Project identification

1. Capital Budgeting

2. Objectives
Upon completion of this session, participants will be
able to:
• Explain the role of capital budgeting in long-range
planning
• Understand the concept of cash flow analysis
• Understand the difference between simple and
discounted cash flow analysis
• Evaluate the strengths and weaknesses of alternative
capital budgeting models

3. Objectives (continued)
•Calculate the discounted cash flows (DCF)
•Estimate the Net Present Value (NPV) of a project
•Determine the Internal rate of Return (IRR) of a project
•Calculate the Profitability Index (PI) of a project
•Determine the simple and discounted pay-back period
of a project
•Evaluate the impact of taxes on the above measures

4. Capital Budgeting Decisions
1. Capital Budgeting Decisions include
the acquisition of long-lived assets.
2. Require that capital (company funds)
be expended to acquire additional
resources.
3. Also known as Capital Expenditure
Decisions.

5. Capital Budgeting Decisions: Examples
1. New retail store outlets.
2. Robotic manufacturing equipment.
3. Digital imaging systems for healthcare
facilities.
4. New chairlift for a ski resort.
5. New fleets:
 Ships
 Planes
 Cars
6. New equipment for food preparation.

6. Evaluating Investment
Opportunities: Time Value of
Money Approaches
1. The Time Value of Money says: a
dollar today is worth more than a dollar
tomorrow.
2. It is necessary to convert future dollars
into their equivalent present value
dollars.
3. Two methods:
a. Net Present Value.
b. Internal Rate of Return.

7. Basic Time Value of Money Calculations
1. To convert future value to present
value:
P = F
(1 + i)n
Where:
P = present value
F = future value
i = (interest) rate of return
n = number of units of time

8. Basic Time Value of Money Calculations:
Example
Calculate the present value of $1.00 to be
paid (or collected) 5-years from now
assuming an interest rate of 8%. Set it up
as follows:
P = 1.00
(1 + .08)5

9. Basic Time Value of Money Calculations:
Example Solution
P = 1.00
(1 + .08)5
P = 1.00
1.46933…
Thus: $0.68

10. The Net Present Value Method
1. Based on the time-value of money.
2. Recall that only incremental cash flows
are relevant.
3. Three-step process.

11. The Net Present Value Method: Step 1
 Identify the amount and time period
of each cash flow associated with a
potential investment.
 Note: Investment projects have both
cash inflows and cash outflows.

12. The Net Present Value Method: Step 2
 Discount the cash flows to their
present values using a required rate
of return (a.k.a. hurdle rate).
 Note: This is the minimum return that
management will accept.

13. The Net Present Value Method:
Step 3
 Evaluate the net present value--the
sum of all of the cash inflows less
cash outflows.
 Note: if the net present value (NPV) is
greater than or equal to zero, the
investment should be made. If less than
zero, it should not be made.

14. The Net Present Value Method:
Example, Step 1
 Identify the amount and time period
of each cash flow associated with a
potential investment.
1. Initial cash outlay: $70,000
2. Year 1 – 4 net cash savings: $21,000 per
year.
3. Year 5 net cash savings: $26,000.
4. Required rate of return: 12%.

15. The Net Present Value Method:
Example Step 2
 Discount the cash flows to their
present values using a required rate
of return (a.k.a. hurdle rate).
 Initial outlay: $70,000 x 1.00
 Year 1: $21,000 x .8929
 Year 2: $21,000 x .7972
 Year 3: $21,000 x .7118
 Year 4: $21,000 x .6355
 Year 5: $26,000 x ..5674

16. The Net Present Value Method:
Example Step 3
 Evaluate the net present value--the
sum of all of the cash inflows less
cash outflows.
 Year 0: ($70,000)
 Year 1: $18,751
 Year 2: $16,741
 Year 3: $14,948
 Year 4: $13,346
 Year 5: $14,752
 NPV: $ 8,538

17. The Net Present Value Method:
Example
 Do it! $8,538 > $0

18. The Net Present Value Method:
Summary

19. The Internal Rate of Return Method
1. Internal Rate of Return (IRR) is an
alternative to the Net Present Value
(NPV) method.
2. IRR uses the time value of money.
3. IRR is the rate of return that equates the
present value of future cash flows to the
investment outlay.

20. The Internal Rate of Return Method
1. Internal Rate of Return (IRR) is an
alternative to the Net Present Value
(NPV) method.
2. IRR uses the time value of money.
3. IRR is the rate of return that equates the
present value of future cash flows to the
investment outlay.
4. IRR analysis yields a yes (IRR > hurdle
rate) or no (IRR < hurdle rate) result.

21. The Internal Rate of Return Method: Setup
Present value factor = Initial Outlay
Annuity Amount

22. The Internal Rate of Return Method:
Example
Investment: $100
Expected 2-year return: $60 per year
Present value factor = 100
60

23. The Internal Rate of Return Method:
Example
1. Present value factor = 1.667
2. Approximately equal to the PV factor of
1.6681 or 13% (from PV tables).

24. The Internal Rate of Return Method:
Summary

25. The Internal Rate of Return With Unequal
Cash Flows
1. For cases with unequal yearly cash
flows.
2. Thus one cannot use a single present
value factor.
3. Must estimate the IRR (we will use
EXCEL in class to calculate the NPV
and IRR).

26. Summary of Net Present Value and
Internal Rate of Return Methods
1. Both the Net Present Value method and
the Internal Rate of Return method take
into account the time value of money.
2. They differ in their approach to
evaluating investment alternatives.

27. Estimating the Required Rate of
Return
1. In the textbook examples, required rate of
return was “given.”
2. In practice, required rate of return must be
estimated by management.
3. Under certain conditions, the required rate
of return should be equal to the cost of
capital for the firm.

28. Additional Cash Flow
Considerations
1. Both the NPV and IRR require proper
specification of cash flows.
2. Only cash inflows and cash outflows are
discounted back to the present, not
revenues and expenses.

29. Cash Flows, Taxes, and The
Depreciation Tax Shield
1. Previously the effect of income taxes on
cash flows was ignored.
2. Tax considerations play a major role in
capital budgeting decisions.
3. Though depreciation does not directly affect
cash flows, it indirectly affects cash flows.
4. Depreciation reduces the amount of tax
(which is paid in cash) a company must pay.
5. Thus it is called a Depreciation Tax Shield.

30. Adjusting Cash Flows For Inflation
1. Inflation should not be ignored in net
present value analysis.
2. Many worthwhile investment opportunities
may be rejected.
3. For our calculations, we assume the future
cash flows are inflation-adjusted.

31. Simplified Approaches To Capital
Budgeting
1. Payback Period Method.
2. Accounting Rate of Return.

32. Payback Period Method
1. The length of time it takes to recover the
initial cost of an investment.
2. Example: an investment costs $1,000 and
returns $500 per year, it has a payback
period of 2-years.
3. Two serious limitations:
a. Does not consider cash inflows in years
beyond the payback year.
b. Does not consider the time value of money.
4. We can also do a Discounted Payback
calculation.

33. Accounting Rate of Return
1. Accounting Rate of Return (ARR) is the
average after-tax income from a project
divided by the average investment in the
project.
2. Example: ARR = Average Net Income
Average Investment
3. Ignores the time value of money.

34. Conflict Between Performance
Evaluation and Capital Budgeting
1. Managers should use Net Present Value
and Internal Rate of Return analyses to
maximize shareholder wealth.
2. Manager’s performance (and bonus) is
often measured in the short-term on
accounting income.
3. Inherent conflict between what is good for
the firm and what is good for the manager.

35. Quick Review Question #1
1. If the net present value (NPV) of a
project is zero, the project is earning a
return equal to:
a. Zero.
b. The rate of inflation.
c. The accounting rate of return.
d. The required rate of return.

36. Quick Review Answer #1
1. If the present value of a project is zero,
the project is earning a return equal to:
a. Zero.
b. The rate of inflation.
c. The accounting rate of return.
d. The required rate of return.

37. Quick Review Question #2
2. A project costs $200,000 and yields
cash inflows of $50,000 per year for 5-
years. In this case, the payback period
is:
a. Four years.
b. Five years.
c. $50,000.
d. None of these.

38. Quick Review Answer #2
2. A project costs $200,000 and yields
cash inflows of $50,000 per year for 5-
yrars. In this case, the payback period
is:
a. Four years.
b. Five years.
c. $50,000.
d. None of these.

39. Quick Review Question #3
3. The present value of $2,000 to be
collected in three years using a rate of
11% is:
a. $1,462
b. $2,735
c. $1,333
d. $1,278

40. Quick Review Answer #3
3. The present value of $2,000 to be
collected in three years using a rate of
11% is:
a. $1,462
b. $2,735
c. $1,333
d. $1,278

41. Quick Review Question #4
4. New equipment costing $5,000 is
expected to yield net cash inflows of
$1,350 each year for the next five
years. Assuming a required rate of
return of 14%, should the equipment
be purchased (use IRR)?
a. Yes (accept).
b. No (reject).

42. Quick Review Answer #4
4. New equipment costing $5,000 is
expected to yield net cash inflows of
$1,350 each year for the next five
years. Assuming a required rate of
return of 14%, should the equipment
be purchased (use IRR)?
a. Yes (accept).
b. No (reject).
Note: $1,350 * 3.4331 = $4,635

43. • Then, try to complete this analysis:
BRUNO INCORPORATED INSTALLS A NEW MACHINE FOR PRODUCING
CARPETS AT A COST OF $335,220. THE MACHINE HAS A USEFUL LIFE OF
FIVE YEARS, AT THE END OF WHICH THE MACHINE CAN BE SOLD OFF FOR
$50,000. THE ANNUAL REVENUES FOR THE FIVE YEARS ARE AS FOLLOWS:
$200,000; $300,000; $300,000; $200,000; AND $100,000, RESPECTIVELY.
THE TOTAL VARIABLE COSTS ARE: $60,000; $90,000; $90,000; $60,000;
AND $30,000, RESPECTIVELY. THE TOTAL FIXED COSTS ARE: $40,000;
$110,000; $95,000; $40,000; AND $20,000, RESPECTIVELY. IN THE THIRD
YEAR OF OPERATION, THE MACHINE WILL REQUIRE MAJOR MAINTENANCE
AT A COST OF $15,000. THE COMPANY PAYS NO TAXES AND USES A
DISCOUNT RATE OF 14%.
• CALCULATE THE NPV AND IRR OF THE MACHINE.