Chapter 13 Capital Budgeting Decisions.docx

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University of Waterloo
Accounting & Financial Management
AFM 102
Tom Vance

13– capitalbudgetingdecisions Chapter 13: Capital budgeting decisions Capital Budgeting – Planning Investments  capital budgeting: the process of planning significant outlays on projects that have long-term implications, such as the purchase of new equipment or the introduction of a new product Typical Capital Budgeting Decisions  a capital budgeting decision is any decision that involves an outlay now in order to obtain some return in the future  typical budgeting decisions:  cost-reduction decisions  expansion decisions  equipment selection decisions  lease or buy decisions  equipment replacement decisions  screening decision: a decision as to whether a proposed investment meets some preset standard of acceptance  preference decisions: a decision as to which of several competing acceptable investment proposals is best Approaches to Capital BudgetingDecisions The Payback Method  payback period: the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates investment period  paybackperiod= net annual cashinflow  if new equipment is replacing old equipment, the net annual cash inflow becomes incremental net annual cash flow York Company needs a new milling machine. The company is considering two machines: A, and B. A costs $15,000 and will reduce costs by $5,000 per year. B costs only $12,000 but will also reduce the operating costs by $5,000 per year. Which machine should be purchased according to the payback method? payback A = $15/5 = 3 years; payback B = $12/5 = 2.4 years shorter payback period.k calculations, York Company should purchase B since it has a Evaluation of the Payback Method  disadvantages  not a true measure of the profitability of an investment  has no inherent mechanism for highlighting differences in useful life between investments  does not adequately consider the time value of money  advantages  can help identify which investment proposals are in the ‘ballpark’  sometimes used in industries where products become obsolete very fast Payback and Uneven Cash Flows Year Investment (a) Cash inflow (b) Unrecovered investment (c) 1 $4,000 $1,000 $3,000 2 -0- $3,000 3 0 $2000 $1,000 4 $2,000 $1,000 $2,000 page 1 of 8 13– capitalbudgetingdecisions 5 $500 $1500 6 $3,000 -0- 7 $2,000 -0- *year X uncovered investment (c) = year X – 1 unrecovered investment, column (c) + year X investment, column (a) – year X cash inflow, column (b) The Simple Rate ofReturn Method  simple rate of return: the rate of return computed by dividing a project`s annual accounting operating income by the initial investment required  aka accounting rate of return, or the unadjusted rate of return incrementalrevenues-incrementalexpenses,incl. depreciation=incrementalOI  simple rateof return= initial investment  the initial investment should be reduced by any salvage from the sale of old equipment  if a cost reduction project is involved costsavings-depr.onnewequip  simple rateof return= initial investment  any salvage from the sale of old equipment should be deducted from the initial investment Brigham Tea, Inc. Is a processor of a low-acid tea. The company is contemplating purchasing equipment for an additional processing line. The additional processing line would increase revenues by $90,000 per year. Incremental cash operating expenses would be $40,000 per year. The equipment would cost $180,000 and have a nine-year life. No salvage value is projected $90000 -($40000 +$20000) simple rateof return= =16.7% $180000 Criticismsof the Simple Rate of Return  it does not adequately consider the time value of money  can be misleading if the alternatives being considered have different cash flow patterns  provides info consistent with the return on investment (ROI)  provides info to management about what the potential impact of the investment mightb e on the performance assessment of managers The Time Value of Money  a dollar today is worth more than a dollar a year from now  capital budgeting techniques that recognize the time valueof money involve discounted cash flows Discounted Cash Flows – the Net Present ValueMethod The Net Present value Method Illustrated  the present value of a project’s cash inflows is compared to the present value of the project’s cash outflows  net present value: the diff. between the present value of the cash inflows and the present value of the cash outflows associated with an investment project Harper Company is contemplating the purchase of a machine capable of performing certain operations that are now performed manually. The machine will cost %50,000 and will last 5 years. At the end of the five year period, the machine will have a zero scrap value. Use of the machine will reduce labour costs by $18,000 per year. Harper Company requires a minimum return of 20% before taxes on all investment projects. Cost savings = $18000 per year × 5 years = $90,000 The present value of the cost savings is $53,838 The net present value is $3,838  to determine whether the investment is desirable, the stream of annual $18,000 cost savings is discounted to its present value, which is then compared to the cost of the new machine  this rate is used in the discounting process and is called the discount rate page 2 of 8 13– capitalbudgetingdecisions  whenever the net present value is >= 0, an investment project is acceptable  if the net present value is < 0 then the investment project is unacceptable Emphasis on CashFlows  the timing of cash flows is critical, since a dollar received today is more valuable than a dollar rec’d a year later  Typical Cash Outflows  working capital: the excess of current assets over current liabilities  additional working capital needs should be treated as a part of the initial investment in a project  any salvage value realized from the sale of old equip. can be recognized as a cash inflow or reduction in required investment  initial investment (incl. installation costs), increased working capital needs, repairs & maintenance, incremental operating costs  Typical Cash Inflows  a project will normally either increase revenues or reduce costs  the amount involved should be treated as a cash inflow  a reduction in costs = an increase in revenues  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  incremental revenues, reduction in costs, salvage value, release of working capital Recovery of the OriginalInvestment  depreciation is not deducted when computing the present value of a project because  depreciation is not a current cash outflow  discounted cash flow methods automatically provide for return of the original investment Carver Dental Clinic is considering the purchase of an attachment for its X-ray machine that will cost $3,170. The attachment sill be usable for 4 years after which it will have no salvage value. It will increase net cash inflows by $1,000 per year in the X-ray dept. The clinic’s board of directors has instructed that no investments are to be made unless they have an annual return of at least 10% Year Investment Cash inflow Return on Recovery of Unrecovered outstanding during investment investment during investment at the end of the year the year the year 1 $3170 1000 317 683 2487 2 2487 1000 249 751 1736 3 1736 1000 173 827 909 4 909 1000 91 909 -0- Total investment recovered $3170 Simplifying Assumptions  (1) all cash flows other than the initial investment occur at the end of periods  but cash flows typically occur throughout a period  (2) all cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate ChoosingaDiscount Rate  the firm’s cost of capital is usually regarded as the most appropriate choice for the discount rate  cost of capital: the overall cost to an organization of obtaining investment funds, incl. the cost of both debt sources and equity sources  aka hurdle rate, cut-off rate, required rate of return  any rate of return less than the cost of capital should not be accepted An Extended Example ofthe Net Present ValueMethod Cost of equipment 60000 Working capital needed 100000 Overhaul of the equip in 4 years 5000 Salvage value of the equipment in 5 years 10000 page 3 of 8 13– capitalbudgetingdecisions Annual revenues and costs: Sales revenues 200000 Cost of goods sold 125000 Out-of-pocket operating costs (salaries, ad) 35000 Sales revenue $200,000 Less cost of goods sold 125,000 Less out-of-pocket costs 35,000 Annual net cash inflows 40,000 Item Year(s) Amount of cash flows 14% factor Present value of cash flows Purchase of equip Now (60,000) 1 (60,000) Working capital needed Now (100,000) 1 (100,000) Overhaul of equipment 4 (5,000) 0.592 (2,960) Annual net cash inflows 1-5 40,000 3.433 137,320 Salvage value of equip 5 10,000 0.519 5,190 Working capital released 5 100,000 0.519 91,900 Net present value 31,450 Discounted Cash Flows –The Internal Rate of Return Method Glendale School District is considering the purchase of a large tractor-pulled lawnmower. At present, the lawn is mowed using a small hand-pushed gas mower. The large, tractor-pulled mower will cost $16,950 and will have a useful life of 10 years. It will have only a negligible scrap value, which can be ignored. The tractor-pulled mower would do the job much more quickly than the old mower and would result in a labour savings of $3,000 per year. investment required 16950  factorof theinternal rateof return= = = 5.650 net annual cashinflow 3000  working backwards, a 12% discount rate will give 5.65 Salvage Value and OtherCash Flows  what if a project’s cash flow are not identical each year?  a trial and error process is needed to find the rate of return that will equate the cash inflows with outflows  uneven cash flows should not prevent a manger from determining a project’s internal rate of return Using the Internal Rate of Return  required rate of return: the minim
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