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Topic 4 Capital Budgeting Part 1 - Topic 4 Capital...

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Topic 4 Capital Budgeting - Part 1
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What is capital budgeting? Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firm’s future.
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Methods of Project Evaluation 1. Non-discounted cash flow methods - payback period - accounting rate of return 2. Discounted cash flow methods - internal rate of return - net present value
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Payback Period The amount of time required for an investment to generate cash flows to recover its initial cost. An investment is acceptable if its calculated payback is less than some prescribed number of years.
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Payback Period Illustrated Initial outlay -$1 000 Year Cash flow 1 $200 2 400 3 600 Accumulated Year Cash flow 1 $200 2 600 3 1 200 Payback period = 2.67 years
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Example Year 0 1 2 3 Payback Project A -50 1 49 0 2 years Project B -50 49 0 1 3 years Project C -50 0 0 500 3 years Decision: Choose project A But clearly wrong!
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Advantages of Payback Period No need for detailed analysis. Simple to calculate and understand. Adjusts for uncertainty of later cash flows. Biased towards liquidity. Disadvantages of Payback Period Time value of money and risk ignored. Ad hoc determination of acceptable payback period. Ignores cash flows beyond the cut-off date. Biased against long-term projects.
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Accounting Rate of Return (ARR ) Measure of an investment’s profitability . A project is accepted if ARR > target average return . book value average profit net average ARR =
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ARR Example Year 1 2 3 Sales $440 $240 $160 Expenses 220 120 80 Gross profit 220 120 80 Depreciation 80 80 80 Earnings before taxes 140 40 0 Taxes (25%) 35 10 0 Net profit $105 $30 $0 Assume initial investment = $240
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ARR Example (continued) $120 2 $0 $240 2 value Salvage investment Initial book value Average $45 3 $0 $30 $105 profit net Average = + = + = = + + = 37.5% $120 $45 book value Average profit net Average ARR = = =
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Disadvantages of ARR The measure is not a ‘true’ reflection of return. Time value of money is ignored. Ad hoc determination of target average return. Uses profit and book value instead of cash flow and market value. Advantages of ARR Easy to calculate and understand. Considers all profits of the project .
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Net Present Value (NPV) Net present value is the difference between an investment’s market value (in today’s dollars) and its cost (also in today’s dollars). Net present value is a measure of how much value (in dollars) is created by undertaking this investment.
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Steps 1 . Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs. 3. Determine r = discount rate for the project. 1. Find NPV 2. Accept if NPV > 0
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NPV Illustrated 0 1 2 Initial outlay ($1 100 ) Revenues $1 000 Expenses 500 Cash flow $ 500 Revenues $2 000 Expenses 1 000 Cash flow $1 000 – $1 100.00 +454.55 +826.45 + $ 181.00 $ 500 1.10 $1 000 ( 1.10) 2 NPV
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NPV An investment should be accepted if the NPV is positive and rejected if it is negative.
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