Capital Budgeting and Investment Analysis Chapter 24 Capital Budgeting and Investment Analysis

Capital Budgeting & Investment Decisions These are decisions about when and how much to spend on capital assets Capital budgeting is the process of making such decisions Identify alternatives Evaluate and rank choices Make the decision

Measures Used in Capital Budgeting Net cash inflows include the increases in cash receipts less the cash payments made on a project. Can be a series of equal or unequal amounts. Cost savings are measured as the reduction of costs under each alternative.

Other Considerations Income taxes will affect cash flows and must be considered. Depreciation expense does reduce income and income taxes, but it does not decrease cash flows. Sale of the old assets will provide additional cash receipts up front. Sale of the new assets at the end of their useful life is an additional cash flow at the end of the project life.

Payback Period Payback is a measure of how long it will take to recover the initial investment. When you have equal cash flows Payback = (Initial cost)/(annual net cash inflow) If Payback <= useful life of project, then accept

Cash Payback Method Assumptions: Investment cost $200,000 Expected useful life 8 years Expected annual net cash flows (equal) $40,000 Cash Payback Period Total Investment = Annual Net Cash Inflows What is the cash payback period?

Cash Payback Method Assumptions: Investment cost $200,000 Expected useful life 8 years Expected annual net cash flows (equal) $40,000 Cash Payback Period Total Investment = Annual Net Cash Inflows Cash Payback Period $200,000 = = 5 years $40,000

Payback with unequal cash flows When cash flows are not the same every year, you cannot apply the previous formula. Rather you must determine at what point the cumulative cash flows become positive. Where Cumulative CF = (initial investment) + CF(yr1) + CF(yr2) + …

Cash Payback Method Assumptions: Net Cash Cumulative Flow Net Cash Flow Year 1 $ 60,000 $ 60,000 Year 2 80,000 140,000 Year 3 105,000 245,000 Year 4 155,000 400,000 Year 5 100,000 500,000 Year 6 90,000 590,000 If the proposed investment is $400,000, what is the payback period?

Cash Payback Method Assumptions: Net Cash Cumulative Flow Net Cash Flow Year 1 $ 60,000 $ 60,000 Year 2 80,000 140,000 Year 3 105,000 245,000 Year 4 155,000 400,000 Year 5 100,000 500,000 Year 6 90,000 590,000 If the proposed investment is $450,000, what is the payback period?

Using Payback Period Payback is the easiest of the methods to use and it gives us a quick idea of whether or not to consider the investment option further. Weaknesses: It does not consider the timing of the cash flows (relative amounts over the years) It ignores any cash flows received after the point where cash is fully recovered.

Accounting Rate of Return ARR is another method of evaluating alternatives. It is easy to determine, but it also ignores the time value of money. ARR = (average annual net income)/(avg. investment cost), where Average investment cost = (Initial cost + residual value)/2 If ARR > cost of capital, then accept

Average Rate of Return Method Assumptions: Machine cost $500,000 Expected useful life 4 years Residual value none Expected total income $200,000 Estimated Average Annual Income Average Rate of Return = Average Investment

Average Rate of Return Method Assumptions: Machine cost $500,000 Expected useful life 4 years Residual value none Expected total income $200,000 Estimated Average Annual Income Average Rate of Return = Average Investment Average Rate of Return $200,000 / 4 yrs. = = 20% ($500,000 + $0) / 2

Time Value of Money Money received today has greater value than money to be received in the future because of the effects of compound interest. PV(lump sum) = Future value*PV factor PV(annuity) = payment*PVA factor Where the PV factors are a function of the interest rate and the time An annuity is a series of equal payments.

Net Present Value Method This method of evaluating capital projects involves the Calculation of present values of all net cash inflows less the Cost of the initial investment. If NPV >= 0, then the project is acceptable. This method is the best in evaluating alternatives.

Net Present Value Method Exh. 24-7 To find the present value of a future cash flow, we multiply the cash flow by the present value of one dollar for twelve percent and the year in which the cash flow occurs. You will find these interest factors in Table B.1 of Appendix B of your textbook. At this point you should turn to Appendix B and verify the interest factors. If it has been awhile since you have worked with present value computations, or if this topic is new to you, you will probably want to read Appendix B and work some of the exercises found there before continuing.

Net Present Value Method Present value factors for 12 percent Exh. 24-7 Present value factors for 12 percent Did you find the twelve percent interest factors in Appendix B for each year?

Net Present Value Method Exh. 24-7 To find the net present value, we sum the present values for each year and then subtract the cost of the new machine from the sum. The sum of present values is greater than the cost of the investment, resulting in a net present value of four thousand, three hundred sixty seven dollars. A positive net present value indicates that this project earns more than twelve percent on the investment of sixteen thousand dollars. A positive net present value indicates that this project earns more than 12 percent on the investment.

Net Present Value Method Exh. 24-7 To find the present value of a future cash flow, we multiply the cash flow by the present value of one dollar for twelve percent and the year in which the cash flow occurs. You will find these interest factors in Table B.1 of Appendix B of your textbook. At this point you should turn to Appendix B and verify the interest factors. If it has been awhile since you have worked with present value computations, or if this topic is new to you, you will probably want to read Appendix B and work some of the exercises found there before continuing.

Internal Rate of Return (IRR) The interest rate that makes . . . Present value of cash inflows Present value of cash outflows =  The internal rate of return is the interest rate that will cause the net present value of a project to be equal to zero. Stated another way, the internal rate of return is the interest rate that will make the present value of future cash inflows equal to the present value of outflows (cost of the investment). The net present value equal zero.

Projects with even annual cash flows Internal Rate of Return (IRR) Method Exh. 24-9 Projects with even annual cash flows Project life = 3 years Initial cost = $12,000 Annual net cash inflows = $5,000 Determine the IRR for this project. 1. Compute present value factor. 2. Using present value of annuity table . . . Consider this example where a project is being considered that costs twelve thousand dollars, returns annual net cash flows of five thousand dollars, and has a useful life of three years. We must first compute an interest factor to use in the interest tables of Appendix B, where we will find the internal rate of return.

Projects with even annual cash flows Internal Rate of Return (IRR) Method Exh. 24-9 Projects with even annual cash flows Project life = 3 years Initial cost = $12,000 Annual net cash inflows = $5,000 Determine the IRR for this project. 1. Compute present value factor. $12,000 ÷ $5,000 per year = 2.4 2. Using present value of annuity table ... We divide the cost of the investment by the annual net cash inflow to get the interest factor of two point four. We will use this interest factor to find the internal rate of return in the present value of an annuity table, Table B.3 in Appendix B. Recall that the term annuity means an equal annual cash flow amount.

2. Using present value of annuity table . . . Internal Rate of Return (IRR) Method Exh. 26-9 1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000 2. Using present value of annuity table . . . Locate the row whose number equals the periods in the project’s life. Here’s a portion of Table B.3 from Appendix B. First, locate the row whose number equals the life of the project. You may actually want to turn to Appendix B to work through this exercise.

Internal Rate of Return (IRR) Method Exh. 26-9 1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000 2. Using present value of annuity table . . . In that row, locate the interest factor closest in amount to the present value factor. Now look across to the right on the three period row until you find an interest factor that is equal to or close to the two point four that we calculated earlier.

Internal Rate of Return (IRR) Method 4 Internal Rate of Return (IRR) Method Exh. 26-9 1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000 2. Using present value of annuity table . . . IRR is approximately 12%. IRR is the interest rate of the column in which the present value factor is found. Next, look to the top of the column where you found the interest factor closest to two point four, and you will find that it is the twelve percent column. The internal rate of return is approximately twelve percent. If the factor falls between two interest rate columns, we interpolate to approximate the internal rate of return.

Comparing Methods On this screen, we see a summary comparing the strengths and limitations of each of the four capital budgeting methods that we have studied. Recall that the major limitation of the payback method and the accounting rate of return method is that they neglect the time value of money. This limitation is overcome by using either the net present value or internal rate of return methods.

Hang in there! Only One More Chapter!