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Capital Budgeting
• Capital budgeting is difficult because it
involves estimates in cash flows over
time and the time value of money
should be incorporated into the
decision.
• Sometimes, it is also difficult to know
how long a particular asset will last.
Payback Period
• Payback period in capital budgeting
refers to the period of time required for
the return on an investment to "repay"
the sum of the original investment.
Payback Period
• It is considered to be one of the weaker
capital budgeting techniques due to its
limitations.
• It is, however, still widely used in
business today due to its ease of use.
Disadvantages of Payback
• It ignores cash flows after the payback
period and does not measure
profitability.
• It ignores the time value of money
because cash flows are not discounted.
(this is done in NPV)
Summary
• In summary, the payback period provides
information to managers that can be used as
follows:
• Help control the risks associated with the
uncertainty of future cash flows
• Help minimise the impact of an investment
on a firm’s liquidity problems
• Help control the risk of obsolescence
Options
• There are 2 different examples we will
look at using the payback period. One
involves having the same cash inflows
each period while the other one
involves different cash inflows each
period.
Example 1
• Project X costs $21 000 and will return a
net cash inflow of $5 000 per period.
What will the payback period be for
this project?
Example 1 Solution
Payback Period = Initial Investment
Payback Period = Net Cash Inflow
Payback Period = $21 000
Payback Period = $5 000
Payback Period = 4.2
We keep the 4 years and now times the .2 by 12 for the number of months in a year.
This will give us 2.4 months which we can then round up to 3 as that will be the minimum amount of time
Example 2• Project Y has an initial investment of
$21 000 and will offer the following net
cash inflows over the next 5 years.
YEAR NET CASH INFLOW CUMULATIVE TOTAL
1 3 000 3 000
2 5 000 8 000
3 7 000 15 000
4 4 000 19 000
5 9 000 28 000
Example 2 Solution
YEARNET CASH
INFLOWCUMULATIVE TOTAL
1 3 000 3 000
2 5 000 8 000
3 7 000 15 000
4 4 000 19 000
5 9 000 28 000
Payback Period = Initial Investment
Payback Period = Net Cash Inflow
$21 000
Example Solution 2• Therefore, we know that it will take at
least 4 years to pay the project back as
the cumulative net cash inflow up to
year 4 is $19 000.
• That leaves us to calculate how many
months it will take to get the extra
$2 000 from the $9 000 in Year 5.
9,000/12 = $750 per month. Thus it will take 3 months to reach $2 000. ie: $750 x 3 = 2 250
Example 1 and 2
• So we can see from these examples that
both projects would take the same
amount of time so how would we
choose which one to invest in?
Payback Student Example• Millipore Mechanics have decided that they need to
replace some of the machinery in their workshop. The
new assets will cost $80,000 and is depreciated at 20%
pa on cost using the straight line method.
• The estimated cash inflows over the next few years is
listed here: Year 1 15,000
2 16,000
3 10,000
4 11,000
5 16,000
6 16,000
7 19,000
8 21,000
Student Solution Payback Period =
Initial Investment Payback Period =
Net Cash Inflow
Year 1 15,000
2 16,000
3 10,000
4 11,000
5 16,000
6 16,000
7 19,000
8 21,000
$68,000
Student Solution• Therefore, we know that it will take at
least 5 years to pay the project back as
the cumulative net cash inflow up to
year 5 is $68 000.
• That leaves us to calculate how many
months it will take to get the extra
$12 000 from the $ 16 000 in Year 6.
16,000/12 = $1,333 per month. Thus it will take 9 months to reach $12 000. ie: $1,333 x 9 = $12 200
Thus it will take 5 years and 9 months
Payback + Cost Savings
• There are times when a business will
look at implementing some new
machinery in order to save costs and
they have to decide whether it’s
worthwhile investing in it.
• There normally is a time period
associated with these types of
investment.
Example 1
• Spacely Sprockets is looking to get a new piece
of machinery that will replace 5 workers who
currently do the packing manually on the
conveyer belt. The workers are each paid
$40,000 a year and the new machinery costs
$850,000.
• Spacely Sprockets has a rule that says the
payback period must be 5 years of less.
Example 1 Solution Payback Period =
Initial Investment Payback Period =
Annual Net Cost Saving
Payback Period = $850,000
Payback Period = $200,000
The payback period will be 4.25 years and thus would be accepted as it fits within the 5 year pattern.
Payback + Cost Savings + Different Inflows
• There are times when a business will
look at implementing some new
machinery in order to save costs but
will also have an impact on their overall
cashflows as well.
• There normally is a time period
associated with these types of
investment.
Example 1• Spacely Sprockets is looking to get a new piece
of machinery that will replace 5 workers who
currently do the packing manually on the
conveyer belt. The workers are each paid
$40,000 a year and the new machinery costs
$850,000. The business will have to pay
additional insurance costs of $20,000 per year
and repair and maintenance costs of $30,000.
• Spacely Sprockets has a rule that says the
payback period must be 5 years of less.
Example 1 Solution Payback Period =
Initial Investment Payback Period =
Annual Net Cost Saving
Payback Period = $850,000
Payback Period = $150,000
The payback period will be 5.66 years & thus would NOT be accepted as it fits within the 5 year criteria.
Savings = 200,000 - 30,000 - 20,000 = $150,000
Payback Cost Saving Student Example
• Gledhow Industries are deciding whether to replace their manual packing system with a more automated approach. The cost of the automated system will set back the company $90,000.
• The business state the payback period must be less than 5 years to be accepted. The business will have the following additional costs and savings with the introduction of the new system.
Savings Per Year Costs Per Year
Wages 30,000 Electricity 4,000
Packing Materials 4,000 Repairs 2,000
Insurance 1,500
Parts 1,500
Student Solution Payback Period =
Initial Investment Payback Period =
Annual Net Cost Saving
Payback Period = $90,000
Payback Period = $25,000
The payback period will be 3.6 years & thus WOULD be accepted as it fits within the 5 year criteria.
Savings = 30,000 + 4,000 - 4,000 - 2,000 - 1,500 - 1,500 = $25,000
Return on Average Investment
• This method is no longer popular for
assessing capital budgeting decisions
but is still important that you
understand it.
Advantages
• It is easy to understand
• Most people including managers are
familiar with the concepts of income,
book value, profit, residual value and
rate of return.
Disadvantages
• It ignores the time value of money
• It uses accounting measures of income
rather than cash flows. Income can be
easily manipulated by managers while
cash flow can’t.
Formula
Return on Average Investment = Average Profit after Tax
Return on Average Investment = Average Investment
Average Investment = Initial Investment + Residual Value
Average Investment = 2
Example 1
Return on Average Investment = Average Profit after Tax
Return on Average Investment = Average Investment
Average Investment = Initial Investment + Residual Value
Average Investment = 2
An investment proposal is being looked at by Business P. It has an initial investment of $500,000 and residual value of
$40,000 and should generate the following profits after tax:
Year 1 Year 2 Year 3
Profit after Tax $72 000 $60 000 $80 000
Example 1 Solution
Return on Average Investment = Average Profit after Tax
Return on Average Investment = Average Investment
An investment proposal is being looked at by Business P. It has an initial investment of $500,000 and residual value of
$40,000 and should generate the following profits after tax:
Year 1 Year 2 Year 3
Profit after Tax $72 000 $64 000 $80 000
Step 1: Average Profit 72,000 + 64,000 + 80,000 /3 $72 000
Example 1 Solution
Return on Average Investment = Average Profit after Tax
Return on Average Investment = Average Investment
An investment proposal is being looked at by Business P. It has an initial investment of $500,000 and residual value of
$40,000 and should generate the following profits after tax:
Year 1 Year 2 Year 3
Profit after Tax $72 000 $64 000 $80 000
Step 2: Average Investment 500,000 + 40,000 /2 $270 000
Example 1 Solution
Return on Average Investment = Average Profit after Tax
Return on Average Investment = Average Investment
Step 2: Average Investment 500,000 + 40,000 /2 $270 000
Step 1: Average Profit 72,000 + 64,000 + 80,000 /3 $72 000
Return on Average Investment = 72,000
Return on Average Investment = 270,000
Return on Average Investment = 26.67%
Things to be wary of
• When doing these questions, make sure
that you look carefully at the question,
particularly in terms of the following
items:
• Depreciation on Asset
• Prepaid and Accrued Items
Return on Investment Student example
• Forest Hill Couriers are looking to buy a new vehicle to
expand their business into the Albany area. The new
vehicle will cost $35,000 and have a residual value of
$9,000. They want a return of 15% to go ahead with it.
• By expanding the business into Albany they expect to have
the following estimates for income and expenses per year:
Income Expenses
Courier Fees 60,000 Petrol 15,000
Wages 30,000
Advertising 5,000
Return on Investment Student SolutionIncome
Courier Fees 60,000
Less Expenses
Petrol 15,000
Wages 30,000
Advertising 5,000
Profit $10,000
Return on Average Investment = 10,000
Return on Average Investment = 22,000
Return on Average Investment = 45 %
Therefore, we should progress with the investment.
Net Present Value
• This involves the discounting of the cash
flows for a project to a present value
using the minimum desired rate of
return as the discount rate.
• The decision criteria is to accept all
projects with a positive NPV except for
mutually exclusive ones where we
would choose the one with the highest
NPV.
Advantages
• It recognises the time value of money
• Dollars can be added because they are in
present values
• It gives correct ranking of mutually
exclusive projects
• It is dependant on future cash flows and
the opportunity cost of capital rather than
some arbitrary guess by management.
Disadvantages
• How do we determine the minimum
desired rate of return?
• How accurate are future cash forecasts
Formula
Present Value = Future Value
Present Value = (1 + i)n
where:
i = Interest rate per periodn = Number of periods
Example 1- Different inflows
• Dog Rock Industries have been handed a
proposal where they would invest in a new
piece of machinery. The piece of machinery is
going to cost $70 000 and have the following
net cash inflows over the 5 years of the assets
life and cost of capital is 10%:
Net Cash Inflow Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
10,000 12,000 13,000 11,000 15,000
Example 1 Solution
Present Value = Future Value
Present Value = (1 + i)n
10,000
(1.10)1
12,000
(1.10)2
13,000
(1.10)3
11,000
(1.10)4
15,000
(1.10)5+ +++
9090.90 9917.35 9767.09 7513.14 9313.81+ +++
Example 2
• There are times when we are doing the
Capital Budgeting NPV technique
where the net cash inflow will be the
same for each period. This allows us to
do the calculation much easier.
• Let’s look at an example of how this
works.
Different Inflows Student Example
• Walpole Investments have 3 projects presented
to them and they are not sure which one to
choose. Given the cost of capital is 10% which of
the following 3 projects would you recommend
and why?
Project Cost Year 1 Year 2 Year 3 Year 4
A 10,000 1,000 1,300 1,500 2,000
B 25,000 2,500 4,000 6,000 8,000
C 50,000 12,000 15,000 18,000 32,000
Different Inflows Student SolutionProject Cost Year 1 0.9091 Year 2 0.8264 Year 3 0.7513 Year 4 0.6830 Total
A 10,000 1,000 909.1 1,300 1074.38 1,500 1126.97 2,000 1366.02 4476.47
B 25,000 2,500 2272.72 4,000 3305.78 6,000 4507.88 8,000 5464.10 15550.5
C 50,000 12,000 10909.1 15,000 12396.7 18,000 13523.7 32,000 21856.4 58685.9
Total
The business should accept proposal C as it its the only one which has a positive NPV.
Project Future Value Initial Investment NPV
A 4 476.47 10 000 -$5 523.53
B 15 550.5 25 000 -$9 449.5
C 58 685.9 50 000 $8 685.9
Example 2 - Same inflows
• Walpole Manufacturers have been handed a
proposal where they would invest in a new
piece of machinery. The piece of machinery is
going to cost $50 000 and have the following
net cash inflows over the 5 years of the assets
life and cost of capital is 10%:
Net Cash Inflow Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
8,000 8,000 8,000 8,000 8,000
Example 2 - Solution
In this case the present value will be calculatedas follows:
PV = 8,000 x 3.7907 = $30,325.60
If we take this off the initial value of $50,000 it leaves us a negative value of $19,674.40. Therefore, we should reject this proposal.
Same Inflows Student Example
• Emu Point Sports Store is looking at 2 different sites in expand its business. Proposal A will cost $60,000 while Proposal B will cost $75,000. The business is expected to have the following net cash inflows over the next 5 years and the cost of capital will be 10%. Which one would you recommend?
Year 1 Year 2 Year 3 Year 4 Year 5
Proposal A 18,000 18,000 18,000 18,000 18,000
Proposal B 21,000 21,000 21,000 21,000 21,000
Same Inflows Student Solution
Year 1 Year 2 Year 3 Year 4 Year 5
Proposal A 18,000 18,000 18,000 18,000 18,000
Proposal B 21,000 21,000 21,000 21,000 21,000
Proposal A 18,000 * 3.7907 $68232.60 60,000 $8,232.6
Proposal B 21,000 * 3.7907 $79604.70 75,000 $4604.70
Example 3 - Same & Different inflows
• There are also scenarios that will show
inflows the same for a number of
periods and different for other periods.
• Depending on when the same period is
will determine how we will approach
the solution and which
recommendation we would make to the
business.
Example 3 - Same first• Denmark Timbers have been given the
opportunity to expand their business by investing in a new business opportunity. The cost to invest in the new business will be $35,000 and the business wants a minimum return of 8%.
• The business expects the following returns over the next 5 years.
Net Cash Inflow Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
8,000 8,000 8,000 11,000 15,000
Example 3 SolutionIn this case the present value will be calculatedas follows:
PV = 8,000 x 2.5770 = $20, 616
This will cover the first 3 years. For the next 2 years, we need to use table to calculate each year
individually.
Year 4 PV = 11,000 x .7351 = $8,086.10
Year 4 PV = 15,000 x .6806 = $10,209
Total = 20,616 + 8,086.10 + 10,209 = $38,911.10
Example 3 Solution cont.
• In this scenario, we can see that the
business would have a positive net value
by $38,911.10 - $35,000 = $3,911.10.
• Therefore, we would recommend that
Denmark Timbers invest in the new
business.
Situation 4 - Different First• Denmark Timbers have been given the
opportunity to expand their business by investing in a new business opportunity. The cost to invest in the new business will be $35,000 and the business wants a minimum return of 8%.
• The business expects the following returns over the next 5 years.
Net Cash Inflow Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
11,000 15,000 8,000 8,000 8,000
Different 4 Solution
Present Value = Future Value
Present Value = (1 + i)n
11,000
(1.08)1
15,000
(1.08)2
8,000
(1.08)3
8,000
(1.08)4
8,000
(1.08)5+ +++
10,185.18 12,860.08 6,350.65 5,464.1 4,967.37
Project Future Value Initial Investment NPV
A 39827.38 35,000 $4,827.38
Same and Different Student Examples
• Little Grove Traders have the opportunity to
invest in a new property development down at
Goode Beach. The property development will
cost $250,000 and is expected to have the
following net cash inflows over the 10 years
with a cost of capital of 8%.Year Return Year Return
1 0 6 40,000
2 0 7 40,000
3 0 8 50,000
4 21,000 9 50,000
5 30,000 10 50,000
Same and Different Student SolutionYear Return Year Return
1 0 6 40,000
2 0 7 40,000
3 0 8 50,000
4 21,000 9 50,000
5 30,000 10 50,000
21,000
(1.08)4
30,000
(1.08)5++
40,000
(1.08)6
40,000
(1.08)7
50,000
(1.08)8
50,000
(1.08)9
50,000
(1.08)10+ +++
0
0 0 0 15,435.62 20,417.49
25,206.78 23,339.61 27,013.44 25,012.45 23159.67
Project Future Value Initial Investment NPV
A 159,585.06 250,000 -90414.94