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CHAPTER 9CHAPTER 9CHAPTER 9CHAPTER 9
Capital Budgeting and Other Capital Budgeting and Other Long-Run DecisionsLong-Run Decisions
Capital Budgeting and Other Capital Budgeting and Other Long-Run DecisionsLong-Run Decisions
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Capital Budgeting Capital Budgeting DecisionsDecisions
Capital Budgeting Capital Budgeting DecisionsDecisions
Capital Expenditure Decisions Decisions involving the acquisition of
long-lived assets Capital Budgeting
Process of evaluating investment opportunities
The final list of approved projects is referred to as the capital budget
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Capital Budgeting Decision Capital Budgeting Decision ExamplesExamples
Capital Budgeting Decision Capital Budgeting Decision ExamplesExamples
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StarbucksStarbucksStarbucksStarbucks
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Evaluating Opportunities: Evaluating Opportunities: Time Value of Money Time Value of Money
ApproachesApproaches
Evaluating Opportunities: Evaluating Opportunities: Time Value of Money Time Value of Money
ApproachesApproachesTime Value of Money
A dollar today is worth more than a dollar tomorrow!
Must convert future dollars into their equivalent present value
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Basic Time Value of Money Basic Time Value of Money CalculationsCalculations
Basic Time Value of Money Basic Time Value of Money CalculationsCalculations
`Formula to convert future value to present value
P = ___F___ (1 + i)n
Where: P = Present ValueF = Future Valuei = Interest Rate (rate of
return)n = Number of units of
time
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Basic Time Value of Money Basic Time Value of Money Calculations - ExampleCalculations - Example
Basic Time Value of Money Basic Time Value of Money Calculations - ExampleCalculations - Example
What is the present value of $1,000 receive five years from now if your required rate of return is 12%?
P = __$1,000__ (1 + .12)5
= __$1,000__1.7623417
= $567.43
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Evaluating Opportunities: Evaluating Opportunities: Time Value of Money Time Value of Money
ApproachesApproaches
Evaluating Opportunities: Evaluating Opportunities: Time Value of Money Time Value of Money
ApproachesApproachesTwo Methods
Net Present Value Method Internal Rate of Return Method
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The Net Present Value The Net Present Value MethodMethod
The Net Present Value The Net Present Value MethodMethod
Steps in the NPV Method1. Identify the amount and time
period of each cash flow associated with a potential investment
2. Identify required rate of return and calculate the present values of the cash flows
3. Evaluate the net present value
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Net Present Value Net Present Value ApproachApproach
Net Present Value Net Present Value ApproachApproach
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Net Present Value ExampleNet Present Value ExampleNet Present Value ExampleNet Present Value ExampleAn auto repair shop considering the purchase of an automated paint spraying machine. The machine will last five years and the following information is available: Each year $2,000 will be saved on wasted
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%
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Net Present Value ExampleNet Present Value ExampleNet Present Value ExampleNet Present Value Example
Since the Net Present Value is positive, the company should purchase the equipment.
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Example Exercise #1Example Exercise #1Example Exercise #1Example Exercise #1
An investment that costs $50,000 will return $22,000 per year for five years. Determine the net present value of the investment if the required rate of return is 14%. Ignore taxes. Should the investment be undertaken?
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Example Exercise #1 Example Exercise #1 SolutionSolution
Example Exercise #1 Example Exercise #1 SolutionSolution
Net Present Value Calculation PV of Return (Table 2, PV of Annuity where
n=5 and i = 14%) = 3.4331 So,
$22,000 x 3.4331 $75,528.20($50,000) x 1.000 _($50,000)
$25,528.20
Should it be undertaken? Yes, NPV is positive
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The Internal Rate of Return The Internal Rate of Return MethodMethod
The Internal Rate of Return The Internal Rate of Return MethodMethod
IRR Method An alternative to the net present
value method Takes into account the time
value of money Rate of return that equates the
present value of future cash flows to the investment outlay
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The Internal Rate of Return The Internal Rate of Return MethodMethod
The Internal Rate of Return The Internal Rate of Return MethodMethod
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Internal Rate of Return Internal Rate of Return ExampleExample
Internal Rate of Return Internal Rate of Return ExampleExample
A company invests $100 to yield $60 at the end of year one and $60 at the end of year two. What rate of return equates the two-year, $60 annuity to $100? Calculate Present Value Factor
=__Initial Outlay_ Annuity Amount
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Internal Rate of Return Internal Rate of Return ExampleExample
Internal Rate of Return Internal Rate of Return ExampleExample
Present Value Factor= $100
$60
= 1.667
Compare with PV of Annuity table for two periods 1.667 very close to 1.6681 IRR is approximately 13%
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Example Exercise #2Example Exercise #2Example Exercise #2Example Exercise #2
An investment that costs $79,100 will reduce operating costs by $14,000 per year for ten years. Determine the internal rate of return of the investment (ignore taxes). Should the investment be undertaken if the required rate of return is 18%?
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Example Exercise #2 Example Exercise #2 SolutionSolution
Example Exercise #2 Example Exercise #2 SolutionSolution
IRR Calculation=Initial Outlay / Annuity Amount=$79,100 / $14,000= 5.6500
PV of Annuity Identification 5.6500 @ 10 years is approximately 5.6502 So, IRR = 12%
Should the project be undertaken? No, IRR is less than required rate of return
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Study Break #1Study Break #1Study Break #1Study Break #1
Which of the following is not a capital expenditure decision?a. Building a new factoryb. Purchasing a new piece of equipmentc. Purchasing a new computer systemd. All are capital expenditure decisions
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Study Break #1Study Break #1Study Break #1Study Break #1
Which of the following is not a capital expenditure decision?a. Building a new factoryb. Purchasing a new piece of equipmentc. Purchasing a new computer systemd. All are capital expenditure decisions
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Study Break #2Study Break #2Study Break #2Study Break #2
If the net present value of a project is zero, the project is earning a return equal to:a. Zerob. The rate of inflationc. The accounting rate of returnd. The required rate of return
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Study Break #2Study Break #2Study Break #2Study Break #2
If the net present value of a project is zero, the project is earning a return equal to:a. Zerob. The rate of inflationc. The accounting rate of returnd. The required rate of return
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Study Break #3Study Break #3Study Break #3Study Break #3
An investment should be made if:a. The IRR is equal to or greater than the
required rate of returnb. The IRR is equal to or greater than
zeroc. The IRR is greater than the accounting
rate of returnd. The IRR is greater than the present
value factor
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Study Break #3Study Break #3Study Break #3Study Break #3
An investment should be made if:a. The IRR is equal to or greater than
the required rate of returnb. The IRR is equal to or greater than
zeroc. The IRR is greater than the
accounting rate of returnd. The IRR is greater than the
present value factor
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Internal Rate of Return With Internal Rate of Return With Unequal Cash FlowsUnequal Cash Flows
Internal Rate of Return With Internal Rate of Return With Unequal Cash FlowsUnequal Cash Flows
Utilized when yearly cash flows are not equal amounts
Must estimate the IRR and calculate the NPV of the project
If NPV > Zero, then IRR should be increased
If NPV < Zero, then IRR should be decreased
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Internal Rate of Return With Internal Rate of Return With Unequal Cash Flows ExampleUnequal Cash Flows ExampleInternal Rate of Return With Internal Rate of Return With Unequal Cash Flows ExampleUnequal Cash Flows Example
The IRR is approximately 16%
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CFO use of NPV and IRRCFO use of NPV and IRRCFO use of NPV and IRRCFO use of NPV and IRR
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Considering “Soft” Benefits in Considering “Soft” Benefits in Investment DecisionsInvestment Decisions
Considering “Soft” Benefits in Considering “Soft” Benefits in Investment DecisionsInvestment Decisions
NPV and IRR allow for a quantitative analysis of a situation
“Soft” benefits include a project’s impact on Future Sales Firm’s Reputation
“Soft” benefits are difficult to quantify
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Calculating the Value of “Soft” Calculating the Value of “Soft” BenefitsBenefits
Calculating the Value of “Soft” Calculating the Value of “Soft” BenefitsBenefits
Managers should make a reasonable attempt to quantify the value of soft benefits A high-tech wheelchair project has a
NPV of negative $80,000. The finance department used a required rate of return of 15% with a 10-year life. What must be the value of the soft benefits each year?
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Calculating the Value of “Soft” Calculating the Value of “Soft” BenefitsBenefits
Calculating the Value of “Soft” Calculating the Value of “Soft” BenefitsBenefits
This implies that as long as the soft benefits are worth at least $15,959 per year, the project should be funded
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Estimating the Required Rate Estimating the Required Rate of Returnof Return
Estimating the Required Rate Estimating the Required Rate of Returnof Return
In previous examples the required rate of return was simply stated
In practice, management must estimate the required rate of return Typically, the required rate of return must
equal the cost of capital for the firm
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Cost of CapitalCost of CapitalCost of CapitalCost of Capital
Weighted average of the costs of debt and equity financing used to generate the capital for investments
Cost of Debt Financing Interest paid to individuals, banks, or
other companies that lend money to the firm
Cost of Equity Financing Return demanded by shareholders
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Cost of Capital ExamplesCost of Capital ExamplesCost of Capital ExamplesCost of Capital Examples
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Additional Cash Flow Additional Cash Flow ConsiderationsConsiderations
Additional Cash Flow Additional Cash Flow ConsiderationsConsiderations
Both NPV and IRR consider cash flows, but not revenues and expenses
Two Special Topics Depreciation Inflation
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Cash Flows, Taxes, and the Cash Flows, Taxes, and the Depreciation Tax Shield Depreciation Tax Shield
Cash Flows, Taxes, and the Cash Flows, Taxes, and the Depreciation Tax Shield Depreciation Tax Shield
Depreciation indirectly affects cash flows
Depreciation reduces the amount of tax a company must pay Referred to as the Depreciation Tax Shield
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Adjusting Cash Flow for Adjusting Cash Flow for InflationInflation
Adjusting Cash Flow for Adjusting Cash Flow for InflationInflation
It is important to consider the rate of inflation for investment decisions Typically, inflation is factored into the
cost of capital If inflation is not factored into
expected cash flows, suitable projects may appear to have a negative NPV
– The cash inflows will be relatively low, although the required rate of return will be relatively high
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Other Long-Run DecisionsOther Long-Run DecisionsOther Long-Run DecisionsOther Long-Run Decisions Decisions that affect cash flows for a
number of future periods Utilize NPV and IRR to analyze Examples include
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Simplified Approaches to Simplified Approaches to Capital BudgetingCapital Budgeting
Simplified Approaches to Simplified Approaches to Capital BudgetingCapital Budgeting
Payback Period Method Calculating the length of time it takes to
recover the initial cost of an investment; does not consider the
Time value of money Total stream of cash flows
Accounting Rate of Return Used to evaluate investment opportunities by
comparing the accounting rates of return with a required accounting rate of return
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Payback Period Method Payback Period Method ExamplesExamples
Payback Period Method Payback Period Method ExamplesExamples
If an investment opportunity costs $1,000 and yields cash flows of $500 per year, it has a payback period of 2 years.
If an investment opportunity costs $1,000 and yields cash flows of $300 per year, it has a payback period of 3-1/3 years.
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Example Exercise #3Example Exercise #3Example Exercise #3Example Exercise #3
The Sunny Valley Wheat Cooperative is considering the construction of a new silo. It will cost $55,000 to construct the silo. Determine the payback period if the expected cash inflows are $10,000 per year.
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Example Exercise #3 Example Exercise #3 SolutionSolution
Example Exercise #3 Example Exercise #3 SolutionSolution
Payback Period= $55,000 / $10,000= 5.5
The payback period is 5.5 years
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Accounting Rate of ReturnAccounting Rate of ReturnAccounting Rate of ReturnAccounting Rate of Return
Formula Average Net Income
Average Investment Example
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Conflict Between Performance Conflict Between Performance Evaluation and Capital Evaluation and Capital
BudgetingBudgeting
Conflict Between Performance Conflict Between Performance Evaluation and Capital Evaluation and Capital
BudgetingBudgeting Managers may be discouraged from
using present value techniques for evaluating investments because of the way in which their own performance is evaluated Manager’s performance could be evaluated
based on short-term outcomes Managers who wish to maximize
shareholder wealth should use present value techniques to evaluate investments
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Study Break #4Study Break #4Study Break #4Study Break #4
Which of the following methods equates future dollars to current dollars?a. Net present value methodb. Internal rate of return methodc. Payback period methodd. Both a and b
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Study Break #4Study Break #4Study Break #4Study Break #4
Which of the following methods equates future dollars to current dollars?a. Net present value methodb. Internal rate of return methodc. Payback period methodd. Both a and b
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Study Break #5Study Break #5Study Break #5Study Break #5
The cost of capital is:a. The cost of debt financingb. The cost of equity financingc. The weighted average of the
costs of debt and equity financingd. The internal rate of return
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Study Break #5Study Break #5Study Break #5Study Break #5
The cost of capital is:a. The cost of debt financingb. The cost of equity financingc. The weighted average of the
costs of debt and equity financingd. The internal rate of return
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NPV and IRRNPV and IRRNPV and IRRNPV and IRR
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