In Capital Budgeting There Are Two Types of Decisions
Transcripts T8M5
Slide 1
Capital budgets are “plans” on how to spend huge amounts of resources on projects that have positive future implications to the organization. It is critical that major projects undergo the capital budgeting process to ensure that the projects create value for the company. I have heard horror stories of companies who have doubled their capacity at immense expense when the demand for the product didn’t warrant the capital expenditure. That’s a recipe for bankruptcy.
Slide 2
In capital budgeting there are two types of decisions
- Screening – were the project’s elements are screened or compared to the minimum acceptable levels and accepted or rejected.
- Preference – were several projects are evaluated against each other and the best one is selected based upon its merits.
Slide 3
Capital budgeting uses several methods to evaluate capital expenditures. The methods reviewed in this course are:
- Net Present value
- IRR (See T8M6)
- Payback Period (See T8M6)
- Simple Rate of Return (See T8M6)
Slide 4
The first capital budget method to be evaluated is Net present value or NPV from here on out. This method compares the difference between discounted cash inflows and discounted cash outflows. The resulting difference can be zero, positive or negative. If the NPV of the project is zero the project makes the required rate of return exactly. If the NPV of the project is positive the project is showing a higher rate of return than required. Projects with NPV’s zero and higher should be accepted. If the NPV is negative the rate of return is lower than required and the project should be rejected.
Slide 5
Here are the common cash inflows and outflows used in net present value calculations. Just a note on working capital, working capital is the money used to purchase and continue purchasing inventory, supplies etc. Think of it as money that is continually recycled until the project ends. For example, you buy inventory, sell the product to customers for money, use part of that money to buy more inventory, sell more product to customers and this goes on and on until the project ends. Thus the money is working for you. When the project ends the working capital is released for use in another project.
Slide 6
Notice that NPV emphasizes cash flows and not net income. Why? Because companies can have a strong net income value but without cash flow they will be unable to pay their employees, suppliers, etc. Lack of cash flow can cause big problems which will lead the company into bankruptcy land.Thereforethe cash flows of capital expenditures need to be reviewed to ensure they are positive.
Slide 7
Here is a great template to use for capital budgeting problems. It will help you keep all the data organized.
Slide 8
In this example, Parkway is considering the addition of a new product line to their product mix. I have gone through and circled all the pertinent data in the story problem. I recommend that you do something similar and then organize your data to help you make correct calculations. One of the problems I have observed is that students fail to manage their information in a clear manner. This often leads to errors and reduced points.
Slide 9
I have taken the information from slide 8 and organized it into the template from slide 7. Notice that the initial investment and the working capital are at time zero and thus the present value factor is 1.000 or that the cash flows are not discounted. That is because you are using the money today thus there should be no discount. Now go down to the increased revenues and the rent expense...notice that in the year category I have listed for increase revenue and rent 1-8 which means that for each year the company will see an increase in revenues and rent expense. Since this is a yearly cash flow we will be calculating the present value factor for an annuity. Remember that annuities are streams of equal cash flows. Below the increased revenue and rent is the salvage value of the equipment purchased for the new product line and the release of working capital. These cash flows come at the end of the project in year eight. They are one time cash flows. We use the equation to calculate the PV factor of a lump sum to determine the discounted cash flow value. After all the cash flows have been appropriately discounted we total them up to get the net present value of the project.
Slide 10
Because the net present value of the project is a negative number we can ascertain that the project would get a return less than the required 15% rate of return. Therefore we reject the project.
Slide 11
Here is another problem. Once again I circled all the pertinent data to make my calculations. Notice that I didn’t circle the $600,000. Why? Well it is just part of the story it has nothing to do with the calculation. It is Jane’s entire inheritance. She only uses $150,000 or ¼ of the inheritance to start the catering business. Try organizing the data into the slide 7 template before moving onto slide 12 to see how I organized it.
Slide 12
I have taken the important figures and organized them into the template. Now I entered each item separately, but I could have netted all the year cash inflows and outflows into a single number and discounted one number. It is a personal choice on how you set the problem up. These are just good options that you can follow. Once again after all the cash flows have been appropriately discounted then add the values together to determine net present value.
Slide 13
This project shows a positive net present value. Thus the project should be accepted.