Capital Budgeting Chapter 14 Learning Objectives Determine Determine the payback period for an investment Evaluate Evaluate the acceptability of an investment project using the net present value method Evaluate Evaluate the acceptability of an investment project using the internal rate of return method Evaluate Rank Compute Evaluate an investment project that has uncertain cash flows Rank investment projects in order of preference Compute the simple rate of return for an investment Capital Budgeting Any decision that involves a cash outlay now to obtain a future return Screening decisions accept decline based on a preset hurdle rate Preference decisions selecting from several acceptable alternatives Typical Capital Budgeting Decisions Plant expansion Equipment selection Lease or buy Equipment replacement Cost reduction Cash Flows versus Operating Income Payback Method Net Present Value Internal Rate of Return These methods focus on analyzing the cash flows associated with capital investment projects The simple rate of return method focuses on incremental net operating income Typical Cash Outflows Repairs and maintenance Initial investment Incremental operating costs Working capital Typical Cash Inflows Salvage value Reduction of costs Incremental revenues Release of working capital Payback Method Payback period length of time that it takes for a project to recoup its initial cost from the net cash inflows that it generates In other words it is the time it takes for an investment to pay for itself 0 1 2 3045 Payback Period years Drawbacks 1 Not a measure of the investment s profitability 2 Does not consider the time value of money The Payback Method Part 3 Management at the Daily Grind wants to install an espresso bar in its restaurant that 1 Costs 140 000 and has a 10 year life 2 The espresso bar generate annual net cash inflows of 35 000 Management requires a payback period of 5 years or less on all investments What is the payback period for the espresso bar The Payback Method 14 13 Payback period Payback period Investment required Annual net cash inflow 140 000 35 000 Payback period 4 0 years According to the company s criterion management would invest in the espresso bar because its payback period is less than 5 years Quick Check 1 14 14 Consider the following two investments Project X Project Y 100 000 100 000 Initial investment 60 000 60 000 Year 1 cash inflow 40 000 35 000 Year 2 cash inflow 25 000 0 Year 3 cash inflow Which project has the shortest payback period a Project X b Project Y c Cannot be determined Quick Check 1a 14 15 Consider the following two investments Project X Project Y 100 000 100 000 Initial investment 60 000 60 000 Year 1 cash inflow 40 000 35 000 Year 2 cash inflow 25 000 0 Year 3 cash inflow Which project has the shortest payback period a Project X b Project Y c Cannot be determined Project X has a payback period of 2 years Project Y has a payback period of slightly more than 2 years Which project do you think is better Evaluation of the Payback Method Weaknesses Ignores the time value of money Ignores cash flows after the payback period Shorter payback period does not always mean a more desirable investment Evaluation of the Payback Method Strengths Serves as screening tool Identifies investments that recoup cash investments quickly Identifies products that recoup initial investment quickly Payback and Uneven Cash Flows When the cash flows associated with an investment project change from year to year the payback formula introduced earlier cannot be used Instead the un recovered investment must be tracked year by year Year 1 1 000 Year 2 0 Year 3 2 000 Year 4 1 000 Year 5 500 Payback and Uneven Cash Flows Part 2 14 19 For example if a project requires an initial investment of 4 000 and provides uneven net cash inflows in years 1 5 as shown the investment would be fully recovered in year 4 Year 1 1 000 Year 2 0 Year 3 2 000 Year 4 1 000 Year 5 500 Time Value of Money A dollar today is worth more than a dollar a year from now Therefore projects that promise earlier returns are preferable to those that promise later returns You could put the dollar in the bank today and have more than a dollar a year from now Time Value of Money The capital budgeting techniques that best recognize the time value of money are those that are based upon discounted cash flows The Net Present Value Method The net present value method compares the present value of a project s cash inflows with the present value of its cash outflows The difference between these two streams of cash flows is called the net present value The Net Present Value Method Two Simplifying Assumptions All cash flows other than the initial investment occur at the end of periods All cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate If NPV 0 Accept the project NPV PV of Cash Inflows PV of Cash Outflows Decision Rule 1 The project will recover the initial investment plus sufficient excess cash flows to compensate for tying up funds in the project If NPV 0 Reject the project 2 The project will not recover the initial investment and sufficient excess cash flows to compensation for tying up funds in the project The Net Present Value Method Lester Company has been offered a five year contract to provide component parts for a large manufacturer A C CA A 0 1 C2 3 0 A 9 W 1C0 AC2 3 2 3 0 A C C2 C C2 3 0 A C A C2 1C B C 1 A C C2 0C A A 0C A 2 C2C 8 B 00 8 A1c 4RS78777 R778777 78777 8777 a 78777 E778777 da78777 The Net Present Value Method 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 11 Should the contract be accepted The Net Present Value Method Annual net cash inflow from operations A C A A A 01 2C13C4 2 C 1 5 9A C 9449 CA2 C A2C C9 3 1 C CCS7 8 S 8 CC A CCC The Net Present Value Method 526 07 20C82C V48W7 20 C a82EC W80 C2 c c I I C C F I C CYC A CCCC A C F 0 CCCCC B B CCCCC N 20C P 4 A A YCCC CCCCC 0CW 20C6 4 The Net Present Value Method Part 7 Investment in equipment Working capital needed Annual net cash inflows Years Now Now 1 5 Cash Flows 160 000 100 000 80 000 11 Factor 1 000 1 000 3 696 Present Value 160 000 100 000 295 680 Present value of an annuity of 1 factor for 5 years at 11 Alternatively the individual annual net cash inflows could be discounted using the related five separate present value of a single payment of 1 factors That method
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