Prepared by Debby Bloom-Hill CMA, CFM CHAPTER 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 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 Cash Flows, Taxes, and the Depreciation Tax Shield  In the previous examples we ignored the effect of taxes on cash flow  Tax considerations play a major role in capital budgeting  If a project generates taxable revenue, cash inflows will be reduced by taxes paid on the revenue  If a project generates tax deductible expenses, cash inflows will be increased by the tax savings generated Slide 9-39 Learning objective 4: Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes Cash Flows, Taxes, and the Depreciation Tax Shield  We stated that depreciation is not relevant in present value analysis  Depreciation affects cash flows indirectly  Depreciation reduces the amount of tax a company must pay  The term depreciation tax shield refers to the tax savings from depreciation Slide 9-40 Learning objective 4: Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes Example of the Depreciation Tax Shield Slide 9-41 Learning objective 4: Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes Adjusting Cash Flows for Inflation  It may be important to consider inflation when estimating the cash flows associated with investment opportunities  Inflation can be taken into account by multiplying the current cash flows by the expected rate of inflation Slide 9-42 Learning objective 4: Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes Adjusting Cash Flows for Inflation  If inflation is ignored in net present value analysis, worthwhile opportunities might be rejected  That is because current rates of return for debt and equity financing already include estimates of future inflation  Cash flows will be low  Required rates of return will be high Slide 9-43 Learning objective 4: Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes Other Long-Run Decisions  Time value of money techniques are also applicable to the analysis of other long-run decisions  Examples of these decisions include:  Decision to outsource grounds maintenance  Decision to drop a product line  Decision to buy rather than make a subcomponent of a product Slide 9-44 Learning objective 5: Evaluate long-run decisions, other than investment decisions, using time value of money techniques Other Long-Run Decisions Evaluation of decision to sponsor a golf tournament Slide 9-45 Learning objective 5: Evaluate long-run decisions, other than investment decisions, using time value of money techniques Simplified Approaches to Capital Budgeting  Many companies continue to use simpler approaches  Two of these are  Payback period method  Accounting rate of return  Both methods have significant limitations in comparison to NPV and IRR Slide 9-46 Learning objective 6: Use the payback period and the accounting rate of return methods to evaluate investment opportunities Payback Period Method The payback period is the length of time it takes to recover the initial cost of an investment An investment which costs $1,000 and yields cash flows of $500 per year has a payback period of years ($1,000 / $500) If an investment costs $1,000 and yields cash flows of $300 per year it has a payback period of 1/3 years Slide 9-47 Learning objective 6: Use the payback period and the accounting rate of return methods to evaluate investment opportunities Payback Period Method One approach is to accept projects that have a payback period less than some specified requirement This can lead to poor decisions The payback method does not take into account the total cash flows It only considers the stream of cash flows up until the investment is repaid It does not consider the time value of money Slide 9-48 Learning objective 6: Use the payback period and the accounting rate of return methods to evaluate investment opportunities Test Your Knowledge Which of the following methods ignores the time value of money (present and future values) in its calculation? a b c d Net present value Internal rate of return Payback period External rate of return Answer: c Payback period Slide 9-49 Learning objective 6: Use the payback period and the accounting rate of return methods to evaluate investment opportunities Accounting Rate of Return (ARR)  Accounting Rate of Return Formula: ARR = Average Net Income Average Investment  Average investment is the initial investment divided by  Like the payback period method, the accounting rate of return ignores the time value of money Slide 9-50 Learning objective 6: Use the payback period and the accounting rate of return methods to evaluate investment opportunities Conflict Between Performance Evaluation and Capital Budgeting  Managers may be discouraged from using PV techniques for evaluating investments depending on how their performance is evaluated  An investment may have high depreciation in the early years, or revenue may be low  Managers need to be assured that if they approve projects with long run positive NPV their compensation will take the expected benefits into account Slide 9-51 Learning objective 7: Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values Short-Run Accounting Profit Slide 9-52 Learning objective 7: Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values Copyright  © 2010 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein Slide 9-53 ... 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... 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