annual rate of return over the asset s life or its profitability using accrual accounting figures i Average Annual Net Cash Flow Annual Depreciation Expense Initial Investment 1 Depreciation Expense Initial Cost of Asset Residual Value Useful Life of the investment Asset 2 Total Net Cash Flow Unequal Cash Flows a Total net cash inflows during operating life of asset Assets Operating life in years ii If expected accounting rate of return exceeds the required rate invest iii If expected accounting rate of return is less than required rate of return do not invest 3 How do Managers Compute the Time Value of Money a Time Value of Money Invested money earns income over time i NPV IRR always incorporate the time value of money b Factors Affecting the Time Value of Money i The Principle Amount p The amount of the investment or borrowing 1 Annuity Stream of equal installments made at equal time intervals a Ordinary Annuity Installments occur at the end of each period ii The number of periods n Length of time from the beginning of the investment until termination 1 Shorter the investment period the lower the total amount of interest earned iii The interest rate i Annual percentage earned on the investment 1 Simple Interest Interest is calculated only on the principle amount 2 Compound Interest Interest is calculated on the principal and on all interest earned to date a Assumes that all interest earned will remain invested at the same interest rate not withdrawn and spent c Future Values Present Values Refers to the value of an investment at different points in time i Future Value Principal Present Value Interest Earned 1 Principal Amount FV for i n non annuity 2 Amount of each cash installment Annuity FV for i n ii Present Value Future Value Interest Earned 1 Amount of each cash installment Annuity PV for i n 2 Principal Amount PV for i n non annuity 4 How do Managers Calculate the Net Present Value and the Internal Rate of Return a The NPV and the IRR methods rely on present value calculations to compare the amount of the investment the investment s initial cost with its expected net cash inflows i Net Cash Inflows Includes all future cash flows related to the investment b Net Present Value NPV The difference between the present value of the investment s net cash inflows and the investment s cost i Discount the net cash inflows to their present value using a desired rate of return 1 Interest rate used for present value calculations ii Required Rate of Return Hurdle Rate Management s minimum desired rate of return on an investment 1 THIS CALLED THE DISCOUNT RATE AS WELL iii With Equal Annual Cash Inflows Annuity 1 Present Value Amount of each cash inflow Annuity PV i n 2 Present Value Investment Cost Net present value 3 Positive NPV Project earns more than required rate of return 4 Negative NPV Project fails to earn required rate of return iv With Unequal Annual Net Cash Inflows 1 Use the 1 dollar table and calculate each n separately v Capital Rationing The Profitability Index When comparing alternatives that have different investment costs 1 Profitability Index Present Value Index Present Value of Net Cash Inflows Investment vi NPV of a Project W Residual Value Many assets yield cash inflows at the end of their useful lives because they have residual value 1 Companies discount an investment s residual value to its present value when determining the total present value of the project s net cash inflows a Residual value is discounted as a single lump sum not an annuity 5 Internal Rate of Return IRR a Internal Rate of Return IRR Rate of return based on discounted cash flows which a company can expect to earn by investing in the project b The interest rate that makes the cost of the investment equal to the present value of the investment s net cash flows i The interest rate that makes the NPV of the investment equal to zero ii Present value of the investment s net cash inflows Investment s
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