Capital Budgeting and Managerial Decisions

Capital Budgeting and Managerial Decisions Chapter 25

Outcomeis uncertain. • Large amounts ofmoney are usuallyinvolved. • Decision may bedifficult or impossibleto reverse. • Investment involves along-term commitment. Capital Budgeting Capital budgeting:Analyzing alternative long-term investments and deciding which assets to acquire or sell.

Payback period Cost of Investment Annual Net Cash Flow = Payback Period Exh. 25-2 The payback period of an investmentis the time expected to recoverthe initial investment amount. Managers prefer investing in projects with shorter payback periods.

Payback period Cost of Investment Annual Net Cash Flow = Payback period $16,000 $4,100 = = 3.9 years Payback Period with Even Cash Flows FasTrac is considering buying a new machine that will be used in its manufacturing operations. The machine costs $16,000 and is expected to produceannual 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.

$5,000 $4,100 Payback Period withUneven Cash Flows 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.

Payback Period withUneven Cash Flows Exh. 25-3 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:

4.2 Payback Period withUneven Cash Flows Exh. 25-3 We recover the $16,000 purchase price between years 4 and 5, about4.2 years for the payback period.

Unacceptable forprojects with longlives where timevalue ofmoney effectsare major. Using the Payback Period Ignores the time value of money. Ignores cash flows after the payback period.

Using the Payback Period Consider two projects, each with a five-year lifeand each costing $6,000. Would you invest in Project One just because it has a shorter payback period?

Accounting Annual after-tax net incomerate of return Annual average investment = Accounting Rate of Return Exh. 25-5,6 The accounting rate of return focuses onannual income instead of cash flows. Beginning book value + Ending book value2

Accounting Annual after-tax net incomerate of return Annual average investment = Accounting Rate of Return Exh. 25-5,6 Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute theaccounting rate of return. Beginning book value + Ending book value2

Accounting $2,100rate of return $8,000 = = 26.25% Accounting Rate of Return Exh. 25-5,6 Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute theaccounting rate of return. $16,000 + $02

Using Accounting Rate of Return • 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?

Net Present Value Now let’s look at a capital budgeting modelthat considers the time value of cash flows.

Net Present Value • 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 Valuewith Even Cash Flows Exh. 26-7

Net Present Valuewith Even Cash Flows Exh. 26-7 Present value factorsfor 12 percent

Net Present Valuewith Even Cash Flows Exh. 26-7 A positive net present value indicates that thisproject earns more than 12 percent on the investment.

Using Net Present Value General decision rule . . .

Net Present Valuewith Uneven Cash Flows Exh. 26-8 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.

 Presentvalue ofcashinflows Presentvalue ofcashoutflows = Internal Rate of Return (IRR) The interest rate that makes . . . • The net present value equal zero.

Internal Rate of Return (IRR) Exh. 26-9 Projects with even annual cash flows Project life = 3 yearsInitial cost = $12,000Annual 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) Exh. 26-9 Projects with even annual cash flows Project life = 3 yearsInitial cost = $12,000Annual net cash inflows = $5,000 Determine the IRR for this project. 1. Compute present value factor.$12,000 ÷ $5,000 per year = 2.4000 2. Using present value of annuity table . . .

Internal Rate of Return (IRR) Exh. 26-9 1. Determine the present value factor.$12,000 ÷ $5,000 per year = 2.4000 2. Using present value of annuity table . . . Locate the rowwhose numberequals the periods in theproject’s life.

Internal Rate of Return (IRR) Exh. 26-9 1. Determine the present value factor.$12,000 ÷ $5,000 per year = 2.4000 2. Using present value of annuity table . . . In that row,locate theinterest factorclosest inamount to thepresent valuefactor.

Internal Rate of Return (IRR) Exh. 26-9 1. Determine the present value factor.$12,000 ÷ $5,000 per year = 2.4000 2. Using present value of annuity table . . . IRR isapproximately12%. IRR is theinterest rateof the columnin which thepresent valuefactor is found.

Internal Rate of Return –Uneven Cash Flows If cash inflows are unequal, trial and error solution will result if present value tablesare used. Sophisticated business calculators and electronic spreadsheets can be used to easily solve these problems.

Internal Rate of Return Compare the internal rateof 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 Return

Comparing Methods Exh. 25-10

Capital Budgeting and Managerial Decisions