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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.
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
Existing
Assets
Investments
Deferred
Capital
in Working Capital
Investments
Terminal Value
Residual
Value
Acquisitions
Working
Capital
Nonmonetary Considerations
Estimate the differential cash inflows for each year during the
economic life, being careful that the base case is properly defined
and quantified.
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.
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.
2.
3.
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.
Payback Method
Discounted Payback Method
More
In
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.
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.
Preference Problems
Two Investment Problems
1.
Screening Problem
Preference Problems
Also called ranking or capital rationing problems.
Preference Problems
Criteria for Preference Problems
IRR
NPV
Nonprofit Organizations
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.