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Unformatted text preview: time zero. TABLE 9.1 Capital Expenditure
Data for Bennett
Project A Initial investment
Year Project B $42,000 $45,000 Operating cash inflows 1 $14,000 $28,000 2 14,000 12,000 3 14,000 10,000 4 14,000 10,000 5 14,000 10,000 1. For simplification, these 5-year-lived projects with 5 years of cash inflows are used throughout this chapter. Projects with usable lives equal to the number of years of cash inflows are also included in the end-of-chapter problems.
Recall from Chapter 8 that under current tax law, MACRS depreciation results in n 1 years of depreciation for an
n-year class asset. This means that projects will commonly have at least 1 year of cash flow beyond their recovery
period. In actual practice, the usable lives of projects (and the associated cash inflows) may differ significantly from
their depreciable lives. Generally, under MACRS, usable lives are longer than depreciable lives.
2. Two other, closely related techniques that are sometimes used to evaluate capital budgeting projects are the average (or accounting) rate of return (ARR) and the profitability index (PI). The ARR is an unsophisticated technique
that is calculated by dividing a project’s average profits after taxes by its average investment. Because it fails to con- CHAPTER 9 FIGURE 9.1 Capital Budgeting Techniques 397 Project A
$14,000 $14,000 $14,000 $14,000 $14,000 1 Bennett Company’s
projects A and B
Time lines depicting the
conventional cash flows of
projects A and B 2 3 4 5 0 $42,000
End of Year
$28,000 $12,000 $10,000 $10,000 $10,000 1 2 3 4 5 0 $45,000
End of Year Review Question
9–1 LG2 Once the firm has determined its projects’ relevant cash flows, what must
it do next? What is its goal in selecting projects? 9.2 Payback Period payback period
The amount of time required for a
firm to recover its initial investment in a project, as calculated
from cash inflows. Payback periods are commonly used to evaluate proposed investments. The
payback period is the amount of time required for the firm to recover its initial
investment in a project, as calculated from cash inflows. In the case of an annuity,
the payback period can be found by dividing the initial investment by the annual sider cash flows and the time value of money, it is ignored here. The PI, sometimes called the benefit–cost ratio, is
calculated by dividing the present value of cash inflows by the initial investment. This technique, which does consider the time value of money, is sometimes used as a starting point in the selection of projects under capital
rationing; the more popular NPV and IRR methods are discussed here. 398 PART 3 Long-Term Investment Decisions cash inflow. For a mixed stream of cash inflows, the yearly cash inflows must be
accumulated until the initial investment is recovered. Although popular, the payback period is generally viewed as an unsophisticated capital budgeting technique, because it does not explicitly consider the time value of money. The Decision Criteria
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This document was uploaded on 01/19/2014.
- Fall '13