Chapter 11

Working Capital

Current assets ( Acc. Rec. & Inv.) less current liabilities Current assets - Current Liabilites

+ Net Present Value

Indicates that the project's return exceeds the discount rate.

-- Net Present Value

Indicates that the project's return less that the discount rate

Project Profitability Index =

Net Present Value of the project / Investment Required - The Higher the project profitability index, the more desirable the project.

Preference Decisions

Relate to selecting from among several acceptable alternatives. Ex) Company is replacing a machine, the one they choose to buy to replace the one they have is the preference decision.

Screening Decisions

Relate to whether a proposed project is acceptable - whether it passes a preset hurdle. - hurdle is a like a requirement ex) company doesn't accept project unless it receives a return of atleast 20%

Net Present Value (NPV)

The difference between cash inflows and outflows. Determines if the project is an acceptable investment.

Capital budgeting

Used to describe how managers plan significant investments in projects that have long-term implications such as the purchase of new equipment or the introduction of new products.

Cost of Capital

- Minimum required rate of return - Is the average rate of return that the company must pay to its long- term creditors and its shareholders for the use of their funds.

Common Capital Budgeting Decisions

1) Cost Reduction Decisions 2) Expansion Decisions 3) Equipment Selection Decisions (Purchase of machines) 4) Lease or Buy Decisions 5) Equipment replacement decisions

Cash Outflows (3)

1) Initial Investment in assets, equipment and installations costs 2) Expending of Working Capital 3) Periodic outlays for repairs and maintenance & additional operating cost

3 Capital Budgeting Decisions

1) Payback Method: Focus on analyzing cash flows associated with capital investment projects. 2) Net Present Value Method: Focus on analyzing cash flows associated with capital investment projects. 3) Simple Rate Return Method: Focuses on incremental net operating income.

Cash Inflows (3)

1) Projects tend to increase Revenue or reduce costs (reduction in cost is equivalent to an increase in revenue) 2) Selling equipment for its salvage value 3) Any free working capital that was previously tied up in another project.

Formula to Compute *Payback Period*

= Investment Required / Annual Net Cash Inflow

Discount Rate

All cash flows generated by an investment project are immediately reinvested at a rate of return equal to the rate used to discount the future cash flows.

Simple Rate of Return (Accounting rate of return) =

Annual Incremental net Operating Income / Initial Investment * The numerator value should be reduced by the depreciation charges that result from making the investment * The Denominator Value Should be reduced by any salvage value realized fro the sale of old equipment.

Capital Budgeting Decision

Any decision that involves a cash outlay now in order to obtain a future return.

Payback Method: *Payback Period*

Is the length of time that it takes for a project to recover its initial cost from the net cash inflows that it generates. " Time it takes for an investment to pay for itself"

Internal rate of Return

Is the rate of return promised by an investment over its useful life.

Net Present Value Method

It compares the present value of a project's cash inflows to the present value o its cash outflows. Assumptions: Cash flows occur at end of period, Discount rate*.

Depreciation

Not a cash outlay

Time Value of Money

Recognizes that a dollar today is worth more than a dollar a year from now if for no other reason than you could put the dollar in a bank today and have more than a dollar a year from now.