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McGraw-Hill/Irwin1 25-1 © The McGraw-Hill Companies, Inc., 2006 Capital Budgeting and Managerial Decisions Chapter 25

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McGraw-Hill/Irwin2 25-2 © The McGraw-Hill Companies, Inc., 2006 Capital budgeting: Analyzing alternative long- term investments and deciding which assets to acquire or sell. Outcome is uncertain. Large amounts of money are usually involved. Investment involves a long-term commitment. Decision may be difficult or impossible to reverse. Capital Budgeting

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McGraw-Hill/Irwin3 25-3 © The McGraw-Hill Companies, Inc., 2006 Payback period = Cost of Investment Annual Net Cash Flow Payback Period The payback period of an investment is the time expected to recover the initial investment amount. Managers prefer investing in projects with shorter payback periods. Exh. 25-2

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McGraw-Hill/Irwin4 25-4 © The McGraw-Hill Companies, Inc., 2006 FasTrac is considering buying a new machine that will be used in its manufacturing operations. The machine costs $16,000 and is expected to produce annual net cash flows of $4,100. The machine is expected to have an 8-year useful life with no salvage value. Calculate the payback period. Payback period = Cost of Investment Annual Net Cash Flow Payback period = $16,000 $4,100 = 3.9 years Payback Period with Even Cash Flows

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McGraw-Hill/Irwin5 25-5 © The McGraw-Hill Companies, Inc., 2006 In the previous example, we assumed that the increase in cash flows would be the same each year. Now, let’s look at an example where the cash flows vary each year. $4,100 $5,000 Payback Period with Uneven Cash Flows

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McGraw-Hill/Irwin6 25-6 © The McGraw-Hill Companies, Inc., 2006 FasTrac wants to install a machine that costs $16,000 and has an 8-year useful life with zero salvage value. Annual net cash flows are: Payback Period with Uneven Cash Flows Exh. 25-3

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McGraw-Hill/Irwin7 25-7 © The McGraw-Hill Companies, Inc., 2006 4.2 We recover the $16,000 purchase price between years 4 and 5, about 4.2 years for the payback period. Payback Period with Uneven Cash Flows Exh. 25-3

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McGraw-Hill/Irwin8 25-8 © The McGraw-Hill Companies, Inc., 2006 Ignores the time value of money. Ignores cash flows after the payback period. Unacceptable for projects with long lives where time value of money effects are major. Using the Payback Period

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McGraw-Hill/Irwin9 25-9 © The McGraw-Hill Companies, Inc., 2006 Consider two projects, each with a five-year life and each costing $6,000. Would you invest in Project One just because it has a shorter payback period? Using the Payback Period

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McGraw-Hill/Irwin10 25-10 © The McGraw-Hill Companies, Inc., 2006 The accounting rate of return focuses on annual income instead of cash flows. Accounting Rate of Return Accounting Annual after-tax net income rate of return Annual average investment = Beginning book value + Ending book value 2 Exh. 25-5,6

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McGraw-Hill/Irwin11 25-11 © The McGraw-Hill Companies, Inc., 2006 Accounting Annual after-tax net income rate of return Annual average investment = Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the accounting rate of return. Beginning book value + Ending book value 2 Accounting Rate of Return Exh. 25-5,6

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McGraw-Hill/Irwin12 25-12 © The McGraw-Hill Companies, Inc., 2006 Accounting Annual after-tax net income rate of return Annual average investment = Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the accounting rate of return. Accounting Rate of Return Beginning book value + Ending book value 2 Exh. 25-5,6

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McGraw-Hill/Irwin13 25-13 © The McGraw-Hill Companies, Inc., 2006 Accounting $2,100 rate of return $8,000 == 26.25% $16,000 + $0 2 Accounting Rate of Return Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the accounting rate of return. Exh. 25-5,6

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McGraw-Hill/Irwin14 25-14 © The McGraw-Hill Companies, Inc., 2006 Depreciation may be calculated several ways. Income may vary from year to year. Time value of money is ignored. So why would I ever want to use this method anyway? Using Accounting Rate of Return

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McGraw-Hill/Irwin15 25-15 © The McGraw-Hill Companies, Inc., 2006 Now let’s look at a capital budgeting model that considers the time value of cash flows. Net Present Value

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McGraw-Hill/Irwin16 25-16 © The McGraw-Hill Companies, Inc., 2006 Discount the future net cash flows from the investment at the required rate of return. Subtract the initial amount invested from sum of the discounted cash flows. FasTrac is considering the purchase of a conveyor costing $16,000 with an 8-year useful life with zero salvage value that promises annual net cash flows of $4,100. FasTrac requires a 12 percent compounded annual return on its investments. Net Present Value

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McGraw-Hill/Irwin17 25-17 © The McGraw-Hill Companies, Inc., 2006 Net Present Value with Even Cash Flows Exh. 26-7

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McGraw-Hill/Irwin18 25-18 © The McGraw-Hill Companies, Inc., 2006 Present value factors for 12 percent Net Present Value with Even Cash Flows Exh. 26-7

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McGraw-Hill/Irwin19 25-19 © The McGraw-Hill Companies, Inc., 2006 A positive net present value indicates that this project earns more than 12 percent on the investment. Net Present Value with Even Cash Flows Exh. 26-7

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McGraw-Hill/Irwin20 25-20 © The McGraw-Hill Companies, Inc., 2006 General decision rule... Using Net Present Value

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McGraw-Hill/Irwin21 25-21 © The McGraw-Hill Companies, Inc., 2006 Although all projects require the same investment and have the same total net cash flows, project B has a higher net present value because of a larger net cash flow in year 1. Net Present Value with Uneven Cash Flows Exh. 26-8

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McGraw-Hill/Irwin22 25-22 © The McGraw-Hill Companies, Inc., 2006 Internal Rate of Return (IRR) The interest rate that makes... Present value of cash inflows Present value of cash outflows = The net present value equal zero.

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McGraw-Hill/Irwin23 25-23 © The McGraw-Hill Companies, Inc., 2006 Projects with even annual cash flows Project life = 3 years Initial cost = $12,000 Annual net cash inflows = $5,000 Determine the IRR for this project. 1. Compute present value factor. 2.Using present value of annuity table... Internal Rate of Return (IRR) Exh. 26-9

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McGraw-Hill/Irwin24 25-24 © The McGraw-Hill Companies, Inc., 2006 1. Compute present value factor. $12,000 ÷ $5,000 per year = 2.4000 2.Using present value of annuity table... Projects with even annual cash flows Internal Rate of Return (IRR) Exh. 26-9 Project life = 3 years Initial cost = $12,000 Annual net cash inflows = $5,000 Determine the IRR for this project.

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McGraw-Hill/Irwin25 25-25 © The McGraw-Hill Companies, Inc., 2006 Locate the row whose number equals the periods in the project’s life. 1.Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000 2.Using present value of annuity table... Internal Rate of Return (IRR) Exh. 26-9

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McGraw-Hill/Irwin26 25-26 © The McGraw-Hill Companies, Inc., 2006 In that row, locate the interest factor closest in amount to the present value factor. 1.Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000 2.Using present value of annuity table... Internal Rate of Return (IRR) Exh. 26-9

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McGraw-Hill/Irwin27 25-27 © The McGraw-Hill Companies, Inc., 2006 1.Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000 2.Using present value of annuity table... IRR is the interest rate of the column in which the present value factor is found. IRR is approximately 12%. Internal Rate of Return (IRR) Exh. 26-9

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McGraw-Hill/Irwin28 25-28 © The McGraw-Hill Companies, Inc., 2006 If cash inflows are unequal, trial and error solution will result if present value tables are used. Sophisticated business calculators and electronic spreadsheets can be used to easily solve these problems. Internal Rate of Return – Uneven Cash Flows

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McGraw-Hill/Irwin29 25-29 © The McGraw-Hill Companies, Inc., 2006 Internal Rate of Return l Compare the internal rate of return on a project to a predetermined hurdle rate (cost of capital). l To be acceptable, a project’s rate of return cannot be less than the cost of capital. Using Internal Rate of Return

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McGraw-Hill/Irwin30 25-30 © The McGraw-Hill Companies, Inc., 2006 Exh. 25-10 Comparing Methods

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