Chapter 27De Guzman, Mancia, Mendoza, Oliquino, Santos

Nature of the problem:

*Replacement - Shall we replace existing equipment with more efficient equipment?

*Expansion - Shall we build or otherwise acquire new facilities?

*Cost Reduction - Shall we buy equipment to perform operation now done manually?

*Choice of equipment - which of several proposed items of equipment shall we purchase for a given purpose?

*New product - Should a new product be added to the line?

General Approach:*Investment, which is usually made in a lump sum at the beginning of the project.

*Stream of Cash inflow expected to result from this investment over a period of future years

General Approach:*Investment, which is usually made in a lump sum at the beginning of the project.

*Stream of Cash inflow expected to result from this investment over a period of future years

Note: these two types of amount cannot be compared directly because they occur at different times.

Net Present Value:*We multiply the cash inflow for each year by the present value of $1 for that year at the appropriate rate of return.

*The rate at which the cash inflows are discounted is required rate of return, hurdle/discount rate.

*the difference between Cash inflows and the amount of investment is called Net Present Value. Nonnegative amount means proposal is acceptable.

Net Present Value:Problem NPV

A proposed investment of $1000 is expected to produce cash inflows of $625 per year for each of the next two years. The required rate if return 14%.

Discounting factor formula: = (1+r) ^ -t

Return on Investment:

Problem (ROI):

A proposed investment of $25000 is expected to generate annual cash inflows of $2500 a year for the next five years, with $25,000 to be recovered in a lump sum at the end of the fifth year.

Rate: $2,500 / $25,000=.10

INSERT THE LATE SCOTT’s WORK HERE.

Investment

The Investment is the amount of funds an entity risks if it accepts an investment proposal.

Existing Assets Investments in Working CapitalDeferred InvestmentsCapital Gains and Losses

Terminal Value

Residual ValueAcquisitions and New ProductsWorking Capital

Nonmonetary Considerations

The quantitative analysis involved in a capital investment proposal does not provide the complete solution to the problem because it encompasses only those elements that can be reduced to numbers.

Even if the proposal is amenable to a quantitative analysis, the result is, at most, a guide for the decision maker.

The techniques that were described are by no means the whole story of capital budgeting decisions. It is only part of the story that can be described as a definite procedure. The remainder generally is learned only through experience or trial and error.

Summary of the Analytical Process Select a required rate of return.

Estimate the economic life of the proposed project.

Estimate the differential cash inflows for each year during the economic life, being careful that the base case is properly defined and quantified.

Find the net investment.

Estimate the terminal values at the end of the economic life, including the residual value of equipment and current assets that will be liquidated.

Find the present value of all the inflows identified in bullet # 3 and # 5 by discounting them at the required rate of return.

Find the Net Present Value (NPV) by subtracting the net investment from the present value of the inflows. If the NPV is zero or positive, it can be said that the proposal is acceptable in terms of the monetary factors.

Other Methods of Analysis

Internal Rate of Return (IRR) Method When the Net Present Value (NPV) is used,

the required rate of return must be selected in advance of making the calculations because this rate is used to discount the cash inflows in each year. The IRR computes the rate of return that equates the present value of the cash inflows with the present value of the investment - the rate that makes the NPV equal zero. The IRR method is also called the Discounted Cash Flow (DCF) method.

Payback period Investment/inflow ratio

Number of years over which the investment outlay will be recovered (paid back) from the cash inflows if the estimates turn out to be correct

Decision Rule:

1. Accept the project only if its payback is LESS than the targeted payback period*.

2. Reject the project if the payback is equal to, or slightly less than the payback period.

*Economic life of the project

Payback Period =

Initial Investment

Cash Inflow per Period

Payback Method

Sample Problem:

Company C is planning to undertake a project requiring initial investment of $105 million. The project is expected to generate $25 million per year for 7 years. Calculate the payback period of the project.

Given: Initial investment= $105 million

Annual Cash Inflow= $25 million

Solution:

Payback period = $105

$25

Payback period = 4.2 years

Payback Method

Advantages:

1. Payback period is very simple to calculate.

2. It can be a measure of risk inherent in a project. Since cash flows that occur later in a project's life are considered more uncertain, payback period provides an indication of how certain the project cash inflows are.

3. For companies facing liquidity problems, it provides a good ranking of projects that would return money early.

Payback MethodDisadvantages:

1. It gives no consideration to consideration to differences in the length of the estimated economic lives of various projects

2. It makes no distinction between projects whose entire investment is made at Time Zero and those for which the investment is incurred over a period of several years.

3. It ignores the time value of money.

Payback Method

Discounted Payback Method More useful and more valid form of the

payback method In this method, the present value of each

year’s cash inflows is found, and these are cumulated year by year until they equal of exceed the amount of investment.

Unadjusted Return on Investment Method Computes the net income expected to be earned from the project

each year, in accordance with the principles of accrual accounting, including a provision for depreciation expense.

The amount of profit, or return, that an individual can expect based on an investment made.

Also known as the Accounting Rate of Return (ARR)

Decision Rule:

Accept the project only if its ARR is equal to or greater than the required accounting rate of return. In case of mutually exclusive projects, accept the one with highest ARR.

ARR = Average Accounting Profit

Average Investment

Sample Problem

An initial investment of $130,000 is expected to generate annual cash inflow of $32,000 for 6 years. Depreciation is allowed on the straight line basis. It is estimated that the project will generate scrap value of $10,500 at end of the 6th year. Calculate its accounting rate of return assuming that there are no other expenses on the project.

Solution:Annual Depreciation = (Initial Investment − Scrap Value) ÷ Useful Life in YearsAnnual Depreciation = ($130,000 − $10,500) ÷ 6 ≈ $19,917Average Accounting Income = $32,000 − $19,917 = $12,083Accounting Rate of Return = $12,083 ÷ $130,000 ≈ 9.3%

Unadjusted Return on Investment Method

Two Investment Problems

1. Screening Problem

The question is whether or not to accept a proposed investment. The discussion so far has been limited to this class of problem.

Many individual proposals come to management’s attention; by the techniques described above, those that are worthwhile can be screened out from others.

2. Preference Problems

Also called ranking or capital rationing problems.

More difficult question is asked: Of a number of proposals, each of which has an adequate return, how do they rank in terms of preference?

Preference Problems

Criteria for Preference Problems

IRR The highest the IRR, the better the project

NPV The higher the profitability index, the better the

project. Profitability Index- ratio of present value of the cash

inflows and the amount of investment

Preference Problems

Comparison of Preference Rules

The profitability index is superior to the internal rate of return as a device for ranking projects.

Make decision involving the acquisition of capital assets, and their analytical techniques are essentially the same as with profit-oriented companies.

The capital required for an investment in plant or equipment is obtained from either debt or equity capital or combination of both.

The cost of borrowed funds is easily measured. Do not pay income taxes, so that part of the

calculation is unnecessary. NPV is preferred than IRR

Nonprofit Organizations

Problem 27 - 1

Donated Sold

Gross income 10,000,000 10,000,000

Tax deduction/addition (110,000) 110,000

Taxable income 9,890,000 10,110,000

Income Tax Due (40%) 3,956,000 4,044,000

Calculate Tax

Problem 27 - 1

Donated Sold

Gross income 10,000,000 10,000,000

Less: Book Value of land 10,000 0

Gain from sale of land 0 100,000

Income before tax 9,990,00 10,100,000

Less: Income tax computed

3,956,000 4,044,000

Net Income after taxes 6,034,000 6,056,000

Calculate Net income after taxes

Problem 27 - 1

Donated Sold

Tax Savings 40% x 110,000

44,000 0

Cash from sale of land 0 110,000

Less: Additional Taxes 0 88,000

Additional Cash 44,000 22,000

Cash Flow

Problem 27 - 2

Comparison of income, cash flow, and taxes1 2 3 4 5 Total

Straight-Line

6,000

6,000

6,000

6,000

6,000

30,000

MACRS

6,000

9,600

5,400

4,500

4,500

30,000

Diff. in taxable income

0

(3,600)

600

1,500

1,500

0

Diff. in tax at 40%

0

(1,440)

240

600

600

0

Diff. in income after tax

0

(2,160)

360

900

900

0

Diff. in tax postponed

0

1,440

1,200

600

0

The End.Thank you.