CAPITAL BUDGETING TECHNIQUES 1 Capital Budgeting Techniques. A number of techniques used to analyze the relevant cash flows to asses whether a project is acceptable or to rank projects. 1.Payback period (PP)

2 Project AB Initial Investment$ 42,000.00$ 45, Year 1$ 14,000.00$ 28, $ 14,000.00$ 12, $ 14,000.00$ 10, $ 14,000.00$ 10, $ 14,000.00$ 10, Average $ 14,000.00

3 At the end of year 3, $ 50, will be recovered. Since the amount received by the end of year 3 is greater than the initial investment of $ 45,000.00, the payback period is somewhere between two and three years. It is only $ 5, must be recovered during year 3. So, it needs 50 percent of $ 10, to complete the payback of initial investment. Therefore paybeck period for project B is 2.5 years 2. Net Present Value (NPV)

4 NPV calculation for Project A Annual cash inflows$ 14, PVIFA, 10%, 5 years PV of cash inflows$ 53, Initial Investment$ 42, NPV$ 11, NPV calculation for Project B YearCash InflowsPVIF, 10%, 5 Years PV 1$ 28, $ 25,452 2$ 12, ,912 3$ 10, ,510 4$ 10, ,830 5$ 10, ,210 PV of cash inflows$ 55,914 Initial Investment$ 45,000 NPV$ 10,914

5 3. Internal Rate of Return (IRR)

6 Project AB Initial Investment$ 42,000.00$ 45, Year 1$ 14,000.00$ 28, $ 14,000.00$ 12, $ 14,000.00$ 10, $ 14,000.00$ 10, $ 14,000.00$ 10, Average $ 14, In the case of annuity Project Ak1 = 18%k2 = 20% 1 $14, $11, $14, $9, $14, $8, $14, $6, $14, $5, PV of cash inflows Initial Investment42,000 NPV1,

7 IRR = k 1 + (k 2 – k 1 ) IRR = 18% + (20% – 18%) IRR = 19,8% Project Bk1 = 18%k2 = 22% 1 $28, $12, $10, $10, $10, PV of cash inflows Initial Investment45,000 NPV2,

8 CASE 1 A machine currently in use was originally purchased two years ago for $ 40,000. The machine is being depreciated under ACRSusing 5 recovery period. It has three years of usable life remaining. The current machine can be sold today to net $ 42,000. A new machine using 3 year ACRS recovery period can be purchased at a price of $ 140,000. It will require $ 10,000 to install and has 3 years useble life. If the new machine is acquired, the investment in account receivables is expected to rise by $ 10,000, the inventory investment will increase by $ 25,000 and account payable will increase by $ 15,000. EBIT is expected to be $ 70,000for each of next three years with the old machine and $ 120,000 in the first year and $ 130,000 in the second year and third year with the new machine At the end of three years, the market value of the old machine would equal zero, but the new machine could be sold to net $ 35,000 befor taxes. Both ordinary corporate income and capital gains are subject to a 40% tax. Determine initial investment associated with the purposed replacement decision. Calculate the incremental operating cash inflows for years 1 to 4 associated with the purposed replacement decision Calculate the terminal cash inflows associated with the purposed replacement decision ACRS depreciation method YearNew MachineOld Machine 133%19% 245%12% 315%12% 47%5%

9 CASE 2 Fitch industry is in the process of choosing the better of two equal risk, mutually exclusive project- M and N. Information for each project as follows. Project MN Initial Investment$ 28,500.00$ 27, Year 1$ 10,000.00$ 11, $ 10, $ 9, $ 10,000.00$ 8, Calculate payback period, NPV and IRR

10 Comparing NPV and IRR Techniques.

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12 Conflicting Rankings.

13 Approaches For Dealing With Risk.

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15 Sensitivity and Scenario Analysis. Project AProject B Initial investment$ 10,000 Annual Cash Inflows Outcomes Pesimistic Most likely Optimistic $ 1,500 2,000 2,500 $ 0 2,000 4,000 Range1,0004,000 NPV Pesimistic Most likely Optimistic $ 1,409 5,212 9,015 ($10,000) 5,212 20,424 Range7,60630,424

16 Risk Adjustment Techniques.

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