Capital Budgeting LECTURE 29

Ignores the time value of money. Ignores cash flows after the payback period. Payback Period

Consider two projects, each with a five-year life and each costing $6,000. Would you invest in Project One just because it has a shorter payback period? Payback Period

ROI = Average estimated net income Average investment ROI focuses on annual income instead of cash flows. Original cost + Salvage value 2 Return on Average Investment (ROI)

ROI = = 25% $10,000 $40,000 ROI focuses on annual income instead of cash flows. $75,000 + $5,000 2 Return on Average Investment (ROI)

Income may vary from year to year. Time value of money is ignored. So why would I ever want to use this method anyway? Return on Average Investment (ROI)

Now let’s look at a capital budgeting model that considers the time value of cash flows. Discounting Future Cash Flows

A comparison of the present value of cash inflows with the present value of cash outflows Net Present Value (NPV)

 Chose a discount rate – the minimum required rate of return.  Calculate the present value of cash inflows.  Calculate the present value of cash outflows. NPV =  –  Net Present Value (NPV)

General decision rule... Net Present Value (NPV)

Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a.$ 4,300 b.$12,700 c. $11,000 d. $17,000 Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a.$ 4,300 b.$12,700 c. $11,000 d. $17,000 Net Present Value (NPV) Question

Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a.$ 4,300 b.$12,700 c. $11,000 d. $17,000 Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent, what is the NPV? Ignore taxes. a.$ 4,300 b.$12,700 c. $11,000 d. $17,000 Using the present value of an annuity (table 2) PV of inflows = $20,000 × = $113,000 NPV = $113,000 - $96,000 = $17,000 Net Present Value (NPV) Question

Calculate the NPV if Savak Company’s required return is 15 percent instead of 12 percent. Note that the NPV is smaller using the larger interest rate. Using the present value of an annuity (table 2) PV of inflows = $20,000 × = $100,380 NPV = $100,380 - $96,000 = $4,380 Net Present Value (NPV) Question

Now that you have mastered the basic concept of net present value, it’s time for a more sophisticated checkup! Let’s return to Stars’ Stadium. Net Present Value (NPV)

Stars’ Stadium is considering purchasing vending machines with a 5-year life. ($75,000 - $5,000) ÷ 5 years Evaluating Capital Investment Proposals: An Illustration

Most capital budgeting techniques use annual net cash flow. Depreciation is not a cash outflow. Evaluating Capital Investment Proposals: An Illustration

Star’s Stadium Net Present Value Analysis Stars uses a 15% discount rate. Net Present Value (NPV)

Present value of an annuity of $1 factor for 5 years at 15%. Star’s Stadium Net Present Value Analysis $24,000 × = $80,448 Net Present Value (NPV)

Present value of $1 factor for 5 years at 15%. Star’s Stadium Net Present Value Analysis Net Present Value (NPV)

Since the NPV is positive, we know the rate of return is greater than the 15 percent discount rate. Star’s Stadium Net Present Value Analysis Net Present Value (NPV)

Let’s use NPV concepts with an asset replacement decision. Net Present Value (NPV) Replacing Assets

The Maine LobStars are considering replacing an old bus with a new bus, each with a 5-year life and zero salvage. Evaluating Capital Investment Proposals: An Illustration

Depreciation is not a cash outflow. Tax savings from loss on disposal of old bus: $15,000 × 40% = $6,000 Evaluating Capital Investment Proposals: An Illustration

LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate. Net Present Value (NPV)

LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate. Net Present Value (NPV)

LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate. Net Present Value (NPV)

Since the NPV is negative, we know the rate of return is less than the 15 percent discount rate. LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate. Net Present Value (NPV)

Capital budgeting involves many estimates. Estimates may be pessimistic or optimistic. Uncertainty about the future may impact estimates. Behavioral Issues in Capital Budgeting

Conflicts may exist between short-run performance measures and long-run capital budgeting criteria. Behavioral Issues in Capital Budgeting

A follow-up after the project has been approved to see whether or not expected results are actually realized. Capital Budget Audit

Source: Adopted from McGraw-Hill/Irvin