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 Make the decision

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.

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.

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

Cash Payback Method

Investment cost $200,000Expected useful life 8 yearsExpected annual net cash flows (equal) $40,000

Assumptions:

CashPayback Period

Total Investment

Annual NetCash Inflows

=

What is the cash payback period?

What is the cash payback period?

Cash Payback Method

Investment cost $200,000Expected useful life 8 yearsExpected annual net cash flows (equal) $40,000

Assumptions:

=$200,000Cash

PaybackPeriod

=$40,000

5 years

CashPayback Period

Total Investment

Annual NetCash Inflows

=

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) +

…

Year 1 $ 60,000 $ 60,000Year 2 80,000140,000Year 3 105,000245,000Year 4 155,000400,000Year 5 100,000500,000Year 6 90,000590,000

Assumptions:

Net Cash CumulativeFlow Net Cash Flow

Cash Payback Method

If the proposed investment is $400,000, what is the payback period?


Year 1 $ 60,000 $ 60,000Year 2 80,000140,000Year 3 105,000245,000Year 4 155,000400,000Year 5 100,000500,000Year 6 90,000590,000

Assumptions:

Cash Payback Method



Net Cash CumulativeFlow Net Cash Flow

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.

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

Average Rate of Return Method

Machine cost $500,000Expected useful life 4 yearsResidual value noneExpected total income$200,000

Assumptions:

Average Rate

of Return

Estimated Average

Annual IncomeAverage Investment

=

Average Rate of Return Method

Machine cost $500,000Expected useful life 4 yearsResidual value noneExpected total income$200,000

Assumptions:

Average Rate

of Return

Estimated Average

Annual IncomeAverage Investment

=

=$200,000 / 4 yrs.Average

Rate of Return

=($500,000 + $0) /

2

20%

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.

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.

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$

Exh. 24-7

Net Present Value Method


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$


Present value factorsfor 12 percent

Exh. 24-7



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$


A positive net present value indicates that thisproject earns more than 12 percent on the investment.

Exh. 24-7



PV of an Annuity Factor

Present Value of

Cash Flows1 4,100$ 4.9676 20,367$


Assumptions: 8 years, 12% Interest Rate

Exh. 24-7Net Present Value Method

Internal Rate of Return (IRR)

The interest rate that makes . . .

Presentvalue of

cash inflows

Presentvalue of

cash outflows=

The net present value equal zero.

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 . . .

Exh. 24-9

Internal Rate of Return (IRR) Method

1. Compute present value factor. $12,000 ÷ $5,000 per year = 2.4

2. Using present value of annuity table ...

Projects with even annual cash flows

Exh. 24-9

Project life = 3 yearsInitial cost = $12,000

Annual net cash inflows = $5,000

Determine the IRR for this project.


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


Exh. 26-9


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.



Exh. 26-9


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



IRR is theinterest rateof the columnin which the

present valuefactor is found.

IRR isapproximately

12%.

Exh. 26-9

4


Comparing Methods

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

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Chapter 24