Presentation on theme: "Capabilities 1. Discuss the difficulty encountered in finding profitable projects in competitive markets and the importance of the search. 2. Determine."— Presentation transcript:
1Capabilities1. 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.
2● 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 BudgetingA Glance at Actual Capital-Budgeting Practices
3Objective 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.
4The payback period is the number of years needed to recover the initial cash outlay.
5Objective 2 CAPITAL-BUDGETING DECISION CRITERIA A BInitial cash outlay －$10, －$10,000Annual net cash inflowsYear $ 6, $ 5,000, ,000,,,
6Net Present ValueThe 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.
8NPV ACFt = the annual after-tax cash flow in time period t . k = the appropriate discount rate; that is, the required rate of return or cost of capitalIO = the initial cash outlayn = the project’s expected life
10NPV Illustration of Investment in New Machinery AFTER-TAX CASH FLOW Inflow year ,000,000,000,000,000Initial outlay －$40,000
11Calculation for NPV Illustration of Investment in New Machinery PRESENT VALUEAFTER-TAX FACTOR AT PRESENTCASH FLOW PERCENT VALUE, ,158, ,256, ,632, ,237Initial outlay －40,000Inflow year , $13,395Present value of cash flows $ 47,678Net present value $ 7,678
12Profitability 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.
14ACFt = the annual after-tax cash flow in time 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 capitalIO = the initial cash outlayn = the project’s expected life
20IRRACFt = the annual after-tax cash flow in time period t (this can take on either positive or negative values )IO = the initial cash outlayn = the project’s expected lifeIRR = the project’s internal rate of return
22$45,555 = $15,000 (PVIFA i , 4yr )Dividing both sides by $15,000, this becomes3.037 = PVIFA i, 4yr
23IRR for Uneven Cash Flows Present ValueNet Cash Flows Factor at 15 Percent Present ValueInflow year $1, $ 870Inflow year , ,512Inflow year , ,974Present value of inflows $ 4,356Initial outlay －$ 3,8172. TRY i = 20 PERCENT:
25Present value of inflows $ 3,958 Initial outlay －$ 3,817 Net Cash Flows Factor at 20 Percent Present ValueInflow year $1, $ 833Inflow year , ,388Inflow year , ,737Present value of inflows $ 3,958Initial outlay －$ 3,8173. TRY i = 22 PERCENT:
26Present value of inflows $ 3,817 Initial outlay －$ 3,817 Net Cash Flows Factor at 22 Percent Present ValueInflow year $1, $ 820Inflow year , ,344Inflow year , ,653Present value of inflows $ 3,817Initial outlay －$ 3,817
27Three IRR Investment A B C Initial outlay －$10,000 －$10,000 －$10,000 Inflow year , ,000Inflow year , ,000Inflow year , ,000Inflow year , , ,000
2815% Inflow year 1 $1,000 .870 $ 870 Inflow year 2 3,000 .756 2,268 Present ValueNet Cash Flows Factor at 15 Percent Present ValueInflow year $1, $ 870Inflow year , ,268Inflow year , ,948Inflow year , ,004Present value of inflows $11,090Initial outlay －$ 10,000
29Net Cash Flows Factor at 19 Percent Present Value Inflow year $1, $ 840Inflow year , ,118Inflow year , ,558Inflow year , ,493Present value of inflows $10,009Initial outlay －$ 10,000
31Objective 4 1 Size disparity 2 Time disparity 3 Unequal live PROBLEMS IN PROJECT RANKING-CAPITAL RATIONING, MUTUALLY EXCLUSIVE PROJECTS, AND PROBLEMS WITH THE IRR.1 Size disparity2 Time disparity3 Unequal live
32Capital-Rationing Example of Five Indivisible Projects Project Initial Outlay Profitability Index Net Present ValueA $200, $280,000B , ,000C , ,000D , ,000E , ,000
33Internal rate of return 88% 11% 99% Net present value 63% 22% 85% Investment Evaluation A Primary A Secondary Total UsingMethods Used: Method Method This MethodPayback period % % %Internal rate of return % % %Net present value % % %Profitability index % % %
34 Very small Up to $100,000 Plant Small $100,000 to $1 million Division Project Size and Decision-Making AuthorityProject Size Typical Boundaries Primary Decision SiteVery small Up to $100, PlantSmall $100,000 to $1 million DivisionMedium $1 million to $10 million Corporate investment committeeLarge Over $10 million CEO & board
35KEY TERMS Benefit-Cost Ratio (see Profitability Index) Capital BudgetingCapital RationingEquivalent Annual Annuity (EAA)Internal Rate of Return (IRR)Mutually Exclusive ProjectsNet Present Value (NPV)Payback periodProfitability Index (PI or Benefit-Cost Ratio)