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Chapter 21 1 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Describe the importance of capital investments and the capital budgeting process Use the payback period and rate of return methods to make capital investment decisions Use the time value of money to compute the present and future values of single lump sums and annuities Use discounted cash flow models to make capital investment decisions 2 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 1 Describe the importance of capital investments and the capital budgeting process 3 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Last chapter looked at recurring parallel options Took place in the same time sequence Revenues and expenses primarily This chapter we remove that timing restriction Any time you want Revenues, expenses, and investments How do we compare return and investment if they come in different amounts at different times? 4 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Should we make the capital investment? Should we open another store or open an online store? Should we install solar panels? 5 Should we start this new business? Should we buy new, or rebuild? Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Simple techniques The payback method (Simple) rate of return (ROR) Techniques using time value of money Present & future value of a single amount (lump sum) Present & future value of a payment stream (annuity) Net present value (NPV) Profitability index Internal rate of return (IRR) What we won’t look at today Sensitivity analysis Monte Carlo analysis Other advanced computer models Our simple and TVM techniques cover virtually all of the analysis needs most of us are likely to ever need. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 2 Use the payback and rate of return methods to make capital investment decisions 9 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Measures how quickly managers expect to recover their investment dollars The shorter the payback period, the more attractive the investment Used to screen capital investment choices May be the only tool in simple situations 10 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. If the project provides equal annual returns, then use this formula: 11 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Unequal annual net cash inflows Total net cash inflows until the amount invested is recovered 12 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Consider the following two investment options for the My Coffee: Sell Caffe Rent Caffe Machines Machines Initial investment $100,000 $100,000 Year 1 net cash inflows $50,000 $30,000 Year 2 net cash inflows $50,000 $30,000 Year 3 net cash inflows $50,000 $30,000 Year 4 net cash inflows $50,000 $30,000 Years 5-10 net cash inflows $0 $30,000 Based on the payback period. Which project would you prefer and why? Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. So much better than nothing Emphasis on payback, not additional profits Easy story telling, good for sales Ignores cash flows after the payback period An experienced user can do well with it Requires human thought “seat of the pants” additional analysis 15 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. ROR measures the average accounting rate of return over the asset’s entire life Focuses on the operating income, from the financials Maximize reported profitability, not necessarily cash flows Formula Average annual operating income The asset’s total operating income over the course of its operating life divided by its lifespan Average amount invested Net book value at the beginning of the asset’s useful life plus the net book value at the end of the asset’s useful life divided by 2 16 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Preston, Co. is considering buying a manufacturing plant for $1,100,000. They expect the plan to generate average annual cash inflows of $297,000 for 6 years. They expect to salvage the obsolete factory for $550,000 after 6 years. What is the rate of return of this project? 17 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 18 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 3 Use the time value of money to compute the present and future values of single lump sums and annuities 25 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Invested money earns income over time Timing of capital investments’ net cash inflows is important Two methods of capital investment using TVM The net present value (NPV) Internal rate of return (IRR) 26 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Let’s take a look at what those fancy tables do on the board! Watch closely as I turn $1 into $2! i=15%, N=5 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Simple interest Interest calculated only on the principal amount Compound interest Interest is calculated on the principal and on all previously earned interest Assumes that all interest earned will remain invested and earn additional interest at the same interest rate Capital investments yield compound interest Assume compounding interest for rest of this chapter 29 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The value of an investment at different points in time 30 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Simplify present and future value math Programmed into business calculators and spreadsheet programs See Appendix B for present and future factor tables: Let’s play with the future value table first. 31 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Lump sum Multiply amount by the factor number found in table Table based on interest rate and number of periods $10,000 invested for 5 periods at 6% $10,000 X 1.3382 = $13,382 Differences due to table decimal places 32 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. If you invested $1,000 today into a 6% fixed rate security, how much would it be worth in 50 years? Draw a time line indicating knowns and unknowns Identify table needed and go to it Look up the factor for the rate and time indicated Set up the formula and calculate Ask yourself if your answer makes sense 33 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Lump sum Multiply amount by the factor found in table Table based on interest rate and number of periods $13,383 to be received in 5 periods at 6% $13,382 X 0.7473 = $10,000 Differences due to table decimal places 34 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. How much would you have to invest today so that you could buy a $10,000 car for cash 5 years from today? We earn 3% on our money. Draw a time line indicating knowns and unknowns Identify table needed and go to it Look up the factor for the rate and time indicated Set up the formula and calculate Ask yourself if your answer makes sense 35 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Annuity: A cash flow that occurs in identical amounts at repeating intervals. You could take each and every year and calculate present/future values for each year….. OR, you could recognize the annuity and take just one calculation using the annuity table. Present Value $100 $100 $100 $100 Future $100 Value $100 ? ? 1 2 3 4 5 6 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. If we Invest $2,000 at 6%, at the end of each year for 5 years, how much do we have at the end? $2,000 X 5.6371 11,274.20 37 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. How much do we need to squirrel away today , so we can pull $2,000 out to spend at the end of every year for 5 years? Assume 6% interest. $8,424 $2,000 X 4.212 $8.424 38 Draw a time line indicating knowns and unknowns Identify table needed and go to it Look up the factor for the rate and time indicated Set up the formula and calculate Ask yourself if your answer makes sense Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. How much do you need? Annual expenditure expectations Solve for balance at the beginning of retirement How are you going to get it there? Lump sum deposit now Annual retirement contributions 39 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 4 Use discounted cash flow models to make capital investment decisions 40 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Payback and ROR do not recognize time value of money Net present value (NPV) and internal rate of return (IRR) do recognize time value of money Both compare amount of investment with its expected net cash inflows Cash outflow for investment usually occurs now Cash inflows usually occur in the future Companies use present value to make the investment comparison, not future value 41 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. NPV—the net difference between the present value of the investment’s net cash inflows and the investment’s cost (cash outflows) Discount rate—the interest rate that discounts or reduces future amounts to their lesser value in the present (today). Discount rate uses the firms desired rate of return Based on cost of capital If present value of the investment’s net cash inflows exceeds the initial cost of the investment, then it is a good investment 42 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Buy a new welder for cash. Cost $10,000 Lease the welder for $1,500/year for 10 years Assume: Discount rate 10% Zero salvage Average welder life in our hands is 10 years. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Investment required: $250,000 Annual earnings of $50,000 You will own it for 20 years. You will then sell it for $1,000,000. Your cost of capital is 10% What is the NET present value of this project? Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Harley Davidson Purchase cost $25,000 Salvage value $17,000 Annual costs $500 more than Kawasaki. Kawasaki Purchase cost $12,000 Salvage value $1,000 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Assume you win the lottery Option #1: $1,000,000 now Option #2: $150,000 the end of each year for next ten years Option #3: $2,000,000 ten years from now Which option is the best? Use PV factors for single sum and annuities to find out Option #1 is $1,000,000 in your hand today Option #2 is an annuity, 10 payments Using PV annuity tables, assuming 8% $150,000 x 6.7101 = $1,006,515 10 payments yield a present value of $1,006,515 and more than $1,000,000 46 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Assume you win the lottery Option #1: $1,000,000 now Option #2: $150,000 the end of each year for next ten years Option #3: $2,000,000 ten years from now Use PV factors for single sum to find out what option #3 is worth today Option #3 $2,000,000 x .4632 = $ 926,400 Option #1 = $1,000,000 Option #2 = $1,006,515 Option #3 = $ 926,400 Option #2 is the highest of the three 47 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Computes the number of dollars returned for every dollar invested Profitability index = 55 Present value of net cash inflows Investment Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Another discounted cash flow model for capital budgeting Rate of return a company can expect to earn by investing in the project The interest rate that will cause the present value to equal zero Present value of the investment’s net cash inflows – Investment’s cost (Present value of cash outflows) $0 58 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The internal rate of return measures the real rate of return provided by the project. Higher return better Lower return worse 59 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Year(s) Flow Type Present Cash Discount Value of Flow Rate & Cash Amount Factor Flow 12% 0 Lump -18600 1 -18600 6 Annuity 5000 4.111 20555 6 Lump 9125 0.507 4626 Net Present Value 6581 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. NPV is easier to use. NPV Provides $$ results to compare: $$ pay the bills! IRR provides a comparable % return vs. strict dollar value. This can facilitate better evaluation of different scale/size/cost projects. Too much voodoo math? Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Capital budgeting is planning to invest in long-term assets in a way that returns the greatest profitability to the company. Capital rationing occurs when the company has limited assets available to invest in longterm assets. The four most popular capital budgeting techniques used are payback period, rate of return (ROR), net present value (NPV), and internal rate of return (IRR). 72 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The payback period focuses on the time it takes for the company to recoup its cash investment, but ignores all cash flows occurring after the payback period. Because it ignores any additional cash flows (including any residual value), the method does not consider the profitability of the project. The ROR, however, measures the profitability of the asset over its entire life using accrual accounting figures. It is the only method that uses accrual accounting rather than net cash inflows in its computations. The payback period and ROR methods are simple and quick to compute, so managers often use them to screen out undesirable investments. However, both methods ignore the time value of money. 73 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Invested money earns income over time. This is called the time value of money, and it explains why we would prefer to receive cash sooner rather than later. The time value of money means that the timing of capital investments’ net cash inflows is important. The cash inflows and outflows are either single amounts or annuities. An annuity is equal cash flows over equal time periods at the same interest rate. Time value of money tables in Appendix B help us to adjust the cash flows to the same time period (i.e., today or the present value, or a future date or the future value). 74 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The NPV is the net difference between the present value of the investment’s net cash inflows and the investment’s cost (cash outflows), discounted at the company’s required rate of return (hurdle) rate. The investment must meet or exceed the hurdle rate to be acceptable. The IRR is the interest rate that makes the cost of the investment equal to the present value of the investment’s net cash inflows. Capital investment (budgeting) methods that consider the time value of money (like NPV and IRR) are best for decision making. 75 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 76 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Copyright All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. 77 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.