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Slide Contents
Learning Objectives Principles Used in This Chapter
1. 2. 3. 4. An Overview of Capital Budgeting Net Present Value Other Investment Criteria A Glance at Actual Capital Budgeting Practices
Key Terms
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Learning Objectives
1. Understand how to identify the sources and types of profitable investment opportunities.
2. Evaluate investment opportunities using net present value and describe why net present value provides the best measure for evaluating investments.
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4. Understand current business practice with respect to the use of capital budgeting criteria.
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Checkpoint 11.1
Calculating the NPV for Project Long
Project Long requires an initial investment of $100,000 and is expected to generate a cash flow of $70,000 in year one, $30,000 per year in years two and three, $25,000 in year four, and $10,000 in year 5. The discount rate (k) appropriate for calculating the NPV of Project Long is 17 percent. Is Project Long a good investment opportunity?
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Checkpoint 11.1
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Checkpoint 11.1
Step 3 cont.
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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Checkpoint 11.1
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Checkpoint 11.1
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0
-$3M
1
+$0.5M
4
$2M
5
$2M
+$0.75M +$1.5M
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Step 3: Solve
Using Mathematical Formula
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Step 4: Analyze
The project requires an initial investment of $3,000,000 and generates futures cash flows that have a present value of $3,573,817. Consequently, the project cash flows are $573,817 more than the required investment. Since the NPV is positive, the project is an acceptable project.
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Checkpoint 11.2
Calculating the Equivalent Annual Cost (EAC)
Suppose your bottling plant is in need of a new bottle capper. You are considering two different capping machines that will perform equally well, but have different expected lives. The more expensive one costs $30,000 to buy, requires the payment of $3,000 per year for maintenance and operation expenses, and will last for 5 years. The cheaper model costs only $22,000, requires operating and maintenance costs of $4,000 per year, and lasts for only 3 years. Regardless of which machine you select, you intend to replace it at the end of its life with an identical machine with identical costs and operating performance characteristics. Because there is not a market for used cappers, there will be no salvage value associated with either machine. Lets also assume that the discount rate on both of these machines is 8 percent.
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Checkpoint 11.2
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Checkpoint 11.2
Step 3 cont.
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Checkpoint 11.2
Step 3 cont.
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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Checkpoint 11.2
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Checkpoint 11.2
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0
-$50
1
-$6
2
-$6
3
-$6
4
-$6
5
-$6
6
$6
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Step 3: Solve
Using Mathematical Formula It requires 2 steps:
Computation of NPV
Here the cash inflows are equal so we can use the annuity equation to determine the PV of cash inflows.
Computation of EAC
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NPV = -$50,000 + PV of $6,000 each year = -$50,000 + -$6,000 (PV of Annuity Factor) = -$50,000 + -$6,000 { 1-(1/(1.09)6
(.06)}
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Step 4: Analyze
Here EAC is equal to $17,145.86. EAC indicates the annual cost that is adjusted for time value of money.
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Profitability Index
The profitability index (PI) is a costbenefit ratio equal to the present value of an investments future cash flows divided by its initial cost:
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Checkpoint 11.3
Calculating the Profitability Index for Project Long
Project Long is expected to provide five years of cash inflows and to require an initial investment of $100,000. The discount rate that is appropriate for calculating the PI of Project Long is 17 percent. Is Project Long a good investment opportunity?
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Checkpoint 11.3
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Checkpoint 11.3
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Checkpoint 11.3
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$16,000
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0
-$50
1
+$15
2
+$8
3
+$10
4
+$12
5
+$14
6
+$16
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Step 3: Solve
We can proceed in two steps:
1. Compute PV of expected cash flows by discounting the cash flows from Year 1 to Year 6 at 10%.
PVt = CFt(1.09)t
2. Compute PI
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Present Value at 10% discount rate $13,636.36 $6,611.57 $7,513.14 $8,196.16 $8,692.90 $9,031.58 $53,681.72
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Step 4: Analyze
PNG Pharmaceuticals requires an initial investment of $50,000 and provides future cash flows that have a present value of $53,681.72. Thus, the future cash flows are worth 1.073 times the initial investment or PI is equal to 1.073. It is an acceptable project since PI is greater than 1.
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Checkpoint 11.4
Calculating the IRR for Project Long
Project Long is expected to provide five years of cash inflows and to require an initial investment of $100,000. The required rate of return or discount rate that is appropriate for valuing the cash flows of Project Long is 17 percent. What is Project Longs IRR, and is it a good investment opportunity?
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Checkpoint 11.4
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Checkpoint 11.4
Checkpoint 11.4
Step 3 cont.
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Checkpoint 11.4
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Checkpoint 11.4
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Checkpoint 11.4: Check Yourself Knowledge Associates is a small consulting firm in Portland, Oregon, and they are considering the purchase of a new copying center for the office that can copy, fax, and scan documents. The new machine costs $10,010 to purchase and is expected to provide cash flow savings over the next four years of $1,000; $3,000; $6,000; and $7,000.
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IRR =?
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Step 3: Solve
Using Mathematical Formula
This will require finding the rate at which NPV is equal to zero. We compute the NPV at different rates to determine the range of IRR.
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Display
CFO=-100000 CO1=1000 FO1=1.00 C02=3000 FO2=1.00 C03=6000 FO3=1.00 CO4 = 7000 FO4 =1.00 IRR = 19%
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Column B in Excel Annual Cash flow -$10,010 $1,000 $3,000 $6,000 $7,000 19% Enter: IRR(b2:b6)
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Step 4: Analyze
The new copying center requires an initial investment of $10,010 and provides future cash flows that offer a return of 19%. Since the firm has decided 15% as the minimum acceptable return, this is a good investment for the firm.
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Checkpoint 11.5
The Problem of Multiple IRRs for Projects
Descartes Rule of Signs tells us that there can be as many IRRs for an investment project as there are changes in the sign of the cash flows over its n-year life. To illustrate the problem, consider a project that has three cash flows: a $235,000 outlay in year 0, a $540,500 inflow in year 1, and a $310,200 outflow at the end of year 2. Calculate the IRR for the investment.
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Checkpoint 11.5
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Checkpoint 11.5
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Checkpoint 11.5
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0 Years
Cash flows -$200,000
1
+$1.2m
2
-$2.2m
3
+$1.2m
IRR =?
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We will use discount rates of 0 to 200% in increments of 50% to compute the NPV.
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Step 3: Solve
The NPV profile on next slide is based on various discount rates. For example, NPV at discount rate of 50% is computed as follows: NPV = -$200,000 + $1,200,000/(1.5)1 + -2,200,000/(1.5)2 + $1,200,000/(1.5)3 = -$22,222.22
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Step 4: Analyze
There are three IRRs for this project 0%, 100% and 200%. At all of these rates, NPV is equal to zero.
However, NPV will be a better decision tool to use under this situation as it is not subject to multiple answers like IRR.
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This is done by rearranging the cash flows so that there is only one change of sign of the cash flows over the life of the project.
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Checkpoint 11.6
Calculating the Modified Internal Rate of Return (MIRR)
Reconsider the investment project in Checkpoint 11.5. The project we analyze has three cash flows: a $235,000 outlay in year 0, a $540,500 cash inflow in year 1, and a $310,200 outflow at the end of year 2. Our analysis in Checkpoint 11.5 indicated that this investment has two IRRs, 10% and 20%. One way to reduce the number of IRRs to only one is to use the MIRR method, which moves negative cash flows backward discounting them using the required rate of return or discount rate for the project which is 12%.
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Checkpoint 11.6
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Checkpoint 11.6
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Checkpoint 11.6
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1
$540,500
2
-$310,200
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Step 3: Solve
Discount the year 3 negative cash flows to year 0. 0 1 2
Years
Cash flows -$235,000 $540,500 -$310,200
-$265,947 -$500,947
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Calculating the IRR for the above modified cash flows produces MIRR equal to 7.9%
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Step 4: Analyze
We were able to compute IRR by eliminating the second sign change and thus modifying the cash flows.
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Payback Period
The Payback period for an investment opportunity is the number of years needed to recover the initial cash outlay required to make the investment. Decision Criteria: Accept the project if the payback period is less than a pre-specified number of years.
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2. Payback period can be seen as a crude indicator of risk as payback favors initial year cash flows, which, in general, are less risky than more distant cash flows.
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Key Terms
Capital rationing Discounted payback Equivalent annual cost (EAC) Independent investment project Internal rate of return (IRR) Modified internal rate of return (MIRR) Mutually exclusive investments
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