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Capital Budgeting (Part 1)

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75 views13 pages

Capital Budgeting (Part 1)

Uploaded by

aastproject10
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CHAPTER 8

THE FUNDAMENTALS
OF CAPITAL
BUDGETING
Dr. Doaa El-Diftar
Chapter Outline

I. Net present value


II. The payback Rule
III. The average accounting return
IV. The internal rate of return
I. Net present value (NPV)
■ The basic idea here is to undertake investments that
generate more value than the costs associated with it.
■ Net present value (NPV)  the difference between the market
value of a project and its cost.
NPV = PV of future cash flows – cost of investment
■ Decision Criteria:
– Accept if the project generates (+) NPV
– Reject if the project generates (-) NPV
■ A (+) NPV means that the project will add value to the firm,
hence increase the wealth of the owners.
Problem one:
You are making a $50,000 investment and feel that a 13
percent rate of return is reasonable given the nature of the
risks involved. You feel you will receive at least $8,000 in
the first year, $21,000 in the second year, $43,000 in the
third year, and potentially could see a cash outflow of
$7,000 in the fourth year. Should you accept this
investment given your expectations?
Problem two:
Tina is considering a project with the cash flows shown below.
She is content earning 10 percent on the project, should she
accept this project?
Summary:
■ Does the NPV rule account for the time value of money?
YES
■ Does the NPV rule account for the risk of the cash flows?
YES
■ Does the NPV rule provide an indication about the increase in value?
YES
■ Should we consider the NPV rule for our primary decision criteria?
YES
NPV is a preferred approach
II. The payback period
■ How long does it take to cover the initial investment
costs???

■ Decision Criteria:
– Accept if the payback period is less than some preset limit.
– Reject if the payback period is more than some preset limit.
Problem three:
A project has the following cash flows. What is the payback period? Will the
project be accepted or not if it is required to pay back within 2 years?
Year: 0 1 2 3
Cash Flow -165,000 63,120 70,800 91,080
Problem four:
A project has the following cash flows. What is the payback period?
Year: 0 1 2 3
Cash Flow -8,400 3,900 5,500 1,200
Summary:
■ Does the payback rule account for the time value of money?
NO
■ Does the payback rule account for the risk of the cash flows?
NO
■ Does the payback rule provide an indication about the increase in
value?
NO
■ Should we consider the payback rule for our primary decision
criteria?
NO
III. The average accounting return (AAR)
■ Equals to a measure of accounting profit
Average Net Income
AAR 
Average Book Value
■ The average book value depends on how the asset is
depreciated.
■ Requires a target cutoff rate
■ Decision Criteria:
– Accept the project if the AAR is greater than the target rate.
– Reject the project if the AAR is less than the target rate
Problem four:
Caldo Professional Movers is considering purchasing some new
equipment costing $210,000. The equipment will be depreciated on a
straight-line basis to a zero book value over the four-year life of the
project. Projected net income for the four years are $7,200, $11,300,
$14,100, and $20,000. What is the average accounting rate of
return? Assume the required AAR is 12%, should we buy the new
equipment?
Summary:
■ Does the AAR account for the time value of money?
NO
■ Does the AAR account for the risk of the cash flows?
NO
■ Does the AAR provide an indication about the increase in value?
NO
■ Should we consider the AAR for our primary decision criteria?
NO

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