CHAPTER 9. Capital Budgeting and Other Long-Run Decisions. Slide 9-2

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2 CHAPTER 9 Capital Budgeting and Other Long-Run Decisions Slide 9-2

3 Long Run Decisions Capital expenditure decisions - Decisions related to investments in property, plant and equipment - Proper analysis requires taking into account the time value of money - Capital expenditure decisions affect cash flows across multiple years Slide 9-3

4 Capital Budgeting Decisions Investment decisions are important because they have a long run impact Capital expenditure decisions - Decisions involving the acquisition of longlived assets Capital budgeting - Process of evaluating investment opportunities - The final list of approved projects is referred to as the capital budget Slide 9-4 Learning objective 1: Define capital expenditure decisions and capital budgets

5 Capital Budgeting Decision Examples Slide 9-5 Learning objective 1: Define capital expenditure decisions and capital budgets

6 The Net Present Value Method Steps in the NPV method 1. Identify the amount and time period of each cash flow associated with a potential investment 2. Identify required rate of return and calculate the present values of the cash flows 3. Evaluate the net present value Slide 9-6 Learning objective 2: Evaluate investment opportunities using the net present value approach

7 The Net Present Value Method Amount and time period of each cash flow - Cash outflows are negative - Cash inflows are positive Only incremental cash flows are relevant to the decision - Cash flows already incurred (sunk costs) are not relevant Slide 9-7 Learning objective 2: Evaluate investment opportunities using the net present value approach

8 The Net Present Value Method Required rate of return (i.e. hurdle rate) Evaluate the investment opportunity - If NPV = 0, the investment earns the hurdle rate - If NPV > 0, the investment earns more than the hurdle rate - If NPV < 0, the investment earns less than the hurdle rate Slide 9-8 Learning objective 2: Evaluate investment opportunities using the net present value approach

9 Net Present Value Approach Slide 9-9 Learning objective 2: Evaluate investment opportunities using the net present value approach

10 Net Present Value Example Since the NPV > 0, the company should buy the equipment. Slide 9-10 Learning objective 2: Evaluate investment opportunities using the net present value approach

11 Comparing Alternatives with NPV Slide 9-11 Learning objective 2: Evaluate investment opportunities using the net present value approach

12 The Internal Rate of Return Method Slide 9-12 Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

13 Internal Rate of Return Example Investment = $100 Cash flow $60 per year for two years PV factor = 100 / 60 = Check PV annuity table, row 2 Closest factor is in 13% column Present Value of an Annuity 11% 12% 13% 14% Factor closest to 1.667, IRR approx 13% Slide 9-13 Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

14 Internal Rate of Return With Unequal Cash Flows Utilized when annual cash flows are not equal amounts - Must estimate IRR - Use estimated IRR to calculate the NPV of the project If NPV > 0, increase estimated IRR If NPV < 0, decrease estimated IRR - Recalculate until NPV is equal to or close to zero Slide 9-14 Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

15 Internal Rate of Return With Unequal Cash Flows The IRR is approximately 16% Slide 9-15 Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

16 Use of NPV and IRR Slide 9-16 Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

17 Considering Soft Benefits in Investment Decisions NPV and IRR allow for a quantitative analysis of a situation Soft benefits are difficult to quantify Soft benefits include a project s impact on: - Future sales - Firm s reputation - New production techniques Slide 9-17 Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

18 Soft Benefits Slide 9-18 Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

19 Calculating the Value of Soft Benefits Example A high-tech wheelchair project -NPV of negative $80,000 -Required rate of return 15%, 10-year life Slide 9-19 Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

20 Cost of Capital Examples Slide 9-20 Learning objective 3: Evaluate investment opportunities using the internal rate of return approach

21 Example of the Depreciation Tax Shield Slide 9-21 Learning objective 4: Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes

22 Other Long-Run Decisions Evaluation of decision to sponsor a golf tournament Slide 9-22 Learning objective 5: Evaluate long-run decisions, other than investment decisions, using time value of money techniques