Chap 014
Chap 014
Chap 014
Chapter 14
Plant expansion
Equipment selection
McGraw-Hill/Irwin Slide 2
Typical Capital Budgeting Decisions
McGraw-Hill/Irwin Slide 3
Time Value of Money
A dollar today is
worth more than a
dollar a year from
now. Therefore,
projects that promise
earlier returns are
preferable to those
that promise later
returns.
McGraw-Hill/Irwin Slide 4
Time Value of Money
The capital
budgeting
techniques that best
recognize the time
value of money are
those that involve
discounted cash
flows.
McGraw-Hill/Irwin Slide 5
Learning Objective 1
McGraw-Hill/Irwin Slide 6
The Net Present Value Method
McGraw-Hill/Irwin Slide 7
The Net Present Value Method
McGraw-Hill/Irwin Slide 8
The Net Present Value Method
McGraw-Hill/Irwin Slide 9
Typical Cash Outflows
Repairs and
maintenance
Working Initial
capital investment
Incremental
operating
costs
McGraw-Hill/Irwin Slide 10
Typical Cash Inflows
Salvage
value
Release of
Reduction
working
of costs
capital
Incremental
revenues
McGraw-Hill/Irwin Slide 11
Recovery of the Original Investment
McGraw-Hill/Irwin Slide 12
Recovery of the Original Investment
Carver Hospital is considering the purchase of an
attachment for its X-ray machine.
Present Value of $1
Periods 10% 12% 14%
1 0.909 0.893 0.877 Present
Present value
value
2 1.736 1.690 1.647
3 2.487 2.402 2.322
of
of an
an annuity
annuity
4 3.170 3.037 2.914 of
of $1
$1 table
table
5 3.791 3.605 3.433
McGraw-Hill/Irwin Slide 14
Recovery of the Original Investment
(1) (2) (3) (4) (5)
Recover of Unrecovered
Investment Investment Investment at
Outstanding Return on during the the end of the
during the Cash Investment year year
Year year Inflow (1) 10% (2) - (3) (1) - (4)
1 $ 3,170 $ 1,000 $ 317 $ 683 $ 2,487
2 2,487 1,000 249 751 1,736
3 1,736 1,000 173 827 909
4 909 1,000 91 909 0
Total investment recovered $ 3,170
This implies that the cash inflows are sufficient to recover the $3,170
initial investment (therefore depreciation is unnecessary) and to
provide exactly a 10% return on the investment.
McGraw-Hill/Irwin Slide 15
Two Simplifying Assumptions
Two simplifying assumptions are usually made
in net present value analysis:
McGraw-Hill/Irwin Slide 16
Choosing a Discount Rate
The firm’s cost of capital
is usually regarded as the
minimum required rate of
return.
McGraw-Hill/Irwin Slide 17
The Net Present Value Method
Lester Company has been offered a five year contract
to provide component parts for a large manufacturer.
McGraw-Hill/Irwin Slide 18
The Net Present Value Method
At the end of five years the working capital will
be released and may be used elsewhere by
Lester.
Lester Company uses a discount rate of 10%.
McGraw-Hill/Irwin Slide 19
The Net Present Value Method
Annual net cash inflow from operations
McGraw-Hill/Irwin Slide 20
The Net Present Value Method
McGraw-Hill/Irwin Slide 21
The Net Present Value Method
McGraw-Hill/Irwin Slide 22
The Net Present Value Method
McGraw-Hill/Irwin Slide 23
The Net Present Value Method
Present value of $1
factor for 5 years at 10%.
McGraw-Hill/Irwin Slide 24
The Net Present Value Method
McGraw-Hill/Irwin Slide 25
Quick Check
Denny Associates has been offered a four-year contract to
supply the computing requirements for a local bank.
McGraw-Hill/Irwin Slide 26
Quick Check
McGraw-Hill/Irwin Slide 27
Quick Check
McGraw-Hill/Irwin Slide 28
Learning Objective 2
McGraw-Hill/Irwin Slide 29
Internal Rate of Return Method
The internal rate of return is the rate of return
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 project to be
zero.
McGraw-Hill/Irwin Slide 30
Internal Rate of Return Method
General decision rule . . .
If the Internal Rate of Return is . . . Then the Project is . . .
McGraw-Hill/Irwin Slide 31
Internal Rate of Return Method
Decker Company can purchase a new
machine at a cost of $104,320 that will
save $20,000 per year in cash operating
costs.
The machine has a 10-year life.
McGraw-Hill/Irwin Slide 32
Internal Rate of Return Method
Future
Future cash
cash flows
flows are
are the
the same
same every
every year
year in
in
this
this example,
example, so
so we
we can
can calculate
calculate the
the internal
internal
rate
rate of
of return
return as
as follows:
follows:
McGraw-Hill/Irwin Slide 33
Internal Rate of Return Method
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%
McGraw-Hill/Irwin Slide 34
Internal Rate of Return Method
McGraw-Hill/Irwin Slide 36
Quick Check
McGraw-Hill/Irwin Slide 37
Comparing the Net Present Value and
Internal Rate of Return Methods
Questionable assumption:
Internal rate of return method
assumes cash inflows are
reinvested at the internal rate of
return.
McGraw-Hill/Irwin Slide 38
Comparing the Net Present Value and
Internal Rate of Return Methods
Questionable assumption:
Internal rate of return method
assumes cash inflows are
reinvested at the internal rate of
return.
McGraw-Hill/Irwin Slide 39
Expanding the Net Present Value Method
To compare competing investment projects
we can use the following net present
value approaches:
Total-cost
Incremental cost
McGraw-Hill/Irwin Slide 40
The Total-Cost Approach
White Company has two alternatives:
(1) remodel an old car wash or,
(2) remove it and install a new one.
The company uses a discount rate of 10%.
McGraw-Hill/Irwin Slide 41
The Total-Cost Approach
McGraw-Hill/Irwin Slide 43
The Total-Cost Approach
McGraw-Hill/Irwin Slide 44
The Total-Cost Approach
Remodel the Old Washer
Cash 10%
Year Flows Factor Present Value
Initial investment Now $ (175,000) 1.000 $ (175,000)
Replace brushes 6 (80,000) 0.564 (45,120)
Annual net cash inflows 1-10 45,000 6.145 276,525
Net present value $ 56,405
McGraw-Hill/Irwin Slide 45
The Total-Cost Approach
Both projects yield a positive
net present value.
McGraw-Hill/Irwin Slide 46
The Incremental-Cost Approach
Under
Under the
the incremental-cost
incremental-cost approach,
approach, only
only
those
those cash
cash flows
flows that
that differ
differ between
between the
the two
two
alternatives
alternatives are
are considered.
considered.
McGraw-Hill/Irwin Slide 47
The Incremental-Cost Approach
McGraw-Hill/Irwin Slide 48
Quick Check
Consider the following alternative projects. Each project would last
for five years.
Project A Project B
Initial investment $80,000 $60,000
Annual net cash inflows 20,000 16,000
Salvage value 10,000 8,000
The company uses a discount rate of 14% to evaluate projects.
Which of the following statements is true?
a. NPV of Project A > NPV of Project B by $5,230
b. NPV of Project B > NPV of Project A by $5,230
c. NPV of Project A > NPV of Project B by $2,000
d. NPV of Project B > NPV of Project A by $2,000
McGraw-Hill/Irwin Slide 49
Quick Check
Consider the following alternative projects. Each project would last
for five years.
Project A Project B
Initial investment $80,000 $60,000
Annual net cash inflows 20,000 16,000
Salvage value 10,000 8,000
The company uses a discount rate of 14% to evaluate projects.
Which of the following statements is true?
a. NPV of Project A > NPV of Project B by $5,230
b. NPV of Project B > NPV of Project A by $5,230
c. NPV of Project A > NPV of Project B by $2,000
d. NPV of Project B > NPV of Project A by $2,000
McGraw-Hill/Irwin Slide 50
Least Cost Decisions
McGraw-Hill/Irwin Slide 51
Least Cost Decisions
Home Furniture Company is trying to
decide whether to overhaul an old delivery
truck now or purchase a new one.
The company uses a discount rate of 10%.
McGraw-Hill/Irwin Slide 52
Least Cost Decisions
Here is information about the trucks . . .
Old Truck
Overhaul cost now $ 4,500
Annual operating costs 10,000
Salvage value in 5 years 250
Salvage value now 9,000
McGraw-Hill/Irwin Slide 53
Least Cost Decisions
Buy the New Truck
Cash 10% Present
Year Flows Factor Value
Purchase price Now $ (21,000) 1.000 $ (21,000)
Annual operating costs 1-5 (6,000) 3.791 (22,746)
Salvage value of old truck Now 9,000 1.000 9,000
Salvage value of new truck 5 3,000 0.621 1,863
Net present value (32,883)
McGraw-Hill/Irwin Slide 54
Least Cost Decisions
McGraw-Hill/Irwin Slide 55
Quick Check
Bay Architects is considering a drafting machine that
would cost $100,000, last four years, provide annual
cash savings of $10,000, and considerable intangible
benefits each year. How large (in cash terms) would
the intangible benefits have to be per year to justify
investing in the machine if the discount rate is 14%?
a. $15,000
b. $90,000
c. $24,317
d. $60,000
McGraw-Hill/Irwin Slide 56
Quick Check
Bay Architects is considering a drafting machine that
would cost $100,000, , last four years, provide annual
cash savings of $10,000, and considerable intangible
$70,860/2.914
benefits each year. How large = (in
$24,317
cash terms) would
the intangible benefits have to be per year to justify
investing in the machine if the discount rate is 14%?
a. $15,000
b. $90,000
c. $24,317
d. $60,000
McGraw-Hill/Irwin Slide 57
Learning Objective 3
Evaluate an investment
project that has uncertain
cash flows.
McGraw-Hill/Irwin Slide 58
Uncertain Cash Flows – An Example
Assume that all of the cash flows related to an
investment in a supertanker have been
estimated, except for its salvage value in 20
years.
Using a discount rate of 12%, management has
determined that the net present value of all the
cash flows, except the salvage value is a
negative $1.04 million.
McGraw-Hill/Irwin Slide 60
Real Options
McGraw-Hill/Irwin Slide 61
Learning Objective 4
McGraw-Hill/Irwin Slide 62
Preference Decision – The Ranking of
Investment Projects
Screening Decisions Preference Decisions
McGraw-Hill/Irwin Slide 63
Internal Rate of Return Method
McGraw-Hill/Irwin Slide 64
Net Present Value Method
McGraw-Hill/Irwin Slide 65
Ranking Investment Projects
Project Net present value of the project
=
profitability Investment required
index
Project A Project B
Net present value (a) $ 1,000 $ 1,000
Investment required (b) $ 10,000 $ 5,000
Profitability index (a) ÷ (b) 0.10 0.20
The
The higher
higher the
the profitability
profitability index,
index, the
the
more
more desirable
desirable the
the project.
project.
McGraw-Hill/Irwin Slide 66
Other Approaches to
Capital Budgeting Decisions
McGraw-Hill/Irwin Slide 67
Learning Objective 5
McGraw-Hill/Irwin Slide 68
The Payback Method
McGraw-Hill/Irwin Slide 69
The Payback Method
Management
Management atat The
The Daily
Daily Grind
Grind wants
wants to
to install
install
an
an espresso
espresso bar
bar in
in its
its restaurant.
restaurant.
The
The espresso
espresso bar:
bar:
1.
1. Costs
Costs $140,000
$140,000 and
and has
has aa 10-year
10-year life.
life.
2.
2. Will
Will generate
generate annual
annual net
net cash
cash inflows
inflows of of $35,000.
$35,000.
Management
Management requires
requires aa payback
payback period
period of
of 55
years
years or
or less
less on
on all
all investments.
investments.
What
What is
is the
the payback
payback period
period for
for the
the espresso
espresso bar?
bar?
McGraw-Hill/Irwin Slide 70
The Payback Method
Investment required
Payback period =
Annual net cash inflow
$140,000
Payback period = $35,000
According
According to
to the
the company’s
company’s criterion,
criterion,
management
management would
would invest
invest in
in the
the espresso
espresso bar
bar
because
because its
its payback
payback period
period is
is less
less than
than 55 years.
years.
McGraw-Hill/Irwin Slide 71
Quick Check
Consider the following two investments:
Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 14-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined
McGraw-Hill/Irwin Slide 72
Quick Check
Consider the following two investments:
Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 14-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project
•Project Y
X has a payback period of 2 years.
c. Cannot
•Project Y has abe determined
payback period of slightly more than 2 years.
•Which project do you think is better?
McGraw-Hill/Irwin Slide 73
Evaluation of the Payback Method
Ignores the
time value
of money.
Short-comings
of the payback
period. Ignores cash
flows after
the payback
period.
McGraw-Hill/Irwin Slide 74
Evaluation of the Payback Method
Serves as
screening
tool.
Identifies
Strengths investments that
of the payback recoup cash
period. investments
quickly.
Identifies
products that
recoup initial
investment
quickly.
McGraw-Hill/Irwin Slide 75
Payback and Uneven Cash Flows
1 2 3 4 5
McGraw-Hill/Irwin Slide 76
Payback and Uneven Cash Flows
1 2 3 4 5
McGraw-Hill/Irwin Slide 77
Learning Objective 6
McGraw-Hill/Irwin Slide 78
Simple Rate of Return Method
*Should be reduced by any salvage from the sale of the old equipment
McGraw-Hill/Irwin Slide 79
Simple Rate of Return Method
McGraw-Hill/Irwin Slide 80
Simple Rate of Return Method
McGraw-Hill/Irwin Slide 81
Criticism of the Simple Rate of Return
Ignores the
time value
of money.
Short-comings
of the simple
The same project
rate of return.
may appear
desirable in some
years and
undesirable
in other years.
McGraw-Hill/Irwin Slide 82
Postaudit of Investment Projects
AA postaudit
postaudit is
is aa follow-up
follow-up after
after the
the
project
project has
has been
been completed
completed toto see
see
whether
whether or
or not
not expected
expected results
results were
were
actually
actually realized.
realized.
McGraw-Hill/Irwin Slide 83
The Concept of Present Value
Appendix 14A
(Appendix 14A)
Understand present value
concepts and the use of
present value tables.
McGraw-Hill/Irwin Slide 85
The Mathematics of Interest
A dollar received
today is worth more
than a dollar received
a year from now
because you can put
it in the bank today
and have more than a
dollar a year from
now.
McGraw-Hill/Irwin Slide 86
The Mathematics of Interest – An Example
Fn = P(1 + r) n
McGraw-Hill/Irwin Slide 87
The Mathematics of Interest – An Example
Fn = P(1 + r) n
F1 = $100(1 + .08)1
F1 = $108.00
McGraw-Hill/Irwin Slide 88
Compound Interest – An Example
Fn = P(1 + r) n
McGraw-Hill/Irwin Slide 89
Compound Interest – An Example
F2 = $100(1 + .08) 2
F2 = $116.64
The interest that is paid in the second year
on the interest earned in the first year is
known as compound interest.
McGraw-Hill/Irwin Slide 90
Computation of Present Value
Present Future
Value Value
Let’s look at a situation where the
future value is known and the present
value is the unknown.
McGraw-Hill/Irwin Slide 91
Present Value – An Example
Fn
P=
(1 + r) n
McGraw-Hill/Irwin Slide 92
Present Value – An Example
$100
P=
(1 + .12)2
P = $79.72
This process is called discounting. We have
discounted the $100 to its present value of
$79.72. The interest rate used to find the
present value is called the discount rate.
McGraw-Hill/Irwin Slide 93
Present Value – An Example
McGraw-Hill/Irwin Slide 95
Quick Check
McGraw-Hill/Irwin Slide 96
Quick Check
McGraw-Hill/Irwin Slide 97
Present Value of a Series of Cash Flows
1 2 3 4 5 6
McGraw-Hill/Irwin Slide 98
Present Value of a Series of Cash Flows –
An Example
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%?
McGraw-Hill/Irwin Slide 99
Present Value of a Series of Cash Flows –
An Example
(Appendix 14C)
Include income taxes in a
capital budgeting analysis.
Taxable income
equals net income as
computed for
financial reports.
After-tax cost
= (1-Tax rate) Tax-deductible cash expense
(net cash outflow)
After-tax cost
= (1-Tax rate) Tax-deductible cash expense
(net cash outflow)
After-tax benefit
= (1-Tax rate) Taxable cash receipt
(net cash inflow)
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