Midterm

• Next week (review in the first hour, exam in the second hour)
• 20 multiple-choice questions, ch 6-10, 50 minutes
• Closed-books/notes
• Cheat sheet: one sheet 8.5*11’, double-sided,
HANDWRITTEN ONLY
• Review slides and prepare the cheat sheet
• Work on practice version of past homeworks and improve the
cheat sheet
• Practice questions posted on Canvas
 SOLVE THEM ON YOUR OWN using only your cheat
sheet
• Office hours: Wed, 2:30 pm, Alter 403e, or email questions
• Tutoring center: Mon-Fri 10am-2pm, Alter 403d
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 Chapter 11

Capital Budgeting: Evaluating

Long-Term Investment Projects
 Lecture outline
• Elements of project cash flow
• Methods to evaluate profitability of investment projects
 net present value (NPV)
 payback period
 accounting rate of return (ARR)
 Capital Budgeting
• Capital budgeting = tools used to evaluate long-term
investment projects
 Should we invest in new equipment that will generate
cost savings over the next 5 years?
 Should we develop a new oil field that will generate
revenue over the next 20 years?

• Need to account for the time value of money:

$1 today is worth more than $1 a year from now
 if you borrow $1 today, you must pay interest
 if you have $1 today, you can earn interest

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 Why Do We Care?
• Firms make large long-term investments in
equipment, R&D, etc.
Boeing 747 Oil refinery Apple’s HQ
cost = $350 million cost = ~$10 billion cost = ~$5 billion
useful life = ~25 years useful life = ~20 years useful life = 40+ years

• Are these investments profitable or unprofitable?

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 Example: Long-Term Investment Project
A hospital is thinking of buying a new MRI machine. The
machine costs $50,000 and will last for 5 years. The cost of
capital is 10% a year (i.e., you can borrow at 10% and you can
invest your own money at 10%). The expected operating net
cash flows from the machine are:
• $20,000 a year in years 1–2
• $15,000 a year in years 3–5
The machine will be worthless at the end of year 5.
Should they invest in the MRI machine?

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 Summary of Cash Flows for the MRI Machine

operating cash flows during the asset’s

useful life: the machine can either
initial outlay: increase revenue (cash inflows) or reduce
invest $50,000 costs (cash outflows)
zero salvage value
today
after 5 years

year 0 year 1 year 2 year 3 year 4 year 5

($50,000) $20,000 $20,000 $15,000 $15,000 $15,000

Cost of capital = 10%

Is this a profitable investment?

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 Method 1: Net Present Value (NPV)
• NPV is total present value of all cash flows from the project
i.e., how much they are worth in today’s dollars

• Computing present value of future cash flows:

 The cost of capital is 10% a year
 $100 one year from now: How much is it worth today?
$100 $100
PV    $90.9
1  10% 1.1
 $100 two years from now: How much is it worth today?
$100 $100
PV    $82.64
(1  10%) 2
1.21
 $100 t years from now: How much is it worth today?
$100 $100
PV  t 
(1  10%) 1.1t
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 Computing NPV
• 

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 NPV for the MRI Machine
 

t=0 t=1 t=2 t=3 t=4 t=5 zero salvage value

($50,000) $20,000 $20,000 $15,000 $15,000 $15,000 after 5 years

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 Exercise: Computing NPV
 

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 Method 2: Payback Period
Payback period = how long it takes to recoup the investment
This method has two major drawbacks:
• it ignores the time value of money
• it ignores cash flows that occur after the payback period
=> do NOT use it to make major investment decisions in real life.

• In the case of equal operating cash flows in all future years,

Payback period = initial outlay / annual cash flow
e.g., Initial outlay is $60,000. Operating net cash flows are $24,000 a
year.
Payback period = $60,000/$24,000 = 2.5 years

• In the case of unequal operating cash flows, see next slide.

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 Payback Period for the MRI Machine
t=0 t=1 t=2 t=3 t=4 t=5 zero salvage value
($50,000) $20,000 $20,000 $15,000 $15,000 $15,000 after 5 years

Different operating cash flows in different future years

=> compute payback period using cumulative cash flow.

net cash flow cumulative cash flow

omit the year 1 $20,000 year 1 = $20,000
initial
outlay in year 2 $20,000 years 1,2 = $40,000
year 0
year 3 $15,000 years 1,2,3 = $55,000 vs initial outlay
$50,000
year 4 $15,000 years 1,2,3,4 = $70,000
year 5 $15,000 years 1,2,3,4,5 = $85,000

The initial outlay is fully recouped sometime between year 2 and year 3
=>
payback period = between 2 and 3 years

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 Method 3: Accounting Rate of Return (ARR)
Average annual income from the project
ARR =
Average investment

where
annual income = annual cash flow – depreciation
average investment = average book value of the asset =
= (beginning book value + ending book value)/2

• This method ignores the time value of money

=> do NOT use it to make major investment decisions in real life.

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 ARR for the MRI Machine
The original purchase price of the MRI machine is $50,000.
The useful life of the machine is 5 years. After 5 years, the
machine is worthless.
Annual net cash flow from the machine is $17,000 on average
(two years of $20,000 + three years of $15,000).
Compute ARR.
beginning book value in year 0 =
ending book value after 5 years =
average investment =
annual depreciation =
average annual income =
ARR =

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 Can use the same methods in
Product Life Cycle Analysis

& profit

maximize NPV over the entire product life cycle

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 Additional Exercises

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 Exercise: Evaluating Investment Projects
You are thinking of buying a new machine for $900.
It will generate cost savings of $600 a year for the next 3
years, after that the salvage value is zero. The cost of capital
is 25% a year.

1. Compute net present value

NPV =

Should you invest?  YES  NO Why?

2. Compute the payback period

payback period =
Should you use the payback method in real life? Why?
 YES  NO
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 (continued) Evaluating Investment Projects
You are thinking of buying a new machine for $900.
It will generate cost savings of $600 a year for the next 3
years, after that the salvage value is zero. The cost of capital
is 25% a year.

3. Compute the accounting rate of return (ARR)

annual depreciation =

annual income =

average investment =

ARR =
Should you use ARR in real life? Why?
 YES  NO
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 Exercise: Investment in Customer Contracts
Verizon Wireless buys iPhones from Apple for $600 and sells them to
customers for $200 with a two-year contract (i.e., Verizon invests $400 at the
beginning of each iPhone contract).
On average, each contract will generate net cash flows of $300 in year 1 and
$200 in year 2 for Verizon. The salvage value of a contract after two years is
zero. Verizon’s cost of capital is 25% a year.
1. Compute the payback period
net cash flow cumulative cash flow

year 1 $300 year 1 =

vs initial outlay
year 2 $200 years 1,2 = $_______
Payback period is
 between 0 and 1 years
 between 1 and 2 years
 more than 2 years
Based on the payback period, is this an attractive investment?  YES 
20NO
 (continued) Investment in Customer
Contracts
Verizon Wireless buys iPhones from Apple for $600 and sells them to
customers for $200 with a two-year contract (i.e., Verizon invests $400 at the
beginning of each iPhone contract).
On average, each contract will generate net cash flows of $300 in year 1 and
$200 in year 2 for Verizon. The salvage value of a contract after two years is
zero. Verizon’s cost of capital is 25% a year.
2. Compute the net present value
NPV =
Based on NPV, is this an attractive investment?  YES  NO

Should you make your decision based on

 payback period?
 NPV?

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