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Capital Budgeting Here

Capital Budgeting:
How managers plan
significant outlays on projects
that have long-term implications
(such as the purchase of new equipment
or introduction of new products).
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Methods for Click

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Capital Budgeting Decisions

Methods which do not consider the time value
of money:
* Payback Method
* Simple Rate of Return
Method that does consider the time value of money:
* Net Present Value (NPV) Method covered here
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Time Value of Money Here

 Business investments extend

over long periods of time.
 Investments that promise
returns earlier in time are
preferable to those that
promise returns later in time.
 As such, the time value of
money must be considered.
A dollar today is worth more than
a dollar a year from now
since a dollar received today can be invested -
yielding more than a dollar a year from now.
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Typical Cash Outflows Here

Repairs and
maintenance

Working Initial
capital investment

Incremental
operating
costs
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Typical Cash Inflows Here

Salvage
value

Release of
Reduction
working
of costs
capital

Incremental
revenues
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The Net Present Value Method Here

To determine net present value:

* Calculate the present value of cash inflows,
* Calculate the present value of cash outflows,
* Subtract the present value of the outflows
from the present value of the inflows.
* Apply the general decision rule.
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The Net Present Value Method Here

General decision rule . . .

If the Net Present
Value is . . . Then the Project is . . .
Acceptable, since it promises a
Positive . . . return greater than the required
rate of return.

Acceptable, since it promises a

Zero . . . return equal to the required rate
of return.

Not acceptable, since it promises

Negative . . . a return less than the required
rate of return.
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Choosing a Discount Page

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(or Hurdle)Rate
 The firm’s cost of capital is
usually regarded as the most
appropriate choice for the
discount (or hurdle) rate.
 The cost of capital is the
average rate of return the
company must pay to its
long-term creditors and
stockholders for the use
of their funds.
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Simple Illustration
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of the NPV Method

Carver Hospital is considering the purchase of an

attachment for its X-ray machine.
No investments are made unless they have an annual
return of at least 10%.

Cost $3,170
Life 4 years
Salvage value zero
Increase in annual cash inflows 1,000
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Present Value of Initial Investment Here

Start with the present value of the initial investment(s):

Present
Value of
Amount of 10% Cash
Item Year(s) Cash Flow Factor Flows
Initial investment (outflow) Now (3,170) 1.000 (3,170)

Since the initial investment takes place immediately,

the present value of the initial investment equals the outflow.
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Present Value of Cash Inflows Here

Calculate the present value(s) of the other cash flows:

Present
Value of
An annuity Amount of Cash
Item Year(s) Cash Flow 10% Factor Flows
Initial investment (outflow) Now (3,170) 1.000 (3,170)
Annual cash inflows 1-4 $ 1,000 x 3.170 = $ 3,170
Discount (or Hurdle)
Rate

Periods 10% 12% 14%

Present value 1 0.909 0.893 0.877
2 1.736 1.690 1.647
of an annuity 3 2.487 2.402 2.322
of $1 table 4 3.170 3.037 2.914
5 3.791 3.605 3.433
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Illustration of the NPV Method Here

Determine the NPV of the cash flows (subtract the present value(s)
of the cash outflow(s) from the present value(s) of the cash inflow(s)):

Present
Value of
Amount of 10% Cash
Item Year(s) Cash Flow Factor Flows
Initial investment (outflow) Now (3,170) 1.000 (3,170)
Annual cash inflows 1-4 $ 1,000 3.170 $ 3,170
Net present value $ -0-

Apply general decision rule:

Because the net present value is equal to zero,

the investment provides exactly a 10% return.
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Another Illustration Here

Lester Company has been offered a five year contract to provide

component parts for a large manufacturer:

Cost and revenue information

Cost of special equipment $160,000
Working capital required 100,000
Relining of equipment (end of year 3) 30,000
Salvage value of equipment (end of year 5) 5,000
Annual cash revenue and costs:
Sales revenue from parts 750,000
Cost of parts sold 400,000
Salaries, shipping, etc. 270,000

At the end of year 5, the working capital will be released for use
elsewhere. Lester Company uses a discount (or hurdle) rate of 10%.
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Present Value of Page

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Initial Investments
Start with the present value of the initial investment(s):

Cash 10% Present

Years Flows Factor Value
Investment in equipment Now $ (160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)

Since the initial investments

(the investment in the equipment and the working capital needed)
take place immediately,
the present values equal those outflows.
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Present Values Page

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of Other Cash Flows

Calculate the present value of the other cash flows:
Annual net cash inflows from operations:
Sales revenue $ 750,000
Cost of parts sold (400,000)
Salaries, shipping, etc. (270,000)
Annual net cash inflows $ 80,000

An annuity Cash 10% Present

Years Flows Factor Value
Investment in equipment Now $ (160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1-5 80,000 x 3.791 = 303,280

Present value of an annuity of $1 factor for 5 years at 10%.

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Present Value Page

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of Other Cash Flows

Calculate the present value of the other cash flows, continued:

Cash outflow to reline equipment at end of year 3

Cash 10% Present
A single payment
Years Flows Factor Value
Investment in equipment Now $ (160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1-5 80,000 3.791 303,280
Relining of equipment 3 (30,000) x 0.751 = (22,530)

Present value of $1 factor for 3 years at 10%.

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Present Value Page

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of Other Cash Flows

Calculate the present value of the other cash flows, continued:

Cash inflows from sale of equipment and release of

working capital at end of year 5
Single payments Cash 10% Present
Years Flows Factor Value
Investment in equipment Now $ (160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1-5 80,000 3.791 303,280
Relining of equipment 3 (30,000) 0.751 (22,530)
Salvage value of equip. 5 5,000 x 0.621 = 3,105
Working capital released 5 100,000 x 0.621 = 62,100

Present value of $1 factor for 5 years at 10%.

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Apply General Decision Rule Here

Determine the NPV of the cash flows (subtract the present value(s)
of the cash outflow(s) from the present value(s) of the cash inflows)):
Cash 10% Present
Years Flows Factor Value
Investment in equipment Now $ (160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1-5 80,000 3.791 303,280
Relining of equipment 3 (30,000) 0.751 (22,530)
Salvage value of equip. 5 5,000 0.621 3,105
Working capital released 5 100,000 0.621 62,100
Net present value $ 85,955

Apply general decision rule:

The project has a positive net present value
(that is, its return is greater than 10%); accept the project.