Capital Investment Decisions
Outcome is uncertain.
Investment involves a long-term commitment.
Capital budgeting: Analyzing alternative long- term investments and deciding which assets to acquire or sell.
Decision may be difficult or impossible to reverse.
Large amounts of money are usually involved.

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Capital BudgetingChapter25Capital budgeting:Analyzing alternative long-term investments and deciding which assets to acquire or sell. Outcomeis uncertain. Large amounts ofmoney are usuallyinvolved. Investment involves along-term commitment. Decision may bedifficult or impossibleto reverse.Capital Investment Decisions???LimitedInvestmentFundsPlantExpansionNewEquipmentOfficeRenovationI will choose theproject with the mostprofitable return onavailable funds.Capital Investment DecisionsInitialinvestmentRepairs andmaintenanceIncrementaloperatingcostsCapital Investment Decisions: Typical Cash OutflowsCostsavingsSalvagevalueIncrementalrevenuesCapital Investment Decisions: Typical Cash InflowsEmployee moraleEnvironmental concernsCorporate imageEmployee working conditionsProduct qualityCapital Investment Decisions:Nonfinancial ConsiderationsLet’s look atmethods used to make capitalinvestmentdecisions.Evaluating Capital Investment Proposals: An IllustrationStars’ Stadium is considering purchasingvending machines with a 5-year life.($75,000 - $5,000) ÷ 5 yearsEvaluating Capital Investment Proposals: An IllustrationMost capital budgeting techniques use annual net cash flow. Depreciation is not a cash outflow.Evaluating Capital Investment Proposals: An IllustrationThe payback period of an investmentis the time expected to recoverthe initial investment amount.Paybackperiod= Cost of Investment Annual Net Cash FlowManagers prefer investing in projects with shorter payback periods.Payback PeriodThe payback period of an investmentis the time expected to recoverthe initial investment amount.Paybackperiod= Cost of Investment Annual Net Cash FlowPaybackperiod=$75,000$24,000= 3.125 yearsPayback PeriodIgnores the time valueof money.Ignores cashflows after the paybackperiod.Payback Period Consider two projects, each with a five-year life and each costing $6,000.Would you invest in Project One just because it has a shorter payback period?Payback PeriodROI =Average estimated net income Average investment ROI focuses on annual incomeinstead of cash flows.Original cost + Salvage value2Return on Average Investment (ROI)ROI = = 25%$10,000$40,000 ROI focuses on annual incomeinstead of cash flows.$75,000 + $5,0002Return on Average Investment (ROI)Income may vary from year to year.Time value ofmoney is ignored. So why would I ever want to use this method anyway?Return on Average Investment (ROI) Now let’s look at a capital budgeting model that considers the time value of cash flows. Discounting Future Cash FlowsA comparison of the present value of cash inflows with the present value of cash outflowsNet Present Value (NPV)Chose a discount rate – the minimum required rate of return.Calculate the presentvalue of cash inflows.Calculate the presentvalue of cash outflows.NPV = – Net Present Value (NPV)General decision rule . . .Net Present Value (NPV) Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a. $ 4,300 b. $12,700 c. $11,000 d. $17,000Net Present Value (NPV)Question Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a. $ 4,300 b. $12,700 c. $11,000 d. $17,000Using the present value of an annuity (table 2)PV of inflows = $20,000 × 5.650 = $113,000NPV = $113,000 - $96,000 = $17,000Net Present Value (NPV)Question Calculate the NPV if Savak Company’s required return is 15 percent instead of 12 percent. Note that the NPV is smallerusing the larger interest rate.Using the present value of an annuity (table 2)PV of inflows = $20,000 × 5.019 = $100,380NPV = $100,380 - $96,000 = $4,380Net Present Value (NPV)QuestionNow that you have mastered the basic concept of net present value, it’s time for a more sophisticated checkup!Let’s return to Stars’ Stadium.Net Present Value (NPV)Stars’ Stadium is considering purchasingvending machines with a 5-year life.($75,000 - $5,000) ÷ 5 yearsEvaluating Capital Investment Proposals: An IllustrationMost capital budgeting techniques use annual net cash flow. Depreciation is not a cash outflow.Evaluating Capital Investment Proposals: An IllustrationStar’s Stadium Net Present Value AnalysisStars uses a 15% discount rate.Net Present Value (NPV)Present value of an annuity of $1 factor for 5 years at 15%.Star’s Stadium Net Present Value Analysis $24,000 × 3.352 = $80,448 Net Present Value (NPV)Present value of $1 factor for 5 years at 15%.Star’s Stadium Net Present Value AnalysisNet Present Value (NPV)Since the NPV is positive, we know the rate of return is greater than the 15 percent discount rate.Star’s Stadium Net Present Value AnalysisNet Present Value (NPV)Let’s use NPVconcepts withan asset replacement decision.Net Present Value (NPV)Replacing Assets The Maine LobStars are considering replacing an old bus with a new bus, each with a 5-year life and zero salvage. Evaluating Capital Investment Proposals: An IllustrationDepreciation is not a cash outflow.Tax savings from loss ondisposal of old bus:$15,000 × 40% = $6,000Evaluating Capital Investment Proposals: An IllustrationLobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.Net Present Value (NPV)LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.Net Present Value (NPV)LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.Net Present Value (NPV)Since the NPV is negative, we know the rate of return is less than the 15 percent discount rate.LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.Net Present Value (NPV)Capital budgeting involves many estimates.Estimates may be pessimistic or optimistic.Uncertainty about the future may impact estimates.Behavioral Issuesin Capital Budgeting Conflicts may exist between short-run performance measures and long-run capital budgeting criteria.Behavioral Issuesin Capital Budgeting A follow-up after the project has been approved to see whether or not expected results are actually realized.Capital Budget AuditI told you that’s the end. You can’t work any more accounting problems in my class!THE END