typical capital budgeting decisions plant expansion equipment selection equipment replacementlease...
TRANSCRIPT
Typical Capital Budgeting Decisions
Plant expansion
Equipment selection
Lease or buy Cost reduction
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Typical Capital Budgeting DecisionsCapital budgeting tends to fall into two broad
categories . . .Screening decisions. Does a proposed
project meet some present standard of acceptance?
Preference decisions. Selecting from among several competing courses of action.
Capital budgeting tends to fall into two broad categories . . .
Screening decisions. Does a proposed project meet some present standard of acceptance?
Preference decisions. Selecting from among several competing courses of action.
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The Net Present Value Method
To determine net present value we . . .Calculate the present value of cash inflows,Calculate the present value of cash outflows,The difference between the two streams of
cash flows is called the net present value.
To determine net present value we . . .Calculate the present value of cash inflows,Calculate the present value of cash outflows,The difference between the two streams of
cash flows is called the net present value.
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The Net Present Value MethodGeneral decision rule . . .General decision rule . . .
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Net present value analysis Net present value analysis emphasizes cash flows and not emphasizes cash flows and not
accounting net income.accounting net income.
Net present value analysis Net present value analysis emphasizes cash flows and not emphasizes cash flows and not
accounting net income.accounting net income.
The reason is that accounting net income is
based on accruals that ignore the timing of cash flows into and out of an
organization.
The reason is that accounting net income is
based on accruals that ignore the timing of cash flows into and out of an
organization.
The Net Present Value Method
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Repairs andRepairs andmaintenancemaintenance
IncrementalIncrementaloperatingoperating
costscosts
InitialInitialinvestmentinvestment
WorkingWorkingcapitalcapital
Typical Cash Outflows
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ReductionReductionof costsof costs
SalvageSalvagevaluevalue
IncrementalIncrementalrevenuesrevenues
Release ofRelease ofworkingworkingcapitalcapital
Typical Cash Inflows
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Two simplifying assumptions are usually Two simplifying assumptions are usually made in net present value analysis:made in net present value analysis:
All cash flows other than the initial
investment occur at the end of periods.
All cash flows other than the initial
investment occur at the end of periods.
All cash flows generated by an
investment project are immediately
reinvested at a rate of return equal to the
discount rate.
All cash flows generated by an
investment project are immediately
reinvested at a rate of return equal to the
discount rate.
Two Simplifying Assumptions
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Choosing a Discount Rate•The company’s 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.
•The company’s 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.
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Expanding the Net Present Value Method
To compare competing investment projects, we can use the following net
present value approaches:▫Total-cost
▫Incremental cost
To compare competing investment projects, we can use the following net
present value approaches:▫Total-cost
▫Incremental cost
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Least Cost DecisionsIn decisions where revenues are not In decisions where revenues are not
directly involved, managers should directly involved, managers should choose the alternative that has the least choose the alternative that has the least
total cost from a present value total cost from a present value perspective.perspective.
Let’s look at the Home Furniture CompanyLet’s look at the Home Furniture Company..
In decisions where revenues are not In decisions where revenues are not directly involved, managers should directly involved, managers should
choose the alternative that has the least choose the alternative that has the least total cost from a present value total cost from a present value
perspective.perspective.
Let’s look at the Home Furniture CompanyLet’s look at the Home Furniture Company..
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Screening Decisions
Pertain to whether or not some proposed
investment is acceptable; these
decisions come first.
Preference Decisions
Attempt to rank acceptable alternatives from the most to least
appealing.
Preference Decision – The Ranking of Investment Projects
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The net present value of one project cannot be directly compared to the net present
value of another project unless the investments are equal.
Net Present Value Method
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Ranking Investment Projects Project Net present value of project Profitability Investment required Index
=
A BNet present value of project $1,000 $1,000Investment required 80,000 5,000Project profitability index 1% 20%
Investment
The higher the project profitability index,The higher the project profitability index,the more desirable the project.the more desirable the project.
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The higher the internal The higher the internal rate of return, the rate of return, the
more desirable the more desirable the project.project.
The higher the internal The higher the internal rate of return, the rate of return, the
more desirable the more desirable the project.project.
When using the internal rate of return method to rank competing investment
projects, the preference rule is:
Internal Rate of Return Method
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The Payback Method
The payback period is the length of time that it takes for a project to recover its initial cost out
of the cash receipts that it generates. When the net annual cash inflow is the same
each year, this formula can be used to compute the payback period:
The payback period is the length of time that it takes for a project to recover its initial cost out
of the cash receipts that it generates. When the net annual cash inflow is the same
each year, this formula can be used to compute the payback period:
Payback period = Investment required Net annual cash inflow
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The Payback Method
Management at The Daily Grind wants to install an Management at The Daily Grind wants to install an espresso bar in its restaurant.espresso bar in its restaurant. The espresso bar:The espresso bar:
1.1. Costs $140,000 and has a 10-year life.Costs $140,000 and has a 10-year life.2.2. Will generate annual net cash inflows of $35,000.Will generate annual net cash inflows of $35,000.
Management requires a payback period of 5 years or Management requires a payback period of 5 years or less on all investments.less on all investments.
What is the payback period for the espresso bar?What is the payback period for the espresso bar?
Management at The Daily Grind wants to install an Management at The Daily Grind wants to install an espresso bar in its restaurant.espresso bar in its restaurant. The espresso bar:The espresso bar:
1.1. Costs $140,000 and has a 10-year life.Costs $140,000 and has a 10-year life.2.2. Will generate annual net cash inflows of $35,000.Will generate annual net cash inflows of $35,000.
Management requires a payback period of 5 years or Management requires a payback period of 5 years or less on all investments.less on all investments.
What is the payback period for the espresso bar?What is the payback period for the espresso bar?
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Payback period = Payback period = Investment required Investment required Net annual cash inflowNet annual cash inflow
Payback period = Payback period = $140,000 $140,000 $35,000$35,000
Payback period = Payback period = 4.0 years4.0 years
The payback period is 4.0 years. Therefore, management would choose
to invest in the bar.
The payback period is 4.0 years. Therefore, management would choose
to invest in the bar.
The Payback Method
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Ignores the Ignores the time valuetime valueof money.of money.
Ignores cashIgnores cashflows after flows after the paybackthe payback
period.period.
CriticismsCriticismsof the paybackof the payback
period.period.
Evaluation of the Payback Method
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Identifies Identifies investments that investments that
recoup cash recoup cash investments investments
quickly.quickly.
Evaluation of the Payback Method
StrengthsStrengthsof theof the
paybackpaybackmethod.method.
Serves as Serves as screening screening
tool.tool.
If productsIf productsbecome obsolete,become obsolete,It will help focus It will help focus on short paybackon short paybackperiod projects.period projects.
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11 22 33 44 55
$1,000$1,000 $0$0 $2,000$2,000 $1,000$1,000 $500$500
When the cash flows associated with an investment project change from year to year,
the payback formula introduced earlier cannot be used.
Instead, the un-recovered investment must be tracked year by year.
When the cash flows associated with an investment project change from year to year,
the payback formula introduced earlier cannot be used.
Instead, the un-recovered investment must be tracked year by year.
Payback and Uneven Cash Flows
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Simple Rate of Return Method•Does not focus on cash flows -- rather it
focuses on accounting net operating accounting net operating incomeincome.
•The following formula is used to calculate the simple rate of return:
Simple rateSimple rateof returnof return ==
Annual IncrementalAnnual IncrementalNet Operating IncomeNet Operating Income
Initial investmentInitial investment**
**Should be reduced by any salvage from the sale of the old equipment
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Simple Rate of Return Method
Management of The Daily Grind wants to install an espresso bar in its restaurant. The espresso bar:
1. Cost $140,000 and has a 10-year life.2. Will generate incremental revenues of
$100,000 and incremental expenses of $65,000, including depreciation.
What is the simple rate of return on the investment project?
Management of The Daily Grind wants to install an espresso bar in its restaurant. The espresso bar:
1. Cost $140,000 and has a 10-year life.2. Will generate incremental revenues of
$100,000 and incremental expenses of $65,000, including depreciation.
What is the simple rate of return on the investment project?
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Simple rateSimple rateof returnof return
$100,000 - $65,000 $100,000 - $65,000 $140,000$140,000 = 25%= 25%==
The simple rate of return method is The simple rate of return method is not not recommended because it ignores the time recommended because it ignores the time
value of money and the simple rate of value of money and the simple rate of return can fluctuate from year to year.return can fluctuate from year to year.
The simple rate of return method is The simple rate of return method is not not recommended because it ignores the time recommended because it ignores the time
value of money and the simple rate of value of money and the simple rate of return can fluctuate from year to year.return can fluctuate from year to year.
Simple Rate of Return Method
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Postaudit of Investment Projects
A postaudit is a follow-up after the project has been completed to see
whether or not expected results were actually realized.
A postaudit is a follow-up after the project has been completed to see
whether or not expected results were actually realized.
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