capital budgeting and managerial decisions
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Capital Budgeting and Managerial Decisions. Chapter. 25. Outcome is uncertain. Large amounts of money are usually involved. Decision may be difficult or impossible to reverse. Investment involves a long-term commitment. Capital Budgeting. - PowerPoint PPT PresentationTRANSCRIPT
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Capital Budgeting and Managerial Decisions
Chapter
2525
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Capital budgeting:Analyzing alternative long-
term investments and deciding which assets to acquire or sell.
Outcomeis uncertain.
Large amounts ofmoney are usually
involved.
Investment involves along-term commitment.
Decision may bedifficult or impossible
to reverse.
Capital BudgetingCapital Budgeting
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Paybackperiod
= Cost of Investment Annual Net Cash Flow
Payback PeriodPayback Period
The payback period of an investmentis the time expected to recoverthe initial investment amount.
The payback period of an investmentis the time expected to recoverthe initial investment amount.
Managers prefer investing in projects with shorter payback periods.
Exh. 25-2
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FasTrac is considering buying a new machine that will be used in its manufacturing operations. The machine costs $16,000 and is expected to produce annual net cash flows
of $4,100. The machine is expected to have an 8-year useful life with no salvage value.
Calculate the payback period.
Paybackperiod
= Cost of Investment Annual Net Cash Flow
Paybackperiod
= $16,000
$4,100= 3.9 years
Payback Period with Even Cash FlowsPayback Period with Even Cash Flows
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In the previous example, we assumed that the increase in cash flows would be the same each year. Now, let’s look at an
example where the cash flows vary each year.
$4,100
$5,000
Payback Period withUneven Cash FlowsPayback Period withUneven Cash Flows
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FasTrac wants to install a machine
that costs $16,000 and has an 8-year
useful life with zero salvage
value. Annual net cash flows are:
YearAnnual Net Cash Flows
Cumulative Net Cash
Flows0 (16,000)$ (16,000)$ 1 3,000 (13,000) 2 4,000 (9,000) 3 4,000 (5,000) 4 4,000 (1,000) 5 5,000 4,000 6 3,000 7,000 7 2,000 9,000 8 2,000 11,000
Payback Period withUneven Cash FlowsPayback Period withUneven Cash Flows Exh.
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YearAnnual Net Cash Flows
Cumulative Net Cash
Flows0 (16,000)$ (16,000)$ 1 3,000 (13,000) 2 4,000 (9,000) 3 4,000 (5,000) 4 4,000 (1,000) 5 5,000 4,000 6 3,000 7,000 7 2,000 9,000 8 2,000 11,000
4.2
We recover the $16,000purchase price between
years 4 and 5, about4.2 years for the payback period.
Payback Period withUneven Cash FlowsPayback Period withUneven Cash Flows Exh.
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Ignores the time valueof money.
Ignores cashflows after the payback
period.
Unacceptable forprojects with longlives where time
value ofmoney effects
are major.
Using the Payback PeriodUsing the Payback Period
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Consider two projects, each with a five-year lifeand each costing $6,000.
Project One Project TwoNet Cash Net Cash
Year Inflows Inflows
1 2,000$ 1,000$ 2 2,000 1,000 3 2,000 1,000 4 2,000 1,000 5 2,000 1,000,000
Would you invest in Project One just because it has a shorter payback period?
Using the Payback PeriodUsing the Payback Period
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The accounting rate of return focuses onannual income instead of cash flows.
Accounting Rate of ReturnAccounting Rate of Return
Accounting Annual after-tax net incomerate of return Annual average investment
Accounting Annual after-tax net incomerate of return Annual average investment
=
Beginning book value + Ending book value2
Exh. 25-5,6
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Accounting Annual after-tax net incomerate of return Annual average investment
Accounting Annual after-tax net incomerate of return Annual average investment
=
Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the
accounting rate of return.
Beginning book value + Ending book value2
Accounting Rate of ReturnAccounting Rate of Return Exh. 25-5,6
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Accounting Annual after-tax net incomerate of return Annual average investment
Accounting Annual after-tax net incomerate of return Annual average investment
=
Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the
accounting rate of return.
Accounting Rate of ReturnAccounting Rate of Return
Beginning book value + Ending book value2
Exh. 25-5,6
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Accounting $2,100rate of return $8,000
Accounting $2,100rate of return $8,000
= = 26.25%
$16,000 + $02
Accounting Rate of ReturnAccounting Rate of Return
Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the
accounting rate of return.
Exh. 25-5,6
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Depreciation may be calculated several ways.
Income may vary from year to year.
Time value ofmoney is ignored.
So why would I ever want to use this method
anyway?
Using Accounting Rate of ReturnUsing Accounting Rate of Return
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Now let’s look at a capital budgeting modelthat considers the time value of cash flows.
Net Present ValueNet Present Value
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Discount the future net cash flows from the investment at the required rate of return.
Subtract the initial amount invested from sum of the discounted cash flows.
FasTrac is considering the purchase of a conveyor costing $16,000 with an 8-year useful life with zero salvage value that promises annual net cash flows of $4,100. FasTrac requires a 12 percent compounded annual return on its
investments.
Net Present ValueNet Present Value
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YearAnnual Net Cash Flows
Present Value of $1
Factor
Present Value of
Cash Flows1 4,100$ 0.8929 3,661$ 2 4,100 0.7972 3,269 3 4,100 0.7118 2,918 4 4,100 0.6355 2,606 5 4,100 0.5674 2,326 6 4,100 0.5066 2,077 7 4,100 0.4523 1,854 8 4,100 0.4039 1,656
Total 32,800$ 20,367$
Amount to be invested (16,000) Net present value of investment 4,367$
Net Present Valuewith Even Cash FlowsNet Present Valuewith Even Cash Flows Exh.
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YearAnnual Net Cash Flows
Present Value of $1
Factor
Present Value of
Cash Flows1 4,100$ 0.8929 3,661$ 2 4,100 0.7972 3,269 3 4,100 0.7118 2,918 4 4,100 0.6355 2,606 5 4,100 0.5674 2,326 6 4,100 0.5066 2,077 7 4,100 0.4523 1,854 8 4,100 0.4039 1,656
Total 32,800$ 20,367$
Amount to be invested (16,000) Net present value of investment 4,367$
Present value factorsfor 12 percent
Net Present Valuewith Even Cash FlowsNet Present Valuewith Even Cash Flows Exh.
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YearAnnual Net Cash Flows
Present Value of $1
Factor
Present Value of
Cash Flows1 4,100$ 0.8929 3,661$ 2 4,100 0.7972 3,269 3 4,100 0.7118 2,918 4 4,100 0.6355 2,606 5 4,100 0.5674 2,326 6 4,100 0.5066 2,077 7 4,100 0.4523 1,854 8 4,100 0.4039 1,656
Total 32,800$ 20,367$
Amount to be invested (16,000) Net present value of investment 4,367$
A positive net present value indicates that thisproject earns more than 12 percent on the investment.
Net Present Valuewith Even Cash FlowsNet Present Valuewith Even Cash Flows Exh.
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General decision rule . . .If the Net Present
Value is . . . Then the Project is . . .
Positive . . . Acceptable, since it promises a return greater than the required
rate of return.
Zero . . . Acceptable, since it promises a return equal to the required rate
of return.
Negative . . . Not acceptable, since it
promises a return less than the required rate of return.
Using Net Present ValueUsing Net Present Value
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PresentVa lue of
Net Cash Flow s $1 Factor PV of Net Cash Flow sYear A B C at 10% A B C
1 5,000$ 8,000$ 1,000$ 0.9091 4,546$ 7,273$ 909$ 2 5,000 5,000 5,000 0.8264 4,132 4,132 4,132 3 5,000 2,000 9,000 0.7513 3,757 1,503 6,762
Tota l 15,000$ 15,000$ 15,000$ 12,435$ 12,908$ 11,803$
Amount invested (12,000) (12,000) (12,000) Net Present Va lue 435$ 908$ (197)$
Although all projects require the same investment and havethe same total net cash flows, project B has a higher net present
value because of a larger net cash flow in year 1.
Net Present Valuewith Uneven Cash FlowsNet Present Valuewith Uneven Cash Flows Exh.
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Internal Rate of Return (IRR)Internal Rate of Return (IRR)
The interest rate that makes . . .
Presentvalue of
cash inflows
Presentvalue of
cash outflows=
The net present value equal zero.
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Projects with even annual cash flows
Project life = 3 yearsInitial cost = $12,000
Annual net cash inflows = $5,000
Determine the IRR for this project.
1. Compute present value factor.
2. Using present value of annuity table . . .
Internal Rate of Return (IRR)Internal Rate of Return (IRR) Exh. 26-9
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1. Compute present value factor. $12,000 ÷ $5,000 per year = 2.4000
2. Using present value of annuity table . . .
Projects with even annual cash flows
Internal Rate of Return (IRR)Internal Rate of Return (IRR) Exh. 26-9
Project life = 3 yearsInitial cost = $12,000
Annual net cash inflows = $5,000
Determine the IRR for this project.
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Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308
Locate the rowwhose number
equals the periods in theproject’s life.
1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000
2. Using present value of annuity table . . .
Internal Rate of Return (IRR)Internal Rate of Return (IRR) Exh. 26-9
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Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308
In that row,locate the
interest factorclosest in
amount to thepresent value
factor.
1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000
2. Using present value of annuity table . . .
Internal Rate of Return (IRR)Internal Rate of Return (IRR) Exh. 26-9
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Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308
1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000
2. Using present value of annuity table . . .
IRR is theinterest rate
of the columnin which the
present valuefactor is found.
IRR isapproximately
12%.
Internal Rate of Return (IRR)Internal Rate of Return (IRR) Exh. 26-9
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If cash inflows are unequal, trial and error solution will result if present value tables
are used.
Sophisticated business calculators and electronic spreadsheets can be used to
easily solve these problems.
Internal Rate of Return –Uneven Cash FlowsInternal Rate of Return –Uneven Cash Flows
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Internal Rate of Return Compare the internal rate
of return on a project to a predetermined hurdle rate (cost of capital).
To be acceptable, a project’s rate of return cannot be less than thecost of capital.
Using Internal Rate of ReturnUsing Internal Rate of Return
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Exh. 25-10
Payback Accounting Net present Internal rateperiod rate of return value of return
Basis of Cash Accrual Cash flows Cash flowsmeasurement flows income Profitability Profitability
Measure Number Percent Dollar Percentexpressed as of years Amount
Easy to Easy to Considers time Considers timeUnderstand Understand value of money value of money
Strengths Allows Allows Accommodates Allowscomparison comparison different risk comparisons
across projects across projects levels over of dissimilara project's life projects
Doesn't Doesn't Difficult to Doesn't reflectconsider time consider time compare varying risk
value of money value of money dissimilar levels over theLimitations projects project's life
Doesn't Doesn't giveconsider cash annual rates
flows after over the lifepayback period of a project
Comparing Methods