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Ch 13 SLides - 3-1 Typical Capital Budgeting Decisions...

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3-1 Typical Capital Budgeting Decisions Capital budgeting tends to fall into two broad categories . . oScreening decisions Does a proposed project meet sotne preset standard of acceptance? €Preference decisions. Selecting from among several competing courses of action Gapital Budgeting Decisions Chapter Thirteen Typical Capital Budgeting Decisions Equipment replacement Time Value of Money A dollar today is worth more than a dollar a year from now. Therefore, investments that promise earlier returns are preferable to those that promise later returns Learning Objective 1 Time Value of Money The capital budgeting techniques that best recognize the time value of money are those that involve discounted cash flows.
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The Net Present Value Method To determine net present value we . . . OGalculate tle present value of cash inflows, ACalculate the present vaiue of cash outflows, Osubtract ttrc present value of the outflows from the present value of the inflows The Net Present Value Method General decision rule lf the Net Present Value is - - ; Aceptable, since il promises a ; P6itive . . - return great€r thiluthe required I tueptable, sine it promises a 1 bto. . ret"- *"1;:fl?required rate j Not aceptable, sine it promises i Negative. . , a return less than the required rate of return. 3-2 Typical Cash Outflows Recovery of the Original lnvestment The Net Present Value Method Net present value analysis emphasizes cash flows and not accounting net income- Typical Cash lnflows Reduction of costs lncremental revenues
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Recovery of the Original lnvestment Carver Hospital is considering the purchase of an attachment for its X-ray machine Cod $3,170 Life 4 years Salvage value zero lncreasB in annual cash inflows 1,000 No investments are to be made unless they have an annual return of at least '10% Will we be allowed to invest in the attachment? J-J Recovery of the Original lnvestment Pe.iod3 1O./. 1 0909 O 9O9 Otfr O A77 2 1.736 /rf69o 1 647 3 2.447 t 2.402 2.322 l z rto/ J o37 2.914 5 3791 3605 3433 Recovery of the Original Investment (1) l2l (3) (4) 1 S 3.17t51,A0A S 317S 68?$ 2.487 Recover of Unrecovered lnvestment lnvelment lnve$flent at Outdanding Return on during the the end ofthe during the Cash lnvedment yeat year Year year lnflow (1i / 1o'/a (2) - (3) (1) - (4) 2 S 2,487 S 1.00A S 249 $ 751 S 1.736 3 S 1,735 S 1,000 S 173 S B?7 I sos 4 5 909 S 1.000 5 91 S SCe 5 otal investment recovered $ 3,170 This implies that the cash inflows are sufticient to recover the $3,170 initial investment (therefore depreciation is unnecessary) and to provide exactly a 10% retum on the investment. Two Simplifying Assumptions Two simplifying assumptions are usually made in net present value analysis: : All cash flows aancafsi hw an M"x reinvested at a rate of return equal to the discount rate. Choosing a Discount Rate The firm's cost ol 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 The Net Present Value Method Lester Company has been offered a five year contracl to provide component parts for a large
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