Chapter13

Chapter13 - Typical Capital Budgeting Decisions Decisions...

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Unformatted text preview: Typical Capital Budgeting Decisions Decisions Capital budgeting tends to fall into two broad Capital categories . . . categories Screening decisions. Does a proposed project meet some present standard of acceptance? acceptance? Preference decisions. Selecting from among several competing courses of action. Time Value of Money Time A dollar today is worth dollar more than a dollar a year from now. Therefore, investments that promise earlier returns are preferable to those that promise later returns. The capital budgeting techniques that best recognize the time value of money are those that involve discounted cash flows. The Net Present Value Method The To determine net present value we . . . Calculate the present value of cash inflows, Calculate the present value of cash Calculate outflows, outflows, Subtract the present value of the outflows Subtract from the present value of the inflows. from The Net Present Value Method General decision rule . . . General The Net Present Value Method The Net present value analysis emphasizes cash flows and not accounting net income. The reason is that accounting net income is based on accruals that ignore the timing of cash flows into and out of an organization. Recovery of the Original Investment Investment Depreciation is not deducted in computing the present Depreciation value of a project because . . . value It is not a current cash outflow. Discounted cash flow methods automatically Discounted provide for return of the original investment. provide Two Simplifying Assumptions Two Two simplifying assumptions are usually made in net present value analysis: All cash flows other than the initial investment occur at the end of periods. All cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate. Choosing a Discount Rate Choosing The firm’s cost of capital is cost usually regarded as the minimum required rate of return. return. The cost of capital is the The average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds. their The Net Present Value Method Lester Company has been offered a five year contract to provide component parts for a large manufacturer. manufacturer. The Net Present Value Method At the end of five years the working capital will At be released and may be used elsewhere by Lester. Lester. Lester Company uses a discount rate of 10%. Should the contract be accepted? The Net Present Value Method Annual net cash inflows from operations Annual The Net Present Value Method Accept the contract because the project has a positive net present value. positive Internal Rate of Return Method Internal The internal rate of return is the rate of return The internal promised by an investment project over its useful life. It is computed by finding the discount rate that will cause the net present value of a net project to be zero. zero It works very well if a project’s cash flows are It identical every year. If the annual cash flows are not identical, a trial and error process must be used to find the internal rate of return. be Internal Rate of Return Method Internal General decision rule . . . If the Internal Rate of Return is . . . Then the Project is . . . Equal to or greater than the minimum required rate of return . . . Acceptable. Less than the minimum required rate of return . . . Rejected. When using the internal rate of return, the cost of capital acts as a hurdle rate that a project must clear for acceptance. Internal Rate of Return Method Internal Future cash flows are the same every year Future in this example, so we can calculate the internal rate of return as follows: internal PV factor for the = internal rate of return $104, 320 $20,000 Investment required Net annual cash flows = 5.216 Internal Rate of Return Method Internal Using the present value of an annuity of $1 table . . . Find the 10-period row, move across until you find the factor 5.216. Look at the top of the column and you find a rate of 14%. 14% Periods 1 2 ... 9 10 10% 0.909 1.736 ... 5.759 6.145 12% 0.893 1.690 ... 5.328 5.650 14% 0.877 1.647 ... 4.946 5.216 Internal Rate of Return Method Internal Decker Company can purchase a new machine at Decker a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life. The internal rate of return on this project is 14%. If the internal rate of return is equal to or If greater than the company’s required rate of return, the project is acceptable. return, The Total-Cost Approach The White Co. has two alternatives: (1) remodel an old car wash or, (1) (2) remove it and install a new one. (2) The company uses a discount rate of 10%. New Car W ash Annual revenues $ 90,000 Annual cash operating costs 30,000 Net annual cash inflows $ 60,000 Old Car W ash $ 70,000 25,000 $ 45,000 The Total-Cost Approach The If White installs a new washer . . . Cost Productive life Salvage value Replace brushes at the end of 6 years Salvage of old equip. $300,000 10 years 7,000 50,000 40,000 Let’s look at the present value of this alternative. The Total-Cost Approach The Install the New Washer Cash Year Flows Initial investment Now $ (300,000) Replace brushes 6 (50,000) Net annual cash inflows 1-10 60,000 Salvage of old equipment Now 40,000 Salvage of new equipment 10 7,000 Net present value 10% Factor 1.000 0.564 6.145 1.000 0.386 If we install the new washer, the If investment will yield a positive net present value of $83,202. present Present Value $ (300,000) (28,200) 368,700 40,000 2,702 $ 83,202 The Total-Cost Approach The If White remodels the existing washer . . If . Remodel costs Replace brushes at the end of 6 years $175,000 80,000 Let’s look at the present value of this second alternative. The Total-Cost Approach The 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 1-10 45,000 6.145 Net present value Present Value $ (175,000) (45,120) 276,525 $ 56,405 If we remodel the existing washer, we will If produce a positive net present value of $56,405. $56,405. The Total-Cost Approach The Both projects yield a positive net Both present value. present However, investing in the new washer will However, produce a higher net present value than remodeling the old washer. remodeling The Incremental-Cost Approach The Incremental investment Incremental cost of brushes Increased net cash inflows Salvage of old equipment Salvage of new equipment Net present value Year Now 6 1-10 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 We get the same answer under either the We total-cost or incremental-cost approach. Present Value $(125,000) 16,920 92,175 40,000 2,702 $ 26,797 Least Cost Decisions Least In decisions where revenues are not In directly involved, managers should choose the alternative that has the least total cost from a present value perspective. perspective. Let’s look at the Home Furniture Company. Least Cost Decisions Least Home Furniture Company is trying to Home decide whether to overhaul an old delivery truck now or purchase a new one. one. The company uses a discount rate of The 10%. 10%. Least Cost Decisions Least Here is information about the trucks . . . Here Old Truck Overhaul cost now Annual operating costs Salvage value in 5 years Salvage value now $ 4,500 10,000 250 9,000 Least Cost Decisions Least Buy the New Truck Cash Year Flows Purchase price Now $ (21,000) Annual operating costs 1-5 (6,000) Salvage value of old truck Now 9,000 Salvage value of new truck 5 3,000 Net present value Keep the Old Truck Cash Year Flows Overhaul cost Now $ (4,500) Annual operating costs 1-5 (10,000) Salvage value of old truck 5 250 Net present value 10% Factor 1.000 3.791 1.000 0.621 10% Factor 1.000 3.791 0.621 Present V alue $ (21,000) (22,746) 9,000 1,863 (32,883) Present Value $ (4,500) (37,910) 155 (42,255) Least Cost Decisions Least Home Furniture should purchase Home the new truck. the Net present value of costs associated with purchase of new truck Net present value of costs associated with remodeling existing truck Net present value in favor of purchasing the new truck $(32,883) (42,255) $ 9,372 Uncertain Cash Flows – An Example Uncertain Assume that all of the cash flows related to Assume an investment in a supertanker have been estimated except for its salvage value in 20 years. years. Using a discount rate of 12%, management Using has determined that the net present value of all the cash flows except the salvage value is a negative $1.04 million. negative How large would the salvage value need to be to make this investment attractive? Uncertain Cash Flows – An Example Example Net present value to be offset Present value factor $1,040,000 = $ 10,000,000 0.104 This equation can be used to determine that if the salvage value of the supertanker is at least $10,000,000, the net present value of the investment would be positive and therefore acceptable. NPV & IRR Rules of Thumb NPV The net present value of one project cannot be directly compared to the net present value of another project unless the investments are equal. The higher the internal rate of return, the more desirable the project. The Payback Method The The payback period is the length of time that it payback takes for a project to recover its initial cost out of the cash receipts that it generates. of When the net annual cash inflow is the same each year, this formula can be used to compute the payback period: compute Payback period = Investment required Net annual cash inflow Evaluation of the Payback Method Method Ignores the Ignores time value time of money. Short-comings of the payback period. Ignores cash flows after flows the payback the period. Evaluation of the Payback Method Method Serves as Serves screening tool. tool. Strengths of the payback period. Identifies Identifies investments that recoup cash investments quickly. quickly. Identifies Identifies products that recoup initial investment quickly. quickly. Payback and Uneven Cash Flows Flows When the cash flows associated with an investment project change from year to year, the payback formula introduced earlier cannot be used. Instead, the un-recovered investment must be tracked year by year. $1,000 1 $0 $2,000 $1,000 2 3 4 $500 5 Simple Rate of Return Method Simple Does not focus on cash flows -- rather it Does focuses on accounting net operating income. accounting The following formula is used to calculate the The simple rate of return: simple Simple rate = of return Incremental Incremental expenses, Incremental revenues including depreciation revenues Initial investment* *Should be reduced by any salvage from the sale of the old equipment The Mathematics of Interest – An Example An Assume a bank pays 8% interest on a $100 deposit made today. How much will the $100 be worth in one year? Fn = P(1 + r) n Fn = $100(1 + .08)1 Fn = $108.00 The Mathematics of Interest – An Example An Assume a bank pays 8% interest on a $100 deposit made today. How much will the $100 be worth in one year? Periods 1 2 3 4 5 Future Value of $1 8% 10% 1.080 1.100 1.166 1.210 1.260 1.331 1.360 1.464 1.469 1.611 12% 1.120 1.254 1.405 1.574 1.762 Compound Interest – An Example Example What if the $108 was left in the bank for a What second year? How much would the original $100 be worth at the end of the second year? Fn = P(1 + r) n Compound Interest – An Example Example Fn = $100(1 + .08) 2 Fn = $116.64 The interest that is paid in the second year The on the interest earned in the first year is known as compound interest. compound Computation of Present Value Computation An investment can be viewed in two ways—its future value or its present value. Present Value Future Value Let’s look at a situation where the future value is known and the present value is the unknown. Present Value – An Example Present If a bond will pay $100 in two years, If what is the present value of the $100 if an investor can earn a return of 12% on investments? investments? Fn P= (1 + r)n Present Value – An Example Present $100 P= (1 + .12)2 (1 P = $79.72 This process is called discounting. We have This discounting We discounted the $100 to its present value of $79.72. The interest rate used to find the present value is called the discount rate. discount Present Value of a Series of Cash Flows Cash An investment that involves a An series of identical cash flows at the end of each year is called an annuity. annuity $100 1 $100 $100 2 $100 3 $100 4 $100 5 6 Present Value of a Series of Cash Flows – An Example Flows Lacey Inc. purchased a tract of land on which a $60,000 payment will be due each year for the next five years. What is the present value of this stream of cash payments when the discount rate is 12%? payments Present Value of a Series of Cash Flows – An Example Flows We could solve the problem like this . . . Present Periods 1 2 3 4 5 Value of an Annuity 10% 12% 0.909 0.893 1.736 1.690 2.487 2.402 3.170 3.037 3.791 3.605 of $1 14% 0.877 1.647 2.322 2.914 3.433 $60,000 × 3.605 = $216,300 Homework Homework Exercises: 13-7 13-14 Questions? Jason.Gonsalves@Humber.ca ...
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This note was uploaded on 12/31/2011 for the course ACCT 441 taught by Professor Johnvermeer during the Spring '08 term at Humber.

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