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# 267 Note for B A 301 with Professor Gray at PSU

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Date Created: 02/06/15

BA 301 Capital Budgeting and Measures of Investment Return Woolridge amp Gray Text Chapter 11 Capital Budgeting and Measures of Investment Return Chapter Objectives I Learn the process of capital budgeting and estimation of incremental cash costs and bene ts I Learn the standard techniques for measuring investment returns relating to capital budgeting problems I Understand the contribution of capital budgeting towards increasing stock prices of a company and maximizing shareholder value Capital Budgeting and Measures of Investment Return Chapter I 111 I 112 I 113 eturn I 114 elating to Capital urn Pro tability Index Capital Budgeting and Measures of Investment Return 111 Capital Budgeting I Capital budgetingprocess of planning and managing a rm s longterm investment in projects and ventures I Capital Budgeting involves estimating the amount timing and risk of future cash ows I Capital budgeting Istarts with estimation of incremental cash ows from a project Icreate a time line of expected cash ows and Icompare the present value of the cash ows with cost of project Capital Budgeting and Measures of Investment Return 112 Net Present Value NPV I NPV of an investmentdifference between the value and cost of investment I The value of any project is equal to the present value of its expected cash ows discounted for risk and timing I NPV Ruleinvest in projects if NPV is positive Reject if NPV is negative Capital Budgeting and Measures of Investment Return Net Present Value Example Textile Inc is considering buying a new machine The machine requires an initial outlay of 250000 and is expected to generate incremental cash in ows of 120000 for the next 5 years and requires 30000 yearly cash out ows for maintenance At the end of ve years the machine will have no disposable value Calculate the Net Present Value of the project if the discount rate is m per year Capital Budgeting and Measures of Investment Return Procedure for solving the NPV Problem 1 Estimate cash ows from the new machine Year 0 1 2 3 4 5 In ows 120 120 120 120 120 Out ows 250 30 30 30 30 30 Net Cash 250 90 90 90 90 90 Flows Capital Budgeting and Measures of Investment Return Procedure for solving the NPV Problem 2 Calculate the discounted cash ows Year 0 1 2 3 4 5 Net 250 90 90 90 90 90 PVFactor 1000 0870 0756 0658 0572 0497 Discounted 250 7826 6805 5918 5146 4475 Cash Flow PV Factor 11 r t Capital Budgeting and Measures of Investment Return 0 17 Procedure for solving the NPV Problem 3 Calculate N PV and make the dw sed on NPV Rule E Year 0 amp 2 3 4 5 Discounted W26 6805 5918 5146 4475 5169 Capit Capital Budgeting and Measures of Investment Return Internal Rate of Return Example I Let s continue with the same example of Textile Inc Textile Inc is considering buying a new machine for spinning The machine I 397 1 1 requires an initial outlay of 250000 and i is expected to generate incremental cash in ows of 120000 for the next 5 years and requires 30000 yearly cash out ows for maintenance At the end of ve years the machine will have no disposable value Calculate the IRR of the project Capital Budgeting and Measures of Investment Return Procedure for solving the IRR 1 Estimate NPV from the machine based on a discount rate In our case let us start With 15 per year Year 0 1 2 3 4 5 Net Cash 250 90 90 90 90 90 Flows PV Factor 1000 0870 0756 0658 0572 0497 Discounted 250 7826 6805 5918 5146 4475 Cash Flow NPV 5169 Capital Budgeting and Measures of Investment Return Procedure for solving the IRR 2 Since the NPV calculated at step 1 is positive we increase the discount rate because IRR is the rate at which NPV of the project is 0 Now we take a discount rate of 25 per year Year 0 1 2 3 4 5 Cash Flows 250 90 90 90 90 90 PVFactor 1000 0800 0640 0512 0410 0328 Discounted 250 7200 5760 4608 3686 2949 Cash Flow NPV 796 Capital Budgeting and Measures of Investment Returr l l Procedure for solving the IR 3 We continue the process till NPV is 0 In this example a disc an NPV of0 and hence IRR is 239 the rate at Which te of 2344 gives er ear qs 90 90 90 90 1000 0810 0 1 gt 0656 0532 0431 0349 um 250 7291 Cash 250 90 d A 5907 4785 3876 3140 NPV Capital Budgeting and Me ures of Inveslnt Return Procedi for solving thrl 4 We 11 calculated determined ate 0f IRR of 2344 is greater than the required rate of return of 15 per year Invest in the new machine Capital Budgeting and Measures of Investment Return 114 Other Measures Payback Period I Payback periodlength of time for the return on an investment takes to cover the cost of the investment I Payback periodinvolves only gross cash ows and not discounted cash ows I Payback rule as an investment criterion Iaccept the investment if its payback period is less than a predetermined number of years Irej ect the investment if its payback period is greater than the predetermined number of years r 3 39 Measures of I Tools Inc pl machinery t 100000 T generate cas If the compa payback peri the estimateq accept the pri3 the project Capital Budgeting and Measures of Investment Return 114 Other Measures Book Rate of Return I Book Rate of Returnan accounting ratio calculated by dividing the company s accounting pro ts by the book value of the company s assets I Book rate of return rule as an investment criterion 39accept the investment if its book rate of return exceeds a predetermined target book return 39reject the investment if its book rate of return is less than a target book return Capital Budgeting and Measures of Investment Return Book Rate of Return Problem Continuing with Tools Inc problem and given that Tools Inc will depreciate the machine fully over the ve year period Calculate the book rate of return Book Value Beg Income Book Rate of Return 100000 20000 20000100000 20 80000 20000 20000 80000 25 60000 20000 20000 60000 33 40000 20000 20000 40000 50 20000 20000 20000 20000 100 Capital Budgeting and Measures of Investment Return 114 Other Measures Pro tability Index PI I PI The NPV of an investment divided by its cost I PI is used to identify projects that will receive the best return associated with the amount of dollars invested by ranking the projects by P1 I PI rule is Iaccept the venture with the highest pro tability index rst Ithen accept ventures with lower and lower positive PI s until the projects expend the capital budget Ido not accept projects with a negative PI Capital Budgeting and Measures of Investment Return Pro tability Index Problem Calculate the pro tability Index for the 3 projects given below Project PV Cost NPV Pro tability Index 1 5000 4200 800 8004200 019 2 2500 2000 500 5002000 025 3 3000 2700 300 3002700 011 Based on Pro tability Index Project 2 will be chosen rst followed by project 1 and then by project 3

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