Chapter 14 (Garrison Text)
Chapter 14 (Garrison Text) Dr. M.S. Bazaz
Capital Budgeting – involves investment – a company must commit funds now in order to receive a return in the future.
• Two decisions:
• Screening decisions – whether a project is acceptable
• Preference decisions – selecting one among several acceptable choices.
• Criteria for Capital budgeting decisions:
• Net present value (NPV)
• Internal rate of return (IRR)
• Payback period
• Simple (accounting) rate of return
• Emphasis on Cash flow (NOT on accounting net income) for the first three criteria:
[The reason is that accounting net income is based on accrual concepts that ignore the timing of cash flows into and out of an organization.]
• Cash outflows:
• Initial investment (net of salvage value of existing assets to be replaced)
• Working capital
• Repairs and maintenance
• Incremental operating costs
• Cash inflows:
• Incremental revenues
• Reduction in costs
• Salvage value
• Release of working capital
• Assumptions:
• All cash flows other than the initial investment occur at the end of a period
• All cash flows generated by an investment project are immediately reinvested.
• Discount rate or Cost of capital is the average rate of return the company must pay to its long-term creditors and shareholders for the use of their funds.
• Internal rate of return -- interest yield promised by an investment project over its useful life.
• IRR (yield) will cause the NPV of a project to be equal to zero.
• Factor of the IRR = investment required / net annual cash inflow
• IRR is compare with the company’s required rate of return
• Comparison of NPV and IRR
• NPV is often simpler to use.
• Both methods assume that cash flows generated by a project during its useful life are immediately reinvested elsewhere.
• The NPV method can be used to compare competing investment projects in two ways:
• Total-cost approach
• Incremental –cost approach
• Whenever there are no revenues involved, the most desire alternative is the project, which promises the least total cost from the present value perspective.
• For ranking projects, NPV is useful for equal size projects
• To compare two or more unequal size projects it is more appropriate to use the profitability index.
• Profitability index = present value of cash inflow/investment required or
• Profitability index = present value of cash inflow/ present value of cash outflows.
• Payback period – defined as the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates.
• When the net annual cash inflow is the same every year:
• Payback Period = Investment required / Net annual cash inflow
• When it is uneven – it is necessary to track the unrecovered investment year by year.
• Payback period does not consider the time value of money.
• The Simple Rate of return (Accounting rate of return, ARR):
• It does not focus on cash flows.
• It focuses on accounting net income.
• It does not consider time value of money.
• ARR = (Incremental revenue – incremental expenses including depreciation = incremental net income) / initial investment.
• If the cost reduction project is involved: ARR = (Cost savings – Depreciation on new equipment) / initial investment.
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