Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Chapter 21 1.

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Capital Investment Decisions and the Time Value of Money

Chapter 21

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Learning Objectives

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Describe the importance of capital investments and the capital budgeting process

Use the payback period and rate of return methods to make capital investment decisions

Use the time value of money to compute the present and future values of single lump sums and annuities

Use discounted cash flow models to make capital investment decisions


Describe the importance of capital investments and the capital budgeting process

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Short term vs. Long term

Last chapter looked at recurring parallel options

Took place in the same time sequenceRevenues and expenses primarily

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This chapter we remove that timing restriction

Any time you wantRevenues, expenses, and investments

How do we compare return and investment if they come in different amounts at different times?


You are the Decider:Should we make the capital investment?

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Should we buy new, or

rebuild?

Should we install solar

panels?

Should we open

another store or open an online store?

Should we start this

new business?


What We’ll look atSimple techniques

The payback method(Simple) rate of return (ROR)

Techniques using time value of moneyPresent & future value of a single amount (lump sum)Present & future value of a payment stream (annuity)Net present value (NPV)Profitability indexInternal rate of return (IRR)

What we won’t look at todaySensitivity analysisMonte Carlo analysisOther advanced computer models

Our simple and TVM techniques cover virtually all of the analysis needs most of us are likely to ever need.


Use the payback and rate of return methods to make capital investment decisions

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Payback PeriodMeasures how quickly managers expect to recover their investment dollarsThe shorter the payback period, the more attractive the investmentUsed to screen capital investment choices May be the only tool in simple situations

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Calculating Payback PeriodIf the project provides equal annual returns, then use this formula:

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.12

Unequal annual net cash inflowsTotal net cash inflows until the amount invested is recovered

Calculating Payback Period


Caffeinated practice

Consider the following two investment options for the My Coffee: Sell Caffe Rent Caffe

Machines MachinesInitial investment $100,000 $100,000 Year 1 net cash inflows $50,000 $30,000 Year 2 net cash inflows $50,000 $30,000 Year 3 net cash inflows $50,000 $30,000 Year 4 net cash inflows $50,000 $30,000 Years 5-10 net cash inflows $0 $30,000

Based on the payback period. Which project would you prefer and why?

Consider the following two investment options for the My Coffee: Sell Caffe Rent Caffe

Machines MachinesInitial investment $100,000 $100,000 Year 1 net cash inflows $50,000 $30,000 Year 2 net cash inflows $50,000 $30,000 Year 3 net cash inflows $50,000 $30,000 Year 4 net cash inflows $50,000 $30,000 Years 5-10 net cash inflows $0 $30,000

Based on the payback period. Which project would you prefer and why?

http://www.alibaba.com/trade/search?SearchText=coffee+vending+machines&Country=&CatId=0&IndexArea=product_en&ssk=y&sq=y


Af/Neg of the Payback Period Method So much better than nothingEmphasis on payback, not additional profitsEasy story telling, good for salesIgnores cash flows after the payback periodAn experienced user can do well with itRequires human thought “seat of the pants” additional analysis

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Rate of Return (ROR)ROR measures the average accounting rate of return over the asset’s entire life

Focuses on the operating income, from the financialsMaximize reported profitability, not necessarily cash flows

Formula

Average annual operating incomeThe asset’s total operating income over the course of its operating life divided by its lifespan

Average amount invested Net book value at the beginning of the asset’s useful life plus the net book value at the end of the asset’s useful life divided by 2

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E21-15 bonus: Preston Co. Capital BudgetingPreston, Co. is considering buying a manufacturing plant for $1,100,000. They expect the plan to generate average annual cash inflows of $297,000 for 6 years. They expect to salvage the obsolete factory for $550,000 after 6 years.What is the rate of return of this project?

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Rate of Return Decision Rule

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Use the time value of money to compute the present and future values of single lump sums and

annuities

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Time Value of Money (TVM)

Invested money earns income over timeTiming of capital investments’ net cash inflows is importantTwo methods of capital investment using TVM

The net present value (NPV) Internal rate of return (IRR)

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Interest and the Time Value of Money

Let’s take a look at what those fancy tables do on the board!

Watch closely as I turn $1 into $2!

i=15%, N=5


InterestSimple interest

Interest calculated only on the principal amount

Compound interestInterest is calculated on the principal and on all previously earned interestAssumes that all interest earned will remain invested and earn additional interest at the same interest rate

Capital investments yield compound interestAssume compounding interest for rest of this chapter

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Present and Future Value Along a Time Continuum

The value of an investment at different points in time

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Appendix B: Factors for Present Value and Future Value

Simplify present and future value mathProgrammed into business calculators and spreadsheet programsSee Appendix B for present and future factor tables:

Let’s play with the future value table first.

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Using Future Value FactorsLump sum

Multiply amount by the factor number found in table

Table based on interest rate and number of periods$10,000 invested for 5 periods at 6%

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$10,000 X 1.3382 = $13,382 Differences due to table decimal places


Your turn:

If you invested $1,000 today into a 6% fixed rate security, how much would it be worth in 50 years?

Draw a time line indicating knowns and unknownsIdentify table needed and go to itLook up the factor for the rate and time indicatedSet up the formula and calculateAsk yourself if your answer makes sense

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Using Present Value FactorsLump sum

Multiply amount by the factor found in tableTable based on interest rate and number of periods$13,383 to be received in 5 periods at 6%

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$13,382 X 0.7473 = $10,000 Differences due to table decimal places


Your turn again:

How much would you have to invest today so that you could buy a $10,000 car for cash 5 years from today? We earn 3% on our money.


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Future Value

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Present Value

?

Annuities: Future and Present value

Annuity: A cash flow that occurs in identical amounts at repeating intervals.

You could take each and every year and calculate present/future values for each year…..

OR, you could recognize the annuity and take just one calculation using the annuity table.

1 2 3 4 5 6

$100 $100 $100 $100 $100 $100


If we Invest $2,000 at 6%, at the end of each year for 5 years, how much do we have at the end?

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Using Future Value Factors for Annuities

$2,000X 5.637111,274.20


How much do we need to squirrel away today , so we can pull $2,000 out to spend at the end of every year for 5 years? Assume 6% interest.

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Using Present Value Factors for Annuities

$2,000X 4.212$8.424


$8,424


Retirement Planning

How much do you need?Annual expenditure expectationsSolve for balance at the beginning of retirement

How are you going to get it there?Lump sum deposit nowAnnual retirement contributions

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Use discounted cash flow models to make capital investment decisions

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Discounted Cash Flows Models

Payback and ROR do not recognize time value of moneyNet present value (NPV) and internal rate of return (IRR) do recognize time value of money

Both compare amount of investment with its expected net cash inflows

Cash outflow for investment usually occurs nowCash inflows usually occur in the future

Companies use present value to make the investment comparison, not future value

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Net Present Value (NPV)NPV—the net difference between the present value of the investment’s net cash inflows and the investment’s cost (cash outflows)Discount rate—the interest rate that discounts or reduces future amounts to their lesser value in the present (today).

Discount rate uses the firms desired rate of returnBased on cost of capital

If present value of the investment’s net cash inflows exceeds the initial cost of the investment, then it is a good investment

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Using the annuity table:Buy or Rent Decision

Buy a new welder for cash.Cost $10,000

Lease the welder for $1,500/year for 10 years

Assume:Discount rate 10%Zero salvageAverage welder life in our hands is 10 years.


Will this new pizza store be worthwhile?

Investment required: $250,000Annual earnings of $50,000You will own it for 20 years.You will then sell it for $1,000,000.Your cost of capital is 10%

What is the NET present value of this project?


Which is the cheaper Police bike?Use a discount rate of 6% & useful life of 5 years

Harley DavidsonPurchase cost $25,000Salvage value $17,000Annual costs $500 more than Kawasaki.

Kawasaki

Purchase cost $12,000

Salvage value $1,000


Assume you win the lotteryOption #1: $1,000,000 nowOption #2: $150,000 the end of each year for next ten yearsOption #3: $2,000,000 ten years from now

Which option is the best?Use PV factors for single sum and annuities to find out

Option #1 is $1,000,000 in your hand todayOption #2 is an annuity, 10 paymentsUsing PV annuity tables, assuming 8%

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$150,000 x 6.7101 = $1,006,515

10 payments yield a present value of $1,006,515 and more than $1,000,000


Assume you win the lotteryOption #1: $1,000,000 nowOption #2: $150,000 the end of each year for next ten yearsOption #3: $2,000,000 ten years from now

Use PV factors for single sum to find out what option #3 is worth today

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Option #3 $2,000,000 x .4632 = $ 926,400

Option #1 = $1,000,000Option #2 = $1,006,515 Option #3 = $ 926,400

Option #2 is the highest of the three


Profitability IndexComputes the number of dollars returned for every dollar invested Present value of net cash inflows

Investment

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Profitability index =


Internal Rate of Return (IRR)

Another discounted cash flow model for capital budgeting Rate of return a company can expect to earn by investing in the projectThe interest rate that will cause the present value to equal zero

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Present value of the investment’s net cash inflows – Investment’s cost (Present value of cash outflows)

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IRR Decision Rule

The internal rate of return measures the real rate of return provided by the project.Higher return betterLower return worse

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Demo: IRR

Year(s)Flow Type

Cash Flow

Amount

Discount Rate & Factor

Present Value of

Cash Flow

12%

0 Lump -18600 1 -18600

6 Annuity 5000 4.111 20555

6 Lump 9125 0.507 4626

Net Present Value 6581


Net Present Value vs. Internal Rate of Return

NPV is easier to use.NPV Provides $$ results to compare: $$ pay the bills!IRR provides a comparable % return vs. strict dollar value. This can facilitate better evaluation of different scale/size/cost projects.Too much voodoo math?


Chapter 21SummaryCapital budgeting is planning to invest in long-term assets in a way that returns the greatest profitability to the company. Capital rationing occurs when the company has limited assets available to invest in long-term assets. The four most popular capital budgeting techniques used are payback period, rate of return (ROR), net present value (NPV), and internal rate of return (IRR).

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Chapter 21SummaryThe payback period focuses on the time it takes for the company to recoup its cash investment, but ignores all cash flows occurring after the payback period. Because it ignores any additional cash flows (including any residual value), the method does not consider the profitability of the project. The ROR, however, measures the profitability of the asset over its entire life using accrual accounting figures. It is the only method that uses accrual accounting rather than net cash inflows in its computations. The payback period and ROR methods are simple and quick to compute, so managers often use them to screen out undesirable investments. However, both methods ignore the time value of money.

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Chapter 21 SummaryInvested money earns income over time. This is called the time value of money, and it explains why we would prefer to receive cash sooner rather than later. The time value of money means that the timing of capital investments’ net cash inflows is important. The cash inflows and outflows are either single amounts or annuities. An annuity is equal cash flows over equal time periods at the same interest rate. Time value of money tables in Appendix B help us to adjust the cash flows to the same time period (i.e., today or the present value, or a future date or the future value).

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Chapter 21 SummaryThe NPV is the net difference between the present value of the investment’s net cash inflows and the investment’s cost (cash outflows), discounted at the company’s required rate of return (hurdle) rate. The investment must meet or exceed the hurdle rate to be acceptable. The IRR is the interest rate that makes the cost of the investment equal to the present value of the investment’s net cash inflows. Capital investment (budgeting) methods that consider the time value of money (like NPV and IRR) are best for decision making.

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Chapter 21 1.

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