Things You Must Know
Capital Investments (Long-term Decisions)
A decision to make an investment in something that will give returns over a long period of time.
A capital investment is related to property/plant/equipment or an entire business operation.
Types of Capital Budgeting Decisions
1) Purchase new equipment to reduce costs
2) Purchase new property/equipment for expansion
3) Should equipment be leased or purchased
4) Should old equipment be replaced
5) Should you purchase another company
6) Should you enter into a new product line requiring capital investment
Only relevant cash inflows and outflows are considered when making the decision
The Time Value of Money:
A dollar today is worth more than a dollar a year from now. The dollar can be invested to earn if you have it, therefore it is worth more to have it today than later. It costs you more to spend it today than it costs to spend the same dollar amount later.
Always consider what future cash flows are worth today
Present Value is the equivalent of what the future cash flow dollar is worth today. Present Value will vary as the required discount rate varies.
Present Value Table:
Present Value of $1 Table
Use when you have a one-time payment or receipt of cash
Present Value of an Annuity Table
Use when you have a series of equal cash payments or cash receipts – most often annual cash flows.
Cost of Capital
The annual interest the company incurs on long term debt and equity
The company’s required rate of return.
This rate is set by management and must be equal to or higher than the cost of capital.
Net Present Value Method:
Compare the present value of cash inflows to the present value of cash outflows.
A positive net present value means that the investment will give more than the required rate of return. It is not a calculation of how much the asset will earn.
Salvage value when sold
Release of working capital
Initial investment (purchase)
Additional working capital required
Repairs and maintenance
Incremental operating costs
A discount rate (required rate of return) must be selected:
This is the % return that the project must earn to be acceptable.
The assumption is made that all cash flows, other than the initial investment, occur
at the end of the period.
Depreciation is not a cash flow. Depreciation is a tax shield at the tax savings rate if your professor teaches that you should consider the after tax cash flows,
Net Present Value Table:
Set up a table to compare present value of cash inflows and outflows:
|Description||Years||Amount of cash||x Factor||= Value of CF|
Only list relevant cash flows on the net present value table
Least – Cost Decisions:
Determine which alternative has the lowest cost.
Find the net present value of net cash out flows for each.
Select the alternative that has the highest total net present value.
Use same table as above.
Internal Rate of Return (IRR) Method:
|Factor for the internal rate of return =|| Investment Required
Net Annual Cash Flows
Go to the table for net present value of an annuity.
Go down to the number of years and then go across the table until you get to the number that is closet to the factor.
The column you are in is the rate of return number.
Use the table factor closest to your calculated factor.
The Payback Method:
|Payback Period =|| Investment Required
Net Annual Cash Flows
The amount of time (in years) it takes to be paid back the investment required
Payback period does not consider the time value of money. It is the time required to recoup the investment with 0% interest.
Net annual cash flows do not include depreciation (not a cash flow)
Annual Rate of Return:
Annual Net Cash Flows – Annual Depreciation
Annual Rate of Return is also called the Accounting Rate of Return and the Simple Rate of Return
Annual Rate of Return is a representation of a return from an operating income perspective and is not based solely on cash flows. Non cash expenses are included
Income Tax Considerations When Computing Net Present Value
Your instructor may or may not teach that you must consider income tax when you
compute net present value. Please check your notes to see if you are to consider
the impact of income taxes on cash flows.
Considering income tax means all cash flows must be an after-tax amount
After tax cash amount is computed by taking (1 – tax rate %) x the cash flow amount
If you are expected to consider income taxes, you will do everything as explained above and will also do the following:
1) Convert all cash flows to after tax amounts
2) Consider depreciation to be a cash inflow (it is a tax savings)
Depreciation expense x tax % = cash flow savings