Upon completion of this session participants will be able to Explain the role of capital budgeting in longrange planning Understand the concept of cash flow analysis Understand the difference between simple and discounted cash flow analysis ID: 1029637
Download Presentation The PPT/PDF document "Capital Budgeting Objectives" is the property of its rightful owner. Permission is granted to download and print the materials on this web site for personal, non-commercial use only, and to display it on your personal computer provided you do not modify the materials and that you retain all copyright notices contained in the materials. By downloading content from our website, you accept the terms of this agreement.
1. Capital Budgeting
2. ObjectivesUpon completion of this session, participants will be able to:Explain the role of capital budgeting in long-range planningUnderstand the concept of cash flow analysisUnderstand the difference between simple and discounted cash flow analysisEvaluate the strengths and weaknesses of alternative capital budgeting models
3. Objectives (continued)Calculate the discounted cash flows (DCF)Estimate the Net Present Value (NPV) of a projectDetermine the Internal rate of Return (IRR) of a projectCalculate the Profitability Index (PI) of a projectDetermine the simple and discounted pay-back period of a projectEvaluate the impact of taxes on the above measures
4. Capital Budgeting DecisionsCapital Budgeting Decisions include the acquisition of long-lived assets.Require that capital (company funds) be expended to acquire additional resources.Also known as Capital Expenditure Decisions.
5. Capital Budgeting Decisions: ExamplesNew retail store outlets.Robotic manufacturing equipment.Digital imaging systems for healthcare facilities.New chairlift for a ski resort.New fleets:ShipsPlanesCarsNew equipment for food preparation.
6. Evaluating Investment Opportunities: Time Value of Money ApproachesThe Time Value of Money says: a dollar today is worth more than a dollar tomorrow.It is necessary to convert future dollars into their equivalent present value dollars.Two methods:Net Present Value.Internal Rate of Return.
7. Basic Time Value of Money CalculationsTo convert future value to present value: P = F (1 + i)n Where:P = present valueF = future valuei = (interest) rate of returnn = number of units of time
8. Basic Time Value of Money Calculations: ExampleCalculate the present value of $1.00 to bepaid (or collected) 5-years from now assuming an interest rate of 8%. Set it upas follows: P = 1.00 (1 + .08)5
9. Basic Time Value of Money Calculations: Example Solution P = 1.00 (1 + .08)5 P = 1.00 1.46933…Thus: $0.68
10. The Net Present Value MethodBased on the time-value of money.Recall that only incremental cash flows are relevant.Three-step process.
11. The Net Present Value Method: Step 1Identify the amount and time period of each cash flow associated with a potential investment.Note: Investment projects have both cash inflows and cash outflows.
12. The Net Present Value Method: Step 2Discount the cash flows to their present values using a required rate of return (a.k.a. hurdle rate).Note: This is the minimum return that management will accept.
13. The Net Present Value Method: Step 3Evaluate the net present value--the sum of all of the cash inflows less cash outflows.Note: if the net present value (NPV) is greater than or equal to zero, the investment should be made. If less than zero, it should not be made.
14. The Net Present Value Method: Example, Step 1Identify the amount and time period of each cash flow associated with a potential investment.Initial cash outlay: $70,000Year 1 – 4 net cash savings: $21,000 per year.Year 5 net cash savings: $26,000.Required rate of return: 12%.
15. The Net Present Value Method: Example Step 2Discount the cash flows to their present values using a required rate of return (a.k.a. hurdle rate).Initial outlay: $70,000 x 1.00Year 1: $21,000 x .8929Year 2: $21,000 x .7972Year 3: $21,000 x .7118Year 4: $21,000 x .6355Year 5: $26,000 x ..5674
16. The Net Present Value Method: Example Step 3Evaluate the net present value--the sum of all of the cash inflows less cash outflows.Year 0: ($70,000)Year 1: $18,751Year 2: $16,741Year 3: $14,948Year 4: $13,346Year 5: $14,752NPV: $ 8,538
17. The Net Present Value Method: ExampleDo it! $8,538 > $0
18. The Net Present Value Method: Summary
19. The Internal Rate of Return Method Internal Rate of Return (IRR) is an alternative to the Net Present Value (NPV) method.IRR uses the time value of money.IRR is the rate of return that equates the present value of future cash flows to the investment outlay.
20. The Internal Rate of Return Method Internal Rate of Return (IRR) is an alternative to the Net Present Value (NPV) method.IRR uses the time value of money.IRR is the rate of return that equates the present value of future cash flows to the investment outlay.IRR analysis yields a yes (IRR > hurdle rate) or no (IRR < hurdle rate) result.
21. The Internal Rate of Return Method: SetupPresent value factor = Initial Outlay Annuity Amount
22. The Internal Rate of Return Method: ExampleInvestment: $100Expected 2-year return: $60 per yearPresent value factor = 100 60
23. The Internal Rate of Return Method: ExamplePresent value factor = 1.667Approximately equal to the PV factor of 1.6681 or 13% (from PV tables).
24. The Internal Rate of Return Method: Summary
25. The Internal Rate of Return With Unequal Cash FlowsFor cases with unequal yearly cash flows.Thus one cannot use a single present value factor.Must estimate the IRR (we will use EXCEL in class to calculate the NPV and IRR).
26. Summary of Net Present Value and Internal Rate of Return MethodsBoth the Net Present Value method and the Internal Rate of Return method take into account the time value of money.They differ in their approach to evaluating investment alternatives.
27. Estimating the Required Rate of ReturnIn the textbook examples, required rate of return was “given.”In practice, required rate of return must be estimated by management.Under certain conditions, the required rate of return should be equal to the cost of capital for the firm.
28. Additional Cash Flow ConsiderationsBoth the NPV and IRR require proper specification of cash flows.Only cash inflows and cash outflows are discounted back to the present, not revenues and expenses.
29. Cash Flows, Taxes, and The Depreciation Tax ShieldPreviously the effect of income taxes on cash flows was ignored.Tax considerations play a major role in capital budgeting decisions.Though depreciation does not directly affect cash flows, it indirectly affects cash flows.Depreciation reduces the amount of tax (which is paid in cash) a company must pay.Thus it is called a Depreciation Tax Shield.
30. Adjusting Cash Flows For InflationInflation should not be ignored in net present value analysis.Many worthwhile investment opportunities may be rejected.For our calculations, we assume the future cash flows are inflation-adjusted.
31. Simplified Approaches To Capital BudgetingPayback Period Method.Accounting Rate of Return.
32. Payback Period MethodThe length of time it takes to recover the initial cost of an investment.Example: an investment costs $1,000 and returns $500 per year, it has a payback period of 2-years.Two serious limitations:Does not consider cash inflows in years beyond the payback year.Does not consider the time value of money.We can also do a Discounted Payback calculation.
33. Accounting Rate of ReturnAccounting Rate of Return (ARR) is the average after-tax income from a project divided by the average investment in the project.Example: ARR = Average Net Income Average InvestmentIgnores the time value of money.
34. Conflict Between Performance Evaluation and Capital BudgetingManagers should use Net Present Value and Internal Rate of Return analyses to maximize shareholder wealth.Manager’s performance (and bonus) is often measured in the short-term on accounting income.Inherent conflict between what is good for the firm and what is good for the manager.
35. Quick Review Question #1If the net present value (NPV) of a project is zero, the project is earning a return equal to:Zero.The rate of inflation.The accounting rate of return.The required rate of return.
36. Quick Review Answer #1If the present value of a project is zero, the project is earning a return equal to:Zero.The rate of inflation.The accounting rate of return.The required rate of return.
37. Quick Review Question #2A project costs $200,000 and yields cash inflows of $50,000 per year for 5-years. In this case, the payback period is:Four years.Five years.$50,000.None of these.
38. Quick Review Answer #2A project costs $200,000 and yields cash inflows of $50,000 per year for 5-yrars. In this case, the payback period is:Four years.Five years.$50,000.None of these.
39. Quick Review Question #3The present value of $2,000 to be collected in three years using a rate of 11% is:$1,462$2,735$1,333$1,278
40. Quick Review Answer #3The present value of $2,000 to be collected in three years using a rate of 11% is:$1,462$2,735$1,333$1,278
41. Quick Review Question #4New equipment costing $5,000 is expected to yield net cash inflows of $1,350 each year for the next five years. Assuming a required rate of return of 14%, should the equipment be purchased (use IRR)?Yes (accept).No (reject).
42. Quick Review Answer #4New equipment costing $5,000 is expected to yield net cash inflows of $1,350 each year for the next five years. Assuming a required rate of return of 14%, should the equipment be purchased (use IRR)?Yes (accept).No (reject).Note: $1,350 * 3.4331 = $4,635
43. Then, try to complete this analysis:BRUNO INCORPORATED INSTALLS A NEW MACHINE FOR PRODUCING CARPETS AT A COST OF $335,220. THE MACHINE HAS A USEFUL LIFE OF FIVE YEARS, AT THE END OF WHICH THE MACHINE CAN BE SOLD OFF FOR $50,000. THE ANNUAL REVENUES FOR THE FIVE YEARS ARE AS FOLLOWS: $200,000; $300,000; $300,000; $200,000; AND $100,000, RESPECTIVELY. THE TOTAL VARIABLE COSTS ARE: $60,000; $90,000; $90,000; $60,000; AND $30,000, RESPECTIVELY. THE TOTAL FIXED COSTS ARE: $40,000; $110,000; $95,000; $40,000; AND $20,000, RESPECTIVELY. IN THE THIRD YEAR OF OPERATION, THE MACHINE WILL REQUIRE MAJOR MAINTENANCE AT A COST OF $15,000. THE COMPANY PAYS NO TAXES AND USES A DISCOUNT RATE OF 14%.CALCULATE THE NPV AND IRR OF THE MACHINE.