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Chapter 13

# Chapter 13 Capital Budgeting Decisions.docx

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University of Waterloo

Accounting & Financial Management

AFM 102

Tom Vance

Fall

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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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