Managerial accounting 6e jams jambalvo chapter 09

CHAPTER
CHAPTER 99
Capital Budgeting and
Other Long-Run Decisions

Slide 9-2


Capital
Capital Budgeting
Budgeting Decisions
Decisions




Companies, like individuals, make investments in long-lived assets
Examples include






Slide 9-3

Duke Energy invests in 400 roof-top solar panel installations
Pfizer invests in a $294 million biotechnology factory in Ireland
Nordstrom invests in a new store in New Jersey
Starbucks invests in a new product: instant coffee

Capital
Capital Budgeting
Budgeting Decisions
Decisions



Investment decisions are important because they have a long run impact
on a firm’s operations



Decisions involving the acquisition of long-lived assets are referred to as
capital expenditure decisions



They often require that capital (company funds) be expended to acquire
additional resources



Also called capital budgeting decisions

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-4

using the net present value approach and the internal rate of return approach.

Capital
Capital Budgeting
Budgeting Decisions
Decisions



Most firms carefully analyze the potential projects in which they may
invest



The process of evaluating the investment opportunities is referred to as
capital budgeting



The final list of approved projects is referred to as the capital budget

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-5

using the net present value approach and the internal rate of return approach.


Test Your Knowledge 1

Which of the following is not a capital expenditure decision?

a.
b.
c.
d.

Building a new factory
Purchasing a new piece of equipment
Purchasing inventory
Purchasing another company

Answer: c
Purchasing inventory

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-6

using the net present value approach and the internal rate of return approach.


The
The Time
Time Value
Value of
of Money
Money



In evaluating an investment opportunity, a company must not only know

how much but also when cash is received or paid



Time value of money recognizes that it is better to receive a dollar today
than in the future

 This is because a dollar received today can be invested so that it amounts
to more than a dollar in the future

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-7

using the net present value approach and the internal rate of return approach.


Evaluating
Evaluating Opportunities:
Opportunities: Time
Time Value
Value of
of Money
Money Approaches
Approaches



Companies invest money today hoping to receive more money in the
future



By how much must the future cash flows exceed the cost of the
investment?



Money in the future is not equivalent to money today

 A company needs to convert future dollars into their equivalent current , or
present value

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-8

using the net present value approach and the internal rate of return approach.


Basic
Basic Time
Time Value
Value of
of Money
Money Calculations
Calculations
to convert future value to present value
Formula
 

Where: P = Present value

F = Future amount
r = Required rate of return
n = Number of years

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-9

using the net present value approach and the internal rate of return approach.


Basic
Basic Time
Time Value
Value of
of Money
Money Calculations
Calculations -- Example
Example

At an  interest rate of 10%, how much is $121 received two years from now worth
today?

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-10

using the net present value approach and the internal rate of return approach.


Present
Present Value

Value Tables
Tables



 Managers can use present value tables to look up present value factors




Present value factors are simply calculations of
Turn to Table 1 in Appendix B of this chapter

 To find the factor for r = 12% and n = 5
 Go across the top of the table to a discount rate of 12 percent and down five
rows

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-11

using the net present value approach and the internal rate of return approach.


Test Your Knowledge 2

Using
  the formula on slide 9-10, what is the present value of $500 received two
years in the future if you desire a return of 10%?

a.

b.
c.
d.

$413.22
$468.58
$471.60
$480.30

Answer: a

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-12

using the net present value approach and the internal rate of return approach.


The
The Net
Net Present
Present Value
Value Method
Method



The only relevant cash flows are those that are incremental





The cash flows that will be incurred if the project is undertaken

Cash flows that have already been incurred are sunk



They have no bearing on a current investment decision

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-13

using the net present value approach and the internal rate of return approach.


The
The Net
Net Present
Present Value
Value Method
Method
Steps in the NPV method
1.

Identify the amount and time period of each cash flow associated with a
potential investment

2. Discount the cash flows to their present values using a required rate of
return

3.

Evaluate the net present value, which is the sum of the present value of
all cash inflows and outflows

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-14

using the net present value approach and the internal rate of return approach.


The
The Net
Net Present
Present Value
Value Method
Method



Evaluate the investment opportunity



If the NPV is zero, the investment earns the required rate of return





The investment should be undertaken

If the NPV is positive



It should also be undertaken because it earns more than the required
rate



Investments that have a negative NPV are not accepted because they
earn less than the required rate

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-15

using the net present value approach and the internal rate of return approach.


Net
Net Present
Present Value
Value Approach
Approach

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-16

using the net present value approach and the internal rate of return approach.

Test Your Knowledge 3

If the net present value of a project is zero, the project is earning a return
equal to:

a.
b.
c.
d.

Zero
The rate of inflation
The accounting rate of return
The required rate of return

Answer: d
The required rate of return

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-17

using the net present value approach and the internal rate of return approach.


Net
Net Present
Present Value
Value Example

Example
An auto repair shop is considering the purchase of an automated paint spraying
machine. The machine will last five years.
Following information is available:








Each year $2,000 will be saved on paint
It will reduce labor costs by $20,000 each year
It will require maintenance costs of $1,000 each year
The machine costs $70,000
The expected residual value is $5,000
The required rate of return is 12%

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-18

using the net present value approach and the internal rate of return approach.


Net
Net Present
Present Value
Value Example
Example

Since the NPV > 0, the company should buy the equipment

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-19

using the net present value approach and the internal rate of return approach.


Comparing
Comparing Alternatives
Alternatives with
with NPV
NPV



Calculate the NPV of each alternative and choose the alternative with
the highest NPV



The difference between the NPVs of any two alternatives is the
incremental value of the highest NPV investment



Another method to evaluate alternatives is to compute the present
value of their incremental cash flows

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities

Slide 9-20

using the net present value approach and the internal rate of return approach.


Comparing
Comparing Alternatives
Alternatives with
with NPV
NPV

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities

Slide 9-21

using the net present value approach and the internal rate of return approach.


The
The Internal
Internal Rate
Rate of
of Return
Return (IRR)
(IRR) Method
Method



The internal rate of return is that rate of return that equates the present value
of the future cash flows to the investment outlay





The rate of return that makes the net present value equal to zero

If the IRR of a potential investment is equal to or greater than the required
rate of return, the investment should be undertaken

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-22

using the net present value approach and the internal rate of return approach.


The
The Internal
Internal Rate
Rate of
of Return
Return Method
Method

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-23

using the net present value approach and the internal rate of return approach.

Test Your Knowledge 4

An investment should be undertaken if:

a.
b.
c.
d.

The IRR is equal to or greater than the required rate of return
The IRR is equal to or greater than zero
The IRR is greater than the accounting rate of return
The IRR is greater than the present value factor

Answer: a
The IRR is equal to or greater than the required rate of return

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities
Slide 9-24

using the net present value approach and the internal rate of return approach.


The
The Internal
Internal Rate
Rate of
of Return

Return with
with Equal
Equal Cash
Cash Flows
Flows




Equal cash flows are called an annuity
For an annuity,
PV = PV factor x Annuity



Therefore:



Use the table to find the closest PV factor for the same number of
years

Learning objective 1: Define capital expenditure decisions and capital budgets and evaluate investment opportunities

Slide 9-25

using the net present value approach and the internal rate of return approach.