Upload
angie-wiman
View
225
Download
5
Tags:
Embed Size (px)
Citation preview
Capabilities
• 1. Discuss the difficulty encountered in finding profitable projects in competitive markets and the importance of the search.
• 2. Determine whether or not a new project should be accepted or rejected using the payback period, the net present value, the profitability index, and the internal rate of return.
• 3. Explain how the capital-budgeting decision process changes when a dollar limit is placed on the dollar size of the capital budget.
• 4. Discuss the problems encountered in project ranking.
• 5. Explain the importance of ethical considerations in capital-budgeting decisions.
• 6. Discuss the trends in the use of different capital-budgeting criteria.
● Finding Profitable Projects
● Capital-Budgeting Decision Criteria
● Capital Rationing
● Problems in Project Ranking—Capital Rationing, Mutually Exclusive Projects, and Problems with the IRR
● Ethics in Capital Budgeting
A Glance at Actual Capital-Budgeting Practices
• Objective 1 FINDING PROFITABLE PROJECTS
• to evaluate profitable projects or investments in fixed assets, a process referred to as capital budgeting,
• • Axiom 5: The Curse of Competitive Markets—
Why It’s Hard to Find Exceptionally Profitable Projects.
• The payback period is the number of years needed to recover the initial cash outlay.
Objective 2 CAPITAL-BUDGETING
DECISION CRITERIA A B • Initial cash outlay - $10,000 - $10,000• Annual net cash inflows • Year 1 $ 6,000 $ 5,000• 2 4,000 5,000• 3 3,000 0• 4 2,000 0• 5 1,000 0•
Net Present Value
• The net present value (NPV) of an investment proposal is equal to the present value of its annual net cash flows after taxes less the investment’s initial outlay.
n
t 1t
t
k)(1
ACF
NPV = - IO
NPV
• ACFt = the annual after-tax cash flow in tim
e period t .
• k = the appropriate discount rate; that is, the required rate of return or cost of capital
• IO = the initial cash outlay
• n = the project’s expected life
Principal
• NPV ≥ 0.0 : accept
• NPV < 0.0 : reject
NPV Illustration of Investment in New Machinery
AFTER-TAX CASH FLOW Inflow year 1 15,000 2 14,000 3 13,000 4 12,000 5 11,000
Initial outlay - $40,000
Calculation for NPV Illustration of Investment in New Machinery PRESENT VALUE AFTER-TAX FACTOR AT PRESENT CASH FLOW 12 PERCENT VALUE 2 14,000 .797 11,158 3 13,000 .712 9,256 4 12,000 .636 7,632 5 11,000 .567 6,237Initial outlay - 40,000
Inflow year 1 15,000 .893 $13,395
Present value of cash flows $ 47,678
Net present value $ 7,678
Profitability Index (Benefit-Cost Ratio)
• The profitability index (PI), or benefit-cost ratio, is the ratio of the present value of the future net cash flows to the initial outlay.
IO
k
ACFn
tt
t 1 )1(PI =
• ACFt = the annual after-tax cash flow in time
period t (this can take on either positive or negative values )
• k = the appropriate discount rate; that is, the required rate of return or cost of capital
• IO = the initial cash outlay • n = the project’s expected life
Principale
• PI ≥ 1.0 : accept
• PI < 1.0 : reject
PRESENT VALUE AFTER-TAX FACTOR AT PRESENT CASH FLOW 10 PERCENT VALUE Inflow year 1 15,000 0.909 13,635 2 8,000 0.826 6,608 3 10,000 0.751 7,510 4 12,000 0.683 8,196 5 14,000 0.621 8,694 6 16,000 0.564 9,024
Initial outlay - $50,000 1.000 - $50,000
IO
k
ACFn
tt
t 1 )1(
000,50$
024,9$694,8196,8$510,7$608,6$635,13$
000,50$
667,53$
= 1.0733
Internal Rate of Return
• The internal rate of return (IRR) the discount rate that equates the present value of the project’s future net cash flows with the project’s initial cash outlay.
n
t 1t
t
IRR)(1
ACF IO =
IRR
• ACFt = the annual after-tax cash flow in tim
e period t (this can take on either positive or negative values )
• IO = the initial cash outlay
• n = the project’s expected life
• IRR = the project’s internal rate of return
1)1(
000,15$
IRR 2)1(
000,15$
IRR 3)1(
000,15$
IRR 4)1(
000,15$
IRR$45,555 =
4
1 )1(
1
ttIRR
$45,555 = 15,000
$45,555 = $15,000 (PVIFA i , 4yr )
Dividing both sides by $15,000, this becomes
3.037 = PVIFA i, 4yr
IRR for Uneven Cash Flows
Present Value
Net Cash Flows Factor at 15 Percent Present Value
Inflow year 1 $1,000 .870 $ 870
Inflow year 2 2,000 .756 1,512
Inflow year 3 3,000 .658 1,974
Present value of inflows $ 4,356
Initial outlay - $ 3,817
2. TRY i = 20 PERCENT:
Present Value
• Net Cash Flows Factor at 20 Percent Present
Value
• Inflow year 1 $1,000 .833 $ 833
• Inflow year 2 2,000 .694 1,388
• Inflow year 3 3,000 .579 1,737
• Present value of inflows $ 3,958
• Initial outlay - $ 3,817
• 3. TRY i = 22 PERCENT:
Present Value
Net Cash Flows Factor at 22 Percent Present
Value
Inflow year 1 $1,000 .820 $ 820
Inflow year 2 2,000 .672 1,344
Inflow year 3 3,000 .551 1,653
Present value of inflows $ 3,817
Initial outlay - $ 3,817
Three IRR Investment
A B C Initial outlay - $10,000 - $10,000 - $10,000
Inflow year 1 3,362 0 1,000
Inflow year 2 3,362 0 3,000
Inflow year 3 3,362 0 6,000
Inflow year 4 3,362 13,605 7,000
15%
Present Value
Net Cash Flows Factor at 15 Percent Present
Value Inflow year 1 $1,000 .870 $ 870
Inflow year 2 3,000 .756 2,268
Inflow year 3 6,000 .658 3,948
Inflow year 4 7,000 .572 4,004
Present value of inflows $11,090
Initial outlay - $ 10,000
Present Value
• Net Cash Flows Factor at 19 Percent Present Value • Inflow year 1 $1,000 .840 $ 840
• Inflow year 2 3,000 .706 2,118
• Inflow year 3 6,000 .593 3,558
• Inflow year 4 7,000 .499 3,493
• Present value of inflows $10,009
• Initial outlay - $ 10,000
-2, 000
-1, 500
-1, 000
-500
0
500
1, 000
1, 500
0 100 200 300 400 500 600
Di scount rates(%)
Net
pres
ent
valu
e($)
Objective 4
• PROBLEMS IN PROJECT RANKING-CAPITAL RATIONING, MUTUALLY EXCLUSIVE PROJECTS,
AND PROBLEMS WITH THE IRR.
• 1 Size disparity
• 2 Time disparity
• 3 Unequal live
Capital-Rationing Example of Five Indivisible Projects
Project Initial Outlay Profitability Index Net Present Value
A $200,000 2.4 $280,000
B 200,000 2.3 260,000
C 800,000 1.7 560,000
D 300,000 1.3 90,000
E 300,000 1.2 60,000
Investment Evaluation A Primary A Secondary Total Using
Methods Used: Method Method This Method
Payback period 24% 59% 83%
Internal rate of return 88% 11% 99%
Net present value 63% 22% 85%
Profitability index 15% 18% 33%
Project Size and Decision-Making Authority
Project Size Typical Boundaries Primary Decision Site
Very small Up to $100,000 Plant
Small $100,000 to $1 million Division
Medium $1 million to $10 million Corporate investment
committee
Large Over $10 million CEO & board
KEY TERMS
Benefit-Cost Ratio (see Profitability Index)Capital Budgeting Capital Rationing Equivalent Annual Annuity (EAA)Internal Rate of Return (IRR)Mutually Exclusive Projects Net Present Value (NPV)Payback period Profitability Index (PI or Benefit-Cost Ratio)