Chpt_9_outline

Chpt_9_outline - CHAPTER 9 Capital budgeting Four methods:...

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CHAPTER 9 Capital budgeting – Four methods: 1. Payback period 2. Accounting rate of return 3. Net present value 4. Internal rate of return 1. Payback period Pros: Cons:
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Method: If even cash inflows: Payback period = amount invested / annual inflow E.g. Project costs $500,000. Returns $80,000 per year. What is the payback period? If uneven cash flows Add them all up in a spreadsheet. Accumulate the inflows. In the last year, split the total year’s inflows evenly among the year. E.g.: Year Outflow Inflows 1 400 75 2 75 3 80 4 90 5 100 6 80 Solution: Total payback period =
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2. Accounting Rate of Return (ARR) ARR examines the accounting rate of return. That means it looks at net income generated by the asset. ARR = Where Average investment = Asset with no residual value If there is no residual value, then the average investment = ½ of the original cost E.g., Asset costs $500,000. Useful life = 5 years. No residual value. Average cash flows = $125,000 per year over useful life. Solution: 1. Compute average operating income: 2. Compute ARR Asset with residual value Now the average investment = (cost + residual value) / 2 E.g., Asset costs $500,000. Residual value = $100,000. Useful life = 5 years. No residual value. Average operating income = $125,000 per year over useful life.
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Solution: 1. Compute average operating income: 2. Compute average investment $500 $420 $340 $260 $180 $100 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 3. Compute ARR Pros: Cons
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TIME VALUE OF MONEY The next two capital budgeting analyses consider time value of money. PRESENT VALUE AND FUTURE VALUE Say you have $100 today, and you can invest it in the bank and get 10% annually. How much money will you have at the end of four years? $100 ? Year 0 (today) Year 1 Year 2 Year 3 Year 4 To figure out how much you would have at the end of next year, you would simply multiply your principal by (1 + the interest rate), or $100 * (1 + 0.10) = $110. $100 ? Year 0 (today) Year 1 Year 2 Year 3 Year 4 $110 Then you repeat that process to figure out how much you would have by the end of the fourth year. Year 0
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Chpt_9_outline - CHAPTER 9 Capital budgeting Four methods:...

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