University:
California State University, Northridge
Course:
ACCT 220 | Introduction to Financial Accounting
Academic year:

2024
Views:

37

Pages:

43
Author:

acocolesm9s

Chapter 12 Capital Budgeting Decisions Part 1 12-2 Typical Capital Budgeting Decisions Plant expansion Equipment selection Lease or buy Equipment replacement Cost reduction 12-3 Typical Capital Budgeting Decisions Capital budgeting tends to fall into two broad categories . . . Screening decisions. Does a proposed project meet some present standard of acceptance? Preference decisions. Selecting from among several competing courses of action. 12-4 Time Value of Money A dollar today is worth more than a dollar a year from now. Therefore, investments that promise earlier returns are preferable to those that promise later returns. 12-5 Time Value of Money The capital budgeting techniques that best recognize the time value of money are those that involve discounted cash flows. 12-6 Learning Objective 1 Evaluate the acceptability of an investment project using the net present value method. 12-7 The Net Present Value Method To determine net present value we . . . Calculate the present value of cash inflows, Calculate the present value of cash outflows, The difference between the two streams of cash flows is called the net present value. 12-8 The Net Present Value Method General decision rule . . . If the Net Present Value is: Positive . . . Then the Project is . . . Acceptable because it promises a return greater than the required rate of return. Zero . . . Acceptable because it promises a return equal to the required rate of return. Negative . . . Not acceptable because it promises a return less than the required rate of return. 12-9 The Net Present Value Method Net present value analysis emphasizes cash flows and not accounting net income. The reason is that accounting net income is based on accruals that ignore the timing of cash flows into and out of an organization. 12-10 Typical Cash Outflows Repairs and maintenance Working capital Initial investment Incremental operating costs 12-11 Typical Cash Inflows Salvage value Release of working capital Reduction of costs Incremental revenues 12-12 Two Simplifying Assumptions Two simplifying assumptions are usually made in net present value analysis: All cash flows other than the initial investment occur at the end of periods. All cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate. 12-13 Choosing a Discount Rate • The company’s cost of capital is usually regarded as the minimum required rate of return. • The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds. 12-14 The Net Present Value Method Let’s look at how we use the net present value method to make business decisions. 12-15 The Net Present Value Method Lester Company has been offered a five year contract to provide component parts for a large manufacturer. Cost and revenue information Cost of special equipment $160,000 Working capital required 100,000 Relining equipment in 3 years 30,000 Salvage value of equipment in 5 years 5,000 Annual cash revenue and costs: Sales revenue from parts 750,000 Cost of parts sold 400,000 Salaries, shipping, etc. 270,000 12-16 The Net Present Value Method • At the end of five years, the working capital will be released and may be used elsewhere by Lester. • Lester Company uses a discount rate of 10%. Should the contract be accepted? 12-17 The Net Present Value Method Annual net cash inflows from operations Sales revenue Cost of parts sold Salaries, shipping, etc. Annual net cash inflows $ 750,000 (400,000) (270,000) $ 80,000 12-18 The Net Present Value Method Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Salvage value of equip. Release of working capital Net present value Years Now Now 1-5 3 5 5 Cash Flows $ (160,000) (100,000) 80,000 (30,000) 5,000 100,000 10% Factor 1.000 1.000 3.791 0.751 0.621 0.621 Present Value $ (160,000) (100,000) 303,280 (22,530) 3,105 62,100 $ 85,955 12-19 The Net Present Value Method Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Salvage value of equip. Release of working capital Net present value Years Now Now 1-5 3 5 5 Cash Flows $ (160,000) (100,000) 80,000 (30,000) 5,000 100,000 Present value of an annuity of $1 factor for 5 years at 10%. 10% Factor 1.000 1.000 3.791 0.751 0.621 0.621 Present Value $ (160,000) (100,000) 303,280 (22,530) 3,105 62,100 $ 85,955 12-20 The Net Present Value Method Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Salvage value of equip. Release of working capital Net present value Years Now Now 1-5 3 5 5 Cash Flows $ (160,000) (100,000) 80,000 (30,000) 5,000 100,000 Present value of $1 factor for 3 years at 10%. 10% Factor 1.000 1.000 3.791 0.751 0.621 0.621 Present Value $ (160,000) (100,000) 303,280 (22,530) 3,105 62,100 $ 85,955 12-21 The Net Present Value Method Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Salvage value of equip. Release of working capital Net present value Years Now Now 1-5 3 5 5 Cash Flows $ (160,000) (100,000) 80,000 (30,000) 5,000 100,000 Present value of $1 factor for 5 years at 10%. 10% Factor 1.000 1.000 3.791 0.751 0.621 0.621 Present Value $ (160,000) (100,000) 303,280 (22,530) 3,105 62,100 $ 85,955 12-22 The Net Present Value Method Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Salvage value of equip. Release of working capital Net present value Years Now Now 1-5 3 5 5 Cash Flows $ (160,000) (100,000) 80,000 (30,000) 5,000 100,000 10% Factor 1.000 1.000 3.791 0.751 0.621 0.621 Present Value $ (160,000) (100,000) 303,280 (22,530) 3,105 62,100 $ 85,955 Accept the contract because the project has a positive net present value. 12-23 Quick Check  Denny Associates has been offered a four-year contract to supply the computing requirements for a local bank. Cash flow information Cost of computer equipment $ 250,000 Working capital required 20,000 Upgrading of equipment in 2 years 90,000 Salvage value of equipment in 4 years 10,000 Annual net cash inflow 120,000  The working capital is released at the end of the contract.  Denny Associates requires a 14% return. 12-24 Quick Check  What is the net present value of the contract with the local bank? a. $150,000 b. $ 28,230 c. $ 92,340 d. $132,916 12-25 Quick Check  What is the net present value of the contract with the local bank? a. $150,000 b. $ 28,230 c. $ 92,340 d. $132,916 Investment in equipment Working capital needed Annual net cash inflows Upgrading of equipment Salvage value of equip. Working capital released Net present value Years Now Now 1-4 2 4 4 Cash Flows $ (250,000) (20,000) 120,000 (90,000) 10,000 20,000 14% Factor 1.000 1.000 2.914 0.769 0.592 0.592 Present Value $ (250,000) (20,000) 349,680 (69,210) 5,920 11,840 $ 28,230 12-26 Expanding the Net Present Value Method To compare competing investment projects, we can use the following net present value approaches: ▫ Total-cost ▫ Incremental cost 12-27 The Total-Cost Approach  White Co. has two alternatives: (1) remodel an old car wash or, (2) remove it and install a new one.  The company uses a discount rate of 10%. New Car Wash Annual revenues $ 90,000 Annual cash operating costs 30,000 Net annual cash inflows $ 60,000 Old Car Wash $ 70,000 25,000 $ 45,000 12-28 The Total-Cost Approach If White installs a new washer . . . Cost Productive life Salvage value Replace brushes at the end of 6 years Salvage of old equip. $300,000 10 years 7,000 50,000 40,000 Let’s look at the net present value of this alternative. 12-29 The Total-Cost Approach Install the New Washer Cash Year Flows Initial investment Now $ (300,000) Replace brushes 6 (50,000) Annual net cash inflows 1-10 60,000 Salvage of old equipment Now 40,000 Salvage of new equipment 10 7,000 Net present value 10% Factor 1.000 0.564 6.145 1.000 0.386 Present Value $ (300,000) (28,200) 368,700 40,000 2,702 $ 83,202 If we install the new washer, the investment will yield a positive net present value of $83,202. 12-30 The Total-Cost Approach If White remodels the existing washer . . . Remodel costs Replace brushes at the end of 6 years $175,000 80,000 Let’s look at the present value of this second alternative. 12-31 The Total-Cost Approach Remodel the Old Washer Cash 10% Year Flows Factor Initial investment Now $ (175,000) 1.000 Replace brushes 6 (80,000) 0.564 Annual net cash inflows 1-10 45,000 6.145 Net present value Present Value $ (175,000) (45,120) 276,525 $ 56,405 If we remodel the existing washer, we will produce a positive net present value of $56,405. 12-32 The Total-Cost Approach Both projects yield a positive net present value. Invest in new washer Remodel existing washer In favor of new washer Net Present Value $ 83,202 56,405 $ 26,797 However, investing in the new washer will produce a higher net present value than remodeling the old washer. 12-33 The Incremental-Cost Approach Under the incremental-cost approach, only those cash flows that differ between the two alternatives are considered. Let’s look at an analysis of the White Co. decision using the incrementalcost approach. 12-34 The Incremental-Cost Approach Incremental investment Incremental cost of brushes Increased net cash inflows Salvage of old equipment Salvage of new equipment Net present value Year Now 6 1-10 Now 10 Cash Flows $(125,000) $ 30,000 15,000 40,000 7,000 10% Factor 1.000 0.564 6.145 1.000 0.386 Present Value $(125,000) 16,920 92,175 40,000 2,702 $ 26,797 We get the same answer using either the total-cost or incremental-cost approach. 12-35 Quick Check  Consider the following alternative projects. Each project would last for five years. Project B Project A Initial investment $80,000 $60,000 Annual net cash inflows 20,000 16,000 Salvage value 10,000 8,000 The company uses a discount rate of 14% to evaluate projects. Which of the following statements is true? a. NPV of Project A > NPV of Project B by $5,230 b. NPV of Project B > NPV of Project A by $5,230 c. NPV of Project A > NPV of Project B by $2,000 d. NPV of Project B > NPV of Project A by $2,000 12-36 Quick Check  Consider the following alternative projects. Each project would last for five years. Project B Project A Initial investment $80,000 $60,000 Annual net cash inflows 20,000 16,000 Salvage value 10,000 8,000 The company uses a discount rate of 14% to evaluate projects. Which of the following statements is true? a. NPV of Project A > NPV of Project B by $5,230 b. NPV of Project B > NPV of Project A by $5,230 Cash 14% Present c. NPV of Project A > NPV of Project B by $2,000 Differences in cash flows Years Flows Factor Value d. NPVinofequipment Project B >Now NPV of $2,000 $ (20,000) Investment $ Project (20,000) A by1.000 Annual net cash inflows 1-5 Salvage value of equip. 5 Difference in net present value 4,000 2,000 3.433 0.519 $ 13,732 1,038 (5,230) 12-37 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. Let’s look at the Home Furniture Company. 12-38 Least Cost Decisions Home Furniture Company is trying to decide whether to overhaul an old delivery truck now or purchase a new one. The company uses a discount rate of 10%. 12-39 Least Cost Decisions Here is information about the trucks . . . Old Truck Overhaul cost now Annual operating costs Salvage value in 5 years Salvage value now $ 4,500 10,000 250 9,000 New Truck Purchase price Annual operating costs Salvage value in 5 years $ 21,000 6,000 3,000 12-40 Least Cost Decisions Buy the New Truck Cash Year Flows Purchase price Now $ (21,000) Annual operating costs 1-5 (6,000) Salvage value of old truck Now 9,000 Salvage value of new truck 5 3,000 Net present value Keep the Old Truck Cash Year Flows Overhaul cost Now $ (4,500) Annual operating costs 1-5 (10,000) Salvage value of old truck 5 250 Net present value 10% Factor 1.000 3.791 1.000 0.621 10% Factor 1.000 3.791 0.621 Present Value $ (21,000) (22,746) 9,000 1,863 $ (32,883) Present Value $ (4,500) (37,910) 155 $ (42,255) 12-41 Least Cost Decisions Home Furniture should purchase the new truck. Net present value of costs associated with purchase of new truck Net present value of costs associated with remodeling existing truck Net present value in favor of purchasing the new truck $(32,883) (42,255) $ 9,372 12-42 Quick Check  Bay Architects is considering a drafting machine that would cost $100,000, last four years, and provide annual cash savings of $10,000 and considerable intangible benefits each year. How large (in cash terms) would the intangible benefits have to be per year to justify investing in the machine if the discount rate is 14%? a. $15,000 b. $90,000 c. $24,317 d. $60,000 12-43 Cash Flows $ (100,000) 10,000 ? 14% Factor 1.000 2.914 2.914 24,317 2.914 Years Investment in machine Now Annual net cash inflows 1-4 Annual intangible benefits 1-4 Bay Architects is considering Net present value Quick Check  Present Value $ (100,000) 29,140 ? machine $ (70,860) a drafting that would cost $100,000, last four years, and provide annual cash savings of $10,000 and $70,860/2.914 = $24,317 considerable intangible benefits each year. How Cash 14% Present large (in cash terms) would the intangible Years Flows Factor Value benefits have to be per year to justify investing $ (100,000) 1.000 $ (100,000) Investment in machine Now innet thecash machine rate is2.914 14%? 29,140 Annual inflows if the 1-4discount 10,000 Annual intangible benefits a. $15,000 Net present value b. $90,000 c. $24,317 d. $60,000 1-4 $ 70,860 (0)