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*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.

*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.

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%.

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

entity risks if it accepts an investment

proposal.

Existing

Assets

Investments

Deferred

Capital

in Working Capital

Investments

Terminal Value

Residual

Value

Acquisitions

Working

Capital

Nonmonetary Considerations

proposal does not provide the complete solution to the

problem because it encompasses only those elements that

can be reduced to numbers.

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

maker.

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 differential cash inflows for each year during the

economic life, being careful that the base case is properly defined

and quantified.

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

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.

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

Advantages:

1.

simple to calculate.

2.

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.

liquidity problems, it

provides a good ranking of

projects that would return

Disadvantages:

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.

money.

Payback Method

Discounted Payback Method

More

method

In

cash inflows is found, and these are cumulated

year by year until they equal of exceed the

amount of investment.

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.

investment made.

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.

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 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.

which has

an adequate return, how do they rank in terms of

preference?

Preference Problems

Criteria for Preference Problems

IRR

NPV

and the amount of investment

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

ranking projects.

Nonprofit Organizations

and their analytical techniques are essentially the same as

with profit-oriented companies.

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

Tax deduction/addition

(110,000)

110,000

Taxable income

9,890,000

10,110,000

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

Less: Additional Taxes

Additional Cash

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.

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