1. Chapter 14 Capital Budgeting Decisions Part A

2. Typical Capital Budgeting Decisions Capital budgeting tends to fall into two broad categories...  Screening decisions. Does a proposed project meet some present standard of acceptance?  Preference decisions. Selecting from among several competing courses of action. Capital budgeting tends to fall into two broad categories...  Screening decisions. Does a proposed project meet some present standard of acceptance?  Preference decisions. Selecting from among several competing courses of action.

3. Capital Budgeting Methods We will consider four Capital Budgeting methods : 1. Net Present Value Method 2. Internal Rate of Return Method 3. Payback Method 4. Simple Rate of Return Method We will consider four Capital Budgeting methods : 1. Net Present Value Method 2. Internal Rate of Return Method 3. Payback Method 4. Simple Rate of Return Method

4. The Mathematics of Interest A dollar received today is worth more than a dollar received a year from now because you can put it in the bank today and have more than a dollar a year from now.

5. The Mathematics of Interest – An Example Assume a bank pays 10% interest on a $100 deposit made today. How much will the $100 be worth in one year? F n = P(1 + r) n

6. Computation of Present Value Present Value Future Value An investment can be viewed in two ways—its future value or its present value. Let’s look at a situation where the future value is known and the present value is the unknown.

7. Present Value – An Example If a bond will pay $100 in two years, what is the present value of the $100 if an investor can earn a return of 12% on investments? (1 + r) n P = FnFnFnFn

8. Present Value of a Series of Cash Flows 123456$100$100$100$100$100$100 annuity An investment that involves a series of identical cash flows at the end of each year is called an annuity.

9. Present Value Problems 1.What is the present value of $1,000,000 to be received 10 years from now, with interest compounded at 15% annually? 2.What is the present value of an annuity of $10,000 for 5 years at 12%? 3.How much cash would you need to invest in a money market account today in order to have $8,000 at the end of four years? Assume interest rates are 6%.

10. Present Value Problems 4. How much cash would you need to invest in a money market account today in order to be able to withdraw $8,000 per year at the end of each of the next four years? Assume interest rates are 6%. 5. Assume you won the grand prize in a sweepstakes. Would it be better to take your prize in $100,000 payments each year over the next ten years or $600,000 now? Interest rates are 10%.

11. The Net Present Value Method To determine net present value we...  Determine the initial investment in the project  Calculate the sum of the present values of the future cash flows  Subtract the amount of the initial investment from the sum of the present value of the future cash flows to obtain the net present value of the project

12. General decision rule... The Net Present Value Method

13. Typical Cash Outflows Repairs and maintenance Incrementaloperatingcosts InitialinvestmentWorkingcapital

14. Typical Cash InflowsReduction of costs Salvagevalue Incrementalrevenues Release of workingcapital

15. Lester Company has been offered a five year contract to provide component parts for a large manufacturer. The Net Present Value Method

16. At the end of five years the working capital will be released and may be used elsewhere by Lester.At the end of five years the working capital will be released and may be used elsewhere by Lester. Lester Company uses a discount rate of 10%. Should the contract be accepted?Lester Company uses a discount rate of 10%. Should the contract be accepted? At the end of five years the working capital will be released and may be used elsewhere by Lester.At the end of five years the working capital will be released and may be used elsewhere by Lester. Lester Company uses a discount rate of 10%. Should the contract be accepted?Lester Company uses a discount rate of 10%. Should the contract be accepted? The Net Present Value Method

17. Pop Quiz The Zeron Corporation wants to purchase a new machine for its factory operations at a cost of $950,000. The investment is expected to generate $350,000 in annual cash flows for a period of four years. The required rate of return is 14%. The old machine can be sold for $50,000. The machine is expected to have zero value at the end of the four-year period. What is the net present value of the investment? Would the company want to purchase the new machine? The Zeron Corporation wants to purchase a new machine for its factory operations at a cost of $950,000. The investment is expected to generate $350,000 in annual cash flows for a period of four years. The required rate of return is 14%. The old machine can be sold for $50,000. The machine is expected to have zero value at the end of the four-year period. What is the net present value of the investment? Would the company want to purchase the new machine? a.$119,550; yes b.$69,550; no c.$1,019,550; yes d.$326,750; no

18. Internal Rate of Return Method The internal rate of return is the rate of return promised by an investment project over its useful life. It is computed by finding the discount rate that will cause the net present value of a project to be zero.The internal rate of return is the rate of return promised by an investment project over its useful life. It is computed by finding the discount rate that will cause the net present value of a project to be zero. It works very well if a project’s cash flows are identical every year. If the annual cash flows are not identical, a trial and error process must be used to find the internal rate of return.It works very well if a project’s cash flows are identical every year. If the annual cash flows are not identical, a trial and error process must be used to find the internal rate of return.

19. Internal Rate of Return Method General decision rule... When using the internal rate of return, the cost of capital acts as a hurdle rate that a project must clear for acceptance.

20. Internal Rate of Return Method Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs.Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life.The machine has a 10-year life. What is the Internal Rate of Return?What is the Internal Rate of Return? Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs.Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life.The machine has a 10-year life. What is the Internal Rate of Return?What is the Internal Rate of Return?

21. Pop Quiz The Zeron Corporation recently purchased a new machine for its factory operations at a cost of $921,250. The investment is expected to generate $250,000 in annual cash flows for a period of six years. The required rate of return is 14%. The old machine has a remaining life of six years. The new machine is expected to have zero value at the end of the six-year period. The disposal value of the old machine at the time of replacement is zero. What is the internal rate of return? The Zeron Corporation recently purchased a new machine for its factory operations at a cost of $921,250. The investment is expected to generate $250,000 in annual cash flows for a period of six years. The required rate of return is 14%. The old machine has a remaining life of six years. The new machine is expected to have zero value at the end of the six-year period. The disposal value of the old machine at the time of replacement is zero. What is the internal rate of return? a.15% b.16% c.17% d.18%

22. Preference Decision – The Ranking of Investment Projects Screening Decisions Pertain to whether or not some proposed investment is acceptable; these decisions come first. Preference Decisions Attempt to rank acceptable alternatives from the most to least appealing.

23. Internal Rate of Return Method The higher the internal rate of return, the more desirable the project. When using the internal rate of return method to rank competing investment projects, the preference rule is:

24. Net Present Value Method The net present value of one project cannot be directly compared to the net present value of another project unless the investments are equal.

25. Ranking Investment Projects

26. Project A: Project B: $ 90,000 $600,000 $ 80,000 $300,000 =.15 =.27

27. Present Value of $1: 1 (1 + r)ⁿ

28. Present Value of an Annuity of $1 in Arrears: __1__ (1 + r)ⁿ 1r1r 1 - [ ]