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:
1 Capabilities1. 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
3 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.
4 The payback period is the number of years needed to recover the initial cash outlay.
5 Objective 2 CAPITAL-BUDGETING DECISION CRITERIA A BInitial cash outlay －$10, －$10,000Annual net cash inflowsYear $ 6, $ 5,000, ,000,,,
6 Net 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.
8 NPV 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
10 NPV Illustration of Investment in New Machinery AFTER-TAX CASH FLOW Inflow year ,000,000,000,000,000Initial outlay －$40,000
11 Calculation 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
12 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.
14 ACFt = 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
20 IRRACFt = 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
23 IRR 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:
25 Present 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:
26 Present 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
27 Three IRR Investment A B C Initial outlay －$10,000 －$10,000 －$10,000 Inflow year , ,000Inflow year , ,000Inflow year , ,000Inflow year , , ,000
28 15% 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
29 Net 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
31 Objective 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
32 Capital-Rationing Example of Five Indivisible Projects Project Initial Outlay Profitability Index Net Present ValueA $200, $280,000B , ,000C , ,000D , ,000E , ,000
33 Internal 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
35 KEY 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)