Internal Allocation of Scarce Resources

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


Learning Objective 1Learning Objective 1

Explain the processExplain the process

of capital budgeting.of capital budgeting.


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.



Delineate the four sharedDelineate the four shared

characteristics of allcharacteristics of all

capital projects.capital projects.


Characteristics ofCharacteristics ofCapital ProjectsCapital Projects

Sunk costsSunk costsSunk costsSunk costs High degreeHigh degreeof riskof risk

Long livesLong lives High costHigh cost



Describe the cost ofDescribe the cost of

capital and the conceptcapital and the concept

of scarce resources.of scarce resources.


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


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


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.



Determine the informationDetermine the information

relevant to a capitalrelevant to a capital

budgeting decision.budgeting decision.


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.



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.


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


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.


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.


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


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.


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.



$(100,000) 106,423$ 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



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?



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



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


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.


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


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.



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.



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.


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


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.


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.



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.


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.


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?


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.


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.



Determine present and Determine present and

futurefuture

values using present valuevalues using present value

and future value tables.and future value tables.


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%?


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?


End of Chapter 11End of Chapter 11

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Internal Allocation of Scarce Resources