Chapter 13 Capital Budgeting

Capital budgeting - how managers plan significant investments in projects that have long-term
implications like purchase of new equipment or the introduction of new products.
- Most companies have more potential projects than can actually be funded
- Managers have to select projects carefully that will promise the greatest future return

4 methods for making capital budgeting decisions

1. Pay-back method
2. Net present value method (NPV)
3. Internal rate of return method (IRR)
4. Simple rate of return method

Capital budgeting decisions include:

- Cost reduction decisions
o Should new equipment be purchase to reduce costs?
- Expansion decisions
o Should a new plant, warehouse, or other facility be acquired to increase capacity and sales?
- Equipment selection decisions
o Which of several available machines should be purchased?
- Lease or buy decisions
o Should new equipment be leased or purchased?
- Equipment replacement decisions
o Should old equipment be replaced now or later?

Screening decisions relate to whether a proposed project is acceptable

- For example, company has policy of only accepting project with 20% return on investment

Preference decisions relate to selecting from among several acceptable alternatives, like the preferred
choice

Time value of money a dollar today is worth more than a dollar a year from now
- Payback period does not take time value of money into account
- NPV and IRR do take time value of money into account

Payback Method
Payback period length of time that it takes for a project to recover its initial cost from the net cash
inflows that it generates. Is expressed in years.

Payback period = Investment required

Annual net cash inflow
Textbook example (pg 586):

**York Company should purchase machine B because it has a shorter payback period than machine A.

Net Present Value Method

Net present value compares the present value of a projects cash inflows to the present value of its cash
outlfows.

Textbook example:

Should the machine be purchased?

- Calculate the present value of the annual stream of $18,000 savings
- Calculate the present value of the machines salvage value of $5,000
- Add in the present value of the cost outflow
- Add all 3 #s together for NPV
Because the NPV is $8,471, then we would accept this project.

Cost of Capital average rate of return that the company must pay to its long-term creditors and its
shareholders for the use of their funds
- If a projects rate of return is less than the cost of capital, then the company does not earn enough
to compensate its creditors and shareholders
o Any project with a rate of return less than the cost of capital should be rejected

Internal Rate of Return

Internal rate of return -the rate of return of an investment project over its useful life.

Textbook example:
1st find the discount rate that will result in a zero net present value:

2nd find the rate of return this factor of 3.605 represents using Ex 13-B-2. Use the # of periods the inflow
of cash for the 5 years they expect.
- Scan along 13-B-2 for 3.605 and we find an internal rate of return of 12%
- Internal Rate of Return is 12%

Simple Rate of Return

Textbook example:

Then plug #s into the formula.

Postaudit checking whether or not expected results are actually realized