Managerial accounting 5th jiambalvo ch09

Prepared by
Debby Bloom-Hill
CMA, CFM


CHAPTER 9
Capital Budgeting
and
Other Long-Run Decisions
Slide 9-2


Capital Budgeting Decisions
 Companies, like individuals, make
investments in long lived assets
 Examples include
 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
Slide 9-3


Capital Budgeting 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

Slide 9-4

Learning objective 1: Define capital expenditure
decisions and capital budgets


Capital Budgeting 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

Slide 9-5

Learning objective 1: Define capital expenditure
decisions and capital budgets

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

Slide 9-6

Learning objective 1: Define capital
expenditure decisions and capital budgets


The Time Value of 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

Slide 9-7

Learning objective 1: Define capital expenditure
decisions and capital budgets


Evaluating Opportunities: Time
Value of Money 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

Slide 9-8

Learning objective 1: Define capital expenditure
decisions and capital budgets


Basic Time Value of Money
Calculations

Formula to convert future value to present
value

Where:P = Present value
F = Future amount
r = Required rate of return
n = Number of years

Slide 9-9

Learning objective 1: Define capital expenditure
decisions and capital budgets


Basic Time Value of Money
Calculations - Example
At an interest rate of 10%, how much is $121
received two years from now worth today?

Slide 9-10

Learning objective 1: Define capital expenditure
decisions and capital budgets


Present Value 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
Slide 9-11

Learning objective 1: Define capital expenditure
decisions and capital budgets


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

Slide 9-12

Learning objective 1: Define capital
expenditure decisions and capital budgets


The Net Present Value Method


The only relevant cash flows are
those that are incremental




Cash flows that have already been
incurred are sunk


Slide 9-13

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

They have no bearing on a current
investment decision

Learning objective 2: Evaluate investment opportunities using
the net present value approach


The Net Present Value 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.

Slide 9-14

Evaluate the net present value,
which is the sum of the present value
of all cash inflows and outflows
Learning objective 2: Evaluate investment opportunities using
the net present value approach


The Net Present Value Method


Evaluate the investment opportunity


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



If the NPV is positive




Slide 9-15

The investment should be undertaken
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 requiredrate
Learning objective 2: Evaluate investment opportunities using
the net present value approach


Net Present Value Approach

Slide 9-16

Learning objective 2: Evaluate investment opportunities using
the net present value 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
Slide 9-17

Learning objective 2: Evaluate investment opportunities using
the net present value approach


Net Present Value 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%

Slide 9-18

Learning objective 2: Evaluate investment opportunities using
the net present value approach


Net Present Value Example
Since the NPV > 0, the company should buy the equipment

Slide 9-19

Learning objective 2: Evaluate investment opportunities using
the net present value approach


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

Slide 9-20

Learning objective 2: Evaluate investment opportunities using
the net present value approach


Slide 9-21

Learning objective 2: Evaluate investment opportunities using
the net present value approach


The Internal Rate of Return
(IRR) 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
Slide 9-22

Learning objective 3: Evaluate investment opportunities using the
internal rate of return approach


The Internal Rate of Return

Method

Slide 9-23

Learning objective 3: Evaluate investment opportunities using
the internal rate of return approach


Test Your Knowledge 4
An investment should be undertaken if:
a. The IRR is equal to or greater than the
required rate of return
b. The IRR is equal to or greater than zero
c. The IRR is greater than the accounting
rate of return
d. The IRR is greater than the present value
factor
Answer: a
The IRR is equal to or greater than the
required rate of return
Slide 9-24

Learning objective 3: Evaluate investment opportunities using
the internal rate of return approach


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

Slide 9-25

Learning objective 3: Evaluate investment opportunities using
the internal rate of return approach