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Chpt_9_outline - CHAPTER 9 Capital budgeting Four methods 1...

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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 =
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
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 1...

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