IF Capital Budgeting - Lecture

IF Capital Budgeting - Lecture - B USFIN 1030 I nt...

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BUSFIN 1030 – Introduction to Finance Capital Budgeting Example on Investment Criteria: With the expectation that Panthers will succeed in going to Sweet Sixteen next year, we decided to manufacture Panthers- and- Sweet-Sixteen -logo t-shirts. We estimate that we need $9,000 immediately for the costs related to fixed assets. We expect this project to last for 3 years and we are going to depreciate the fixed assets to zero over this period using straight-line depreciation. The fixed assets will have no value at the end. We expect $15,000, $10,000 and $7,000 in revenues while the expenses are expected to be $8,000, $6,000 and $4,000 in years 1 through 3, respectively. We estimate that this type of projects brings 20% return in the market. The applicable tax rate on our income is 15%. We assume we do not have any working capital requirements. The cash flow structure of this project will look like below: Year 0 1 2 3 Revenue $15,00 0 $10,00 0 $7,000 Expenses $8,000 $6,000 $4,00 0 Depreciation (1) $3,000 $3,000 $3,00 0 EBIT $4,000 $1,000 $– Taxes (15%) $600 $150 $– Net Income $3,400 $850 $– Operating Cash Flow (2) $6,400 $3,850 $3,00 0 Capital Spending $9,000 Cash Flow from Assets (3) $9,000 $6,400 $3,850 $3,00 0 (1) Annual depreciation expense is . © 2003-2009 Mehmet Yalin 1
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BUSFIN 1030 – Introduction to Finance Capital Budgeting (2) (3) (There is no net working capital in this question.) Let’s analyze this project using the following investment criteria: a. Average accounting return Average accounting return is the ratio of average expected net income of a project to its average book value. As long as we are using straight-line depreciation, we can measure the average book value as . Thus, 31.481% © 2003-2009 Mehmet Yalin 2
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BUSFIN 1030 – Introduction to Finance Capital Budgeting b. The payback rule The payback rule measures the number of periods it takes for a project’s expected cash flows to cover its initial cost. Thus, Yea r Cash Flo w Balance 0 –$9,000 –$9,000 1 $6,400 2 $3,850 At the end of year 1, we still need $2,600 to cover the initial cost. However, in year 2 we expect $3,850. Assuming that cash flows are evenly distributed through the year, it will take years to earn $2,600 in year 2. Therefore, the payback period of this project is 1.68 years . c. The discounted payback rule The discounted payback rule measures the number of periods it takes for the present value of a project’s expected cash flows to cover its initial cost. Thus, Yea r Cash Flo w PV(Cash Flow) Balance 0 –$9,000 –$9,000 –$9,000 1 $6,400 2 $3,850 3 $3,000 © 2003-2009 Mehmet Yalin 3
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BUSFIN 1030 – Introduction to Finance Capital Budgeting Therefore, because we have to assume that the cash flows happen at the end of the period when discounting, the discounted payback period of this project is 3 years . d.
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This note was uploaded on 10/16/2009 for the course BUSFIN 1030 taught by Professor Zutter during the Fall '08 term at Pittsburgh.

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IF Capital Budgeting - Lecture - B USFIN 1030 I nt...

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