Chapter 12 - Capital Budgeting Decisions
Typical capital budgeting decisions include
1. Cost reduction decisions. Should new equipment be purchased to reduce costs? 2. Expansion decisions. Should a new plant, warehouse, or other facility be acquired to increase capacity and sales? 3. Equipment selection decisions. Which of several available machines should be purchased? 4. Lease or buy decisions. Should new equipment be leased or purchased? 5. Equipment replacement decisions. Should old equipment be replaced now or later?
payback method
Does not consider the time value of money
Project Profitability Index
NPV / Investment Required
Investment
Spending money now to realize future net cash inflows
time value of money
a dollar today is worth more than a dollar a year from now
when NPV is positive
accept
Simple Rate of Return is also known as
accounting or unadjusted rate of return
out-of-pocket costs
actual cash outlays for salaries, advertising, and other operating expenses
simple rate of return
annual incremental net operating income / initial investment
if new equipment is replacing old equipment
any salvage value to be received from old equipment should be deducted from cost of new equipment only incremental investment should be used in payback computation depreciation deducted in arriving at project's net operating income must be added back
postaudit
checking whether or not expected results are actually realized
if project's rate of return is less than cost of capital
company doesn't earn enough to compensate its creditors/shareholders
net present value
compares present value of project's cash inflows to present value of outflow PV Inflows - PV Outflows
working capital
current assets - current liabilities
limitations of simple rate of return
focuses on accounting net operating income rather than cash flows (might look desirable one year but be undesirable the next) does not involve discounting cash flows (a dollar 10 years from now same as dollar today)
Least Cost Decisions
in decisions where revenues are not directly involved, managers should choose the alternative that has the least total cost from a present value perspective
NPV cannot directly compare projects unless
initial investments are equal
payback period formula
investment required / annual net cash inflow
payback period
length of time it takes for project to recover initial cost from net cash inflows it generates "time it takes for an investment to pay for itself" expressed in years
Evaluation of the Payback Method
not a true measure of profitability of an investment shorter payback period doesn't always mean one investment is more desirable than another
Internal Rate of Return (IRR)
rate of return of an investment project over its useful life discount rate that results in a NPV of zero
when NPV is negative
reject
if irr < required rate of return
reject the project
preference decisions
relate to selecting from among several acceptable alternatives also known as rationing or ranking decision
screening decisions
relate to whether a proposed project is accepted - whether it passes a preset hurdle
most projects have three types of cash outflows
require an immediate cash outflow in form of an initial investment in assets (salvage value) working capital periodic outlays for repairs and maintenance and additional costs
capital budgeting decisions fall in two broad categories
screening decisions preference decisions
when cash flows change year to year
simple payback cannot be used
cost of capital
the average rate of return that the company must pay to its long-term creditors and its shareholders for the use of their funds minimum required rate of return
total-cost approach
the inclusion of all cash flows associated with each alternative
the higher the IRR
the more desirable the project
the higher the Project Profitability Index
the more desirable the project