C Capital Budgeting 2011 Lecture

7/28/2019 C Capital Budgeting 2011 Lecture

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Capital Budgeting


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Revision Question 1

A travel company is planning a wine tour of Western Australiaswine growing region. The costs associated with the tour areestimated to be as follows: Bus $1,035, wine tasting at a winery,$10 per person, Wine Appreciation Course $25 per person,

, .

Required

What is the variable cost of each wine tour?

What are the fixed costs of conducting the wine tour?

2


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Solution 1

Variable Cost Fixed Costs

Wine Tasting 10Wine Course 25

Bus Hire 1,035Insurance 500

Lunch 20

55

1,535

3


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Revision Question 2

A travel com an is lannin a wine tour of

Western Australias wine growing region. Thecosts associated with the tour are estimated to, ,

winery, $10 per person, Wine Appreciation

Course $25 er erson, insurance $500, lunch$20 per person.

Required If it is estimated that 44 people will attend, what

4


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Solution 2

= - -

0 = SP(44) 55 (44) 1,535

= , ,

3,955 = 44SP3,955/44 = SP

$89.89 = SP

5


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Revision Question 3





Required

If it is estimated that 30 people will attend and aprofit of $300 is desired, what price would need

6


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Solution 3

= - -

300 = SP(30) 55 (30) 1,535

= , ,

3,485 = 30SP3,485/30 = SP

$116.17 = SP

7


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Revision Question 4





Required If ticket price is $70 each, how many people

-

8


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Solution 4

= - -

0 = 70(X) 55(X) 1,535

= ,

1,535 = 15X1,535/15 = X

102.33 = X

103 people are required to break-even

9


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Revision Question 5 A business currently makes calculators. The variable cost of

making each calculator is 22. The fixed cost per calculator is

$9. The business is currently producing 16,000 calculators. Theselling price per calculator is $45. The maximum capacity of the

, .

A large electronic retail store has offered to buy 5,000.

Required

1. a cua e w a ga n or oss w e ma e e o er s accep e .

10


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Solution 5

,

+ Special Order 5,000

,

Maximum Capacity 19,500

Opportunity Cost 1,500

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Solution 5

Sellin Price 5 000 x 30 150 000

- , ,

- , ,

-

12

,


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Revision Question 6 A business currently makes calculators. The variable

cost of making each calculator is $22. The fixed costper calculator is $9. The business is currently producing16,000 calculators. The sellin rice er calculator is$45. The maximum capacity of the business is 19,500.

,calculators for $30 each.

Required What is the gain or loss if the order is for 6,000 products.

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Solution 6

,

+ Special Order 6,000

,

Maximum Capacity 19,500

Opportunity Cost 2,500

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Solution 6

Sellin Price 6 000 x 30 180 000

- , ,

- , ,

-

15

,


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Lecture Outline

.

Define and explain the importance of Capital.

Use quantitative analysis to determine the.


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Time Value of Money

five years time?

,

$5,000 can be invested today and if it earns 6%

interest each ear for the next 5 ears it willaccumulate to $6,691.

5,000 today will also buy more than 5,000 in fiveyears time.


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Time Value of Money

because of two main factors:

1. Interest Rates

2. Inflation


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Time Value of Money

(45,000) 20,000 20,000 20,000

0 1 2 3

(years)

Would you invest $45,000 now if you were toreceive a return of $20,000 every year for the next

three years


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Time Value of Money

We cannot sim l sa :

Cash Inflow 60,000

ess os ,

Gain 15,000

Money has a time value. $20,000 in one years time

, .


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Time Value of Money

$A100

$HK100

Is the value of these amounts $300?


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Time Value of Money

convert them into a common scale as shownbelow:

$SGD100 = $AUD 80

=$AUD 200


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Time Value of Money

The value, in todays dollars, of a future.

The common scale used in accounting and

periods to be added together.


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Time Value of MoneyPresent Value

(45,000) 20,000 20,000 20,000

0 1 2 3

In calculating present value we convert (discount) all theannual cash flows into todays dollars (i.e. what is $20,000 inone year worth in todays dollars, what is $20,000 in two

.


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Time Value of MoneyLump Sum

umps sum re ers o a one o amoun .

resen a ue = u ure a ue

(1 + i)n

Where; i: Required rate of return

n: um er o years e amoun nee s o e scoun eback


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Present ValueLump Sum

,

the PV of $161 received in five years time?

? $161

0 1 2 3 4 5


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Solution

Present Value = Future Value

(1 + i)n

Present Value = 161

(1.10)5

Present Value = $99.97


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Practice Question 1

,

would need to be invested today in order tohave 15 000 in seven ears?

,

0 1 2 3 4 5 6 7


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Solution to Practice Question 1

Present Value = Future Value

(1 + i)n

Present Value = 15,000

(1.08)7

Present Value = $8,752.36


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Practice Question 2

in two years and $680 in four years. Assumea re uired rate of return of 12%.

500 680


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Present Value = 500 + 680

(1.12)2 (1.12)4

Present Value = $398.60 + 432.15

Present Value = $830.75


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Present ValueAnnuity

. .

received or paid throughout a projects life).

PV = FV1 + FV2 + FV3

(1 + i) (1 +i)2

(1 + i)3


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Practice Question 3

,

much would the government need to investtoda to fund a road safet ro ram costin$5m every year for the next three years?

PV = FV1 + FV2 + FV3


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= + +

(1.10) (1.10)2 (1.10)3

PV = 4,545,454 + 4,132,231 + 3,756,574

PV = $12,434,259

Govt. will invest $12.4m of its own money today and thiswill earn $2.6m in interest over three years.


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Practice Question 4

,

receive a return of $20,000 every year for thenext three ears. Assume a re uired rate ofreturn of 8%.


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PV = 20,000 + 20,000 + 20,000

(1.08) (1.08)2 (1.08)3

PV = 18,518 + 17,146 + 15,877

PV = $51,541

Gain = 51,541 45,000

Gain = 6 541

A $15,000 gain over three years is equivalent to a gain of $6,541 intoda s dollars.


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Present Value of an AnnuityEqual Annual Cash Flows

e cas ows are e same eac year:

= i]n

NCF: Net Annual Cash Flow

n: Useful life of project/asset


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Practice Question 5

cash flows of $40,000 for the next five years.If the re uired rate of return is 12% what isthe present value of these cash flows?


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= n

, 12%]5

= , .

PV = $144,192

A business should not pay more than $144,192 for themachine (assuming payment is made immediately).


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Practice Question 6

cost of $100,000. The machine is estimatedto have a useful life of 7 ears and to roduceestimated annual cash flows of $25,000 per

year. The required rate of return is 8%.

produced by the machine?


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= n

, 8%]7

= , .

,


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Capital Budgeting

the risk associated with capital expendituressuch as:

1. Purchasing new equipment

2. Opening a new retail store

3. Buying new premises

. xpan ng pro uc on ac es


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Importance of Capital Budgeting

characteristics.

Decision will extend well into the future.

cu o reverse ec s on.

The risk associated with capital expenditures istherefore very high.


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Capital Budgeting Process

.

2. Quantitative Analysis and Choice of

3. Implementation

4. u


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Quantitative Analysis

Ste One

Calculate the net annual cash flows. See Lecture Illustration I

Step Two

ppy one or more o e our evaua on ec nques

Payback Method

Net Present Value

Internal Rate of Return (not required in Acc100) Accounting Rate of Return (not required in Acc100)


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Analysis TechniquesPayback Method

Measures the time it will take the net annual cash

flows generated by a project to recover the cost of.

less than the pre-determined period of time set bythe business.


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Analysis TechniquesPayback Method

payback period greater than 4 years.

Potential

Project

Payback

Period (Years)

Outcome

A 2 Acceptable

B 5 Unacceptable

C 3.6 Acceptable


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Calculating Payback Period

,

expected to produce net annual cash flows of12 000 for the next 5 ears.

b k d


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Yea Annual Net InvestmentCash Flow

Recovered

1 12,000 12,000

2 12,000 24,000

3 12,000 36,000

C l l i P b k P i d


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,

After 3 years: $36,000 recovered

Therefore payback period is 2 years and ??mon s.

= 2 years + (8,000/12,000 x 12 months)= 2 years 8 months

P i Q i 7


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Practice Question 7

,

have a useful life of three years and toroduce net annual cash flows of 9 000 in

the first year, $11,000 in the second and

$14,000 in the third.

S l i P i Q i 7


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Recovered

1 9,000 9,000

2 11,000 20,000

3 14,000 34,000

S l i P i Q i 7


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After 2 ears: 20,000 recovered


Therefore payback period is 2 years and ?? months.

= years + , , x mon s

= 2 years 5.14 months

=

P ti Q ti 8


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Practice Question 8

,

produce the following cash flows:

1 2 3 4 5

, , , , ,

What is the payback period?

S l ti t P ti Q ti 8


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Recovered

1 32,600 32,600

2 33,400 66,000

3 35,200 101,200

Sol tion to Practice Q estion 8


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After 2 ears: 66 000 recovered


Therefore payback period is 2 years and ??

months.

= 2 ears + 29 700 35 200 x 12 months

= 2 years 10.125 months=

Analysis Techniques


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Analysis TechniquesPayback Method - Benefits

Simple to use and understand.

. .flows are less risky than later ones).

recover investments quickly.

Analysis Techniques


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Analysis TechniquesPayback Method - Limitations

Ignores the time value of money.

the initial cash outlay has been received.

(60) 20 20 20 100 120 150 180

(years)

Analysis Techniques


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Analysis TechniquesNet Present Value (NPV)

Calculate the present value of the net annual cashflows.

Step 2

Calculate the present value of the cost of theproject/asset.

Step 3

NPV = Answer to Step 1 Answer to Step 2

Analysis Techniques


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Analysis TechniquesNet Present Value

the increase in the entitys wealth, expressed

,accepting the project.

Practice Question 9


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Practice Question 9

cost of $85,000. The machine is estimated tohave a useful life of 6 ears and to roduceestimated net cash flows of $21,000 per year.

The organisation has a required rate of returnequal to 10%.

What is the net present value of themachine?



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NPV = PV of NCF PV Cost of Project

NPV = NCFi]n 85,000

NPV = 21,00010%]6 - 85,000

NPV = (21,000 x 4.3552) - 85,000

= -

NPV = 6,459

Practice Question 10


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,

produce a net annual cash flow of $17,000er ear. The life of the machine is estimatedto be four years and it is will be sold for an

estimated $5,000. The required rate of returnfor the business is 12%.



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NPV = PV of NCF PV Cost of Project

NPV = NCFi]n 45,000

NPV = 17,00012%]4 + 5,000/(1.12)4- 45,000

NPV = (17,000 x 3.0373) + 3,178 - 45,000

= + -

NPV = 9,812

Analysis Techniques


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Analysis Techniques

Net Present Value - Benefits

The time-value of money is considered.

analysis.

Required Rate of Return


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Required Rate of Return

Cost of Capital

The re uired rate of return is the minimumreturn a business needs to achieve from acapital investment.

In many cases the required rate of return isequal to the weighted average cost ofobtaining finance (i.e. the cost of capital)

Refer to the Accounting in Practice 2011.

Cost of Capital - Example


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s p p

Source of Amoun Interest RateFinance

A 90,000 8.5

, .

Cost of Capital - Solution


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p

Source of Amoun Interes Wei htin Cost of Finance

Capital

, . . .

B 10,000 10.2 0.10 1.02

100,000 1.00 8.67%



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Q

What is the Cost of Capital?

Source of Amoun InteresFinance

, .

B 95,000 9.6

C 35,000 11.3



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Q

Source of Amoun Interes Wei htin Cost of Finance

Capital

A 160,000 8.75 0.55 4.81

B 95,000 9.6 0.33 3.17

C 35,000 11.3 0.12 1.36

290,000 1.00 9.34%



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What is the cost of capital?

Source of Finance Amoun InterestRate

A 350,000 8.25%

B 175,000 8.60%

C 45,000 9.40%

D 15,000 11.3%



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Q

Source Amount Interest Rate Weighting Cost ofCapital

A 350,000 8.25% 0.598 4.93

B 175,000 8.60% 0.299 2.57

C 45,000 9.40% 0.077 0.72

, . . .

585,000 1.00 8.51%

NPV and Cost of Capital


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p

=

Return on the project > 14%

If NPV < 0

Return on the project < 14%

Qualitative Considerations


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ualitative factors must also be taken intoconsideration before a capital investment ismade. Examples of qualitative factorsnc u e: Impact on brand or reputation

. u u vmachinery may be deferred due to potentiallyadverse impact on staff morale and in-turnproductivity

Project may be resource intensive and distract.

C Capital Budgeting 2011 Lecture

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