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Chapter 26

Capital Budgeting

Budgeting for the acquisition of ³capital assets´ Capital budgeting techniques (a) Payback period (b) Accounting Rate of Return (c) Net Present Value (d) Internal Rate of Return

.Capital Budgeting Outcome is uncertain. Large amounts of money involved. Decision may be difficult or impossible to reverse. Investment involves long-term commitment. Analyzing alternative longterm investments and deciding which assets to acquire or sell.

It will have zero salvage value at the end of its useful life.000 22. The straight-line method of depreciation is used for accounting purposes.000 13.000 180.000 .000 $13.Example Casey Co. is considering an investment of $130.000 in new equipment. The new equipment is expected to last 10 years.000 $20. The expected annual revenues and costs of the new product that will be produced from the investment are: Sales Cost of goods sold Depreciation expense Selling & Admin expense Income before income tax Income tax expense Net Income $200.000 7.000 $145.

Amount invested Expected annual net cash inflow .Payback Period Time period required to recover the cost of the investment from the annual cash inflow produced by the investment.

Computation of Annual Cash Inflow Expected annual net cash inflow = Net income $13.000 $26.000 .000 Depreciation expense 13.

000 / $26.000 = 5 years .Cash Payback Period $130.

wants to install a machine that costs $16. Annual net cash flows are: Year 0 1 Annual et Cash Flows $ 16.000 1 .000 .000 and has an 8-year useful life with zero salvage value.000 9.Payback Period ± Uneven Cash Flows Casey Co.000 6 8 .000 .000 Cumulative et Cash Flows $ 16.000 .000 .000 .000 .000 1.000 .000 .000 .

.P yb ck P U W c p c p c b y d b . d± F F F Y 9 . y f p yb ck p d.

000 .000 ear 5 Would you invest in roject One just because it has a shorter payback period? .000 . roject One et Cash nflows $ .000 .000 .Using the ayback eriod ayback = years ayback = 5 years Consider two projects.000.000 .000 . each with a 5-year life and each costing $6.000 roject wo et Cash nflows $ .000 .000 .000.

Accounting Rate of Return Average annual operating income from asset Average amount invested in asset Compare accounting rate of return to company¶s required minimum rate of return for investments of similar risk. The minimum return is based on the company¶s cost of capital. .

Accounting Rate of Return Average Investment = Original Investment + Residual Value 2 For Casey.000 + $0)/ 2 = $65. average investment = ($130.000 .

Solution to Accounting Rate of Return Problem Average annual operating income from asset Average amount invested in asset $13.000 = 20% .000 / $65.

Accounting Rate of Return The decision rule is: A project is acceptable if its rate of return is greater than management¶s minimum rate of return. . the more attractive the investment. The higher the rate of return for a given risk.

Two methods 1) net present value 2) internal rate of return .Discounted Cash lows Considers both the estimated total cash inflows and the time value of money.

the more attractive the investment. The higher the positive NPV.Net Present Value Method ind PV of future cash flows and compare with capital outlay Interest rate used = required minimum rate of return Proposal is acceptable when NPV is zero or positive. .

Assume the company requires a minimum return of 12%. . The present value of the annual cash inflows can be computed by using the present value of an annuity of 1 for 10 periods.000 are uniform over the asset¶s useful life.Net Present Value We will assume that Casey Co¶s annual cash inflows of $26.

000 rs 1-10 Annuity NPV $16.Net Present Value Cash low When? Type of cash flow Present value factor 5. 00 Analysis of the proposal: The proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive .000) 146.000) Now 26. 00 (130.650 Present value of cash flows ($130.

.Net Present Value When annual cash inflows are unequal. use present value of one tables.

7 7 .567 .000 32.000) 32.404 .8 3 .000) 36.361 .000 24.452 .636 .742 12.440 $25.648 17.322 Type of cash flow PV factor Present value ($130.000 21.687 .888 7.000 27.000 NPV When? Net Present Value Now 1 2 3 4 5 6 7 8 10 Lump sum ³ ³ ³ ³ ³ .Cash Flow (130.000 22.507 .148 25.3 6 8.000 2 . ³ ³ ³ ³ .581 6.168 10..712 .000 26.000 23.504 20.000 20.172 14.

Internal Rate of Return Interest yield of the potential investment The interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows. .

000 / $26.000 = 5.Compute the internal rate of return factor using this formula: Capital Investment Annual Cash Inflows $130.0 .Internal Rate of Return STEP 1.

Internal Rate of Return Method STEP 2. 50 1 5. 0 .1 5 1 12 5.1 .0 on the line for 10 periods. 10 .019 . Locate the discount factor that is closest to 5. PR ESENT LU E N) Periods 10 N NNU IT 10 .02 . Use the factor and the present value of an annuity of 1 table to find the internal rate of return.21 15 5.

Internal Rate of Return Decision Criteria The decision rule is: Accept when internal rate of return is equal to or greater than the required rate of return Reject when internal rate of return is less than required rate .

Internal Rate of Return ± Uneven Cash lows If cash inflows are unequal. Use business calculators and electronic spreadsheets . trial and error solution will result if present value tables are used.

Comparing Methods Basis of measurement Measure expressed as Payback period Cash flows Number of years Easy to Understand Accounting rate of return Accrual income Percent Easy to Understand Net present Internal rate value of return Cash flows Cash flows Profitability Profitability Dollar Percent Amount Considers time Considers time value of money value of money Strengths Limitations Allows Allows Accommodates Allows comparison comparison different risk comparisons across projects across projects levels over of dissimilar a project's life projects Doesn't Doesn't Difficult to Doesn't reflect consider time consider time compare varying risk value of money value of money dissimilar levels over the projects project's life Doesn't consider cash flows after payback period Doesn't give annual rates over the life of a project .

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