Present Value Method

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Capital Budgeting

Capital Budgeting
The process of evaluating and selecting
long-term investments that are consistent
with the firms goal of maximizing
owner wealth

A capital An operating
expenditure is expenditure
an outlay of funds by is an outlay of funds by
the firm that is the firm resulting in
expected to produce benefits received
benefits over a period within 1 year
of time greater than
1 year
Typical Capital Budgeting Decisions

Cost reduction
decision

Equipment
Expansion
replacement
decision
decision

Equipment
Lease or buy
selection
decision
decision
Time Value of Money

Projects that
A dollar promise
today is worth earlier returns
more than a dollar are preferable to those
a year from now that promise later
returns
Concept of Present Value

Single Payment Present Uniform Series Present

Worth Worth

P
F P

A 1 i 1
n

1 i n i 1 i n
Choosing Discount Rate

The firms cost of capital is usually regarded as the

minimum required rate of return

The cost of capital is the average rate of return the

company must pay to its long-term creditors and
stockholders for the use of their funds

This (opportunity) cost of capital is known as

discount rate
Present Value Analysis Net Present
Value (NPV) Method
Calculate the present value of cash inflows

Calculate the present value of cash outflows

Subtract the present value of the outflows from the

present value of the inflows

Net Present Value = Present value of cash flows -

Initial investment
Net Present Value Method

If the Net Present

Value is . . . Then the Project is . . .
Acceptable because it promises
Positive . . . a return greater than the
required rate of return.

Acceptable because it promises

Zero . . . a return equal to the required
rate of return.

Not acceptable because it

Negative . . . promises a return less than the
required rate of return.
Example
Thank You