CHAPTER 14 SUPPLEMENTARY SLIDES CAPITAL BUDGETING

CHAPTER 14 SUPPLEMENTARY SLIDES CAPITAL BUDGETING - 16...

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Unformatted text preview: 16 McGraw­Hill/Irwin 16­1 Chapter Sixteen Capital Expenditure Decisions Capital 16­2 Discounted-Cash-Flow Analysis Plant expansion Equipment selection Equipment replacement Cost reduction Lease or buy McGraw­Hill/Irwin 16­3 Net-Present-Value Method – — ˜ ™ Prepare a table showing cash flows for each Prepare year, year, Calculate the present value of each cash flow Calculate using a discount rate, using Compute net present value, If the net present value (NPV) is positive, If accept the investment proposal. Otherwise, reject it. reject McGraw­Hill/Irwin 16­4 Net-Present-Value Method Mattson Co. has been offered a five year contract to Mattson provide component parts for a large manufacturer. provide McGraw­Hill/Irwin 16­5 Net-Present-Value Method T At the end of five years the working capital At will be released and may be used elsewhere by Mattson. elsewhere T Mattson uses a discount rate of 10%. Should the contract be accepted? McGraw­Hill/Irwin 16­6 Net-Present-Value Method Annual net cash inflows from operations McGraw­Hill/Irwin 16­7 Net-Present-Value Method McGraw­Hill/Irwin 16­8 Net-Present-Value Method Present value of an annuity of $1 Present factor for 5 years at 10%. factor McGraw­Hill/Irwin 16­9 Net-Present-Value Method Present value of $1 Present factor for 3 years at 10%. factor McGraw­Hill/Irwin 16­10 Net-Present-Value Method Present value of $1 Present factor for 5 years at 10%. factor McGraw­Hill/Irwin 16­11 Net-Present-Value Method Mattson should accept the contract because the present value of the cash inflows exceeds the present value of the cash outflows by $85,955. The project has a positive net present value. positive McGraw­Hill/Irwin 16­12 Internal-Rate-of-Return Method T The internal rate of return is the true The economic return earned by the asset over its life. its T The internal rate of return is computed by The finding the discount rate that will cause the net present value of a project to be zero. net McGraw­Hill/Irwin 16­13 Internal-Rate-of-Return Method T Black Co. can purchase a new machine at Black a cost of $104,320 that will save $20,000 per year in cash operating costs. T The machine has a 10-year life. McGraw­Hill/Irwin 16­14 Internal-Rate-of-Return Method Future cash flows are the same every year Future in this example, so we can calculate the internal rate of return as follows: internal Investment required Net annual cash flows Net $104, 320 $20,000 $20,000 = Present value factor Present = 5.216 5.216 McGraw­Hill/Irwin 16­15 Internal-Rate-of-Return Method The present value factor (5.216) is located on the Table IV in the Appendix. Scan the 10period row and locate the value 5.216. Look at the top of the column and you find a rate of 14% which is the internal rate of return. which $104, 320 $20,000 $20,000 = 5.216 McGraw­Hill/Irwin 16­16 Internal-Rate-of-Return Method Here’s the proof . . . McGraw­Hill/Irwin 16­17 Comparing the NPV and IRR Methods Net Present Value y The cost of capital is The used as the actual used discount rate. discount y Any project with a Any negative net present value is rejected. value McGraw­Hill/Irwin 16­18 Comparing the NPV and IRR Methods Net Present Value y The cost of capital is The used as the actual used discount rate. discount y Any project with a Any negative net present value is rejected. value Internal Rate of Return y The cost of capital is The compared to the internal rate of return on a project. rate y To be acceptable, a To project’s rate of return must be greater than the cost of capital. cost McGraw­Hill/Irwin 16­19 Comparing the NPV and IRR Methods The net present value method The has the following advantages over the internal rate of return method . . . method Easier to use. Easier Easier to adjust for risk. Easier Provides more usable information. information. McGraw­Hill/Irwin Assumptions Underlying Discounted-Cash-Flow Analysis All cash flows are treated as though they occur at year end. Assumes a perfect capital market. 16­20 Cash flows are Cash treated as if treated they are known with certainty. Cash inflows are immediately reinvested at the required rate of return. McGraw­Hill/Irwin 16­21 Managerial Accountant’s Role Managerial accountants are often asked to predict Managerial cash flows related to operating cost savings, additional working capital requirements, and incremental costs and revenues. incremental When cash flow projections are very uncertain, the When accountant may . . . accountant – increase the hurdle rate, — use sensitivity analysis. McGraw­Hill/Irwin 16­22 Postaudit of Investment Projects A postaudit is a follow-up after the project postaudit has been approved to see whether or not expected results are actually realized. expected McGraw­Hill/Irwin Alternative Methods for Making Investment Decisions Payback Method Payback Initial investment = period Annual after-tax cash inflow Annual 16­23 A company can purchase a machine for $20,000 that will provide annual cash inflows of $4,000 for 7 years. Payback = period McGraw­Hill/Irwin $20,000 $4,000 $4,000 = 5 years 16­24 Payback: Pro and Con – Fails to consider Fails the time value of money. money. — Does not consider Does a project’s cash flows beyond the payback period. payback McGraw­Hill/Irwin 16­25 Payback: Pro and Con – Provides a tool for Provides roughly screening investments. investments. — For some firms, it For may be essential that an investment recoup its initial cash outflows as quickly as possible. quickly McGraw­Hill/Irwin 16­26 Accounting-Rate-of-Return Method Discounted-cash-flow method focuses on Discounted-cash-flow cash flows and the time value of money. and Accounting-rate-of-return method focuses on Accounting-rate-of-return the incremental accounting income that results from a project. results McGraw­Hill/Irwin 16­27 Accounting-Rate-of-Return Method The following formula is used to calculate The the accounting rate of return: the Average Average incremental - incremental expenses, incremental revenues including depreciation revenues = Initial investment Accounting rate of return McGraw­Hill/Irwin 16­28 Accounting-Rate-of-Return Method Meyers Company wants to install an espresso bar in Meyers its restaurant. its The espresso bar: q Cost $140,000 and has a 10-year life. q Will generate incremental revenues of $100,000 and Will incremental expenses of $80,000 including depreciation. depreciation. What is the accounting rate of return on the What investment project? investment McGraw­Hill/Irwin 16­29 Accounting-Rate-of-Return Method Accounting = rate of return $100,000 - $80,000 $140,000 $140,000 = 14.3% 14.3% The accounting rate of return method is not recommended for a variety of reasons, the most important of which for is that it ignores the time value of money. is McGraw­Hill/Irwin 16­30 Capital Budgeting Practices Pe nt of m rce anage who be vee te rs lie ach chniqueis im portant. McGraw­Hill/Irwin Justification of Investments in Advanced Manufacturing Systems Hurdle rates are too high Time horizons are too short Bias towards incremental projects 16­31 Benefits difficult to quantify McGraw­Hill/Irwin Greater cash flow uncertainty ...
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This note was uploaded on 12/21/2010 for the course BUSA 5301 taught by Professor Taylor during the Fall '07 term at UT Arlington.

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