Capital Budgets and Managerial Decisions

1
Capital Budgeting and Managerial Decisions
Chapter
25
2
Capital Budgeting
Capital budgetingAnalyzing alternative
long-term investments and deciding which assets
to acquire or sell.
3
Payback Period
Exh. 25-2
The payback period of an investmentis the time
expected to recoverthe initial investment amount.
Managers prefer investing in projects with
shorter payback periods.
4
Payback Period with Even Cash Flows

• FasTrac is considering buying a new machine
  that will be used in its manufacturing
  operations. The machine costs 16,000 and is
  expected to produce annual net cash flows of
  4,100. The machine is expected to have an
  8-year useful life with no salvage value.
• Calculate the payback period.

5
Payback Period withUneven Cash Flows

• In the previous example, we assumed that the
  increase in cash flows would be the same each
  year. Now, lets look at an example where the
  cash flows vary each year.

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Payback Period withUneven Cash Flows
Exh. 25-3
FasTrac wants to install a machine that costs
16,000 and has an 8-year useful life with zero
salvage value. Annual net cash flows are
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Payback Period withUneven Cash Flows
Exh. 25-3
We recover the 16,000 purchase price
between years 4 and 5, about4.2 years for the
payback period.
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Using the Payback Period
Ignores the time value of money.
Ignores cash flows after the payback period.
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Using the Payback Period

• Consider two projects, each with a five-year
  lifeand each costing 6,000.

Would you invest in Project One just because it
has a shorter payback period?
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Accounting Rate of Return
Exh. 25-5,6

• The accounting rate of return focuses onannual
  income instead of cash flows.

Beginning book value Ending book value2
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Accounting Rate of Return
Exh. 25-5,6

• Reconsider the 16,000 investment being
  considered by FasTrac. The annual after-tax net
  income is 2,100. Compute theaccounting rate
  of return.

Beginning book value Ending book value2
12
Accounting Rate of Return
Exh. 25-5,6

• Reconsider the 16,000 investment being
  considered by FasTrac. The annual after-tax net
  income is 2,100. Compute theaccounting rate
  of return.

Beginning book value Ending book value2
13
Accounting Rate of Return
Exh. 25-5,6

• Reconsider the 16,000 investment being
  considered by FasTrac. The annual after-tax net
  income is 2,100. Compute theaccounting rate
  of return.

16,000 02
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Using Accounting Rate of Return
So why would I ever want to use this method
anyway?

• Depreciation may be calculated several ways.
• Income may vary from year to year.
• Time value ofmoney is ignored.

15
Net Present Value

• Now lets look at a capital budgeting
  modelthat considers the time value of cash
  flows.

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Net Present Value

• Discount the future net cash flows from the
  investment at the required rate of return.
• Subtract the initial amount invested from sum
  of the discounted cash flows.
• FasTrac is considering the purchase of a
  conveyor costing 16,000 with an 8-year useful
  life with zero salvage value that promises annual
  net cash flows of 4,100. FasTrac requires a 12
  percent compounded annual return on its
  investments.

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Net Present Valuewith Even Cash Flows
Exh. 26-7
18
Net Present Valuewith Even Cash Flows
Exh. 26-7
Present value factorsfor 12 percent
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Net Present Valuewith Even Cash Flows
Exh. 26-7
A positive net present value indicates that
thisproject earns more than 12 percent on the
investment.
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Using Net Present Value

• General decision rule . . .

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Net Present Valuewith Uneven Cash Flows
Exh. 26-8
Although all projects require the same investment
and havethe same total net cash flows, project B
has a higher net present value because of a
larger net cash flow in year 1.
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Internal Rate of Return (IRR)
The interest rate that makes . . .

• The net present value equal zero.

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Internal Rate of Return (IRR)
Exh. 26-9

• Projects with even annual cash flows

Project life 3 yearsInitial cost
12,000Annual net cash inflows
5,000 Determine the IRR for this project.
1. Compute present value factor.
2. Using present value of annuity table . .
.
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Internal Rate of Return (IRR)
Exh. 26-9

• Projects with even annual cash flows

Project life 3 yearsInitial cost
12,000Annual net cash inflows
5,000 Determine the IRR for this project.
1. Compute present value factor.
12,000 5,000 per year 2.4000 2. Using
present value of annuity table . . .
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Internal Rate of Return (IRR)
Exh. 26-9

• 1. Determine the present value factor.
  12,000 5,000 per year 2.4000
• 2. Using present value of annuity table . . .

Locate the rowwhose numberequals the periods
in theprojects life.
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Internal Rate of Return (IRR)
Exh. 26-9

• 1. Determine the present value factor.
  12,000 5,000 per year 2.4000
• 2. Using present value of annuity table . . .

In that row,locate theinterest factorclosest
inamount to thepresent valuefactor.
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Internal Rate of Return (IRR)
Exh. 26-9

• 1. Determine the present value factor.
  12,000 5,000 per year 2.4000
• 2. Using present value of annuity table . . .

IRR isapproximately12.
IRR is theinterest rateof the columnin which
thepresent valuefactor is found.
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Internal Rate of Return Uneven Cash Flows

• If cash inflows are unequal, trial and error
  solution will result if present value tablesare
  used.
• Sophisticated business calculators and
  electronic spreadsheets can be used to easily
  solve these problems.

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Using Internal Rate of Return

• Internal Rate of Return
• Compare the internal rateof return on a project
  to a predetermined hurdle rate (cost of capital).
• To be acceptable, a projects rate of return
  cannot be less than thecost of capital.

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Comparing Methods
Exh. 25-10