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Two decisionsMake or buyComparing _ with _Activity analysisUse of facilitiesStrategic issusesJoint product process further Comparing sale value _ and _the processTwo costsOpportunity costSunk cost 1Capital BudgetingChapter 11 Long-Term(Capital)AssetsCapital assets are equipment or facilities that provide services to the organization for more than one fiscal period.Capital assets create these capacity-related costs3Need to Control Capital AssetsOrganizations have developed specific tools to control the acquisition and use of long-term assets because:Organizations are usually committed to long-term assets for an extended time,creating the potential forExcess capacity that creates excess costsScarce capacity that creates lost opportunitiesThe amount of money committed to the acquisition of capital assets is usually quite largeThe long-term nature of capital assets creates technological riskReduce an organizations flexibility4Meaning of Capital BudgetingCapital budgeting can be defined as the process of analyzing,evaluating,and deciding whether resources should be allocated to a project or not.Capital budgeting has three phases:Identifying potential investments,Choosing which investments to make,andFollow-up monitoring of the investments.56Types of Capital Budgeting DecisionsShould we add a new product to our existing product line?Should we expand into a new market?Should we replace our existing machinery?Should we buy fully automatic or semiautomatic machinery Where to locate manufacturing facility?7Investment and ReturnInvestment and return form the foundation of capital budgeting analysis,which focuses on whether the expected increased cash flows(return)will justify the investment in the long-term assetInvestment is the monetary value of the assets the organization gives up to acquire a long-term asset which are often called capital outlays.Return is the increased future cash inflows attributable to the long-term asset8Obviously,$1,000 today$1,000 today.Money received sooner rather than later allows one to use the funds for investment or consumption purposes.This concept is referred to as the TIME VALUE OF MONEYTIME VALUE OF MONEY!The Time Value of MoneyThe Time Value of MoneyWhich would you rather have-$1,000 today$1,000 today or$1,000$1,000 in 5 years?in 5 years?9Time Value of MoneyA dollar A dollar todaytoday is worth is worth more than a dollar a more than a dollar a year year from nowfrom now since a dollar since a dollar received today can be received today can be invested,yielding more invested,yielding more than a dollar a year from than a dollar a year from now.now.10Time Value of Money(1 of 2)Time value of money(TVM)is a central concept in capital budgetingIn making investment decisions,the problem is that investment cash is paid out now,but the cash return is received in the futureWe need an equivalent basis to compare the cash flows that occur at different points in time11Time Value of Money(2 of 2)The critical idea underlying capital budgeting is:Amounts of money spent or received at different periods of time must be converted into their value on a common date in order to be compared12Some Standard NotationFor simplicity,the following notation is used:Abbr.MeaningnFVPVarNumber of periods considered in the investment analysis;common period lengths are a month,a quarter,or a yearFuture value,or ending value,of the investment n periods from nowPresent value,or the value at the current moment in time,of an amount to be received n periods from nowAnnuity,or equal amount,received or paid at the end of each period for n periodsRate of return required,or expected,from an investment opportunity;the rate of interest earned on an investment13Types of InterestTypes of InterestCompound InterestCompound InterestInterest paid(earned)on any previous interest earned,as well as on the principal borrowed(lent).uuSimple InterestInterest paid(earned)on only the original amount,or principal borrowed(lent).SIn=P0(1+i n)CIn=P0(1+i)n14Present ValueAnalysts call a future cash flows value at time zero its present valueThe process of computing present value is called discountingWe can rearrange the FV formula to compute the present value:FV=PV x(1+r)nPV=FV/(1+r)n or PV=FV x(1+r)-nMethods similar to those described earlier may be used to compute this valueCalculator,tables,or spreadsheet software15Assume that you need to have exactly$4,000$4,000 saved 10 years from now.years from now.How much must you deposit today in an account that pays 6%interest,compounded annually,so that you reach your goal of$4,000?0 5 10$4,0006%PV0Present ValuePresent Value (Graphic)(Graphic)16Quick Check How much would you have to put in the bank today to have$100 at the end of five years if the interest rate is 10%?PV or FV?Table:_a.$62.10b.$56.70c.$90.90d.$51.9018 How much would you have to put in the bank today to have$100 at the end of five years if the interest rate is 10%?a.$62.10b.$56.70c.$90.90d.$51.90Quick Check$100$100 0.621=$62.10 0.621=$62.1019 PRESENT VALUEYear 5%10%15%1.952.909.870 2.907.826.756 5.784.621.497 10.614.386.247 20.377.149.061PRESENT VALUE OF$120 PRESENT VALUEYear 5%10%15%1.952.909.870 2.907.826.756 5.784.621.497 10.614.386.247 20.377.149.061PRESENT VALUE OF$1A fixed amount of cash to be received at some future time become less valuable as interest rate increase and the time period increased21AnnuitiesuuAn Annuity represents a series of equal payments(or receipts)occurring over a specified number of equidistant periods.Ordinary AnnuityOrdinary Annuity:Payments or receipts occur at the end of each period.Annuity DueAnnuity Due:Payments or receipts occur at the beginning of each period.22Examples of Annuities Student Loan Payments Car Loan Payments Mortgage Payments Retirement Savings23Parts of an AnnuityParts of an Annuity0 1 2 3$100$100$100(Ordinary Annuity)EndEnd ofPeriod 1EndEnd ofPeriod 2TodayEqual Cash Flows Each 1 Period ApartEndEnd ofPeriod 324PVAn=R(PVIFAi%,n)PVA3=$1,000(PVIFA7%,3)=$1,000(2.624)=$2,624Valuation Using Table IVValuation Using Table IV25Approaches to Capital BudgetingOrganizations have developed many approaches to capital budgetingfive approaches are discussed here:PaybackAccounting rate of returnNet present valueInternal rate of returnProfitability indexDCF focus on expected cashflows and TVM 26NPV:Sum of the PVs of inflows and outflows.Cost often is CF0 and is negative.Net Present Value2728Net Present Value(1 of 4)The steps used to compute an investments net present value are as follows:Step 1:Choose the appropriate period length to evaluate the investment proposalThe period length depends on the periodicity of the investments cash flowsThe most common period used in practice is one yearStep 2:Identify the organizations cost of capital,and convert it to an appropriate rate of return for the period length chosen in step 129Cost of CapitalThe cost of capital is the interest rate used for discounting future cash flowsAlso known as the risk-adjusted discount rateThe cost of capital is the return the organization must earn on its investment to meet its investors return requirementsThe organizations cost of capital reflects:The amount and cost of debt and equity in its financial structure (WACC)The financial markets perception of the financial risk of the organizations activities30Net Present Value(2 of 4)Step 3:Identify the incremental cash flow in each period of the projects life.Step 4:Compute the present value of each periods cash flow using the organizations cost of capital for the discount rateStep 5:Sum the present values of all the periodic cash inflows and outflows to determine the investment projects net present valueStep 6:If the projects net present value is positive,the project is acceptable from an economic perspective31Typical Cash OutflowsRepairs andRepairs andmaintenancemaintenanceIncrementalIncrementaloperatingoperatingcostscostsInitialInitialinvestmentinvestmentWorkingWorkingcapitalcapital32Typical Cash InflowsReductionReductionof costsof costsSalvageSalvagevaluevalueIncrementalIncrementalrevenuesrevenuesRelease ofRelease ofworkingworkingcapitalcapital33General decision rule.The Net Present Value Method34The Net Present Value(NPV)Criterion-ExampleA company can purchase a machine for$2200.The machine has a productive life of three years.It will generate net cash flows of$770 in the first year,$968 in the second,and$1331 in the third.If the firm does not buy this machine,it can invest its money elsewhere and earn a return of 10%.Should the machine be bought?35The Net Present Value(NPV)Criterion-ExampleSo,we calculate the NPV using the PV of estimated cash flows.36The Net Present Value(NPV)Criterion-ExampleIn this case,the NPV is positive.This means the investment should be undertaken.37Quick Check DataDenny Associates has been offered a four-year contract to supply the computing requirements for a local bank.The working capital would be released at the end of the contract.Denny Associates requires a 14%return.38Quick Check What is the net present value of the contract with the local bank?a.$150,000b.$28,230c.$92,340d.$132,91639 What is the net present value of the contract with the local bank?a.$150,000b.$28,230c.$92,340d.$132,916Quick Check 40Comparison of Two Projects41Total Project Approach42Differential Approach4344Good Attributes of the NPV Rule1.Uses cash flows2.Uses ALL cash flows of the project3.Discounts ALL cash flows properlyReinvestment assumption:the NPV rule assumes that all cash flows can be reinvested at the discount rate.45“Sales is vanity,profit is necessary,but cash is king”46Sounds goodMy sales have grown by 5%over the last few yearsMy business makes a profit of xm per year the banks and investors need thisBut.47Cash ControlCash is the lifeblood of any business.It is essential to enable the business to carry out day to day transactionsAn organisation can make a profit but without a sustainable flow can be in danger of going into liquidationA business should continue to drive cash generation in order to sustain business operations and to fund future growthPoor cash flow limits opportunities and/or options,can leave little room to respond to threats Cash is often the first sign of deterioration and send signals to stakeholders48Effect of TaxesThe effect of taxes on capital budgeting is two-fold:Organizations must pay taxes on any net benefits provided by the investments.Organizations can use the depreciation associated with a capital investment to reduce income and offset some of their taxes.So,analysis of capital budgeting requires converting all pretax cash flows to after-tax cash flows.49Effects of Depreciation DeductionsTAX50we show how cash flows are related to accounting numbers and taxes.Define the net cash flow generated by certain assets as:Net Cash Flow=Cash Inflow-Cash Outflow=Revenue-Expenses-Capital Expenditure-Taxes The income tax paid is determined by:Taxes=t*(Revenue-Expenses-Depreciation)Net Cash flow=(1-t)*(Revenue Expenses)+t*Depreciation515253Joshua Manufacturing Company(JMC)is considering buying some new equipment that would allow for increased sales of its product.The incremental impact of the proposed$280,000 investment is shown below using straight-line depreciation and an expected useful life of four years for the equipment.The company has a minimum desired rate of return of 14%.Revenues$420,000Nondepreciation expenses$240,000Depreciation 70,000Total expenses$310,000Taxable income$110,000Income tax(40%)44,000Net Income$66,000541.The annual cash inflows expected from the project are:a.$80,000 b.$68,000c.$136,000 d.$108,0002.The present value of the tax savings from straight-line depreciation is:a.$100,000 b.$81,584 c.$28,274d.$03.The NPV of the investment using straight-line depreciation is:a.($280,000)b.($1,868.40)c.$396,264 d.$116,264.55 1.cThe easiest way to compute the cash flows generated by the investment is to add the depreciation back to the net income.In this case,$70,000+$68,000=$136,000.Alternatively,one could add the after-tax cash flows from operations to the tax savings resulting from the depreciation expense.Here,$108,000($420,000-$240,000)x(1-.40)+$28,000$70,000 x.40 also gives$136,000 in total after-tax cash flows.562.bThe annual tax savings from depreciation are$28,000$70,000 x.40.The present value of the savings is computed by multiplying the$28,000 by the present value factor for an annuity for four years at 14%of 2.9137.The result is$81,584.57Inflation effectsInflationThe decline in the general purchasing power of the power of the monetary unit.ConsistencyConsistent treatment of the minimum desired rate of return and the predicted cash flows.58Other methods of analysis59Internal Rate of ReturnThe internal rate of return(IRR)is the actual rate of return expected from an investmentThe IRR is the discount rate that makes the investments net present value equal to zeroIf an investments NPV is positive,then its IRR exceeds its cost of capitalIf an investments NPV is negative,then its IRR is less than its cost of capital60Calculating the IRRLet a projects cash flow be C1,C2,C3,CN.Let the initial cost of the project be C0.Then,the IRR is r in the following equation:61Calculating the IRRTwo casesLevel cash inflows(the same amount each year)uneven inflows62Internal Rate of Return MethodDecker Company can purchase a new machine at a cost of$104,320 that will save$20,000 per year in cash operating costs.The machine has a 10-year life.63Internal Rate of Return MethodFuture cash flows are the same every year in this example,so we can calculate the internal rate of return as follows:Investment required Net annual cash flowsPV factor for theinternal rate of return=$104,320$20,000=5.216Investment/inflow ratio64Internal Rate of Return MethodFind the 10-period row,move across until you find the factor 5.216.Look at the top of the column and you find a rate of 14%14%.Using the present value of an annuity of$1 table.65Uneven cash inflowsConsider the following project:0123$50$100$150-$20066Calculating the IRRThe equation cannot be solved for r.We can use a trial and error approach.Or we could use“solver”or“goal seek”in Excel.67The NPV Payoff Profile for This ExampleIf we graph NPV versus discount rate,we can see the IRR as the x-axis intercept.IRR=19.44%68The IRR Decision RuleMinimum Acceptance Criteria for screening problem:Accept if the IRR exceeds the required return.Ranking Criteria for preference problemsSelect alternative with the highest IRR69The Payback MethodThe The payback periodpayback period is the length of time that it is the length of time that it takes for a project to recover its initial cost out takes for a project to recover its initial cost out of the cash receipts that it generates.of the cash receipts that it generates.Payback Period=number of years to recover initial costs70When the net annual cash inflow is the same each year,this When the net annual cash inflow is the same each year,this formula can be used to compute the payback period:formula can be used to compute the payback period:When the net annual cash inflow is not constant from year to When the net annual cash inflow is not constant from year to year,the payback period is determined by adding up the year,the payback period is determined by adding up the cash inflows expected in successive years until the total is cash inflows expected in successive years until the total is equal to the original outlay.equal to the original outlay.The Payback MethodPayback period =Investment required Net annual cash inflow71Decision criterionThe payback method assumes that risk is time-related:the longer the period,the greater the chance of failure,so:When projects are mutually exclusive,accept the project with shortest payback period.Or accept the proposal which payback period is less the target period(which is determined by companys policy).72The Payback Method Management at The Daily Grind wants to install an espresso bar in its restaurant.The espresso bar:1.1.Costs$140,000 and has a 10-year life.Costs$140,000 and has a 10-year life.2.2.Will generate net annual cash inflows of Will generate net annual cash inflows of$35,000.$35,000.Management requires a payback period of 5 years or less on all investments.What is the payback period for the espresso bar?73The Payback MethodPayback period =Payback period =Investment required Investment required Net annual cash inflowNet annual cash inflowPayback period =Payback period =$140,000$140,000$35,000$35,000Payback period =Payback period =4.0 4.0 yearsyearsAccording to the companys criterion,According to the companys criterion,management would invest in the management would invest in the espresso bar because its payback espresso bar because its payback period is less than 5 years.period is less than 5 years.74Quick Check Consider the following two investments:Project XProject YInitial investment$100,00$100,000Year 1 cash inflow$60,000$60,000Year 2 cash inflow$40,000$35,000Year 3-10 cash inflows$0$25,000Which project has the shortest payback period?a.Project Xb.Project Yc.Cannot be determined75 Consider the following two investments:Project XProject YInitial investment$100,00$100,000Year 1 cash inflow$60,000$60,000Year 2 cash inflow$40,000$35,000Year 3-10 cash inflows$0$25,000Which project has the shortest payback period?a.Project Xb.Project Yc.Cannot be determinedQuick Check Project X has a payback period of 2 years.Project X has a payback period of 2 years.Project Y has a payback period of slightly more than 2 years.Project Y has a payback period of slightly more than 2 years.Which project do you think is better?Which project do you think is better?76Strengths of Payback:1.Provides an indication of a projects risk and liquidity.2.Easy to calculate and understand.Weaknesses of Payback:1.Ignores the TVM.2.Ignores CFs occurring after the payback period.Evaluation of the Payback Method77Evaluation of the Payback MethodIt is the method most widely used in practice and particularly useful approach for:Ranking projects where a firm faces liquidity constraints and require a fast repayment of investmentA situation where risky investments are made in uncertain markets that are subject to fast design and product changes.preliminary screening of many proposals is necessary;Payback method should be used in conjunction with the NPV method.78Accounting Rate of Return MethodDoes not focus on cash flows-rather it focuses on accounting income.The following formula is used to calculate the simple rate of return:accounting rateaccounting rateof returnof return=Average incomeAverage incomeAverage investmentAverage investment79Evaluation of accounting rate of returnFocus on accounting income and ignore the TVM.It is a improvement over the payback method in that it considers income in all periods80Despite the conceptual superiority of methods that involve discounting,surveys show that the payback and accounting return methods are widely used.And the most companies use two or more methods in their investment proposal analyses.Anthony,et al,accounting:text and cases,机械工业出版社，2007，P425 Why？81Potential conflict(P495)Some corporate managers tend to be concerned about the short-run impact a proposed project would have on corporate profitability as reported in the published FSThe manager of a profit center may have similar concerns.Particularly likely to happen if the manager has incentive compensation tied to the profit centers short-run profitabilityManagers risk aversion(fear being penalized if the project does not work out as anticipated).82In sum,factors other than the true economic return(i.e.,IRR),of a project greatly and understandably-influence whether a project is approved and ever whether the project is formally proposed to top management.8384Reconciliation of conflictTo use DCF for both capital-budgeting decisions and performance evaluation.To conduct a follow-up evaluation of capital-budgeting decision.postauditing85Post-Implementation AuditsRevisiting the decis
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