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Unformatted text preview: MGMT 201 (Ganguly) MGMT
Lecture 18: More about NPV, IRR, Lecture Payback period, Accounting Return, etc. (Chapter 16 contd.) Return, Quick Recapitulation Quick
NPV IRR Inferior Alternatives Alternative Methods for Making Investment Decisions Investment
Payback Method
Payback Initial investment = period Annual aftertax cash inflow Annual
Assumes uniform cash inflows over life! A company can purchase a machine for $20,000 that will provide annual cash inflows of $4,000 for 7 years. Payback = period $20,000 $4,000 $4,000 = 5 years Payback: Pro and Con Payback:
Fails to consider Fails the time value of money. money. Does not consider Does a project’s cash flows beyond the payback period. payback Payback: Pro and Con Payback:
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. possible. AccountingRateofReturn Method Method
Discountedcashflow method focuses on Discountedcashflow cash flows and the time value of money. and Accountingrateofreturn method focuses Accountingrateofreturn on the incremental accounting income that results from a project. results AccountingRateofReturn Method Method
The following formula is used to calculate The the accounting rate of return: the
Accounting rate of return Average Average incremental  incremental expenses, incremental revenues including depreciation revenues = Initial investment Meyers Company wants to install an espresso bar Meyers in its restaurant. in
The espresso bar: AccountingRateofReturn Method Method Cost $140,000 and has a 10year life. 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 AccountingRateofReturn Method 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 Back to NPV… Back
To compare competing investment projects To using net present value, we can use either net of these equivalent approaches: approaches: TotalCost Approach. IncrementalCost Approach. TotalCost Approach TotalCost
Black Co. is trying to decide whether to remodel an Black old car wash or remove it entirely and install a new one. one. The company uses a discount rate of 10%. TotalCost Approach TotalCost
The new washer costs $300,000 and will produce The revenues for 10 years. revenues The brushes have to be replaced at the end of 6 The years at a cost of $50,000. years The old washer has a current salvage value of The $40,000. $40,000. The estimated salvage value of the new washer will The be $7,000 at the end of 10 years. be Remodeling the old washer costs $175,000 and the Remodeling brushes must be replaced at the end of 6 years at a cost of $80,000 . cost Should Black replace the washer? TotalCost Approach TotalCost
Install the New Washer Year Now 6 110 Now 10 Cash Flows $ (300,000) (50,000) 60,000 40,000 7,000 10% Factor 1.000 0.564 6.145 1.000 0.386 Present Value $ (300,000) (28,200) 368,700 40,000 2,702 $ 83,202 Initial investment Replace brushes Net annual cash inflows Salvage old equipment Salvage new equipment Net present value If Black Co. installs the new washer, If the investment will yield a positive net present value of $83,202. TotalCost Approach TotalCost
Remodel the Old Washer Cash 10% Year Flows Factor Initial investment Now $ (175,000) 1.000 Replace brushes 6 (80,000) 0.564 Net annual cash inflows 110 45,000 6.145 Net present value Present Value $ (175,000) (45,120) 276,525 $ 56,405 If Black Co. remodels the existing If washer, it will produce a positive net present value of $56,405. TotalCost Approach TotalCost
Both projects yield a positive net present value. However, investing in the new washer will However, produce a higher net present value than remodeling the old washer. remodeling IncrementalCost Approach IncrementalCost
Under the incrementalcost approach, only those cash flows that differ between the two alternatives are considered. two Let’s look at an analysis of the Let’s Black Co. decision using the incrementalcost approach. the IncrementalCost Approach
Incremental investment Year Now Cash Flows $ (125,000) 10% Factor 1.000 Present Value $ (125,000) $300,000 new  $175,000 remodel = $125,000 IncrementalCost Approach IncrementalCost
Incremental investment Incre. cost of brushes Year Now 6 Cash Flows $ (125,000) $ 30,000 10% Factor 1.000 0.564 Present Value $ (125,000) 16,920 $80,000 remodel  $50,000 new = $30,000 IncrementalCost Approach IncrementalCost
Incremental investment Incre. cost of brushes Increased net cash inflows Year Now 6 110 Cash Flows $ (125,000) $ 30,000 15,000 10% Factor 1.000 0.564 6.145 Present Value $ (125,000) 16,920 92,175 $60,000 new  $45,000 remodel = $15,000 IncrementalCost Approach IncrementalCost
Incremental investment Incre. cost of brushes Increased net cash inflows Salvage old equipment Salvage new equipment Net present value Year Now 6 110 Now 10 Cash Flows $ (125,000) $ 30,000 15,000 40,000 7,000 10% Factor 1.000 0.564 6.145 1.000 0.386 Present Value $ (125,000) 16,920 92,175 40,000 2,702 $ 26,797 We get the same answer under either the totalcost and incrementalcost approach. NEXT, NEXT, Income Taxes and Capital Budgeting
Cash flows from an investment proposal Cash affect the company’s profit and its income tax liability. tax
Income = Revenue  Expenses + Gains  Losses AfterTax Cash Flows AfterTax The tax rate is 28%, so income taxes are $525,000 × 28% = $147,000 Cash Revenues Cash
High Country’s management is considering the High purchase of a new truck that will increase cash revenues by $110,000 and increase cash cost of goods sold by $60,000. The company is subject to a tax rate of 28%. to Let’s calculate the company’s aftertax Let’s cash flows. cash Cash Revenues Cash $50,000 × 28% = $14,000 Cash Revenues Cash A short cut works like this: Increase in income × ( 1  tax rate) $50,000 × ( 1  .28) = $36,000 Noncash Expenses Noncash
Not all expenses require cash outflows. The Not most common noncash expense is depreciation. depreciation.
Recall that High Country’s proposal involved the Recall purchase of a truck. The truck cost $40,000 and will be depreciated over four years using straightline depreciation. The truck is to be purchased on June 30, 2001. Onehalf year depreciation is taken in 2001. depreciation Noncash Expenses Noncash
Here is a complete depreciation schedule Here for High Country. for Depreciation Tax Shield Net Present Value Analysis Net
Calculation of the present value of proposal cash Calculation flows. flows. The sum of the present values from this proposal is a positive $71,550 We still have to tie up some loose ends in Chapter 16…. We’ll play catchup next week! We’ll ...
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