ACG 2071 - Spring 2011 1

Chapter Twelve
Capital Investment
Decisions and the Time
Value of Money
ACG 2071 - Spring 2011 2
What is Capital Budgeting
Planning and analytical techniques
utilized by managers in determining
whether to purchase capital assets
or other long-term company
investments.
ACG 2071 - Spring 2011 3
Examples of Capital Assets
and Long-Term Investments

Machinery and Equipment
Buildings
Manufacturing Facilities
New products
New Business Segments
.
ACG 2071 - Spring 2011 4
Specific Methods Utilized to
Analyze Capital Budgeting
Decisions
(1) Payback Period - does not consider
time value of money
(2) Accounting Rate of Return (ARR) - does
not consider time value of money
(3) Net Present Value (NPV) - does
consider time value of money
(4) Internal Rate of Return (IRR) - does
consider time value of money
.
ACG 2071 - Spring 2011 5
What is the focus of capital
budgeting?
Except for ARR, the other methods focus on
expected net cash inflows from acquisition of
the asset.

Net Cash Inflows are the difference between:
- Cash Inflows or Savings such as additional
revenues, cost reductions, etc.
- Cash Outflows such as original investment
cash outlay, ongoing cash payments, etc.



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ACG 2071 - Spring 2011 6
Payback Period
Payback Period measures length of time to
recover initial investment. It does not
consider any cash flows after the payback
period

The shorter the payback period, the more
desirable the investment

If net cash inflows are equal for each year,
then Payback period=
Amount Invested
Expected Annual net cash inflow
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ACG 2071 - Spring 2011 7
Accounting Rate of Return (ARR)
Method focuses on operating income, not net cash
inflows. Measures average annual rate of return over
assets life
ARR =

Average annual operating income from asset
Initial Investment

Or

*Aver. annual net cash flow depreciation expense
Initial Investment

*Assumes depreciation expense is only non-cash expense


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ACG 2071 - Spring 2011 8
The other two methods (1) NPV and
(2) IRR use the concept of the time
value of money
Basic premise that a dollar received today is worth
more than a dollar expected to be received in the
future

Conversely, a dollar expected to be received in the
future is worth less than a dollar received today.

The present value (todays value) of future cash
flows is calculated by multiplying (1) the future cash
flow amount x (2) present value discount factor
.
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Formula for Present Value discount
Factor

PV Discount Factor = 1 / (1+i)
n

where;
i = interest rate
n = number of periods
Note the PV Discount Factors can also be found in Appendix
12A in the book
.
ACG 2071 - Spring 2011 10
What is the Present Value (todays
value) of receiving a lump sum of
$10,000 at the end of one year,
given a 12% rate?
PV = FV x PV Discount factor
PV = FV x 1 / (1+i)
n
PV = 10,000 x 1 / (1+.12)
1
PV = 10,000 x .893
PV = $ 8,930
Note .893 can also be found in Appendix 12A, Table A under
period 1, 12%

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ACG 2071 - Spring 2011 11
What is the Present Value of
receiving a lump sum of $10,000 at
the end of five years, given a 12%
rate?
PV = FV x 1 / (1+i)
n
PV = 10,000 x 1 / (1+.12)
5

PV = 10,000 x 1 / 1.762
PV = 10,000 x .567
PV = $ 5,670
Note .567 can also be found in Appendix 12A, Table A
under period 5, 12%

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ACG 2071 - Spring 2011 12
Annuities
An Annuity is a series of cash flows of equal
amount paid or received at regular
intervals.
To solve for the Present Value of an Annuity,
you essentially add together each period
amount.
Easier method is to use Appendix A, Table B
(PV of an annuity) to get the discount
factor of an annuity
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What is the Present Value of
receiving $10,000 each year for five
years, given a 12% rate?

PV = FV x PV Factor of an Annuity

PV = 10,000 x 3.605
PV = $ 36,050
Note 3.605 can be found in Appendix A, Table B under
period 5, 12%

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ACG 2071 - Spring 2011 14
Net Present Value Method (NPV)
Net Present Value (NPV) of an investment is
the difference between the present value of
the net cash inflows less the investments
cost.
NPV uses a discount (interest) rate that is
based on the companys required rate of
return for a project.
If the NPV is greater than zero, that means
the investment return exceeded the required
rate of return and management will generally
make the investment
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Internal Rate of Return
Method (IRR)

The internal rate of return (IRR)
is the actual yield or return
earned by an investment.
The IRR is the discount rate that
makes the NPV = 0.
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How does a companys decide on
the required rate of return?
Company could use their cost of capital
as a basis
Cost of Capital represents the company
costs to raise and use funds, either
through borrowing (bonds) or equity
(stock)
To adjust for risk in investment decisions,
company may increase the discount
rate above the companys cost of
capital
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