11-1,Two decisions Make or buy Comparing _ with _ Activity analysis Use of facilities Strategic issuses Joint product process further Comparing sale value _ and _the process Two costs Opportunity cost Sunk cost,Capital Budgeting,Chapter 11,11-3,Long-Term (Capital) Assets,Capital assets are equipment or facilities that provide services to the organization for more than one fiscal period. Capital assets create these capacity-related costs,11-4,Need to Control Capital Assets,Organizations have developed specific tools to control the acquisition and use of long-term assets because: Organizations are usually committed to long-term assets for an extended time, creating the potential for Excess capacity that creates excess costs Scarce capacity that creates lost opportunities The amount of money committed to the acquisition of capital assets is usually quite large The long-term nature of capital assets creates technological risk Reduce an organizations flexibility,11-5,Meaning of Capital Budgeting,Capital budgeting can be defined as the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not. Capital budgeting has three phases: Identifying potential investments, Choosing which investments to make, and Follow-up monitoring of the investments.,11-6,11-7,Types of Capital Budgeting Decisions,Should we add a new product to our existing product line? Should we expand into a new market? Should we replace our existing machinery? Should we buy fully automatic or semiautomatic machinery Where to locate manufacturing facility?,11-8,Investment and Return,Investment and return form the foundation of capital budgeting analysis, which focuses on whether the expected increased cash flows (return) will justify the investment in the long-term asset Investment is the monetary value of the assets the organization gives up to acquire a long-term asset which are often called capital outlays. Return is the increased future cash inflows attributable to the long-term asset,11-9,Obviously, $1,000 today. Money received sooner rather than later allows one to use the funds for investment or consumption purposes. This concept is referred to as the TIME VALUE OF MONEY!,The Time Value of Money,Which would you rather have - $1,000 today or $1,000 in 5 years?,11-10,Time Value of Money,A dollar today is worth more than a dollar a year from now since a dollar received today can be invested, yielding more than a dollar a year from now.,11-11,Time Value of Money (1 of 2),Time value of money (TVM) is a central concept in capital budgeting In making investment decisions, the problem is that investment cash is paid out now, but the cash return is received in the future We need an equivalent basis to compare the cash flows that occur at different points in time,11-12,Time Value of Money (2 of 2),The critical idea underlying capital budgeting is: Amounts of money spent or received at different periods of time must be converted into their value on a common date in order to be compared,11-13,Some Standard Notation,For simplicity, the following notation is used:,11-14,Types of Interest,Compound Interest Interest paid (earned) on any previous interest earned, as well as on the principal borrowed (lent).,Simple Interest Interest paid (earned) on only the original amount, or principal borrowed (lent).,SIn = P0(1+ i n),CIn = P0 (1+i)n,11-15,Present Value,Analysts call a future cash flows value at time zero its present value The process of computing present value is called discounting We can rearrange the FV formula to compute the present value: FV = PV x (1 + r)n PV = FV/(1 + r)n or PV = FV x (1 + r)-n Methods similar to those described earlier may be used to compute this value Calculator, tables, or spreadsheet software,11-16,Assume that you need to have exactly $4,000 saved 10 years from now. How much must you deposit today in an account that pays 6% interest, compounded annually, so that you reach your goal of $4,000?,0 5 10,$4,000,6%,PV0,Present Value (Graphic),11-17,PV0 = FV / (1+i)10 = $4,000 / (1.06)10 = $2,233.58,Present Value (Formula),0 5 10,$4,000,6%,PV0,11-18,Quick Check ,How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? PV or FV? Table: _ a. $62.10 b. $56.70 c. $90.90 d. $51.90,11-19,How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62.10 b. $56.70 c. $90.90 d. $51.90,Quick Check ,$100 0.621 = $62.10,11-20,PRESENT VALUE Year 5% 10% 15% 1 .952 .909 .870 2 .907 .826 .756 5 .784 .621 .497 10 .614 .386 .247 20 .377 .149 .061,PRESENT VALUE OF $1,11-21,PRESENT VALUE Year 5% 10% 15% 1 .952 .909 .870 2 .907 .826 .756 5 .784 .621 .497 10 .614 .386 .247 20 .377 .149 .061,PRESENT VALUE OF $1,A fixed amount of cash to be received at some future time become less valuable as interest rate