Capital Budgeting - Greetings from Eng. Nkumbwa...nkumbwa.weebly.com/.../lecturer_6.0.1_ca… ·...
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Capital Budgeting in EngineeringCapital Budgeting in Engineering
Sir. Eng. R. L. Nkumbwa™Sir. Eng. R. L. Nkumbwa™www.nkumbwa.weebly.comwww.nkumbwa.weebly.com
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Capital BudgetingCapital Budgeting
How managers plan significant outlays on projects that have How managers plan significant outlays on projects that have long-term implications such as the purchase of new long-term implications such as the purchase of new
equipment and introduction of new products.equipment and introduction of new products.
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Typical Capital Budgeting DecisionsTypical Capital Budgeting Decisions
Cost reduction
Plant expansion
Equipment selection
Lease or buy
Equipment replacement
Lease or buy Cost reduction
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Typical Capital Budgeting DecisionsTypical Capital Budgeting Decisions
Capital budgeting tends to fall into two broad categories . . .Capital budgeting tends to fall into two broad categories . . . Screening decisionsScreening decisions. Does a proposed project meet . Does a proposed project meet
some present standard of acceptance?some present standard of acceptance? Preference decisionsPreference decisions. Selecting from among several . Selecting from among several
competing courses of action. competing courses of action.
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Time Value of MoneyTime Value of Money
Business investments extend over long periods of time, Business investments extend over long periods of time, so we must recognize the time value of money.so we must recognize the time value of money.
Investments that promise returns earlier in time are Investments that promise returns earlier in time are preferable to those that promise returns later in time.preferable to those that promise returns later in time.
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Time Value of MoneyTime Value of Money
A bond will pay $100 in two years. What is the present value of A bond will pay $100 in two years. What is the present value of the $100 if an investor can earn a return of 12% on the the $100 if an investor can earn a return of 12% on the
investment?investment?
We can determine the present value We can determine the present value factor using the formula or using factor using the formula or using
present value tables.present value tables.
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Time Value of MoneyTime Value of Money
RatePeriods 10% 12% 14%
1 0.909 0.893 0.877 2 0.826 0.797 0.769 3 0.751 0.712 0.675 4 0.683 0.636 0.592 5 0.621 0.567 0.519
Excerpt from Excerpt from Present Value of $1Present Value of $1 Table in the Appendix to Table in the Appendix to Chapter 14Chapter 14
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RatePeriods 10% 12% 14%
1 0.909 0.893 0.877 2 0.826 0.797 0.769 3 0.751 0.712 0.675 4 0.683 0.636 0.592 5 0.621 0.567 0.519
Time Value of MoneyTime Value of Money
Present value factor of $1 for 2 periods at 12%.Present value factor of $1 for 2 periods at 12%.
$100 $100 ×× 0.797 = $79.70 present value 0.797 = $79.70 present value
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Time Value of MoneyTime Value of Money
11 22 33 44 55 66
$100$100 $100$100 $100$100 $100$100 $100$100 $100$100
An investment that involves a series of identical cash flows at the An investment that involves a series of identical cash flows at the end of each year is called an end of each year is called an annuityannuity..
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Time Value of MoneyTime Value of Money
Lacey Company purchased a tract of land on which a Lacey Company purchased a tract of land on which a $60,000 payment will be due each year for the next five $60,000 payment will be due each year for the next five years. What is the present value of this stream of cash years. What is the present value of this stream of cash
payments when the discount rate is 12%?payments when the discount rate is 12%?
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Time Value of MoneyTime Value of Money
We could solve the problem like this . . .We could solve the problem like this . . .
Look in Appendix C of this Chapter for thePresent Value of an Annuity of $1 Table
Periods 10% 12% 14%1 0.909 0.893 0.877 2 1.736 1.690 1.647 3 2.487 2.402 2.322 4 3.170 3.037 2.914 5 3.791 3.605 3.433
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Time Value of MoneyTime Value of Money
We could solve the problem like this . . .We could solve the problem like this . . .
Periods 10% 12% 14%1 0.909 0.893 0.877 2 1.736 1.690 1.647 3 2.487 2.402 2.322 4 3.170 3.037 2.914 5 3.791 3.605 3.433
$60,000 × 3.605 = $216,300$60,000 × 3.605 = $216,300
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Typical Cash OutflowsTypical Cash Outflows
InitialInitialinvestmentinvestment
Repairs andRepairs andmaintenancemaintenance
IncrementalIncrementaloperatingoperating
costscosts
WorkingWorkingcapitalcapital
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Typical Cash InflowsTypical Cash Inflows
ReductionReductionof costsof costs
SalvageSalvagevaluevalue
IncrementalIncrementalrevenuesrevenues
Release ofRelease ofworkingworkingcapitalcapital
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Recovery of the Original InvestmentRecovery of the Original Investment
Carver Hospital is considering the purchase of an attachment for its X-ray Carver Hospital is considering the purchase of an attachment for its X-ray machine. machine.
No investments are to be made unless they have an annual return of at No investments are to be made unless they have an annual return of at least 10%.least 10%.
Will we be allowed to invest in the attachment?Will we be allowed to invest in the attachment?
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Recovery of the Original InvestmentRecovery of the Original Investment
Periods 10% 12% 14%1 0.909 0.893 0.877 2 1.736 1.690 1.647 3 2.487 2.402 2.322 4 3.170 3.037 2.914 5 3.791 3.605 3.433
Present valueof an annuity
of $1 table
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Recovery of the Original InvestmentRecovery of the Original Investment
Because the net present value is equal to zero,the attachment investment provides exactly
a 10% return.
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Recovery of the Original InvestmentRecovery of the Original Investment
Depreciation is not deducted in computing the Depreciation is not deducted in computing the present value of a project because . . .present value of a project because . . .
It is not a current cash outflow.It is not a current cash outflow. Discounted cash flow methods Discounted cash flow methods automaticallyautomatically
provide for return of the original investment.provide for return of the original investment.
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Choosing a Discount RateChoosing a Discount Rate
The firm’sThe firm’s cost of capitalcost of capital is usually regarded as the most is usually regarded as the most appropriate choice for the discount rate.appropriate choice for the discount rate.
The cost of capital is the average rate of return the company The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the must pay to its long-term creditors and stockholders for the use of their funds.use of their funds.
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The Net Present Value MethodThe Net Present Value Method
To determine net present value we . . .To determine net present value we . . . Calculate the present value of cash inflows,Calculate the present value of cash inflows, Calculate the present value of cash outflows,Calculate the present value of cash outflows, Subtract the present value of the outflows from the Subtract the present value of the outflows from the
present value of the inflows.present value of the inflows.
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The Net Present Value MethodThe Net Present Value MethodGeneral decision rule . . .General decision rule . . .
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The Net Present Value MethodThe Net Present Value Method
Lester Company has been offered a five year contract to provide Lester Company has been offered a five year contract to provide component parts for a large manufacturer.component parts for a large manufacturer.
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The Net Present Value MethodThe Net Present Value Method
At the end of five years the working capital will be released and At the end of five years the working capital will be released and may be used elsewhere by Lester.may be used elsewhere by Lester.
Lester Company uses a discount rate of 10%.Lester Company uses a discount rate of 10%.
Should the contract be accepted?Should the contract be accepted?
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The Net Present Value MethodThe Net Present Value Method
Annual net cash inflows from operationsAnnual net cash inflows from operations
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The Net Present Value MethodThe Net Present Value Method
Present value of an annuity of $1 factor for 5 years at 10%.
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The Net Present Value MethodThe Net Present Value Method
Present value of $1 factor for 3 years at 10%.
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The Net Present Value MethodThe Net Present Value Method
Present value of $1 factor for 5 years at 10%.
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The Net Present Value MethodThe Net Present Value Method
Accept the contract because the project has a positivepositive net present value.
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The Internal Rate of Return MethodThe Internal Rate of Return Method
The internal rate of return is the The internal rate of return is the interest yieldinterest yield promised promised by an investment project over its useful life.by an investment project over its useful life.
The internal rate of return is computed by finding the The internal rate of return is computed by finding the discount rate that will cause the discount rate that will cause the net present valuenet present value of a of a project to be project to be zerozero..
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The Internal Rate of Return MethodThe Internal Rate of Return Method
Decker Company can purchase a new machine at a cost of Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating $104,320 that will save $20,000 per year in cash operating costs. costs.
The machine has a 10-year life.The machine has a 10-year life.
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The Internal Rate of Return MethodThe Internal Rate of Return Method
Future cash flows are the same every year in this example, so we Future cash flows are the same every year in this example, so we can calculate the internal rate of return as follows:can calculate the internal rate of return as follows:
Investment required Net annual cash flows
PV factor for theinternal rate of return =
$104, 320 $20,000 = 5.216
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The Internal Rate of Return MethodThe Internal Rate of Return Method
Find the 10-period row, move across until you find the factor
5.216. Look at the top of the column and you find a rate of 14%14%.
Periods 10% 12% 14%1 0.909 0.893 0.877 2 1.736 1.690 1.647
. . . . . . . . . . . .9 5.759 5.328 4.946 10 6.145 5.650 5.216
Using the present value of an annuity of $1 table . . .
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The Internal Rate of Return MethodThe Internal Rate of Return Method
Decker Company can purchase a new machine at a cost of Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating $104,320 that will save $20,000 per year in cash operating costs. costs.
The machine has a 10-year life.The machine has a 10-year life.
The internal rate of return internal rate of return on this project is 14%.
If the internal rate of return is equal to or If the internal rate of return is equal to or greater than the company’s required rate of greater than the company’s required rate of
return, the project is acceptable.return, the project is acceptable.
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Net Present Value vs. Internal Rate of ReturnNet Present Value vs. Internal Rate of Return
Net Present ValueNet Present Value Easier to use.Easier to use.
Assumes cash inflows will be Assumes cash inflows will be reinvested at the discount rate. This reinvested at the discount rate. This is a realistic assumption.is a realistic assumption.
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Expanding the Net Present Value MethodExpanding the Net Present Value Method
To compare competing investment projects we can use the To compare competing investment projects we can use the following net present value approaches:following net present value approaches:
Total-costTotal-cost Incremental costIncremental cost
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The Total-Cost ApproachThe Total-Cost Approach White Co. has two alternatives: (1) remodel an old car wash or, White Co. has two alternatives: (1) remodel an old car wash or,
(2) remove it and install a new one.(2) remove it and install a new one. The company uses a discount rate of 10%.The company uses a discount rate of 10%.
New Car Wash
Old Car Wash
Annual revenues 90,000$ 70,000$ Annual cash operating costs 30,000 25,000 Net annual cash inflows 60,000$ 45,000$
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The Total-Cost ApproachThe Total-Cost ApproachIf White installs a new washer . . .If White installs a new washer . . .
Cost $300,000 Productive life 10 yearsSalvage value 7,000Replace brushes at the end of 6 years 50,000Salvage of old equip. 40,000
Let’s look at the present valueof this alternative.
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The Total-Cost ApproachThe Total-Cost Approach
If we install the new washer, the investment will yield a positive net
present value of $83,202.
Install the New Washer
YearCash Flows
10% Factor
Present Value
Initial investment Now (300,000)$ 1.000 (300,000)$ Replace brushes 6 (50,000) 0.564 (28,200) Net annual cash inflows 1-10 60,000 6.145 368,700 Salvage of old equipment Now 40,000 1.000 40,000 Salvage of new equipment 10 7,000 0.386 2,702 Net present value 83,202$
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The Total-Cost ApproachThe Total-Cost Approach
If White remodels the existing washer . . .If White remodels the existing washer . . .
Remodel costs $175,000 Replace brushes at the end of 6 years 80,000
Let’s look at the present valueof this second alternative.
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The Total-Cost ApproachThe Total-Cost Approach
If we remodel the existing washer, we will produce a positive net present
value of $56,405.
Remodel the Old Washer
YearCash Flows
10% Factor
Present Value
Initial investment Now (175,000)$ 1.000 (175,000)$ Replace brushes 6 (80,000) 0.564 (45,120) Net annual cash inflows 1-10 45,000 6.145 276,525 Net present value 56,405$
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The Total-Cost ApproachThe Total-Cost Approach
Both projects yield a positive net present value.
However, investing in the new washer will produce a higher net present value than
remodeling the old washer.
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The Incremental-Cost ApproachThe Incremental-Cost Approach
Under the incremental-cost approach, only those cash flows that Under the incremental-cost approach, only those cash flows that differ between the two alternatives are considered.differ between the two alternatives are considered.
Let’s look at an analysis of the White Co. decision using the Let’s look at an analysis of the White Co. decision using the incremental-cost approach.incremental-cost approach.
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YearCash Flows
10% Factor
Present Value
Incremental investment Now $(125,000) 1.000 $(125,000)
Net present value
The Incremental-Cost ApproachThe Incremental-Cost Approach
$300,000 new - $175,000 remodel = $125,000
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YearCash Flows
10% Factor
Present Value
Incremental investment Now $(125,000) 1.000 $(125,000)Incremental cost of brushes 6 30,000$ 0.564 16,920
Net present value
The Incremental-Cost ApproachThe Incremental-Cost Approach
$80,000 remodel - $50,000 new = $30,000
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YearCash Flows
10% Factor
Present Value
Incremental investment Now $(125,000) 1.000 $(125,000)Incremental cost of brushes 6 30,000$ 0.564 16,920 Increased net cash inflows 1-10 15,000 6.145 92,175
Net present value
The Incremental-Cost ApproachThe Incremental-Cost Approach
$60,000 new - $45,000 remodel = $15,000
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The Incremental-Cost ApproachThe Incremental-Cost Approach
YearCash Flows
10% Factor
Present Value
Incremental investment Now $(125,000) 1.000 $(125,000)Incremental cost of brushes 6 30,000$ 0.564 16,920 Increased net cash inflows 1-10 15,000 6.145 92,175 Salvage of old equipment Now 40,000 1.000 40,000 Salvage of new equipment 10 7,000 0.386 2,702 Net present value $ 26,797
We get the same answer under either thetotal-cost or incremental-cost approach.
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Least Cost DecisionsLeast Cost Decisions
In decisions where revenues are not directly involved, In decisions where revenues are not directly involved, managers should choose the alternative that has the least managers should choose the alternative that has the least
total cost from a present value perspective.total cost from a present value perspective.
Let’s look at the Home Furniture CompanyLet’s look at the Home Furniture Company..
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Least Cost DecisionsLeast Cost Decisions
Home Furniture Company is trying to decide whether to Home Furniture Company is trying to decide whether to overhaul an old delivery truck now or purchase a new one.overhaul an old delivery truck now or purchase a new one.
The company uses a discount rate of 10%.The company uses a discount rate of 10%.
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Least Cost DecisionsLeast Cost Decisions
Old TruckOverhaul cost now 4,500$ Annual operating costs 10,000 Salvage value in 5 years 250 Salvage value now 9,000
Here is information about the trucks . . .Here is information about the trucks . . .
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Least Cost DecisionsLeast Cost DecisionsBuy the New Truck
YearCash Flows
10% Factor
Present Value
Purchase price Now $(21,000) 1.000 $ (21,000)Annual operating costs 1-5 (6,000) 3.791 (22,746)Salvage value of old truck Now 9,000 1.000 9,000 Salvage value of new truck 5 3,000 0.621 1,863 Net present value (32,883)
Keep the Old Truck
YearCash Flows
10% Factor
Present Value
Overhaul cost Now $ (4,500) 1.000 $ (4,500)Annual operating costs 1-5 (10,000) 3.791 (37,910)Salvage value of old truck 5 250 0.621 155 Net present value (42,255)
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Least Cost DecisionsLeast Cost Decisions
Home Furniture should purchase the new truck.Home Furniture should purchase the new truck.
Net present value of costs associated with purchase of new truck (32,883)$ Net present value of costs associated with remodeling existing truck (42,255) Net present value in favor of purchasing the new truck 9,372$
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Investments in Automated EquipmentInvestments in Automated Equipment
Investments in automated equipment tend to be very large Investments in automated equipment tend to be very large in dollar amount.in dollar amount.
The benefits received are often indirect and intangible.The benefits received are often indirect and intangible.
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Ranking Investment ProjectsRanking Investment Projects
Profitability Present value of cash inflows index Investment required=
A BPresent value of cash inflows $81,000 $6,000Investment required 80,000 5,000Profitability index 1.01 1.20
Investment
The higher the profitability index, themore desirable the project.
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Other Approaches toOther Approaches toCapital Budgeting DecisionsCapital Budgeting Decisions
Other methods of making capital budgeting decisions include . Other methods of making capital budgeting decisions include . . .. .
The Payback Method.The Payback Method. Simple Rate of Return.Simple Rate of Return.
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The Payback MethodThe Payback Method
The The payback periodpayback period is the length of time that it takes for a is the length of time that it takes for a project to recover its initial cost out of the cash receipts project to recover its initial cost out of the cash receipts
that it generates.that it generates. When the net annual cash inflow is the same each year, this When the net annual cash inflow is the same each year, this
formula can be used to compute the payback period:formula can be used to compute the payback period:
Payback period = Investment required Net annual cash inflow
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The Payback MethodThe Payback Method Management at The Daily Grind wants to install an espresso Management at The Daily Grind wants to install an espresso
bar in its restaurant.bar in its restaurant. The espresso bar:The espresso bar:
Costs $140,000 and has a 10-year life.Costs $140,000 and has a 10-year life. Will generate net annual cash inflows of $35,000.Will generate net annual cash inflows of $35,000.
Management requires a payback period of 5 years or less on Management requires a payback period of 5 years or less on all investments.all investments.
What is the payback period for the espresso bar?What is the payback period for the espresso bar?
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The Payback MethodThe Payback Method
Payback period = Payback period = Investment required Investment required Net annual cash inflowNet annual cash inflow
Payback period = Payback period = $140,000 $140,000 $35,000$35,000
Payback period = Payback period = 4.0 years4.0 years
According to the company’s criterion, According to the company’s criterion, management would invest in the management would invest in the
espresso bar because its payback espresso bar because its payback period is less than 5 years.period is less than 5 years.
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Evaluation of the Payback MethodEvaluation of the Payback Method
Ignores the Ignores the time valuetime valueof money.of money.
Ignores cashIgnores cashflows after flows after the paybackthe payback
period.period.
Short-comingsShort-comingsof the Paybackof the Payback
Period.Period.