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Chapter 27

Nature of the problem:

*Replacement - Shall we replace existing equipment with more efficient
equipment?
*Expansion - Shall we build or otherwise acquire new facilities?
*Cost Reduction - Shall we buy equipment to perform operation now done
manually?
*Choice of equipment - which of several proposed items of equipment shall
we purchase for a given purpose?
*New product - Should a new product be added to the line?

General Approach:
*Investment, which is usually made in a lump sum at
the beginning of the project.
*Stream of Cash inflow expected to result from this
investment over a period of future years

General Approach:
*Investment, which is usually made in a lump sum at
the beginning of the project.
*Stream of Cash inflow expected to result from this
investment over a period of future years
Note: these two types of amount cannot be compared
directly because they occur at different times.

Net Present Value:

*We multiply the cash inflow for each year by the
present value of \$1 for that year at the appropriate rate
of return.
*The rate at which the cash inflows are discounted is
required rate of return, hurdle/discount rate.
*the difference between Cash inflows and the amount of
investment is called Net Present Value. Nonnegative
amount means proposal is acceptable.

Net Present Value:

Problem NPV
A proposed investment of \$1000 is expected to produce
cash inflows of \$625 per year for each of the next two
years. The required rate if return 14%.

Discounting factor formula: = (1+r) ^ -t

Return on Investment:
Problem (ROI):
A proposed investment of \$25000 is expected to
generate annual cash inflows of \$2500 a year for
the next five years, with \$25,000 to be
recovered in a lump sum at the end of the fifth
year.

Investment
The

Investment is the amount of funds an

entity risks if it accepts an investment
proposal.

Existing

Assets

Investments
Deferred
Capital

in Working Capital

Investments

Terminal Value
Residual

Value

Acquisitions
Working

and New Products

Capital

Nonmonetary Considerations

The quantitative analysis involved in a capital investment

proposal does not provide the complete solution to the
problem because it encompasses only those elements that
can be reduced to numbers.

Even if the proposal is amenable to a quantitative

analysis, the result is, at most, a guide for the decision
maker.

The techniques that were described are by no means the

whole story of capital budgeting decisions. It is only part
of the story that can be described as a definite procedure.
The remainder generally is learned only through
experience or trial and error.

Estimate the economic life of the proposed project.

Estimate the differential cash inflows for each year during the
economic life, being careful that the base case is properly defined
and quantified.

Estimate the terminal values at the end of the economic life,

including the residual value of equipment and current assets that will
be liquidated.

Find the present value of all the inflows identified in bullet # 3 and #
5 by discounting them at the required rate of return.

Find the Net Present Value (NPV) by subtracting the net investment
from the present value of the inflows. If the NPV is zero or positive, it
can be said that the proposal is acceptable in terms of the monetary
factors.

Internal
When

the Net Present Value (NPV) is used, the

required rate of return must be selected in
advance of making the calculations because this
rate is used to discount the cash inflows in each
year. The IRR computes the rate of return that
equates the present value of the cash inflows with
the present value of the investment - the rate
that makes the NPV equal zero. The IRR method is
also called the Discounted Cash Flow (DCF)
method.

Payback Method
Payback period

Investment/inflow ratio

Number of years over which the investment outlay will be recovered (paid back) from the cash inflows if
the estimates turn out to be correct

Payback
Period
Decision Rule:

Initial
Investment
Cash Inflow per
Period

1.

Accept the project only if its payback is LESS than the targeted payback period*.

2.

Reject the project if the payback is equal to, or slightly less than the payback period.

*Economic life of the project

Payback Method
Sample Problem:
Company C is planning to undertake a project requiring initial
investment of \$105 million. The project is expected to generate \$25
million per year for 7 years. Calculate the payback period of the
project.
Given: Initial investment= \$105 million
Annual Cash Inflow= \$25 million
Solution:
Payback period = \$105
\$25
Payback period = 4.2 years

Payback Method
1.

Payback period is very

simple to calculate.

2.

It can be a measure of risk

inherent in a project. Since
cash flows that occur later
in a project's life are
considered more uncertain,
payback period provides an
indication of how certain
the project cash inflows
are.

3.

For companies facing

liquidity problems, it
provides a good ranking of
projects that would return

1.

It gives no consideration to
consideration to differences
in the length of the estimated
economic lives of various
projects

2.

It makes no distinction
between projects whose
entire investment is made at
Time Zero and those for
which the investment is
incurred over a period of
several years.

3.

It ignores the time value of

money.

Payback Method
Discounted Payback Method
More

method

In

this method, the present value of each years

cash inflows is found, and these are cumulated
year by year until they equal of exceed the
amount of investment.

Unadjusted Return on Investment Method

Computes the net income expected to be earned from the project each year,
in accordance with the principles of accrual accounting, including a provision
for depreciation expense.

Also known as the Accounting Rate of Return (ARR)

ARR

Average Accounting
Profit
Average Investment

Decision Rule:
Accept the project only if its ARR is equal to or greater than the required
accounting rate of return. In case of mutually exclusive projects, accept the
one with highest ARR.

Unadjusted Return on Investment

Method
Sample Problem
An initial investment of \$130,000 is expected to generate annual cash
inflow of \$32,000 for 6 years. Depreciation is allowed on the straight
line basis. It is estimated that the project will generate scrap value of
\$10,500 at end of the 6th year. Calculate its accounting rate of return
assuming that there are no other expenses on the project.
Solution:
Annual Depreciation = (Initial Investment Scrap Value) Useful Life in
Years
Annual Depreciation = (\$130,000 \$10,500) 6 \$19,917
Average Accounting Income = \$32,000 \$19,917 = \$12,083
Accounting Rate of Return = \$12,083 \$130,000 9.3%

Preference Problems
Two Investment Problems
1.

Screening Problem

The question is whether or not to accept a proposed investment.

The discussion so
far has been limited to this class of problem.
Many individual proposals come to managements attention; by
the techniques described above, those that are worthwhile can be
screened out from others.
2.

Preference Problems
Also called ranking or capital rationing problems.

More difficult question is asked: Of a number of proposals, each of

which has
an adequate return, how do they rank in terms of
preference?

Preference Problems
Criteria for Preference Problems
IRR

NPV

Profitability Index- ratio of present value of the cash inflows

and the amount of investment

Comparison of Preference Rules

The profitability index is superior to the internal rate of return as a device for
ranking projects.

Nonprofit Organizations

Make decision involving the acquisition of capital assets,

and their analytical techniques are essentially the same as
with profit-oriented companies.

The capital required for an investment in plant or

equipment is obtained from either debt or equity capital
or combination of both.

unnecessary.

Problem 27 - 1
Calculate Tax
Donated
Gross income

Sold
10,000,000

10,000,000

(110,000)

110,000

Taxable income

9,890,000

10,110,000

Income Tax Due (40%)

3,956,000

4,044,000

Problem 27 - 1
Calculate Net income after taxes
Donated
Gross income
Less: Book Value of land
Gain from sale of land
Income before tax
Less: Income tax computed
Net Income after taxes

Sold
10,000,000

10,000,000

10,000

100,000

9,990,00

10,100,000

3,956,000

4,044,000

6,034,000

6,056,000

Problem 27 - 1
Cash Flow
Donated
Tax Savings 40% x 110,000
Cash from sale of land

Sold
44,000

110,000

88,000

44,000

22,000

Problem 27 - 2
Comparison of income, cash flow, and taxes
1

Straight-Line

6,000

6,000

6,000

6,000

6,000

30,000

MACRS

6,000

9,600

5,400

4,500

4,500

30,000

(3,600)

600

1,500

1,500

Total

(1,440)

240

600

600

(2,160)

360

900

900

1,440

1,200

600

The End.
Thank you.