MGMT_201_(Ganguly)_Lecture_17 - MGMT 201 (Ganguly) Lecture...

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Unformatted text preview: MGMT 201 (Ganguly) Lecture 17: Capital Expenditure Lecture Decisions (Chapter 16) Decisions Introduce NPV & IRR, Payback, ARR 1 What is PV? What is “Present Value” of $1.00, or What simply, “Present Value of 1” ? What are the tables telling us? the What is “Present Value of Series of $1.00 What cash flows” What is the “Present Value of an (ordinary) annuity of 1” ? What are the tables telling us? What is the difference between an “ordinary annuity” and an “annuity due”? Adobe Acrobat Document 2 Net-Present-Value Method Mattson Co. has been offered a five year contract to Mattson provide component parts for a large manufacturer. provide 3 Net-Present-Value Method At the end of five years the working capital At will be released and may be used elsewhere by Mattson. elsewhere Mattson’s cost of capital is 10%. (I.e., Mattison uses a 10% discount rate.) Should the contract be accepted? 4 Net-Present-Value Method Annual net cash inflows from operations 5 Net-Present-Value Method 6 Net-Present-Value Method Present value of an annuity of $1 Present factor for 5 years at 10%. factor 7 Net-Present-Value Method Present value of $1 Present factor for 3 years at 10%. factor 8 Net-Present-Value Method Present value of $1 Present factor for 5 years at 10%. factor 9 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 10 10 NPV Method Summary – 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 11 11 Internal-Rate-of-Return Method The internal rate of return is the true The economic return earned by the asset over its life. its 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 12 12 Internal-Rate-of-Return Method 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. The machine has a 10-year life. The 13 13 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 14 14 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 15 15 Internal-Rate-of-Return Method Here’s the proof . . . 16 16 Recovery of Investments Let’s look at the little spreadsheet we prepared! 17 17 Alternative Methods for Making Alternative Investment Decisions Investment Payback Method Payback Initial investment = period Annual after-tax 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 18 18 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 19 19 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. possible. 20 20 Accounting-Rate-of-Return Accounting-Rate-of-Return Method 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 Accounting-rate-of-return on the incremental accounting income that results from a project. results 21 21 Accounting-Rate-of-Return Accounting-Rate-of-Return 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 22 22 Meyers Company wants to install an espresso bar Meyers in its restaurant. in The espresso bar: Accounting-Rate-of-Return Accounting-Rate-of-Return Method Method Cost $140,000 and has a 10-year 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 23 23 Accounting-Rate-of-Return Accounting-Rate-of-Return 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 24 24 More on this in the next class… 25 25 ...
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This note was uploaded on 03/18/2011 for the course MGMT 201 taught by Professor Rowe during the Spring '08 term at Purdue.

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