Chapter 25 - Capital budgeting. After studying this chapter you will be able to: Explain the nature of capital investment decisions; identify nonfinancial factors in capital investment decisions; evaluate capital investment proposals using (a) payback period, (b) return on investment, and (c) discounted cash flows; discuss the relationship between net present value and an investor's required rate of return;. | Capital Budgeting Chapter 25 2 Capital budgeting: Analyzing alternative long- term investments and deciding which assets to acquire or sell. Outcome is uncertain. Large amounts of money are usually involved. Investment involves a long-term commitment. Decision may be difficult or impossible to reverse. Capital Investment Decisions ? ? ? Limited Investment Funds Plant Expansion New Equipment Office Renovation I will choose the project with the most profitable return on available funds. Capital Investment Decisions Initial investment Repairs and maintenance Incremental operating costs Capital Investment Decisions: Typical Cash Outflows Cost savings Salvage value Incremental revenues Capital Investment Decisions: Typical Cash Inflows Employee morale Environmental concerns Corporate image Employee working conditions Product quality Capital Investment Decisions: Nonfinancial Considerations Let’s look at methods used to make capital investment decisions. Evaluating Capital Investment Proposals: An Illustration Stars’ Stadium is considering purchasing vending machines with a 5-year life. ($75,000 - $5,000) ÷ 5 years Evaluating Capital Investment Proposals: An Illustration Most capital budgeting techniques use annual net cash flow. Depreciation is not a cash outflow. Evaluating Capital Investment Proposals: An Illustration The payback period of an investment is the time expected to recover the initial investment amount. Payback period = Cost of Investment Annual Net Cash Flow Managers prefer investing in projects with shorter payback periods. Payback Period The payback period of an investment is the time expected to recover the initial investment amount. Payback period = Cost of Investment Annual Net Cash Flow Payback period = $75,000 $24,000 = years Payback Period Ignores the time value of money. Ignores cash flows after the payback period. Payback Period Consider two projects, each with a five-year life and each costing $6,000. Would you invest in Project One . | Capital Budgeting Chapter 25 2 Capital budgeting: Analyzing alternative long- term investments and deciding which assets to acquire or sell. Outcome is uncertain. Large amounts of money are usually involved. Investment involves a long-term commitment. Decision may be difficult or impossible to reverse. Capital Investment Decisions ? ? ? Limited Investment Funds Plant Expansion New Equipment Office Renovation I will choose the project with the most profitable return on available funds. Capital Investment Decisions Initial investment Repairs and maintenance Incremental operating costs Capital Investment Decisions: Typical Cash Outflows Cost savings Salvage value Incremental revenues Capital Investment Decisions: Typical Cash Inflows Employee morale Environmental concerns Corporate image Employee working conditions Product quality Capital Investment Decisions: Nonfinancial Considerations Let’s look at methods used to make capital investment decisions. Evaluating Capital Investment .
