CHAPTER 13 CAPITAL BUDGETING DECISIONS Capital Budgeting describes how managers plan significant investments in projects that have long term implications such as the purchase of new equipment or the introduction of new products I CAPITAL BUDGETING PLANNING INVESTMENTS a Typical Capital Budgeting Decisions 1 Cost reduction decisions 2 Expansion decisions 3 Equipment selection decisions 4 Lease or buy decisions 5 Equipment replacement decisions ii Screening Decisions relate to whether a proposed project is acceptable whether it passes a present hurdle Ex The required rate of return is the minimum rate of return a project must yield to be acceptable iii Preference Decisions relate to selecting from among several acceptable alternatives Ex which machine out of the many options should be purchased b The Time Value of Money i Capital investments usually earn returns that extend over fairly long ii periods of time Important to recognize the time value of money when evaluating investment proposals 1 A dollar today is worth more than a dollar a year from now if for no other reason than you could put a dollar in a bank today and have more than a dollar a year from now 2 Projects that promise earlier returns are preferable to those that promise later returns iii Capital budgeting techniques that recognize the time value of money a Two approaches to making capital budgeting decisions both use cash flows involve discounting cash flows II DISCOUNTED CASH FLOWS i Net Present Value Method ii Internal Rate of Return Method III NET PRESENT VALUE METHOD i Net Present Value Method The present value of a project s cash inflows is compared to the present value of the project s cash outflows 1 Net Present Value The difference between the present value of projects cash inflows and the present value of the project s cash outflows Annual Cost Savings Net Present Value 2 Net Present Value determines whether or not the project is an acceptable investment a EX Company deciding if to purchase machine that costs 50 000 that will last 5 years and will have 0 scrap value Use of the machine will reduce labor costs by 18 000 per year Harper Company requires a minimum pretax return of 20 on all investment projects i Can cash investment now of 50 000 be justified if it will result in an 18 000 reduction in cost in each of the next five years ii Total cost savings 90 000 18 000 year X 5 years iii Cost reductions must cover the original cost of the machine and yield a return of at least 20 or company would be better off investing money elsewhere Use appendix table to find 20 factor Initial Cost 50 000 1 2 Life of Project 5 Years 3 Annual Cost Savings 18 000 4 Salvage Value 0 5 Required Rate of Return 20 a Annual Cost Savings 18000 x 2 991 53838 Initial Investment 50000 x 1 50000 b c Net Present Value 3838 3 4 5 iv Company should purchase the new machine If Net Present Value is then the project is acceptable because its return is greater than the required rate of return If the Net Present Value is 0 then the project is acceptable because its return is equal to the required rate of return If the Net Present Value is then the project is NOT acceptable because its return is less than the required rate of return b Emphasis on Cash Flows i In capital budgeting the timing of cash flows is critical Cash flow rather than accounting net income is the focus in capital budgeting 1 The present value of a cash flow depends on when it occurs 2 Net income is based on accruals that ignore when cash flows occur ii Typical Cash Outflows 1 Most Projects have at least three types of cash outflows a First Require an immediate cash outflow in the form of an initial investment in equipment other assets and installation costs Any salvage value realized from the sale of old equipment can be recognized as a reduction in the initial investment or a cash inflow b Second some projects require a company to expand its working capital When a company takes on a new project the balances in the current assets account often increase Additional working capital needs are treated as part of the initial investment in the project i Working Capital current assets current liabilities c Third many projects require periodic outlays for repairs and maintenance and additional operating costs Initial Investment Including Installation Costs Increased Working Capital Needs 2 3 4 Repairs and Maintenance 5 Incremental Operating Costs iii Typical Cash Inflows 1 Most Projects have at least three types of cash inflows a First a project will normally increase revenues or reduce costs Either way the amount involved should be treated as a cash inflow for capital budgeting purposes i Notice that from a cash flow standpoint a reduction in costs is equivalent to an increase in revenues b Second cash inflows are also frequently realized from selling equipment for its salvage value when a project ends although the company may actually have to pay to dispose of some low value of hazardous items c Third any working capital that was tied up in the project can be released for use elsewhere at the end of the project and should be treated as a cash inflow at that time Incremental Revenues 2 3 Reduction in costs 4 Salvage Value 5 Release of Working Capital c Recovery of the Original Investment i The net present value method automatically provides for return of the original investment ii Whenever the net present value of a project is positive the project will recover the original cost of the investment plus sufficient excess cash inflows to compensate the organization for typing up funds in the project d Simplifying Assumptions the end of periods i First Assumption All cash flows other than the initial investment occur at 1 Unrealistic because cash flows typically occur throughout the period rather than just at its end 2 Assumption simplifies computations ii Second Assumption All cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate e Choosing a Discount Rate i Net Present Value The project s return Discount Rate ii Net Present Value The project s return Discount Rate 1 If a company s minimum required rate of return is used as the discount rate a project with a net present value has a return that exceeds the minimum required rate of return that is acceptable iii Company s Minimum Required Rate of Return Company s Cost of Capital 1 Cost of Capital The average rate of return the company must pay to its long term creditors
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