Chapter 12 - Capital Budgeting

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Presentation transcript:

Chapter 12 - Capital Budgeting 12.2 Independent and Mutually Exclusive Projects 12.3 Payback Period 12.4 Accounting Rate of Return (ARR) 12.5 Net Present Value (NPV)

What is Capital Budgeting? A process used to evaluate investment opportunities (projects) and decide which, if any, to undertake. A mutually exclusive project is one in which two or more alternative projects are possible, but only one can be selected at the exclusion of the others. An independent project can be evaluated without reference to an alternative course of action.

Payback Period Measures the time it takes to recoup the original investment. Major criticisms of the payback technique: Does not take into consideration cash flows after the payback period. Ignores the time value of money. See example pg. 428

Accounting Rate of Return (ARR) An accounting technique used to evaluate projects. Two alternative methods can be used: ARR on original investment: Average Annual Net Profit After Tax Original Cost of Investment ARR on average investment: Average Investment

Accounting Rate of Return (ARR) Major criticisms of the ARR technique: The use of accounting measures for the determination of profit and investment. Average annual net profit after tax and not actual cash flows are used to analyse project returns. Does not consider the time value of money.

Net Present Value (NPV) A capital budgeting technique used to estimate the present value of the cash inflows and outflows of a project using an appropriate discount rate. Takes into account the time value of money Takes into account all relevant cash flows.

Accept or Reject under NPV Independent projects should be accepted if the NPV of the project is positive, rejected if the NPV of the project is negative. Any positive NPV value means the project will increase shareholder wealth. Mutually exclusive projects should be accepted if they have the highest NPV value of all available alternatives, rejected if otherwise.

Work out the relevant after-tax future cash flows. NPV Calculation Work out the relevant after-tax future cash flows. Discount each yearly cash flow to their present value using an appropriate discount rate Add together the total value of all present values of future cash flows and subtract an initial outlay for the project. Accept or reject projects according to how they affect shareholder wealth.