Capital Budgeting Decisions

Capital Budgeting
Budgeting for the acquisition of capital assets Capital budgeting techniques (a) Payback period (b) Accounting Rate of Return (c) Net Present Value (d) Internal Rate of Return

Capital Budgeting
Outcome is uncertain. Large amounts of money involved.

Analyzing alternative longterm investments and deciding which assets to acquire or sell.
Decision may be difficult or impossible to reverse.

Investment involves long-term commitment.

Example
Casey Co. is considering an investment of $130,000 in new equipment. The new equipment is expected to last 10 years. It will have zero salvage value at the end of its useful life. The straight-line method of depreciation is used for accounting purposes. The expected annual revenues and costs of the new product that will be produced from the investment are: Sales Cost of goods sold Depreciation expense Selling & Admin expense Income before income tax Income tax expense Net Income $145,000 13,000 22,000 $200,000 180,000 $20,000 7,000 $13,000

Payback Period
Time period required to recover the cost of the investment from the annual cash inflow produced by the investment.
Amount invested Expected annual net cash inflow

Computation of Annual Cash Inflow

Expected annual net cash inflow = Net income $13,000 Depreciation expense 13,000 $26,000

Cash Payback Period

$130,000

$26,000

5 years

Payback Period Uneven Cash Flows

Casey Co. wants to install a machine that costs $16,000 and has an 8-year useful life with zero salvage value. Annual net cash flows are:
Year 0 1 2 3 4 5 6 7 8 Annual Net Cash Flows $ (16,000) 3,000 4,000 4,000 4,000 5,000 3,000 2,000 2,000 Cumulative Net Cash Flows $ (16,000) (13,000) (9,000) (5,000) (1,000)

Payback Period Uneven Cash Flows

We recover the $16,000 purchase price between years 4 and 5, about 4.2 years for the payback period.
Year 0 1 2 3 4 4.2 5 6 7 8 Annual Net Cash Flows $ (16,000) 3,000 4,000 4,000 4,000 5,000 3,000 2,000 2,000 Cumulative Net Cash Flows $ (16,000) (13,000) (9,000) (5,000) (1,000)

Payback = 3 years

Using the Payback Period

Payback = 5 years

Consider two projects, each with a 5-year life and each costing $6,000.
Project One Net Cash Inflows $ 2,000 2,000 2,000 2,000 2,000 Project Two Net Cash Inflows $ 1,000 1,000 1,000 1,000 1,000,000

Year 1 2 3 4 5

Would you invest in Project One just because it has a shorter payback period?

Accounting Rate of Return

Average annual operating income from asset Average amount invested in asset

Compare accounting rate of return to companys required minimum rate of return for investments of similar risk. The minimum return is based on the companys cost of capital.

Accounting Rate of Return

Average Investment = Original Investment + Residual Value 2

For Casey, average investment = ($130,000 + $0)/ 2 = $65,000

Solution to Accounting Rate of Return Problem

Average annual operating income from asset Average amount invested in asset
$13,000 / $65,000 = 20%

Accounting Rate of Return

The decision rule is: A project is acceptable if its rate of return is greater than managements minimum rate of return. The higher the rate of return for a given risk, the more attractive the investment.

Discounted Cash Flows

Considers both the estimated total cash inflows and the time value of money. Two methods 1) net present value 2) internal rate of return

Net Present Value Method

Find PV of future cash flows and compare with capital outlay Interest rate used = required minimum rate of return Proposal is acceptable when NPV is zero or positive. The higher the positive NPV, the more attractive the investment.

Net Present Value

We will assume that Casey Cos annual cash inflows of $26,000 are uniform over the assets useful life. The present value of the annual cash inflows can be computed by using the present value of an annuity of 1 for 10 periods. Assume the company requires a minimum return of 12%.

Net Present Value

Cash Flow When? Type of cash flow Present value factor 5.650 Present value of cash flows ($130,000) Annuity 146,900

(130,000) 26,000

Now Yrs 1-10

NPV

$16,900

Analysis of the proposal: The proposed capital expenditure

is acceptable at a required rate of return of 12% because the net present value is positive

Net Present Value

When annual cash inflows are unequal, use present value of one tables.

Cash Flow When? Type of cash PV factor flow (130,000) 36,000 32,000 29,000 27,000 26,000 24,000 23,000 22,000 21,000 20,000 NPV

Net Present Value Now

1 2 3 4 5 6 7 8 9 10 Lump sum ,, .893 .797 .712 .636 .567 .507 .452 .404 .361 .322

Present value ($130,000) 32,148 25,504 20,648 17,172 14,742 12,168 10,396 8,888 7,581 6,440 $25,687

Internal Rate of Return

Interest yield of the potential investment The interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows.

Internal Rate of Return

STEP 1.Compute the internal rate of return factor using this formula:
Capital Investment Annual Cash Inflows

$130,000 /

$26,000

5.0

Internal Rate of Return Method

STEP 2. Use the factor and the present value of an annuity of 1 table to find the internal rate of return. Locate the discount factor that is closest to 5.0 on the line for 10 periods.

Internal Rate of Return Decision Criteria

The decision rule is: Accept when internal rate of return is equal to or greater than the required rate of return Reject when internal rate of return is less than required rate

Internal Rate of Return Uneven Cash Flows

If cash inflows are unequal, trial and error solution will result if present value tables are used. Use business calculators and electronic spreadsheets

Comparing Methods
Basis of measurement Measure expressed as Payback period Cash flows Number of years Easy to Understand Accounting rate of return Accrual income Percent Easy to Understand Net present Internal rate value of return Cash flows Cash flows Profitability Profitability Dollar Percent Amount Considers time Considers time value of money value of money

Strengths

Limitations

Allows Allows Accommodates Allows comparison comparison different risk comparisons across projects across projects levels over of dissimilar a project's life projects Doesn't Doesn't Difficult to Doesn't reflect consider time consider time compare varying risk value of money value of money dissimilar levels over the projects project's life Doesn't consider cash flows after payback period Doesn't give annual rates over the life of a project