For Ann Harris
Bapestar1
chap013capital_budgeting_decisions.pptPowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Capital Budgeting Decisions
Chapter 13
13-*
Typical Capital Budgeting Decisions
Plant expansion
Equipment selection
Lease or buy
Cost reduction
13-*
Typical Capital Budgeting Decisions
Capital budgeting tends to fall into two broad categories.
- Screening decisions. Does a proposed project meet some preset standard of acceptance?
- Preference decisions. Selecting from among several competing courses of action.
13-*
Time Value of Money
A dollar today is worth more than a dollar a year from now.
Therefore, projects that promise earlier returns are preferable to those that promise later returns.
13-*
Time Value of Money
The capital budgeting techniques that best recognize the time value of money are those that involve discounted cash flows.
13-*
Learning Objective 1
Evaluate the acceptability of an investment project using the net present value method.
13-*
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,
- Subtract the present value of the outflows from the present value of the inflows.
13-*
The Net Present Value Method
Sheet1
| If the Net Present Value is . . . | Then the Project is . . . | ||
| Positive . . . | Acceptable because it promises a return greater than the required rate of return. | ||
| Zero . . . | Acceptable because it promises a return equal to the required rate of return. | ||
| Negative . . . | Not acceptable because it promises a return less than the required rate of return. |
13-*
The Net Present Value Method
Net present value analysis emphasizes cash flows and not 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.
13-*
Typical Cash Outflows
Repairs and
maintenance
Incremental
operating
costs
Initial
investment
Working
capital
13-*
Typical Cash Inflows
Reduction
of costs
Salvage
value
Incremental
revenues
Release of
working
capital
13-*
Recovery of the Original Investment
Depreciation is not deducted in computing the present value of a project because . . .
- It is not a current cash outflow.
- Discounted cash flow methods automatically provide for a return of the original investment.
13-*
Recovery of the Original Investment
- Carver Hospital is considering the purchase of an attachment for its X-ray machine.
No investments are to be made unless they have an annual return of at least 10%.
Will we be allowed to invest in the attachment?
Sheet1
| Cost | $ 3,170 | ||
| Life | 4 years | ||
| Salvage value | zero | ||
| Increase in annual cash inflows | $ 1,000 |
Sheet2
Sheet3
13-*
Present value
of an annuity
of $1 table
Recovery of the Original Investment
Sheet1
| Item | Year(s) | Amount of Cash Flow | 10% Factor | Present Value of Cash Flows | |
| Initial investment (outflow) | Now | (3,170) | 1.000 | (3,170) | |
| Annual cash inflows | 1-4 | $ 1,000 | 3.170 | $ 3,170 | |
| Net present value | $ -0- |
Sheet2
Sheet3
Sheet1
| Present Value of $1 | |||||||
| 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 |
13-*
Recovery of the Original Investment
This implies that the cash inflows are sufficient to recover the $3,170 initial investment (therefore depreciation is unnecessary) and to provide exactly a 10% return on the investment.
Sheet1
| (1) | (2) | (3) | (4) | (5) | |||
| Year | Investment Outstanding during the year | Cash Inflow | Return on Investment (1) ´ 10% | Recovery of Investment during the year (2) - (3) | Unrecovered Investment at the end of the year (1) - (4) | ||
| 1 | $ 3,170 | $ 1,000 | $ 317 | $ 683 | $ 2,487 | ||
| 2 | 2,487 | 1,000 | 249 | 751 | 1,736 | ||
| 3 | 1,736 | 1,000 | 173 | 827 | 909 | ||
| 4 | 909 | 1,000 | 91 | 909 | 0 | ||
| Total investment recovered | $ 3,170 |
Sheet2
Sheet3
13-*
Two Simplifying Assumptions
Two simplifying assumptions are usually made in net present value analysis:
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.
13-*
Choosing a Discount Rate
- The firm’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.
13-*
The Net Present Value Method
Lester Company has been offered a five year contract to provide component parts for a large manufacturer.
Sheet1
| Cost and revenue information | |||||||
| Cost of special equipment | $ 160,000 | ||||||
| Working capital required | 100,000 | ||||||
| Relining equipment in 3 years | 30,000 | ||||||
| Salvage value of equipment in 5 years | 5,000 | ||||||
| Annual cash revenue and costs: | |||||||
| Sales revenue from parts | 750,000 | ||||||
| Cost of parts sold | 400,000 | ||||||
| Salaries, shipping, etc. | 270,000 |
13-*
The Net Present Value Method
At the end of five years the working capital will be released and may be used elsewhere by Lester.
Lester Company uses a discount rate of 10%.
Should the contract be accepted?
13-*
The Net Present Value Method
Annual net cash inflow from operations
Sheet1
| Sales revenue | $ 750,000 | ||||
| Cost of parts sold | (400,000) | ||||
| Salaries, shipping, etc. | (270,000) | ||||
| Annual net cash inflows | $ 80,000 |
13-*
The Net Present Value Method
Sheet1
| Years | Cash Flows | 10% Factor | Present Value | |||||
| Investment in equipment | Now | $ (160,000) | 1.000 | $ (160,000) | ||||
| Working capital needed | Now | (100,000) | 1.000 | (100,000) | ||||
| Net present value |
13-*
The Net Present Value Method
Sheet1
| Years | Cash Flows | 10% Factor | Present Value | |||||
| Investment in equipment | Now | $ (160,000) | 1.000 | $ (160,000) | ||||
| Working capital needed | Now | (100,000) | 1.000 | (100,000) | ||||
| Annual net cash inflows | 1-5 | 80,000 | 3.791 | 303,280 | ||||
| Net present value |
13-*
The Net Present Value Method
Sheet1
| Years | Cash Flows | 10% Factor | Present Value | |||||
| Investment in equipment | Now | $ (160,000) | 1.000 | $ (160,000) | ||||
| Working capital needed | Now | (100,000) | 1.000 | (100,000) | ||||
| Annual net cash inflows | 1-5 | 80,000 | 3.791 | 303,280 | ||||
| Relining of equipment | 3 | (30,000) | 0.751 | (22,530) | ||||
| Net present value |
13-*
The Net Present Value Method
Present value of $1
factor for 5 years at 10%.
Sheet1
| Years | Cash Flows | 10% Factor | Present Value | |||||
| Investment in equipment | Now | $ (160,000) | 1.000 | $ (160,000) | ||||
| Working capital needed | Now | (100,000) | 1.000 | (100,000) | ||||
| Annual net cash inflows | 1-5 | 80,000 | 3.791 | 303,280 | ||||
| Relining of equipment | 3 | (30,000) | 0.751 | (22,530) | ||||
| Salvage value of equip. | 5 | 5,000 | 0.621 | 3,105 | ||||
| Net present value |
13-*
Accept the contract because the project has a positive net present value.
The Net Present Value Method
Sheet1
| Years | Cash Flows | 10% Factor | Present Value | |||||
| Investment in equipment | Now | $ (160,000) | 1.000 | $ (160,000) | ||||
| Working capital needed | Now | (100,000) | 1.000 | (100,000) | ||||
| Annual net cash inflows | 1-5 | 80,000 | 3.791 | 303,280 | ||||
| Relining of equipment | 3 | (30,000) | 0.751 | (22,530) | ||||
| Salvage value of equip. | 5 | 5,000 | 0.621 | 3,105 | ||||
| Working capital released | 5 | 100,000 | 0.621 | 62,100 | ||||
| Net present value | $ 85,955 |
13-*
Quick Check
The working capital would be released at the end of the contract.
Denny Associates requires a 14% return.
Denny Associates has been offered a four-year contract to supply the computing requirements for a local bank.
Sheet1
| Cash flow information | |||||||
| Cost of computer equipment | $ 250,000 | ||||||
| Working capital required | 20,000 | ||||||
| Upgrading of equipment in 2 years | 90,000 | ||||||
| Salvage value of equipment in 4 years | 10,000 | ||||||
| Annual net cash inflow | 120,000 |
13-*
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
13-*
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
Sheet1
| Years | Cash Flows | 14% Factor | Present Value | |||||
| Investment in equipment | Now | $ (250,000) | 1.000 | $ (250,000) | ||||
| Working capital needed | Now | (20,000) | 1.000 | (20,000) | ||||
| Annual net cash inflows | 1-4 | 120,000 | 2.914 | 349,680 | ||||
| Upgrading of equipment | 2 | (90,000) | 0.769 | (69,210) | ||||
| Salvage value of equip. | 4 | 10,000 | 0.592 | 5,920 | ||||
| Working capital released | 4 | 20,000 | 0.592 | 11,840 | ||||
| Net present value | $ 28,230 |
13-*
Learning Objective 2
Evaluate the acceptability of an investment project using the internal rate of return method.
13-*
Internal Rate of Return Method
- The internal rate of return is the rate of return promised by an investment project over its useful life. It is computed by finding the discount rate that will cause the net present value of a project to be zero.
- It works very well if a project’s cash flows are identical every year. If the annual cash flows are not identical, a trial and error process must be used to find the internal rate of return.
13-*
Internal Rate of Return Method
General decision rule . . .
When using the internal rate of return, the cost of capital acts as a hurdle rate that a project must clear for acceptance.
Sheet1
| (1) | (2) | (3) | (4) | (5) | |||||||
| Year | Investment Outstanding during the year | Cash Inflow | Recover of Investment during the year (2) - (3) | Unrecovered Investment at the end of the year (1) - (4) | |||||||
| 1 | $ 3,170 | $ 1,000 | $ 317 | $ 683 | $ 2,487 | ||||||
| 2 | $ 2,487 | $ 1,000 | $ 249 | $ 751 | $ 1,736 | ||||||
| 3 | $ 1,736 | $ 1,000 | $ 173 | $ 827 | $ 909 | ||||||
| 4 | $ 909 | $ 1,000 | $ 91 | $ 909 | $ - | ||||||
| Total investment recovered | $ 3,170 | ||||||||||
| If the Internal Rate of Return is . . . | Then the Project is . . . | ||||||||||
| Equal to or greater than the minimum required rate of return . . . | Acceptable. | ||||||||||
| Less than the minimum required rate of return . . . | Rejected. |
Sheet2
Sheet3
13-*
Internal Rate of Return Method
- Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs.
- The machine has a 10-year life.
13-*
Internal Rate of Return Method
Future cash flows are the same every year in this example, so we can calculate the internal rate of return as follows:
Investment required
Annual net cash flows
PV factor for the
internal rate of return
=
$104, 320
$20,000
= 5.216
13-*
Internal Rate of Return Method
Find the 10-period row, move across until you find the factor 5.216. Look at the top of the column and you find a rate of 14%.
Using the present value of an annuity of $1 table . . .
Sheet1
| Periods | 10% | 12% | 14% | ||||
| 1 | 0.909 | 0.893 | 0.877 | ||||
| 2 | 1.736 | 1.690 | 1.647 | ||||
| . . . | . . . | . . . | . . . | ||||
| 9 | 5.759 | 5.328 | 4.946 | ||||
| 10 | 6.145 | 5.650 | 5.216 |
13-*
Internal Rate of Return Method
- Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs.
- The machine has a 10-year life.
The internal rate of return on this project is 14%.
If the internal rate of return is equal to or greater than the company’s required rate of return, the project is acceptable.
13-*
Quick Check
The expected annual net cash inflow from a project is $22,000 over the next 5 years. The required investment now in the project is $79,310. What is the internal rate of return on the project?
a. 10%
b. 12%
c. 14%
d. Cannot be determined
13-*
Quick Check
The expected annual net cash inflow from a project is $22,000 over the next 5 years. The required investment now in the project is $79,310. What is the internal rate of return on the project?
a. 10%
b. 12%
c. 14%
d. Cannot be determined
$79,310/$22,000 = 3.605,
which is the present value factor for an annuity over five years when the interest rate is 12%.
13-*
Comparing the Net Present Value and
Internal Rate of Return Methods
- NPV is often simpler to use.
- Questionable assumption:
- Internal rate of return method assumes cash inflows are reinvested at the internal rate of return.
13-*
- NPV is often simpler to use.
- Questionable assumption:
- Internal rate of return method assumes cash inflows are reinvested at the internal rate of return.
Comparing the Net Present Value and Internal Rate of Return Methods
13-*
Expanding the Net Present Value Method
To compare competing investment projects we can use the following net present value approaches:
- Total-cost
- Incremental cost
13-*
The Total-Cost Approach
White Company has two alternatives:
remodel an old car wash or,
remove the old car wash and install a new one.
The company uses a discount rate of 10%.
Sheet1
| New Car Wash | Old Car Wash | ||||
| Annual revenues | $ 90,000 | $ 70,000 | |||
| Annual cash operating costs | 30,000 | 25,000 | |||
| Annual net cash inflows | $ 60,000 | $ 45,000 |
13-*
The Total-Cost Approach
If White installs a new washer . . .
Let’s look at the present value
of this alternative.
Sheet1
| Cost | $ 300,000 | ||||
| Productive life | 10 years | ||||
| Salvage value | $ 7,000 | ||||
| Replace brushes at the end of 6 years | $ 50,000 | ||||
| Salvage of old equip. | $ 40,000 |
Sheet2
Sheet3
13-*
The Total-Cost Approach
If we install the new washer, the investment will yield a positive net present value of $83,202.
Sheet1
| Install the New Washer | |||||||||
| Year | Cash Flows | 10% Factor | Present Value | ||||||
| Initial investment | Now | $ (300,000) | 1.000 | $ (300,000) | |||||
| Replace brushes | 6 | (50,000) | 0.564 | (28,200) | |||||
| Annual net 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 |
13-*
The Total-Cost Approach
If White remodels the existing washer . . .
Let’s look at the present value
of this second alternative.
Sheet1
| Remodel costs | $175,000 | ||
| Replace brushes at the end of 6 years | 80,000 |
Sheet2
Sheet3
13-*
The Total-Cost Approach
If we remodel the existing washer, we will produce a positive net present value of $56,405.
Sheet1
| Remodel the Old Washer | |||||||||
| Year | Cash Flows | 10% Factor | Present Value | ||||||
| Initial investment | Now | $ (175,000) | 1.000 | $ (175,000) | |||||
| Replace brushes | 6 | (80,000) | 0.564 | (45,120) | |||||
| Annual net cash inflows | 1-10 | 45,000 | 6.145 | 276,525 | |||||
| Net present value | $ 56,405 |
13-*
The Total-Cost Approach
Both projects yield a positive net present value.
However, investing in the new washer will produce a higher net present value than remodeling the old washer.
Sheet1
| Net Present Value | |||
| Invest in new washer | $ 83,202 | ||
| Remodel existing washer | 56,405 | ||
| In favor of new washer | $ 26,797 |
Sheet2
Sheet3
Sheet4
Sheet5
Sheet6
Sheet7
Sheet8
Sheet9
Sheet10
Sheet11
Sheet12
Sheet13
Sheet14
Sheet15
Sheet16
13-*
The Incremental-Cost Approach
Under the incremental-cost approach, only those cash flows that differ between the two alternatives are considered.
Let’s look at an analysis of the White Company decision using the incremental-cost approach.
13-*
The Incremental-Cost Approach
We get the same answer under either the
total-cost or incremental-cost approach.
Sheet1
| Year | Cash 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 |
13-*
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
13-*
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
Sheet1
| Differences in cash flows | Years | Cash Flows | 14% Factor | Present Value | ||||
| Investment in equipment | Now | $ (20,000) | 1.000 | $ (20,000) | ||||
| Annual net cash inflows | 1-5 | 4,000 | 3.433 | 13,732 | ||||
| Salvage value of equip. | 5 | 2,000 | 0.519 | 1,038 | ||||
| Difference in net present value | $ (5,230) |
13-*
Least Cost Decisions
In decisions where revenues are not directly involved, managers should choose the alternative that has the least total cost from a present value perspective.
Let’s look at the Home Furniture Company.
13-*
Least Cost Decisions
Home Furniture Company is trying to decide whether to overhaul an old delivery truck now or purchase a new one.
The company uses a discount rate of 10%.
13-*
Least Cost Decisions
Here is information about the trucks . . .
Sheet1
| New Truck | |||
| Purchase price | $ 21,000 | ||
| Annual operating costs | 6,000 | ||
| Salvage value in 5 years | 3,000 |
Sheet2
Sheet3
Sheet4
Sheet5
Sheet6
Sheet7
Sheet8
Sheet9
Sheet10
Sheet11
Sheet12
Sheet13
Sheet14
Sheet15
Sheet16
Sheet1
| Old Truck | |||
| Overhaul cost now | $ 4,500 | ||
| Annual operating costs | 10,000 | ||
| Salvage value in 5 years | 250 | ||
| Salvage value now | 9,000 |
Sheet2
Sheet3
Sheet4
Sheet5
Sheet6
Sheet7
Sheet8
Sheet9
Sheet10
Sheet11
Sheet12
Sheet13
Sheet14
Sheet15
Sheet16
13-*
Least Cost Decisions
Sheet1
| Buy the New Truck | ||||||||
| Year | Cash 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) |
Sheet1
| Keep the Old Truck | ||||||||
| Year | Cash 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) |
13-*
Least Cost Decisions
Home Furniture should purchase the new truck.
Sheet1
| Net present value of costs | ||
| associated with purchase | ||
| of new truck | $ (32,883) | |
| Net present value of costs | ||
| associated with overhauling | ||
| existing truck | (42,255) | |
| Net present value in favor of | ||
| purchasing the new truck | $ 9,372 |
13-*
Quick Check
Bay Architects is considering a drafting machine that would cost $100,000, last four years, provide annual cash savings of $10,000, and considerable intangible benefits each year. How large (in cash terms) would the intangible benefits have to be per year to justify investing in the machine if the discount rate is 14%?
a. $15,000
b. $90,000
c. $24,317
d. $60,000
13-*
Bay Architects is considering a drafting machine that would cost $100,000, last four years, provide annual cash savings of $10,000, and considerable intangible benefits each year. How large (in cash terms) would the intangible benefits have to be per year to justify investing in the machine if the discount rate is 14%?
a. $15,000
b. $90,000
c. $24,317
d. $60,000
Quick Check
$70,860/2.914 = $24,317
Sheet1
| Years | Cash Flows | 14% Factor | Present Value | |||||
| Investment in machine | Now | $ (100,000) | 1.000 | $ (100,000) | ||||
| Annual net cash inflows | 1-4 | 10,000 | 2.914 | 29,140 | ||||
| Annual intangible benefits | 1-4 | ? | 2.914 | ? | ||||
| Net present value | $ (70,860) |
13-*
Learning Objective 3
Evaluate an investment project that has uncertain cash flows.
13-*
Uncertain Cash Flows – An Example
- Assume that all of the cash flows related to an investment in a supertanker have been estimated, except for its salvage value in 20 years.
- Using a discount rate of 12%, management has determined that the net present value of all the cash flows, except the salvage value is a negative $1.04 million.
How large would the salvage value need to be to make this investment attractive?
13-*
Uncertain Cash Flows – An Example
This equation can be used to determine that if the salvage value of the supertanker is at least $10,000,000, the net present value of the investment would be positive and therefore acceptable.
Sheet1
| (1) | (2) | (3) | (4) | (5) | ||||||||||||||||
| Year | Investment Outstanding during the year | Cash Inflow | Return on Investment (1) ´ 10% | Recover of Investment during the year (2) - (3) | Unrecovered Investment at the end of the year (1) - (4) | |||||||||||||||
| 1 | $ 3,170 | $ 1,000 | $ 317 | $ 683 | $ 2,487 | |||||||||||||||
| 2 | $ 2,487 | $ 1,000 | $ 249 | $ 751 | $ 1,736 | |||||||||||||||
| 3 | $ 1,736 | $ 1,000 | $ 173 | $ 827 | $ 909 | |||||||||||||||
| 4 | $ 909 | $ 1,000 | $ 91 | $ 909 | $ - | |||||||||||||||
| Total investment recovered | $ 3,170 | |||||||||||||||||||
| If the Internal Rate of Return is . . . | Then the Project is . . . | |||||||||||||||||||
| Equal to or greater than the minimum required rate of return . . . | Acceptable. | |||||||||||||||||||
| Less than the minimum required rate of return . . . | Rejected. | |||||||||||||||||||
| Net present value to be offset | $ 1,040,000 | = | $ 10,000,000 | |||||||||||||||||
| Present value factor | 0.104 |
Sheet2
Sheet3
13-*
Real Options
The ability to consider these real options adds value to many investments. The value of these options can be quantified using what is called real options analysis, which is beyond the scope of the book.
Delay the start of a project.
Expand a project if conditions are favorable.
Cut losses if conditions are unfavorable.
13-*
Learning Objective 4
Rank investment projects in order of preference.
13-*
Preference Decision – The Ranking of Investment Projects
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.
13-*
Internal Rate of Return Method
The higher the internal rate of return, the more desirable the project.
When using the internal rate of return method to rank competing investment projects, the preference rule is:
13-*
Net Present Value Method
The net present value of one project cannot be directly compared to the net present value of another project unless the investments are equal.
13-*
Ranking Investment Projects
The higher the profitability index, the
more desirable the project.
Project Net present value of the project
profitability Investment required
index
=
Sheet1
| ÷ | |||||
| Investment | |||||
| Project A | Project B | ||||
| Net present value (a) | $ 1,000 | $ 1,000 | |||
| Investment required (b) | $ 10,000 | $ 5,000 | |||
| Profitability index (a) ÷ (b) | 0.10 | 0.20 |
Sheet2
Sheet3
13-*
Other Approaches to
Capital Budgeting Decisions
Other methods of making capital budgeting decisions include:
- The Payback Method.
- Simple Rate of Return.
13-*
Learning Objective 5
Determine the payback period for an investment.
13-*
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 annual net cash inflow is the same each year, this formula can be used to compute the payback period:
The Payback Method
Payback period =
Investment required
Annual net cash inflow
13-*
The Payback Method
Management at The Daily Grind wants to install an espresso bar in its restaurant that
- Costs $140,000 and has a 10-year life.
- Will generate annual net cash inflows of $35,000.
Management requires a payback period of 5 years or less on all investments.
What is the payback period for the espresso bar?
13-*
The Payback Method
Payback period =
Investment required
Annual net cash inflow
According to the company’s criterion, management would invest in the espresso bar because its payback period is less than 5 years.
Payback period =
$140,000
$35,000
Payback period =
4.0 years
13-*
Quick Check
Consider the following two investments:
Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 14-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined
13-*
Consider the following two investments:
Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 14-10 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 Y has a payback period of slightly more than 2 years.
Which project do you think is better?
13-*
Evaluation of the Payback Method
Short-comings
of the payback
period.
Ignores the
time value
of money.
Ignores cash
flows after
the payback
period.
13-*
Evaluation of the Payback Method
Serves as screening tool.
Identifies investments that recoup cash investments quickly.
Identifies products that recoup initial investment quickly.
Strengths
of the payback
period.
13-*
Payback and Uneven Cash Flows
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.
1
2
3
4
5
$1,000
$0
$2,000
$1,000
$500
13-*
Payback and Uneven Cash Flows
For example, if a project requires an initial investment of $4,000 and provides uneven net cash inflows in years 1-5 as shown, the investment would be fully recovered in year 4.
1
2
3
4
5
$1,000
$0
$2,000
$1,000
$500
13-*
Learning Objective 6
Compute the simple rate of return for an investment.
13-*
Simple Rate of Return Method
Simple rate
of return
=
Annual incremental net operating income
-
Initial investment*
*Should be reduced by any salvage from the sale of the old equipment
Does not focus on cash flows -- rather it focuses on accounting net operating income.
The following formula is used to calculate the simple rate of return:
13-*
Simple Rate of Return Method
Management of The Daily Grind wants to install an espresso bar in its restaurant that:
- Cost $140,000 and has a 10-year life.
- 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?
13-*
Simple Rate of Return Method
Simple rate
of return
$35,000
$140,000
= 25%
=
13-*
Criticism of the Simple Rate of Return
Short-comings
of the simple
rate of return.
Ignores the
time value
of money.
The same project
may appear
desirable in some
years and
undesirable
in other years.
13-*
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.
If the Net Present
Value is . . . Then the Project is . . .
Positive . . .
Acceptable because it promises
a return greater than the
required rate of return.
Zero . . .
Acceptable because it promises
a return equal to the required
rate of return.
Negative . . .
Not acceptable because it
promises a return less than the
required rate of return.
Cost $3,170
Life4 years
Salvage valuezero
Increase in annual cash inflows $1,000
ItemYear(s)
Amount of
Cash Flow
10%
Factor
Present
Value of
Cash
Flows
Initial investment (outflow)Now(3,170) 1.000 (3,170)
Annual cash inflows1-41,000$ 3.170 3,170$
Net present value$ -0-
Periods10%12%14%
10.909 0.893 0.877
21.736 1.690 1.647
32.487 2.402 2.322
43.170 3.037 2.914
53.791 3.605 3.433
Present Value of $1
(1)(2)(3)(4)(5)
Year
Investment
Outstanding
during the
year
Cash
Inflow
Return on
Investment
(1) 10%
Recovery of
Investment
during the
year
(2) - (3)
Unrecovered
Investment at
the end of the
year
(1) - (4)
13,170$ 1,000$ 317$ 683$ 2,487$
22,4871,0002497511,736
31,7361,000173827909
49091,000919090
Total investment recovered3,170$
Cost and revenue information
Cost of special equipment $160,000
Working capital required100,000
Relining equipment in 3 years30,000
Salvage value of equipment in 5 years5,000
Annual cash revenue and costs:
Sales revenue from parts750,000
Cost of parts sold400,000
Salaries, shipping, etc.270,000
Sales revenue750,000$
Cost of parts sold (400,000)
Salaries, shipping, etc.(270,000)
Annual net cash inflows80,000$
Years
Cash
Flows
10%
Factor
Present
Value
Investment in equipmentNow $ (160,000)1.000 (160,000)$
Working capital neededNow(100,000) 1.000 (100,000)
Net present value
Years
Cash
Flows
10%
Factor
Present
Value
Investment in equipmentNow $ (160,000)1.000 (160,000)$
Working capital neededNow(100,000) 1.000 (100,000)
Annual net cash inflows1-580,000 3.791 303,280
Net present value
Years
Cash
Flows
10%
Factor
Present
Value
Investment in equipmentNow $ (160,000)1.000 (160,000)$
Working capital neededNow(100,000) 1.000 (100,000)
Annual net cash inflows1-580,000 3.791 303,280
Relining of equipment3 (30,000) 0.751 (22,530)
Net present value
Years
Cash
Flows
10%
Factor
Present
Value
Investment in equipmentNow $ (160,000)1.000 (160,000)$
Working capital neededNow(100,000) 1.000 (100,000)
Annual net cash inflows1-580,000 3.791 303,280
Relining of equipment3 (30,000) 0.751 (22,530)
Salvage value of equip.5 5,000 0.621 3,105
Net present value
Years
Cash
Flows
10%
Factor
Present
Value
Investment in equipmentNow $ (160,000)1.000 (160,000)$
Working capital neededNow(100,000) 1.000 (100,000)
Annual net cash inflows1-580,000 3.791 303,280
Relining of equipment3 (30,000) 0.751 (22,530)
Salvage value of equip.5 5,000 0.621 3,105
Working capital released5 100,000 0.621 62,100
Net present value85,955$
Cash flow information
Cost of computer equipment $ 250,000
Working capital required20,000
Upgrading of equipment in 2 years90,000
Salvage value of equipment in 4 years10,000
Annual net cash inflow120,000
Years
Cash
Flows
14%
Factor
Present
Value
Investment in equipmentNow $ (250,000)1.000 (250,000)$
Working capital neededNow(20,000) 1.000 (20,000)
Annual net cash inflows1-4120,000 2.914 349,680
Upgrading of equipment2 (90,000) 0.769 (69,210)
Salvage value of equip.4 10,000 0.592 5,920
Working capital released4 20,000 0.592 11,840
Net present value28,230$
If the Internal Rate of Return is . . . Then the Project is . . .
Equal to or greater than the minimum
required rate of return . . .
Acceptable.
Less than the minimum required rate
of return . . .
Rejected.
Periods10%12%14%
10.909 0.893 0.877
21.736 1.690 1.647
. . .. . .. . . . . .
95.759 5.328 4.946
106.145 5.650 5.216
New Car
Wash
Old Car
Wash
Annual revenues90,000$ 70,000$
Annual cash operating costs30,000 25,000
Annual net cash inflows60,000$ 45,000$
Cost $ 300,000
Productive life10 years
Salvage value
$ 7,000
Replace brushes
at the end of 6 years
$ 50,000
Salvage of old equip.
$ 40,000
Install the New Washer
Year
Cash
Flows
10%
FactorPresent Value
Initial investmentNow(300,000)$ 1.000 (300,000)$
Replace brushes6 (50,000) 0.564 (28,200)
Annual net cash inflows1-1060,000 6.145 368,700
Salvage of old equipmentNow40,000 1.000 40,000
Salvage of new equipment10 7,000 0.386 2,702
Net present value83,202$
Remodel costs$175,000
Replace brushes at
the end of 6 years80,000
Remodel the Old Washer
Year
Cash
Flows
10%
FactorPresent Value
Initial investmentNow(175,000)$ 1.000 (175,000)$
Replace brushes6 (80,000) 0.564 (45,120)
Annual net cash inflows1-1045,000 6.145 276,525
Net present value56,405$
Net Present
Value
Invest in new washer83,202$
Remodel existing washer56,405
In favor of new washer26,797$
Year
Cash
Flows
10%
Factor
Present
Value
Incremental investmentNow $(125,000) 1.000 $(125,000)
Incremental cost of brushes6 30,000$ 0.564 16,920
Increased net cash inflows1-1015,000 6.145 92,175
Salvage of old equipmentNow40,000 1.000 40,000
Salvage of new equipment10 7,000 0.386 2,702
Net present value
$ 26,797
Differences in cash flowsYears
Cash
Flows
14%
Factor
Present
Value
Investment in equipmentNow $ (20,000)1.000 (20,000)$
Annual net cash inflows1-54,000 3.433 13,732
Salvage value of equip.5 2,000 0.519 1,038
Difference in net present value(5,230)$
New Truck
Purchase price21,000$
Annual operating costs6,000
Salvage value in 5 years3,000
Old Truck
Overhaul cost now4,500$
Annual operating costs10,000
Salvage value in 5 years250
Salvage value now9,000
Buy the New Truck
Year
Cash
Flows
10%
Factor
Present
Value
Purchase priceNow $ (21,000) 1.000 $ (21,000)
Annual operating costs1-5(6,000) 3.791 (22,746)
Salvage value of old truckNow9,000 1.000 9,000
Salvage value of new truck5 3,000 0.621 1,863
Net present value
(32,883)
Keep the Old Truck
Year
Cash
Flows
10%
Factor
Present
Value
Overhaul costNow $ (4,500) 1.000 $ (4,500)
Annual operating costs1-5(10,000) 3.791 (37,910)
Salvage value of old truck5 250 0.621 155
Net present value
(42,255)
Net present value of costs
associated with purchase
of new truck(32,883)$
Net present value of costs
associated with overhauling
existing truck(42,255)
Net present value in favor of
purchasing the new truck9,372$
Years
Cash
Flows
14%
Factor
Present
Value
Investment in machineNow $ (100,000)1.000 (100,000)$
Annual net cash inflows1-410,000 2.914 29,140
Annual intangible benefits1-4?2.914 ?
Net present value(70,860)$
Net present value to be offset1,040,000$
Present value factor0.104
=10,000,000$
Project AProject B
Net present value (a)
1,000$ 1,000$
Investment required (b) $ 10,000 $ 5,000
Profitability index (a)
÷
(b)
0.10 0.20
