11 - 11 - 11© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Internal AllocationInternal Allocation
of Scarce Resourcesof Scarce Resources
Chapter 11Chapter 11
11 - 11 - 22© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Learning Objective 1Learning Objective 1
Explain the processExplain the process
of capital budgeting.of capital budgeting.
11 - 11 - 33© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
The Capital BudgetThe Capital Budget
The firm only uses capital budgetingThe firm only uses capital budgetingtechniques for large dollar amountstechniques for large dollar amounts
of long-lived expenditures.of long-lived expenditures.
The firm only uses capital budgetingThe firm only uses capital budgetingtechniques for large dollar amountstechniques for large dollar amounts
of long-lived expenditures.of long-lived expenditures.
The capital budget is the budget thatThe capital budget is the budget thatoutlines how a firm intends to allocateoutlines how a firm intends to allocateits scarce resources over a time period.its scarce resources over a time period.
Capital assets are long-lived assets.Capital assets are long-lived assets.
11 - 11 - 44© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Learning Objective 2Learning Objective 2
Delineate the four sharedDelineate the four shared
characteristics of allcharacteristics of all
capital projects.capital projects.
11 - 11 - 55© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Characteristics ofCharacteristics ofCapital ProjectsCapital Projects
Sunk costsSunk costsSunk costsSunk costs High degreeHigh degreeof riskof risk
Long livesLong lives High costHigh cost
11 - 11 - 66© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Learning Objective 3Learning Objective 3
Describe the cost ofDescribe the cost of
capital and the conceptcapital and the concept
of scarce resources.of scarce resources.
11 - 11 - 77© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Cost of CapitalCost of Capital
It is the cost of obtaining financingIt is the cost of obtaining financingfrom all available financial sources.from all available financial sources.
Required rateRequired rateof returnof return Hurdle rateHurdle rateHurdle rateHurdle rate
11 - 11 - 88© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Blended Cost of CapitalBlended Cost of Capital
It is the combined cost of debt and equity financing.It is the combined cost of debt and equity financing.
FinancingFinancing % of Total% of Total Cost RateCost Rate WeightedWeighted
DebtDebtEquityEquity
60%60%40%40%
××××
7.5%7.5%20.0%20.0%
====
4.5%4.5% 8.0%8.0%12.5%12.5%Blended cost of capitalBlended cost of capital
11 - 11 - 99© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Scarce ResourcesScarce Resources
This means that a companyThis means that a companyhas a limited amount of fundinghas a limited amount of funding
available to spend on capital projects.available to spend on capital projects.
11 - 11 - 1010© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Learning Objective 4Learning Objective 4
Determine the informationDetermine the information
relevant to a capitalrelevant to a capital
budgeting decision.budgeting decision.
11 - 11 - 1111© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Evaluating PotentialEvaluating PotentialCapital ProjectsCapital Projects
3. Select a method of3. Select a method ofevaluating the alternatives.evaluating the alternatives.
3. Select a method of3. Select a method ofevaluating the alternatives.evaluating the alternatives.
4. Evaluate the alternatives and select4. Evaluate the alternatives and selectthe capital projects to be funded.the capital projects to be funded.
1. Identify possible capital projects.1. Identify possible capital projects.
2. Determine the relevant cash2. Determine the relevant cashflows for alternative projects.flows for alternative projects.
11 - 11 - 1212© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Learning Objective 5Learning Objective 5
Evaluate potential capital Evaluate potential capital
investments using three investments using three
capital budgeting decision capital budgeting decision
models: payback method,models: payback method,
net present value, and the net present value, and the
internal rate of return.internal rate of return.
11 - 11 - 1313© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Capital BudgetingCapital BudgetingDecision MethodsDecision Methods
Payback period methodPayback period method
Discounted cash flow methodsDiscounted cash flow methods
Net presentNet presentvaluevalue
Net presentNet presentvaluevalue
Internal rateInternal rateof returnof return
11 - 11 - 1414© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Payback Period MethodPayback Period Method
The payback period method measuresThe payback period method measuresthe length of time a capital projectthe length of time a capital projectmust generate positive net cashmust generate positive net cashflows that equal, or “pay back,”flows that equal, or “pay back,”
the original investment.the original investment.
11 - 11 - 1515© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Payback Period MethodPayback Period Method
Assume that a project’s estimatedAssume that a project’s estimatedinitial outlay is $40,000.initial outlay is $40,000.
What is the payback period?What is the payback period?
It is expected to generate $12,500 per year.It is expected to generate $12,500 per year.
11 - 11 - 1616© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Payback Period withPayback Period withUneven Cash FlowsUneven Cash Flows
YearYear1122334455
It will take about 1/3 of the fourth yearIt will take about 1/3 of the fourth year($5,000/$15,000) to collect the final ($5,000/$15,000) to collect the final $5,000$5,000..
CashCashreceived inreceived inprior yearsprior years
00$12,000$12,000$27,000$27,000$45,000$45,000$60,000$60,000
++++++++++
CashCashreceived inreceived in
current yearcurrent year$12,000$12,000$15,000$15,000$18,000$18,000$15,000$15,000$12,000$12,000
==========
AccumulatedAccumulatedcashcash
receivedreceived$12,000$12,000$27,000$27,000$$45,00045,000$60,000$60,000$72,000$72,000
11 - 11 - 1717© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Discounted Cash Flow Discounted Cash Flow MethodsMethods
The time value of money is the increaseThe time value of money is the increasein the value of cash over time due toin the value of cash over time due to
the accumulation of investment income.the accumulation of investment income.
Discounting cash flowsDiscounting cash flows is determining the present is determining the presentvalue of cash to be received in future periods.value of cash to be received in future periods.
The The net present value (NPV)net present value (NPV) of a proposed of a proposedcapital project is the present value of cashcapital project is the present value of cash
inflows minus the present value of cash outflows.inflows minus the present value of cash outflows.
11 - 11 - 1818© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Net Present Value ExampleNet Present Value Example
The blended cost of capital is equal to 14%.The blended cost of capital is equal to 14%.The blended cost of capital is equal to 14%.The blended cost of capital is equal to 14%.
The new equipment will save $31,000The new equipment will save $31,000annually in production salaries.annually in production salaries.
Therefore, 14% is the discount rate used.Therefore, 14% is the discount rate used.
Elevation Sports, Inc., considersElevation Sports, Inc., considerspurchasing new equipment that willpurchasing new equipment that willrequire an investment of $100,000.require an investment of $100,000.
11 - 11 - 1919© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Net Present Value ExampleNet Present Value Example
$(100,000) 106,423$ 6,423
$31,000 $31,000 $31,000 $31,000 $31,000
Time Period0 1 32 4 5
$31,000 × 3.433 = $106,423$31,000 × 3.433 = $106,423
NPV = $106,423 – $100,000 = NPV = $106,423 – $100,000 = $6,423$6,423
11 - 11 - 2020© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Net Present Value ExampleNet Present Value Example
Assume that the equipmentAssume that the equipmentwill require $12,000 inwill require $12,000 in
maintenance fees in year 3.maintenance fees in year 3.
Also that the equipment canAlso that the equipment canbe sold at the end ofbe sold at the end of
year 5 for $6,000.year 5 for $6,000.
What is the NPV?What is the NPV?What is the NPV?What is the NPV?
11 - 11 - 2121© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Net Present Value ExampleNet Present Value Example
YearYear001122334455
InitialInitialinvestmentinvestment$(100,000)$(100,000)
MaintenanceMaintenance
$12,000$12,000
OperatingOperatingcostscosts
$31,000$31,000$31,000$31,000$31,000$31,000$31,000$31,000$31,000$31,000
ResidualResidualvaluevalue
$6,000$6,000
Net cashNet cash flowflow
$(100,000)$(100,000)$ 31,000$ 31,000$ 31,000$ 31,000$ 19,000$ 19,000$ 31,000$ 31,000$ 37,000$ 37,000
11 - 11 - 2222© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Net Present Value ExampleNet Present Value Example
YearYear001122334455
Net cashNet cashflowflow
$(100,000)$(100,000)$ 31,000$ 31,000$ 31,000$ 31,000$ 19,000$ 19,000$ 31,000$ 31,000$ 37,000$ 37,000
PV of $1,PV of $1,factor at 14%factor at 14%
0.87720.87720.76950.76950.67500.67500.59210.59210.51940.5194
PresentPresentvaluevalue
$(100,000)$(100,000)$ 27,193$ 27,193$ 23,855$ 23,855$ 12,825$ 12,825$ 18,355$ 18,355$ 19,218$ 19,218
Net present value $ 1,446Net present value $ 1,446
11 - 11 - 2323© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Profitability Index ExampleProfitability Index Example
What is the profitability index?What is the profitability index?What is the profitability index?What is the profitability index?
Project A present value of cash inflowsProject A present value of cash inflowswas $105,000 and present value ofwas $105,000 and present value of
cash outflow was $100,000.cash outflow was $100,000.
Project B present value of cash inflowsProject B present value of cash inflowswas $206,000 and present value ofwas $206,000 and present value of
cash outflow was $200,000.cash outflow was $200,000.
11 - 11 - 2424© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Profitability Index ExampleProfitability Index Example
PI for Project B:PI for Project B:$206,000 ÷ $200,000 = 1.03$206,000 ÷ $200,000 = 1.03
PI for Project B:PI for Project B:$206,000 ÷ $200,000 = 1.03$206,000 ÷ $200,000 = 1.03
Project A ranks higher than Project B.Project A ranks higher than Project B.
Profitability index (PI) =Profitability index (PI) =PV of cash inflows ÷ PV of cash outflowsPV of cash inflows ÷ PV of cash outflows
PI for Project A:PI for Project A:$105,000 ÷ $100,000 = 1.05$105,000 ÷ $100,000 = 1.05
11 - 11 - 2525© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Internal Rate of Return Internal Rate of Return ExampleExample
The The internal rate of return (IRR)internal rate of return (IRR) of a of aproposed capital project is the expectedproposed capital project is the expected
percentage return promised by the project.percentage return promised by the project.
Assume that Project C requires an initialAssume that Project C requires an initialinvestment of $300,000 and will provideinvestment of $300,000 and will providecash inflows of $56,232 for eight years.cash inflows of $56,232 for eight years.
11 - 11 - 2626© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Internal Rate of Return Internal Rate of Return ExampleExample
PV = annual paymentsPV = annual payments× Present value interest factor of an annuity× Present value interest factor of an annuity
PV = annual paymentsPV = annual payments× Present value interest factor of an annuity× Present value interest factor of an annuity
Initial InvestmentInitial Investment= Annual payments = Annual payments ×× PVIFAPVIFA
Project C:Project C:$300,000 ÷ $56,232 =$300,000 ÷ $56,232 = 5.3355.335
For 8 periods, the factor 5.335For 8 periods, the factor 5.335equals a 10% rate of return.equals a 10% rate of return.
11 - 11 - 2727© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Internal Rate of Return Internal Rate of Return ExampleExample
Project D requires an initial investment ofProject D requires an initial investment of$330,000 and will generate estimated$330,000 and will generate estimated
annual returns of $64,900 for eight years.annual returns of $64,900 for eight years.
$330,000 ÷ $64,900 =$330,000 ÷ $64,900 = 5.08575.0857$330,000 ÷ $64,900 =$330,000 ÷ $64,900 = 5.08575.0857
For 8 periods, the factor 5.0857For 8 periods, the factor 5.0857is between the factor for theis between the factor for the
10% column and the 12% column.10% column and the 12% column.
11 - 11 - 2828© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Financial CalculatorFinancial Calculator
nn number of years = 8number of years = 8
%i%i interest rate = 11.33762%interest rate = 11.33762%
PVPV initial investment = $330,000initial investment = $330,000
PMTPMT annual return = $64,900annual return = $64,900
FVFV future value = 0future value = 0
CPTCPT computecompute
11 - 11 - 2929© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Comparing the NPVComparing the NPVand IRR Methodsand IRR Methods
Both methods are well-respectedBoth methods are well-respectedtechniques for determining the acceptabilitytechniques for determining the acceptability
of a proposed capital project.of a proposed capital project.
They are based on cash flows,They are based on cash flows,not accounting income.not accounting income.
Both methods considerBoth methods considerthe time value of money.the time value of money.Both methods considerBoth methods consider
the time value of money.the time value of money.
11 - 11 - 3030© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Comparing the NPVComparing the NPVand IRR Methodsand IRR Methods
A drawback of the NPV method isA drawback of the NPV method isthat the calculated net present valuethat the calculated net present value
is stated in dollars rather than percentages. is stated in dollars rather than percentages.
The IRR calculates a proposed capitalThe IRR calculates a proposed capitalproject’s actual expected rate of return.project’s actual expected rate of return.
11 - 11 - 3131© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Learning Objective 6Learning Objective 6
Explain the concept of Explain the concept of
simplesimple
interest and compoundinterest and compound
interest and describeinterest and describe
the concept of an annuity.the concept of an annuity.
11 - 11 - 3232© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
The Concept of InterestThe Concept of Interest
A dollar received today can be investedA dollar received today can be investedand earn a return as time passes.and earn a return as time passes.
Future valueFuture value is the value of a payment, or is the value of a payment, orseries of payments, at a future point in time.series of payments, at a future point in time.
11 - 11 - 3333© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Simple InterestSimple Interest
Simple interest is calculatedSimple interest is calculatedonly on the original principal.only on the original principal.
What is the amount of interest earnedWhat is the amount of interest earnedat 10 percent per year for threeat 10 percent per year for three
years on a $2,000 principal?years on a $2,000 principal?
11 - 11 - 3434© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Compound InterestCompound Interest
10% Compound Interest10% Compound InterestYear 1Year 1 Year 2Year 2 Year 3Year 3 TotalTotal
PrincipalPrincipal $2,000$2,000 $2,200$2,200 $2,420$2,420InterestInterest 200 200 220 220 242 242 $662$662
$2,200$2,200 $2,420$2,420 $2,662$2,662
It is interest calculated on the investmentIt is interest calculated on the investmentprincipal principal plusplus all previously earned interest all previously earned interest
at the end of each compounding period.at the end of each compounding period.
11 - 11 - 3535© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
AnnuityAnnuity
An annuity is a stream of cash flows where theAn annuity is a stream of cash flows where thedollar amount of each payment and the timedollar amount of each payment and the time interval between each payment are uniform.interval between each payment are uniform.
Assume Trevor intends to deposit $2,000Assume Trevor intends to deposit $2,000in an account at the end of each year forin an account at the end of each year for
40 years at 10% compound annually.40 years at 10% compound annually.
11 - 11 - 3636© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Learning Objective 7Learning Objective 7
Determine present and Determine present and
futurefuture
values using present valuevalues using present value
and future value tables.and future value tables.
11 - 11 - 3737© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Present ValuePresent Value
Determining the present value of anDetermining the present value of anamount of cash to be received inamount of cash to be received inthe future is called the future is called discountingdiscounting..
Determining the present value of anDetermining the present value of anamount of cash to be received inamount of cash to be received inthe future is called the future is called discountingdiscounting..
What is the present value of $1,000What is the present value of $1,000to be received a year from now at 6%?to be received a year from now at 6%?
11 - 11 - 3838© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
Future ValueFuture Value
What is the future value of $2,000 in 40 yearsWhat is the future value of $2,000 in 40 yearsat 10% interest compounded annually?at 10% interest compounded annually?
What is the future value of $2,000 in 40 yearsWhat is the future value of $2,000 in 40 yearsat 10% interest compounded annually?at 10% interest compounded annually?
What is the future value of annual paymentsWhat is the future value of annual paymentsof $2,000 at the end of the next 40 yearsof $2,000 at the end of the next 40 yearsat 10% interest compounded annually?at 10% interest compounded annually?
11 - 11 - 3939© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell
End of Chapter 11End of Chapter 11
Top Related