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McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 12
Capital Budgeting Decisions
12-2
Typical Capital Budgeting Decisions
Plant expansionPlant expansion
Equipment selectionEquipment selection Equipment replacementEquipment replacement
Lease or buyLease or buy Cost reductionCost reduction
Capital budgeting analysis can be used for any decision Capital budgeting analysis can be used for any decision that involves an outlay now in order to obtain some future that involves an outlay now in order to obtain some future return. Typical capital budgeting decisions include:return. Typical capital budgeting decisions include:
12-3
Typical Capital Budgeting Decisions
Capital budgeting tends to fall into two broad Capital budgeting tends to fall into two broad categories . . .categories . . .
Screening decisionsScreening decisions.. Does a proposed Does a proposed project meet some present standard of project meet some present standard of acceptance?acceptance?
Preference decisionsPreference decisions.. Selecting from Selecting from among several competing courses of action. among several competing courses of action.
Capital budgeting tends to fall into two broad Capital budgeting tends to fall into two broad categories . . .categories . . .
Screening decisionsScreening decisions.. Does a proposed Does a proposed project meet some present standard of project meet some present standard of acceptance?acceptance?
Preference decisionsPreference decisions.. Selecting from Selecting from among several competing courses of action. among several competing courses of action.
12-4
Time Value of Money
A dollar today is worth A dollar today is worth more than a dollar a more than a dollar a
year from now. year from now. Therefore, investments Therefore, investments
that promise earlier that promise earlier returns are preferable to returns are preferable to those that promise later those that promise later
returns. returns.
12-5
The capital budgeting techniques that best recognize the time value of money are those that involve
discounted cash flowsdiscounted cash flows.
The capital budgeting techniques that best recognize the time value of money are those that involve
discounted cash flowsdiscounted cash flows.
Time Value of Money
12-6
Learning Objective 1
Evaluate the acceptabilityof an investment project
using the net presentvalue method.
12-7
The Net Present Value Method
To determine net present value we . . .To determine net present value we . . .Calculate the present value of cash Calculate the present value of cash
inflows,inflows,Calculate the present value of cash Calculate the present value of cash
outflows,outflows,Subtract the present value of the outflows Subtract the present value of the outflows
from the present value of the inflows.from the present value of the inflows.
To determine net present value we . . .To determine net present value we . . .Calculate the present value of cash Calculate the present value of cash
inflows,inflows,Calculate the present value of cash Calculate the present value of cash
outflows,outflows,Subtract the present value of the outflows Subtract the present value of the outflows
from the present value of the inflows.from the present value of the inflows.
12-8
The Net Present Value Method
General decision rule . . .General decision rule . . .
12-9
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
12-10
Repairs andRepairs andmaintenancemaintenance
IncrementalIncrementaloperatingoperating
costscosts
InitialInitialinvestmentinvestment
WorkingWorkingcapitalcapital
Typical Cash Outflows
12-11
ReductionReductionof costsof costs
SalvageSalvagevaluevalue
IncrementalIncrementalrevenuesrevenues
Release ofRelease ofworkingworkingcapitalcapital
Typical Cash Inflows
12-12
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 periodsend of periods.
All cash flows other than the initial
investment occur at the end of periodsend of periods.
All cash flows generated by an
investment project are immediately immediately
reinvestedreinvested at a rate of return equal to the
discount rate.
All cash flows generated by an
investment project are immediately immediately
reinvestedreinvested at a rate of return equal to the
discount rate.
Two Simplifying Assumptions
12-13
Choosing a Discount Rate
The cost of capital is the The cost of capital is the average rate of return the average rate of return the company must pay to its company must pay to its long-term creditors and long-term creditors and stockholders for the use of stockholders for the use of their funds.their funds.
The firm’s The firm’s cost of capitalcost of capital is is usually regarded as the usually regarded as the minimum required rate of minimum required rate of return.return.
The cost of capital is the The cost of capital is the average rate of return the average rate of return the company must pay to its company must pay to its long-term creditors and long-term creditors and stockholders for the use of stockholders for the use of their funds.their funds.
The firm’s The firm’s cost of capitalcost of capital is is usually regarded as the usually regarded as the minimum required rate of minimum required rate of return.return.
12-14
The Net Present Value Method
Let’s look at how we use the net present value
method to make business decisions.
Let’s look at how we use the net present value
method to make business decisions.
12-15
The Net Present Value Method
Lester Company has been offered a five year contract to provide component parts for a large
manufacturer.
12-16
The Net Present Value Method
At the end of five years, the working At the end of five years, the working capital will be released and may be capital will be released and may be used elsewhere by Lester.used elsewhere by Lester.
Lester Company uses a discount rate Lester Company uses a discount rate of 10%.of 10%.
Should the contract be accepted?Should the contract be accepted?
At the end of five years, the working At the end of five years, the working capital will be released and may be capital will be released and may be used elsewhere by Lester.used elsewhere by Lester.
Lester Company uses a discount rate Lester Company uses a discount rate of 10%.of 10%.
Should the contract be accepted?Should the contract be accepted?
12-17
The Net Present Value Method
Annual net cash inflows from operations
12-18
The Net Present Value Method
12-19
Present value of an annuityannuity of $1 factor for 5 years at 10%.
Present value of an annuityannuity of $1 factor for 5 years at 10%.
The Net Present Value Method
12-20
Present value of $1 factor for 3 years at 10%.
Present value of $1 factor for 3 years at 10%.
The Net Present Value Method
12-21
Present value of $1 Present value of $1 factor for 5 years at 10%.factor for 5 years at 10%.
Present value of $1 Present value of $1 factor for 5 years at 10%.factor for 5 years at 10%.
The Net Present Value Method
12-22
Accept the contract because the project has a positivepositive net present value.
The Net Present Value Method
12-23
Quick Check
Denny Associates has been offered a four-year contract to supply the computing requirements for a local bank.
The working capital is released at the end of the contract. Denny Associates requires a 14% return.
12-24
Quick Check
What is the net present value of the contract with the local bank?
a. $150,000
b. $ 28,230
c. $ 92,340
d. $132,916
What is the net present value of the contract with the local bank?
a. $150,000
b. $ 28,230
c. $ 92,340
d. $132,916
12-25
What is the net present value of the contract with the local bank?
a. $150,000
b. $ 28,230
c. $ 92,340
d. $132,916
What is the net present value of the contract with the local bank?
a. $150,000
b. $ 28,230
c. $ 92,340
d. $132,916
Quick Check
12-26Expanding the Net Present Value Method
To compare competing investment To compare competing investment projects, we can use the following net projects, we can use the following net
present value approaches:present value approaches:Total-costTotal-cost
Incremental costIncremental cost
To compare competing investment To compare competing investment projects, we can use the following net projects, we can use the following net
present value approaches:present value approaches:Total-costTotal-cost
Incremental costIncremental cost
12-27
The Total-Cost Approach
White Co. has two alternatives:White Co. has two alternatives:(1) remodel an old car wash or, (1) remodel an old car wash or, (2) remove it and install a new one.(2) remove it and install a new one.
The company uses a discount rate of 10%.The company uses a discount rate of 10%.
White Co. has two alternatives:White Co. has two alternatives:(1) remodel an old car wash or, (1) remodel an old car wash or, (2) remove it and install a new one.(2) remove it and install a new one.
The company uses a discount rate of 10%.The company uses a discount rate of 10%.
New Car Wash
Old Car Wash
Annual revenues 90,000$ 70,000$ Annual cash operating costs 30,000 25,000 Net annual cash inflows 60,000$ 45,000$
12-28
The Total-Cost Approach
If White installs a new washer . . .If White installs a new washer . . .
Cost $300,000 Productive life 10 yearsSalvage value 7,000Replace brushes at the end of 6 years 50,000Salvage of old equip. 40,000
Let’s look at the net present Let’s look at the net present value of this alternative.value of this alternative.
12-29
If we install the new washer, the If we install the new washer, the investment will yield a positive net investment will yield a positive net
present value of $83,202.present value of $83,202.
If we install the new washer, the If we install the new washer, the investment will yield a positive net investment will yield a positive net
present value of $83,202.present value of $83,202.
Install the New Washer
YearCash Flows
10% Factor
Present Value
Initial investment Now (300,000)$ 1.000 (300,000)$ Replace brushes 6 (50,000) 0.564 (28,200) Net annual cash inflows 1-10 60,000 6.145 368,700 Salvage of old equipment Now 40,000 1.000 40,000 Salvage of new equipment 10 7,000 0.386 2,702 Net present value 83,202$
The Total-Cost Approach
12-30
The Total-Cost Approach
If White remodels the existingIf White remodels the existing washer . . .washer . . .
Remodel costs $175,000 Replace brushes at the end of 6 years 80,000
Let’s look at the present valueLet’s look at the present valueof this second alternative.of this second alternative.
12-31
If we remodel the existing washer, we will If we remodel the existing washer, we will produce a positive net present value of produce a positive net present value of
$56,405.$56,405.
If we remodel the existing washer, we will If we remodel the existing washer, we will produce a positive net present value of produce a positive net present value of
$56,405.$56,405.
Remodel the Old Washer
YearCash Flows
10% Factor
Present Value
Initial investment Now (175,000)$ 1.000 (175,000)$ Replace brushes 6 (80,000) 0.564 (45,120) Net annual cash inflows 1-10 45,000 6.145 276,525 Net present value 56,405$
The Total-Cost Approach
12-32
Both projects yield a positive net present value.Both projects yield a positive net present value.
However, investing in the new washer will However, investing in the new washer will produce a higher net present value than produce a higher net present value than
remodeling the old washer.remodeling the old washer.
However, investing in the new washer will However, investing in the new washer will produce a higher net present value than produce a higher net present value than
remodeling the old washer.remodeling the old washer.
The Total-Cost Approach
12-33
The Incremental-Cost Approach
Under the incremental-cost approach, Under the incremental-cost approach, only those cash flows that differ only those cash flows that differ between the two alternatives are between the two alternatives are
considered.considered.
Let’s look at an analysis of the White Co. Let’s look at an analysis of the White Co. decision using the incremental-cost decision using the incremental-cost
approach.approach.
Under the incremental-cost approach, Under the incremental-cost approach, only those cash flows that differ only those cash flows that differ between the two alternatives are between the two alternatives are
considered.considered.
Let’s look at an analysis of the White Co. Let’s look at an analysis of the White Co. decision using the incremental-cost decision using the incremental-cost
approach.approach.
12-34
YearCash Flows
10% Factor
Present Value
Incremental investment Now $(125,000) 1.000 $(125,000)Incremental cost of brushes 6 30,000$ 0.564 16,920 Increased net cash inflows 1-10 15,000 6.145 92,175 Salvage of old equipment Now 40,000 1.000 40,000 Salvage of new equipment 10 7,000 0.386 2,702 Net present value $ 26,797
We get the same answer using either theWe get the same answer using either thetotal-cost or incremental-cost approach.total-cost or incremental-cost approach.
The Incremental-Cost Approach
12-35
Quick Check
Consider the following alternative projects. Each project would last for five years.
Project A Project B Initial investment $80,000 $60,000 Annual net cash inflows 20,000 16,000 Salvage value 10,000 8,000
The company uses a discount rate of 14% to evaluate projects. Which of the following statements is true?
a. NPV of Project A > NPV of Project B by $5,230
b. NPV of Project B > NPV of Project A by $5,230
c. NPV of Project A > NPV of Project B by $2,000
d. NPV of Project B > NPV of Project A by $2,000
12-36
Consider the following alternative projects. Each project would last for five years.
Project A Project B Initial investment $80,000 $60,000 Annual net cash inflows 20,000 16,000 Salvage value 10,000 8,000
The company uses a discount rate of 14% to evaluate projects. Which of the following statements is true?
a. NPV of Project A > NPV of Project B by $5,230
b. NPV of Project B > NPV of Project A by $5,230
c. NPV of Project A > NPV of Project B by $2,000
d. NPV of Project B > NPV of Project A by $2,000
Quick Check
12-37
Least Cost Decisions
In decisions where revenues are not In decisions where revenues are not directly involved, managers should directly involved, managers should
choose the alternative that has the least choose the alternative that has the least total cost from a present value total cost from a present value
perspective.perspective.
Let’s look at the Home Furniture CompanyLet’s look at the Home Furniture Company..
In decisions where revenues are not In decisions where revenues are not directly involved, managers should directly involved, managers should
choose the alternative that has the least choose the alternative that has the least total cost from a present value total cost from a present value
perspective.perspective.
Let’s look at the Home Furniture CompanyLet’s look at the Home Furniture Company..
12-38
Least Cost Decisions
Home Furniture Company is trying to Home Furniture Company is trying to decide whether to overhaul an old delivery decide whether to overhaul an old delivery truck now or purchase a new one.truck now or purchase a new one.
The company uses a discount rate of 10%.The company uses a discount rate of 10%.
Home Furniture Company is trying to Home Furniture Company is trying to decide whether to overhaul an old delivery decide whether to overhaul an old delivery truck now or purchase a new one.truck now or purchase a new one.
The company uses a discount rate of 10%.The company uses a discount rate of 10%.
12-39
Old TruckOverhaul cost now 4,500$ Annual operating costs 10,000 Salvage value in 5 years 250 Salvage value now 9,000
Here is information about the trucks . . .Here is information about the trucks . . .
Least Cost Decisions
12-40
Buy the New Truck
YearCash Flows
10% Factor
Present Value
Purchase price Now $ (21,000) 1.000 $ (21,000)Annual operating costs 1-5 (6,000) 3.791 (22,746)Salvage value of old truck Now 9,000 1.000 9,000 Salvage value of new truck 5 3,000 0.621 1,863
Net present value (32,883)
Keep the Old Truck
YearCash Flows
10% Factor
Present Value
Overhaul cost Now $ (4,500) 1.000 $ (4,500)Annual operating costs 1-5 (10,000) 3.791 (37,910)Salvage value of old truck 5 250 0.621 155
Net present value (42,255)
Least Cost Decisions
12-41
Least Cost Decisions
Home Furniture should purchase the newnew truck.
Net present value of costs associated with purchase of new truck (32,883)$ Net present value of costs associated with remodeling existing truck (42,255) Net present value in favor of purchasing the new truck 9,372$
12-42
Quick Check
Bay Architects is considering a drafting machine Bay Architects is considering a drafting machine that would cost $100,000, last four years, and that would cost $100,000, last four years, and provide annual cash savings of $10,000 and provide annual cash savings of $10,000 and considerable intangible benefits each year. How considerable intangible benefits each year. How large (in cash terms) would the intangible large (in cash terms) would the intangible benefits have to be per year to justify investing benefits have to be per year to justify investing in the machine if the discount rate is 14%?in the machine if the discount rate is 14%?
a. $15,000a. $15,000b. $90,000b. $90,000c. $24,317c. $24,317d. $60,000d. $60,000
Bay Architects is considering a drafting machine Bay Architects is considering a drafting machine that would cost $100,000, last four years, and that would cost $100,000, last four years, and provide annual cash savings of $10,000 and provide annual cash savings of $10,000 and considerable intangible benefits each year. How considerable intangible benefits each year. How large (in cash terms) would the intangible large (in cash terms) would the intangible benefits have to be per year to justify investing benefits have to be per year to justify investing in the machine if the discount rate is 14%?in the machine if the discount rate is 14%?
a. $15,000a. $15,000b. $90,000b. $90,000c. $24,317c. $24,317d. $60,000d. $60,000
12-43
Bay Architects is considering a drafting machine Bay Architects is considering a drafting machine that would cost $100,000, last four years, and that would cost $100,000, last four years, and provide annual cash savings of $10,000 and provide annual cash savings of $10,000 and considerable intangible benefits each year. How considerable intangible benefits each year. How large (in cash terms) would the intangible large (in cash terms) would the intangible benefits have to be per year to justify investing benefits have to be per year to justify investing in the machine if the discount rate is 14%?in the machine if the discount rate is 14%?
a. $15,000a. $15,000b. $90,000b. $90,000c. $24,317c. $24,317d. $60,000d. $60,000
Bay Architects is considering a drafting machine Bay Architects is considering a drafting machine that would cost $100,000, last four years, and that would cost $100,000, last four years, and provide annual cash savings of $10,000 and provide annual cash savings of $10,000 and considerable intangible benefits each year. How considerable intangible benefits each year. How large (in cash terms) would the intangible large (in cash terms) would the intangible benefits have to be per year to justify investing benefits have to be per year to justify investing in the machine if the discount rate is 14%?in the machine if the discount rate is 14%?
a. $15,000a. $15,000b. $90,000b. $90,000c. $24,317c. $24,317d. $60,000d. $60,000
Quick Check
$70,860$70,860//2.914 = $24,3172.914 = $24,317$70,860$70,860//2.914 = $24,3172.914 = $24,317
12-44
Learning Objective 2
Rank investment projectsin order of preference.
12-45
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
12-46
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
12-47
Ranking Investment Projects
Profitability Net present value of the project index Investment required=
A BNet present value (a) $800 $1,000Investment required (b) $80,000 $5,000Profitability index (a) ÷ (b) 0.01 0.20
Investment
The higher the profitability index, theThe higher the profitability index, themore desirable the project. Therefore, investment B is more desirable the project. Therefore, investment B is
more desirable than investment A. more desirable than investment A.
The higher the profitability index, theThe higher the profitability index, themore desirable the project. Therefore, investment B is more desirable the project. Therefore, investment B is
more desirable than investment A. more desirable than investment A.
12-48
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
12-49Other Approaches toCapital Budgeting Decisions
Other methods of making capital budgeting Other methods of making capital budgeting decisions include . . .decisions include . . .The Payback Method.The Payback Method.Simple Rate of Return.Simple Rate of Return.
Other methods of making capital budgeting Other methods of making capital budgeting decisions include . . .decisions include . . .The Payback Method.The Payback Method.Simple Rate of Return.Simple Rate of Return.
12-50
Learning Objective 3
Determine thepayback period
for an investment.
12-51
The Payback Method
The The payback periodpayback period is the length of time that it is the length of time that it takes for a project to recover its initial cost out takes for a project to recover its initial cost out
of the cash receipts that it generates.of the cash receipts that it generates.
When the net annual cash inflow is the same When the net annual cash inflow is the same each year, this formula can be used to each year, this formula can be used to
compute the payback period:compute the payback period:
The The payback periodpayback period is the length of time that it is the length of time that it takes for a project to recover its initial cost out takes for a project to recover its initial cost out
of the cash receipts that it generates.of the cash receipts that it generates.
When the net annual cash inflow is the same When the net annual cash inflow is the same each year, this formula can be used to each year, this formula can be used to
compute the payback period:compute the payback period:
Payback period = Investment required Net annual cash inflow
12-52
The Payback Method
The management at the Daily Grind wants to install The management at the Daily Grind wants to install an espresso bar in its restaurant.an 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 net annual cash inflows of Will generate net annual cash inflows of $35,000.$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?
The management at the Daily Grind wants to install The management at the Daily Grind wants to install an espresso bar in its restaurant.an 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 net annual cash inflows of Will generate net annual cash inflows of $35,000.$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?
12-53
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
According to the company’s criterion, According to the company’s criterion, management would invest in the management would invest in the
espresso bar because its payback espresso bar because its payback period is less than 5 years.period is less than 5 years.
According to the company’s criterion, According to the company’s criterion, management would invest in the management would invest in the
espresso bar because its payback espresso bar because its payback period is less than 5 years.period is less than 5 years.
The Payback Method
12-54
Quick Check
Consider the following two investments:
Project X Project YInitial investment $100,000 $100,000Year 1 cash inflow $60,000 $60,000Year 2 cash inflow $40,000 $35,000Year 3-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined
Consider the following two investments:
Project X Project YInitial investment $100,000 $100,000Year 1 cash inflow $60,000 $60,000Year 2 cash inflow $40,000 $35,000Year 3-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined
12-55
Consider the following two investments:
Project X Project YInitial investment $100,000 $100,000Year 1 cash inflow $60,000 $60,000Year 2 cash inflow $40,000 $35,000Year 3-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined
Consider the following two investments:
Project X Project YInitial investment $100,000 $100,000Year 1 cash inflow $60,000 $60,000Year 2 cash inflow $40,000 $35,000Year 3-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined
Quick Check
•Project X has a payback period of 2 years.Project X has a payback period of 2 years.•Project Y has a payback period of slightly more than 2 years.Project Y has a payback period of slightly more than 2 years.•Which project do you think is better?Which project do you think is better?
•Project X has a payback period of 2 years.Project X has a payback period of 2 years.•Project Y has a payback period of slightly more than 2 years.Project Y has a payback period of slightly more than 2 years.•Which project do you think is better?Which project do you think is better?
12-56
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
12-57
Serves as Serves as screening screening
tool.tool.
Identifies Identifies investments that investments that
recoup cash recoup cash investments investments
quickly.quickly.Identifies Identifies
products that products that recoup initial recoup initial investment investment
quickly.quickly.
StrengthsStrengthsof the paybackof the payback
period.period.
Evaluation of the Payback Method
12-58
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
12-59
11 22 33 44 55
$1,000$1,000 $0$0 $2,000$2,000 $1,000$1,000 $500$500
For example, if a project requires an For example, if a project requires an initial investment of $4,000 and initial investment of $4,000 and
provides uneven net cash inflows in provides uneven net cash inflows in years 1-5, as shown, the investment years 1-5, as shown, the investment would be fully recovered in year 4.would be fully recovered in year 4.
For example, if a project requires an For example, if a project requires an initial investment of $4,000 and initial investment of $4,000 and
provides uneven net cash inflows in provides uneven net cash inflows in years 1-5, as shown, the investment years 1-5, as shown, the investment would be fully recovered in year 4.would be fully recovered in year 4.
Payback and Uneven Cash Flows
12-60
Learning Objective 4
Compute thesimple rate of returnfor an investment.
12-61
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
12-62
Simple Rate of Return Method
The Management of the Daily Grind wants to The Management of the Daily Grind wants to install an espresso bar in its restaurant.install an espresso bar in its restaurant.
The espresso bar:The espresso bar:1.1. Cost $140,000 and has a 10-year life.Cost $140,000 and has a 10-year life.2.2. Will generate incremental revenues of Will generate incremental revenues of
$100,000 and incremental expenses of $100,000 and incremental expenses of $65,000, including depreciation.$65,000, including depreciation.
What is the simple rate of return on the What is the simple rate of return on the investment project?investment project?
The Management of the Daily Grind wants to The Management of the Daily Grind wants to install an espresso bar in its restaurant.install an espresso bar in its restaurant.
The espresso bar:The espresso bar:1.1. Cost $140,000 and has a 10-year life.Cost $140,000 and has a 10-year life.2.2. Will generate incremental revenues of Will generate incremental revenues of
$100,000 and incremental expenses of $100,000 and incremental expenses of $65,000, including depreciation.$65,000, including depreciation.
What is the simple rate of return on the What is the simple rate of return on the investment project?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%==
Criticisms of the simple rate of return Criticisms of the simple rate of return include that this method ignores the time include that this method ignores the time value of money and it can fluctuate from value of money and it can fluctuate from
year to year.year to year.
Criticisms of the simple rate of return Criticisms of the simple rate of return include that this method ignores the time include that this method ignores the time value of money and it can fluctuate from value of money and it can fluctuate from
year to year.year to year.
Simple Rate of Return Method
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Postaudit of Investment Projects
A postaudit is a follow-up after the A postaudit is a follow-up after the project has been completed to see project has been completed to see
whether or not expected results were whether or not expected results were actually realized.actually realized.
A postaudit is a follow-up after the A postaudit is a follow-up after the project has been completed to see project has been completed to see
whether or not expected results were whether or not expected results were actually realized.actually realized.
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The Concept of Present Value
Appendix 12AAppendix 12AAppendix 12AAppendix 12A
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Learning Objective 5
Understand presentvalue concepts and the
use of present value tables.
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A dollar received today is worth more
than a dollar received a year from now
because you can put it in the bank today
and have more than a dollar a year from
now.
The Mathematics of Interest
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Assume a bank pays 8% interest on a $100 deposit made today. How much
will the $100 be worth in one year?
FFnn = P(1 + r) = P(1 + r)nn
The Mathematics of Interest
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Assume a bank pays 8% interest on a $100 deposit made today. How much
will the $100 be worth in one year?
FFnn = P(1 + r) = P(1 + r)nn
FF11 = $100(1 + .08) = $100(1 + .08)11
FF11 = $108.00 = $108.00
The Mathematics of Interest
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Compound Interest
FFnn = P(1 + r) = P(1 + r)nn
What if the $108 was left in the bank for a What if the $108 was left in the bank for a second year? How much would the second year? How much would the
original $100 be worth at the end of the original $100 be worth at the end of the second year? second year?
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Compound Interest
The interest that is paid in the second year on the interest earned in the first year is
known as compound interest.
FF22 = $100(1 + .08) = $100(1 + .08)22
FF22 = $116.64 = $116.64
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Present Value
Future Value
An investment can be viewed in two ways—its future value or its present
value.
Let’s look at a situation where the future value is known and the present
value is the unknown.
Computation of Present Value
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Present Value
If a bond will pay $100 in two years, If a bond will pay $100 in two years, what is the what is the present value of the $100present value of the $100 if if an investor can earn a return of 12% on an investor can earn a return of 12% on
investments?investments?
(1 + r)(1 + r)nnP =P =FFnn
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Present Value
This process is called discounting. We have discounted the $100 to its present value of $79.72. The interest rate used to find the present value is called the discount rate.
(1 + .12)(1 + .12)22P =P =$100$100
P =P = $79.72$79.72
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Present Value
Let’s verify that if we put $79.72 in the bank today Let’s verify that if we put $79.72 in the bank today at 12% interest that it would grow to $100 at the at 12% interest that it would grow to $100 at the
end of two years.end of two years.
Year 1 Year 2Beginning balance 79.72$ 89.29$ Interest @ 12% 9.57$ 10.71$ Ending balance 89.29$ 100.00$
Year 1 Year 2Beginning balance 79.72$ 89.29$ Interest @ 12% 9.57$ 10.71$ Ending balance 89.29$ 100.00$
If $79.72 is put in the bank today and earns If $79.72 is put in the bank today and earns 12%, it will be worth $100 in two years.12%, it will be worth $100 in two years.
If $79.72 is put in the bank today and earns If $79.72 is put in the bank today and earns 12%, it will be worth $100 in two years.12%, it will be worth $100 in two years.
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RatePeriods 10% 12% 14%
1 0.909 0.893 0.877 2 0.826 0.797 0.769 3 0.751 0.712 0.675 4 0.683 0.636 0.592 5 0.621 0.567 0.519
RatePeriods 10% 12% 14%
1 0.909 0.893 0.877 2 0.826 0.797 0.769 3 0.751 0.712 0.675 4 0.683 0.636 0.592 5 0.621 0.567 0.519
$100 $100 ×× 0.797 = $79.72 present value 0.797 = $79.72 present value (rounded)(rounded)
Present value factor of $1 for 2 periods at 12%.Present value factor of $1 for 2 periods at 12%.Present value factor of $1 for 2 periods at 12%.Present value factor of $1 for 2 periods at 12%.
Present Value – An Example
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Quick Check
How much would you have to put in the How much would you have to put in the bank today to have $100 at the end of five bank today to have $100 at the end of five years if the interest rate is 10%?years if the interest rate is 10%?
a. $62.10a. $62.10
b. $56.70b. $56.70
c. $90.90c. $90.90
d. $51.90d. $51.90
How much would you have to put in the How much would you have to put in the bank today to have $100 at the end of five bank today to have $100 at the end of five years if the interest rate is 10%?years if the interest rate is 10%?
a. $62.10a. $62.10
b. $56.70b. $56.70
c. $90.90c. $90.90
d. $51.90d. $51.90
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How much would you have to put in the How much would you have to put in the bank today to have $100 at the end of five bank today to have $100 at the end of five years if the interest rate is 10%?years if the interest rate is 10%?
a. $62.10a. $62.10
b. $56.70b. $56.70
c. $90.90c. $90.90
d. $51.90d. $51.90
How much would you have to put in the How much would you have to put in the bank today to have $100 at the end of five bank today to have $100 at the end of five years if the interest rate is 10%?years if the interest rate is 10%?
a. $62.10a. $62.10
b. $56.70b. $56.70
c. $90.90c. $90.90
d. $51.90d. $51.90
Quick Check
$100 $100 0.621 = $62.10 0.621 = $62.10$100 $100 0.621 = $62.10 0.621 = $62.10
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11 22 33 44 55 66
$100$100 $100$100 $100$100 $100$100 $100$100 $100$100
Present Value of a Series of Cash Flows
An investment that involves a series of identical cash flows at the end of
each year is called an annuityannuity.
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Present Value of a Series of Cash Flows
Lacey Inc. purchased a tract of land on which a $60,000 payment will be due each
year for the next five years. What is the present value of this stream of cash
payments when the discount rate is 12%?
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Present Value of a Series of Cash Flows
We could solve the problem like this . . .
Periods 10% 12% 14%1 0.909 0.893 0.877 2 1.736 1.690 1.647 3 2.487 2.402 2.322 4 3.170 3.037 2.914 5 3.791 3.605 3.433
Present Value of an Annuity of $1
$60,000 × 3.605 = $216,300$60,000 × 3.605 = $216,300
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Quick Check
If the interest rate is 14%, how much If the interest rate is 14%, how much would you have to put in the bank today so would you have to put in the bank today so as to be able to withdraw $100 at the end as to be able to withdraw $100 at the end of each of the next five years?of each of the next five years?
a. $34.33a. $34.33b. $500.00b. $500.00c. $343.30c. $343.30d. $360.50d. $360.50
If the interest rate is 14%, how much If the interest rate is 14%, how much would you have to put in the bank today so would you have to put in the bank today so as to be able to withdraw $100 at the end as to be able to withdraw $100 at the end of each of the next five years?of each of the next five years?
a. $34.33a. $34.33b. $500.00b. $500.00c. $343.30c. $343.30d. $360.50d. $360.50
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If the interest rate is 14%, how much If the interest rate is 14%, how much would you have to put in the bank today so would you have to put in the bank today so as to be able to withdraw $100 at the end as to be able to withdraw $100 at the end of each of the next five years?of each of the next five years?
a. $34.33a. $34.33b. $500.00b. $500.00c. $343.30c. $343.30d. $360.50d. $360.50
If the interest rate is 14%, how much If the interest rate is 14%, how much would you have to put in the bank today so would you have to put in the bank today so as to be able to withdraw $100 at the end as to be able to withdraw $100 at the end of each of the next five years?of each of the next five years?
a. $34.33a. $34.33b. $500.00b. $500.00c. $343.30c. $343.30d. $360.50d. $360.50
Quick Check
$100 $100 3.433 = $343.30 3.433 = $343.30
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Quick Check
If the interest rate is 14%, what is the If the interest rate is 14%, what is the present value of $100 to be received at present value of $100 to be received at the end of the 3rd, 4th, and 5th years?the end of the 3rd, 4th, and 5th years?
a. $866.90a. $866.90
b. $178.60b. $178.60
c. $ 86.90c. $ 86.90
d. $300.00d. $300.00
If the interest rate is 14%, what is the If the interest rate is 14%, what is the present value of $100 to be received at present value of $100 to be received at the end of the 3rd, 4th, and 5th years?the end of the 3rd, 4th, and 5th years?
a. $866.90a. $866.90
b. $178.60b. $178.60
c. $ 86.90c. $ 86.90
d. $300.00d. $300.00
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If the interest rate is 14%, what is the If the interest rate is 14%, what is the present value of $100 to be received at present value of $100 to be received at the end of the 3rd, 4th, and 5th years?the end of the 3rd, 4th, and 5th years?
a. $866.90a. $866.90
b. $178.60b. $178.60
c. $ 86.90c. $ 86.90
d. $300.00d. $300.00
If the interest rate is 14%, what is the If the interest rate is 14%, what is the present value of $100 to be received at present value of $100 to be received at the end of the 3rd, 4th, and 5th years?the end of the 3rd, 4th, and 5th years?
a. $866.90a. $866.90
b. $178.60b. $178.60
c. $ 86.90c. $ 86.90
d. $300.00d. $300.00
Quick Check
$100 (3.433 - 1.647) = $100 1.786 = $178.60or
$100 (0.675 + 0.592 + 0.519) = $100 1.786 = $178.60
$100 (3.433 - 1.647) = $100 1.786 = $178.60or
$100 (0.675 + 0.592 + 0.519) = $100 1.786 = $178.60
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End of Chapter 12