IPE 4439

Principles of Economics
and Cost Accounting
Course Teacher: Sharmin Akter Urmee
Lecturer, Department of MPE
Room No: 111, Old Academic Building
 CHAPTER 13

CAPITAL BUDGETING
DECISIONS
 Capital budgeting
The process of planning significant outlays on
projects that have long-term implications,
such as purchasing new equipment or
introducing a new product.
a process that bussinesses use to evaluate potential major projects and investments

2 broad catagories- screening decision, preferance decision

 Typical Capital Budgeting Decisions
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 production?
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?
 Typical Capital Budgeting Decisions
Capital budgeting decisions tend to fall into two broad categories—

Screening decisions are those relating to whether a proposed

project is acceptable—whether it passes a pre-established profitability
hurdle. For example, a firm may have a policy of accepting projects only
if they promise a return of at least 10% on the investment. The
required rate of return is the minimum rate of return a project must
yield to be acceptable.
Preference decisions, by contrast, relate to selecting from among
several
acceptable alternatives. To illustrate, a firm may be considering several
different machines to replace an existing machine on the assembly line.
The choice of which machine to purchase is a preference decision.
 The Time Value of Money
A dollar today is worth more than a dollar a year
from now.

The same concept applies in choosing between investment

alternatives. Projects that promise returns earlier in time are preferable
to those that promise later returns.
 The concept of present value
First, a dollar received today is more valuable than a dollar
received a year from now. The dollar received today can be
invested immediately, and by the end of the year it will have
earned some return, making the total amount in hand at the
end of the year greater than the initial investment. The person
receiving the dollar a year from now will simply have a dollar
in hand at that time.
Second, the future involves uncertainty. The longer people
have to wait to receive a dollar, the more uncertain it becomes
that they will actually get the dollar. As time passes,
conditions change and future payment of the dollar might
become impossible.
The concept of present value
The concept of present value
Present Value and Future Value
 Present Value and Future Value
The process of finding the present value of a future
cash flow, which we have just examined, is called
discounting. We have discounted the $200 to its
present value of $181.41. The 5% interest figure that
we have used to find this present value is called the
discount rate.
 Present Value and Future Value
A purchaser promises to pay $100,000 two years
from now for a lot of land. This amount includes
interest at an annual rate of 5%. What is the
selling price of the land today? Round to the
nearest hundred dollars.

90703
 Present Value of a Series of Cash Flows (Annuity)
It is the total amount that allows the withdrawal of a series of equal
amounts at regular intervals if the balance remaining after each
withdrawal earns compound interest.
Present Value of a Series of Cash Flows (Annuity)
Present Value of a Series of Cash Flows (Annuity)

What is the present value of receiving a series of six

semi-annual payments of $2,000 at 4% interest
compounded annually? Assume that it is now January
1, 2015, and the first payment is to be made on June
30, 2015.

11202
Present Value of a Series of Cash Flows (Annuity)
Present Value of a Series of Cash Flows (Annuity)

How much money would a company be willing to

invest in a project that would return $3,000 every
three months for three years and, in addition, a lump
sum of $20,000 at the end of the third year? The
receipts begin three months from now. Interest is 8%
per annum.
Present Value of a Series of Cash Flows (Annuity)
Present Value of an Annuity Due
 Present Value of an Annuity Due
On February 1, 2015, Davis Company signed an 18-month lease with Kelly Leasing
Company. The lease payments begin immediately. Calculate the present value of the
lease, assuming that $2,000 is paid each quarter and that the annual interest rate is
8%.
3 month
 Deferred Annuities
A deferred annuity is one in which the first payment or receipt does not begin until
more than one interest period has expired. This is common for capital expenditure
decisions that may take several periods to become operational.

Example 6
What is the present value on January 1, 2015, of a series of five
annual receipts of $1,000, the first of which is expected to be
received on January 1, 2018? The interest rate is 5% per
annum.
Deferred Annuities
Future Value of an Annuity
Future Value of an Annuity
 Discounted Cash Flows—the Net Present Value
Method

Two approaches to making capital budgeting decisions use

discounted cash flows. One is the net present value method,
and the other is the internal rate of return method.
 Net Present Value

The difference between the present value of the

cash inflows and the present value of the cash
outflows associated with an investment project.
 Net Present Value

Example 1
Management at Harper Company is thinking about buying a
machine to perform certain operations that are now
performed manually. The machine will cost $50,000, and it will
last for five years. At the end of the five-year period, the
machine will have a zero scrap value. Use of the machine will
reduce labour costs by $18,000 per year. Harper Company
requires a minimum return of 20% before taxes on all
investment projects. Should the machine be purchased?
Net Present Value
 Emphasis on Cash Flows
Accounting income is based on accruals that ignore the timing
of cash flows. From a capital budgeting standpoint, the timing of
cash flows is critical, since a dollar received today is more
valuable than a dollar received in the future. Therefore, instead
of determining accounting income when making capital
budgeting decisions, the manager must concentrate on
identifying the specific cash flows associated with an investment
project.
 Typical Cash Outflows
1. First, they often require an immediate cash outflow in the form of an initial
investment in equipment or other assets.
2. Second, some projects require that a company expand its working capital.
Working capital is current assets (cash, accounts receivable, and inventory) less
current liabilities.
3. Third, many projects require periodic outlays for repairs and maintenance and for
additional operating costs.

Cash outflows:
• Initial investment (including installation costs).
• Increased working capital needs.
• Repairs and maintenance.
• Incremental operating costs.
 Typical Cash Inflows
1. First, a project will normally increase revenues or reduce costs. In either case the
amount involved should be treated as a cash inflow for capital budgeting
purposes.
2. Second, cash inflows are also frequently realized from selling equipment for its
salvage value when a project is terminated
3. Third, any working capital that was tied up in the project can be released for use
elsewhere at the end of the project and should be treated as a cash inflow.

Cash inflows:
• Incremental revenues.
• Reduction in costs.
• Salvage value.
• Release of working capital
 Recovery of the Original Investment

When computing the present value of a project,

depreciation is not deducted for two reasons.
• First, depreciation is not a current cash outflow.
• A second reason for not deducting depreciation
is that discounted cash flow methods
automatically provide for return of the original
investment, thereby making a deduction for
depreciation unnecessary
 Recovery of the Original Investment
Example 2
Carver Dental Clinic is considering purchasing an attachment for
its X-ray machine that will cost $3,170. The attachment will be
usable for four years, after which time it will have no salvage
value. It will increase net cash inflows by $1,000 per year in the
X-ray Department. The clinic’s board of directors has decided
that no investments are to be made unless these investments
have an annual return of at least 10
Recovery of the Original Investment
 Choosing a Discount Rate

Weighted-average cost of capital (WACC)

The average rate of return companies must pay to long
term creditors and shareholders for the use of their
funds.

The WACC is known by various names. It is sometimes

called the hurdle rate, the cut-off rate, or the required
rate of return.
 An Extended Example of the Net Present Value
Method

Example 3
Under a special licensing arrangement, Swinyard Company has an
opportunity to market a new product in western Canada for a five-
year period. The product would be purchased from the manufacturer,
with Swinyard Company responsible for all costs of promotion and
distribution.
The licensing arrangement could be renewed at the end of the five-
year period at the option of the manufacturer. After careful study,
Swinyard Company has estimated that the following costs and
revenues would be associated with the new product:
 An Extended Example of the Net Present Value
Method
increase in
fixing cost cash outflow

At the end of the five-year period, the working capital would be released for investment
elsewhere if the manufacturer decided not to renew the licensing arrangement.
Swinyard Company’s discount rate and cost of capital are both 14%. Would you
recommend that the new product be introduced?
An Extended Example of the Net Present Value
Method
scrap of old=inflow of new
The Total-Cost Approach
Example 4
Harris Ferry Company provides a ferry service across Harris Harbour. One of its ferryboats
is in poor condition. This ferry can be renovated at an immediate cost of $200,000.
Further repairs and an overhaul of the motor will be needed 5 years from now at a cost
of $80,000. In all, the ferry will be usable for 10 years if this work is done. At the end of
10 years, the ferry will have to be scrapped at a salvage value of approximately $60,000.
The scrap value of the ferry right now is $70,000. It will cost $300,000 each year to
operate the ferry, and revenues will total $400,000 annually.
As an alternative, Harris Ferry Company can purchase a new ferryboat at a cost of
$360,000. The new ferry will have a life of 10 years, but it will require some repairs at the
end of 5 years. It is estimated that these repairs will amount to $30,000. At the end of 10
years, it is estimated that the ferry will have a scrap value of $60,000. It will cost
$210,000 each year to operate the ferry, and revenues will total $400,000 annually.
Harris Ferry Company requires a return of at least 14% before taxes on all investment
projects. Should the company purchase the new ferry or renovate the old ferry?
The Total-Cost Approach
The Incremental-Cost Approach
 Least-Cost Decisions
Example 5
Val-Tek Company is considering replacing an old threading machine. A new
threading machine is available that could substantially reduce annual operating
costs. Selected data relating to the old and new machines are presented below:
Least-Cost Decisions
Least-Cost Decisions
 DISCOUNTED CASH FLOWS—THE INTERNAL RATE OF RETURN
METHOD

The internal rate of return (IRR) is the return promised by an

investment project over its useful life. The IRR is the discount
rate that equates the present value of a project’s cash outflows
with the present value of its cash inflows. In other words, the
IRR is the discount rate that results in a net present value of
zero.
 DISCOUNTED CASH FLOWS—THE INTERNAL RATE OF RETURN
METHOD

Example 6
Glendale School District is considering purchasing a large
tractor-pulled lawn mower. At present, the lawn is mowed
using a small hand-pushed gas mower. The large, tractor-pulled
mower will cost $16,950 and will have a useful life of 10 years.
It will have only a negligible scrap value, which can be ignored.
The tractor-pulled mower would do the job much more quickly
than the old mower and would result in a labour savings of
$3,000 per year.
The Internal Rate of Return Method Illustrated
The Weighted-Average Cost of Capital as a
Screening Tool
 An Example of Uncertain Cash Flows
As an example of difficult to estimate future cash flows,
consider the case of investments in automated equipment. The
up-front costs of automated equipment and the tangible
benefits, such as reductions in operating costs and waste, tend
to be relatively easy to estimate. However, the intangible
benefits, such as greater reliability, greater speed, and higher
quality, are more difficult to quantify in terms of future cash
flows. These intangible benefits certainly affect future cash
flows—particularly in terms of increased sales and perhaps
higher selling prices—but the cash flow effects are difficult to
estimate. What can be done?
 The Ranking of Investment Projects

To compare the two projects on a valid basis, the present value of the cash inflows
should be divided by the investment required. The result is called the project
profitability index. The formula for the project profitability index is
 The Ranking of Investment Projects

When using the project profitability index to rank competing investment projects,
the preference rule is as follows: the higher the project profitability index, the more
desirable the project. Applying this rule to the two investments above, Investment
B should be chosen over Investment A.
 Comparing the Preference Rules

Example 7
Parker Company is considering two investment
proposals, only one of which can be accepted. Project A
requires an investment of $5,000 and will provide a
single cash inflow of $6,000 at the end of the first year.
Therefore, it promises an IRR of 20%. Project B also
requires an investment of $5,000. It will provide cash
inflows of $1,360 each year for six years. Its IRR is 16%.
Which project should be accepted?
Comparing the Preference Rules
 The Payback Method

The 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.
 The Payback Method
Example 8
York Company needs a new milling machine. The company is
considering two machines: Machine A and Machine B. Machine A costs
$15,000 and will reduce operating costs by $5,000 per year. Machine B
costs only $12,000 but will also reduce operating costs by $5,000 per
year.
 An Extended Example of Payback

Example 9
Goodtime Fun Centres operates amusement parks. Some
of the vending machines in one of its parks provide very
little revenue, so the company is considering removing the
machines and installing equipment to dispense soft ice
cream. The equipment would cost $80,000 and have an
eight-year useful life with no salvage value. Incremental
annual revenues and costs associated with the sale of ice
cream are as follows:
An Extended Example of Payback
An Extended Example of Payback
Payback and Uneven Cash Flows
 The Simple Rate of Return Method
Simple rate of return
The rate of return computed by dividing a project’s annual operating
income by the initial investment required.
The Simple Rate of Return Method
 The Simple Rate of Return Method

Example 10
Brigham Tea Company is a processor of a low-acid tea. The
company is contemplating purchasing equipment for an
additional processing line. The additional processing line
would increase revenues by $90,000 per year. Incremental
cash operating expenses would be $40,000 per year. The
equipment would cost $180,000 and have a nine-year life.
No salvage value is projected
The Simple Rate of Return Method