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Chapter 24

Chapter 24. Capital Budgeting and Investment Analysis. Capital Budgeting & Investment Decisions . These are decisions about when and how much to spend on capital assets Capital budgeting is the process of making such decisions Identify alternatives Evaluate and rank choices

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Chapter 24

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  1. Chapter 24 Capital Budgeting and Investment Analysis

  2. Capital Budgeting & Investment Decisions • These are decisions about when and how much to spend on capital assets • Capital budgeting is the process of making such decisions • Identify alternatives • Evaluate and rank choices • Make the decision

  3. Measures Used in Capital Budgeting • Net cash inflows include the increases in cash receipts less the cash payments made on a project. • Can be a series of equal or unequal amounts. • Cost savings are measured as the reduction of costs under each alternative.

  4. Other Considerations • Income taxes will affect cash flows and must be considered. • Depreciation expense does reduce income and income taxes, but it does not decrease cash flows. • Sale of the old assets will provide additional cash receipts up front. • Sale of the new assets at the end of their useful life is an additional cash flow at the end of the project life.

  5. Payback Period • Payback is a measure of how long it will take to recover the initial investment. • When you have equal cash flows • Payback = (Initial cost)/(annual net cash inflow) • If Payback <= useful life of project, then accept

  6. Cash Payback Method Assumptions: Investment cost $200,000 Expected useful life 8 years Expected annual net cash flows (equal) $40,000 Cash Payback Period Total Investment = Annual Net Cash Inflows What is the cash payback period?

  7. Cash Payback Method Assumptions: Investment cost $200,000 Expected useful life 8 years Expected annual net cash flows (equal) $40,000 Cash Payback Period Total Investment = Annual Net Cash Inflows Cash Payback Period $200,000 = = 5 years $40,000

  8. Payback with unequal cash flows • When cash flows are not the same every year, you cannot apply the previous formula. • Rather you must determine at what point the cumulative cash flows become positive. Where Cumulative CF = • (initial investment) + CF(yr1) + CF(yr2) + …

  9. Cash Payback Method Assumptions: Year 1 $ 60,000 $ 60,000 Year 2 80,000 140,000 Year 3 105,000 245,000 Year 4 155,000 400,000 Year 5 100,000 500,000 Year 6 90,000 590,000 Net Cash Cumulative Flow Net Cash Flow If the proposed investment is $400,000, what is the payback period?

  10. Cash Payback Method Assumptions: Year 1 $ 60,000 $ 60,000 Year 2 80,000 140,000 Year 3 105,000 245,000 Year 4 155,000 400,000 Year 5 100,000 500,000 Year 6 90,000 590,000 Net Cash Cumulative Flow Net Cash Flow If the proposed investment is $450,000, what is the payback period?

  11. Using Payback Period • Payback is the easiest of the methods to use and it gives us a quick idea of whether or not to consider the investment option further. • Weaknesses: • It does not consider the timing of the cash flows (relative amounts over the years) • It ignores any cash flows received after the point where cash is fully recovered.

  12. Accounting Rate of Return • ARR is another method of evaluating alternatives. It is easy to determine, but it also ignores the time value of money. • ARR = (average annual net income)/(avg. investment cost), where • Average investment cost = • (Initial cost + residual value)/2 • If ARR > cost of capital, then accept

  13. Average Rate of Return Method Assumptions: Machine cost $500,000 Expected useful life 4 years Residual value none Expected total income $200,000 Estimated Average Annual Income Average Rate of Return = Average Investment

  14. Average Rate of Return Method Assumptions: Machine cost $500,000 Expected useful life 4 years Residual value none Expected total income $200,000 Estimated Average Annual Income Average Rate of Return = Average Investment Average Rate of Return $200,000 / 4 yrs. = = 20% ($500,000 + $0) / 2

  15. Time Value of Money • Money received today has greater value than money to be received in the future because of the effects of compound interest. • PV(lump sum) = Future value*PV factor • PV(annuity) = payment*PVA factor • Where the PV factors are a function of the interest rate and the time • An annuity is a series of equal payments.

  16. Net Present Value Method • This method of evaluating capital projects involves the • Calculation of present values of all net cash inflows less the • Cost of the initial investment. • If NPV >= 0, then the project is acceptable. • This method is the best in evaluating alternatives.

  17. Net Present Value Method Exh. 24-7

  18. Net Present Value Method Exh. 24-7 Present value factorsfor 12 percent

  19. Net Present Value Method Exh. 24-7 A positive net present value indicates that thisproject earns more than 12 percent on the investment.

  20. Net Present Value Method Exh. 24-7

  21. Internal Rate of Return (IRR)  Presentvalue ofcash inflows Presentvalue ofcash outflows = The interest rate that makes . . . • The net present value equal zero.

  22. Projects with even annual cash flows Internal Rate of Return (IRR) Method Exh. 24-9 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 . . .

  23. Projects with even annual cash flows Internal Rate of Return (IRR) Method Exh. 24-9 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 = 2.4 2. Using present value of annuity table ...

  24. 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) Method Exh. 26-9 Locate the rowwhose numberequals the periods in theproject’s life.

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

  26. 1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000 2. Using present value of annuitytable . . . 4 Internal Rate of Return (IRR) Method Exh. 26-9 IRR isapproximately12%. IRR is theinterest rateof the columnin which thepresent valuefactor is found.

  27. Comparing Methods

  28. Hang in there! Only One More Chapter!

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