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Chapter 14 Capital Budgeting Decision Part B

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Other Approaches to Capital Budgeting Decisions Other methods of making capital budgeting decisions include... The Payback Method. Simple Rate of Return. Other methods of making capital budgeting decisions include... The Payback Method. Simple Rate of Return.

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The Payback Method The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates. When the net annual cash inflow is the same each year, this formula can be used to compute the payback period: When the net annual cash inflow is the same each year, this formula can be used to compute the payback period: The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates. When the net annual cash inflow is the same each year, this formula can be used to compute the payback period: When the net annual cash inflow is the same each year, this formula can be used to compute the payback period: Payback period = Investment required Net annual cash inflow

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Payback Calculation Consider the following two investments: Project AProject B Initial investment$15,000$12,000 Annual Cash Savings$5,000$5,000 What is the Payback Period for the two projects? Consider the following two investments: Project AProject B Initial investment$15,000$12,000 Annual Cash Savings$5,000$5,000 What is the Payback Period for the two projects?

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The Payback Method - Example Myers Company wants to install an espresso bar in place of several coffee vending machines in one of its stores. The company estimates that incremental annual revenues and expenses associated with the espresso bar would be:Myers Company wants to install an espresso bar in place of several coffee vending machines in one of its stores. The company estimates that incremental annual revenues and expenses associated with the espresso bar would be: Sales $100,000 Sales $100,000 Less variable expenses 30,000 Less variable expenses 30,000 Contribution margin 70,000 Contribution margin 70,000 Less fixed expenses: Less fixed expenses: Insurance $ 9,000 Insurance $ 9,000 Salaries 26,000 Salaries 26,000 Depreciation 15,000 50,000 Depreciation 15,000 50,000 Net operating income $ 20,000 Net operating income $ 20,000 Equipment for the espresso bar would cost $150,000 and have a 10-year life. The old vending machines could be sold now for a $10,000 salvage value. The company requires a payback of 5 years or less on all investments.Equipment for the espresso bar would cost $150,000 and have a 10-year life. The old vending machines could be sold now for a $10,000 salvage value. The company requires a payback of 5 years or less on all investments. Let’s calculate the Payback Period

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Payback and Uneven Cash Flows 12345$1,000$0$2,000$1,000$500 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.

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Payback and Uneven Cash Flows 12345$1,000$0$2,000$1,000$500 For example, if a project requires an initial investment of $2,500 and an additional investment of $1,000 in Year 2, and provides uneven net cash inflows in years 1-5 as shown, what would the payback period be?

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Quick Check Consider the following two investments: Project XProject Y Initial investment$100,000$100,000 Year 1 cash inflow$60,000$60,000 Year 2 cash inflow$40,000$35,000 Year 3-10 cash inflows$0$25,000 Which project has the shortest payback period? a. Project X b. Project Y c. Cannot be determined Consider the following two investments: Project XProject Y Initial investment$100,000$100,000 Year 1 cash inflow$60,000$60,000 Year 2 cash inflow$40,000$35,000 Year 3-10 cash inflows$0$25,000 Which project has the shortest payback period? a. Project X b. Project Y c. Cannot be determined

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Simple Rate of Return Method accounting net operating incomeDoes not focus on cash flows -- rather it focuses on accounting net operating income. The following formula is used to calculate the simple rate of return: Simple rate of return = Incremental Incremental expenses, Incremental Incremental expenses, revenues including depreciation revenues including depreciation - Initial investment* * * Should be reduced by any salvage from the sale of the old equipment Let’s calculate the Simple Rate of Return for Myers Company

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Income Taxes in Capital Budgeting: After-Tax Cost A cash expense net of its tax effect is known as an after-tax cost. EXAMPLE: Suppose a company puts on a training program that costs $40,000. What is the after-tax cost of the training program?

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Income Taxes in Capital Budgeting: After-Tax Cost

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Income Taxes in Capital Budgeting: After-Tax Benefit A cash receipt net of its tax effects is known as an after-tax benefit. The formula to compute the after-tax benefit from any taxable cash receipt is: –After-tax benefit = (1 – Tax rate) × Cash receipt EXAMPLE: A company receives $80,000 per year from subleasing part of its office space. If the tax rate is 30%, what is the after-tax benefit? –After-tax benefit = (1 – 0.30) × $80,000 = $56,000

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Income Taxes in Capital Budgeting: After-Tax Benefit Tax-deductible cash expenses can be deducted from taxable cash receipts and the difference multiplied by (1 – Tax rate) to find the net after-tax cash flow. EXAMPLE: A Company can invest in a project that would provide cash receipts of $400,000 per year. Cash operating expenses would be $280,000 per year. If the tax rate is 30%, what is the after-tax net cash inflow each year from the project?

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Depreciation Tax Shield Although depreciation is not a cash flow, it does have an impact on income taxes. Depreciation deductions shield revenues from taxation (called a depreciation tax shield) and thereby reduce tax payments. EXAMPLE: Consider the impact of a $60,000 depreciation expense on a company’s income taxes:

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Depreciation Tax Shield The depreciation deduction reduces the company’s income taxes by $18,000. The tax savings provided by the depreciation tax shield can be computed using the following formula:

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Example The concepts of after-tax cost, after-tax benefit and depreciation tax shield are integrated in the following example: Martin Company has an investment opportunity that would involve the following cash flows: The following additional information is available: Equipment’s estimated useful life: 8 years For tax purposes, the equipment would be depreciated over 8 years using the straight-line method and assuming zero salvage value. After-tax cost of capital: 10% Income tax rate: 30% What is the NPV associated with the project?

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