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1

Evaluation Techniques for Evaluating Capital Budgeting Opportunities:

Six techniques for evaluation and selection of capital projects:

  1. Payback Period Approach
  2. Discounted Payback Period Approach
  3. Accounting Rate of Return Approach
  4. Net Present Value Approach
  5. Profitability Index Approach
  • The first 5 approaches are used primarily to decide whether to accept or reject a project based on the economic feasibility of the project.
  • The last technique, Profitability Index Approach, is particularly useful in ranking acceptable projects. 

2

Payback Period Approach (PPA) Defined:

Payback Period: Determines the # of years needed to recover the initial cash investment in a project and compares that time with a pre-established maximum payback period. 

  • If payback period is less or equal than maximum period = accept project. 
  • If payback period is more than maximum period = reject project. 
  • PPA Illustrated:
    • Proposed Project: $250,000, no residual value
    • Expected cash inflows:
      • Y1 $50,000
      • Y2 $75,000
      • Y3 $75,000
      • Y4 $75,000
      • Y5 $25,000
      • SUM: $300,000
    • Maximum payback period = 3 yrs
    • Payback period = $50,000+$75,000+$75,000 = $200,000 < $250,000 Cost = Reject Project
  • Specific Considerations:
    • Depreciation (non-cash expense) and Residual Value are not considered.

3

Advantages of Payback Period:

Advantages of Payback Period: 

  • Easy to use and understand
  • Useful in evaluating project liquidity
  • Establishing a short maximum period reduces uncertainty

4

Disadvantages of Payback Period:

Disadvantages of Payback Period: 

  • Ignores time value of money (uses nominal values)
  • Ignores cash flows after payback period
  • Does not measure total project profitability
  • Maximum payback period established may be arbitrary. 

5

Under what circumstances would the payback period approach to project evaluation be most appropriate?

Payback Period is most appropriate when:

  1. When used as a preliminary screening technique;
  2. When used in conjunction with other evaluation techniques.

6

Question: 

Capital budgeting is concerned with capital investments that have which one of the following characteristics?

 

A. Have prospects for long-term benefits.

B. Have prospects for short-term benefits.

C. Are undertaken only by large corporations.

D. Apply only to investments in fixed assets.

A. Have prospects for long-term benefits.

 

7

Question:

A company invested in a new machine that will generate revenues of $35,000 annually for seven years. The company will have annual operating expenses of $7,000 on the new machine. Depreciation expense, included in the operating expenses, is $4,000 per year. The expected payback period for the new machine is 5.2 years. What amount did the company pay for the new machine?

 

A.  $145,600
B.  $161,200
C.  $166,400
D.  $182,000

C.  $166,400

  • Cash flows: $35,000 annually
  • Cash Expenses: $7,000 (Operating Expenses) - $4,000 (Depreciation0not cash expense, not used) = $3,000
  • Net Cash Inflows: $35,000 - $3,000 = $32,000
  • $32,000 x 5.2 = $166,400

The expected payback period is computed as the length of time needed for net cash flows to recover the initial cash investment in a project. Since the payback period is given, that period multiplied by the annual net cash inflow will result the cost of the new machine. The annual revenue is $35,000 and the annual cash expenses are $3,000, which is determined as the total operating expenses less the amount of depreciation expense included (since it is a non-cash expense). Thus, the annual net cash flow is $35,000 - $3,000 = $32,000 x 5.2 = $166,400, the correct answer.

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Discounted Payback Period Approach Defined:

Discounted Payback Period Approach: Determines the # of years needed to recover the initial cash investment in a project using discounted cash flows and compares that time with a pre-established maximum payback period. 

  • It's a variation of the payback period approach but takes into account time value of money
  • It does so by discounting the expected future cash flows to their present value and uses the present values to determine the length of time required to recover the initial investment.
  • Because the present value of the cash flows will be less than their future (nominal) values, the discounted payback period will be longer than the undiscounted payback period.   
  • If payback period is less or equal than maximum period = accept project. 
  • If payback period is more than maximum period = reject project. 

           

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Discount Payback Period Illustrated:

Discount Payback Period Illustrated:

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Discount Payback Period Advantages:

Discount Payback Period Advantages: (same as Payback Period Approach but adding usage of time value of money)

  • Easy to use and understand;

  • Uses time value of money approach;

  • Useful in evaluating liquidity of a project;

  • Use of a short payback period reduces uncertainty.

 

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Discount Payback Period Disadvantages:

Discount Payback Period Disadvantages: 

  • Ignores cash flows received after the payback period;

  • Does not measure total project profitability;

  • Maximum payback period may be arbitrary.

12

Will the payback period from using the discounted payback period approach be longer or shorter than using undiscounted payback period approach (to capital budgeting)? 

The discounted payback period will be longer than the undiscounted payback period because the present value of cash flows will be less than the undiscounted values.

13

Evaluation Technique: Accounting Rate of Return (ARR) Defined:

Accounting Rate of Return: Determines the expected annual incremental accounting net income from a project as a precentage of the initial (or avg) investment. 

Expressed as a Formula:

  • ARR = (Avg Annual Incremental Revenue - Avg Annual Incremental Expenses) / Initial (or Average) Investment
  • Incremental revenues and expenses are as determined using accrual accounting
  • If the average amount invested in the project were used in the denominator, rather than the full initial investment, it would be computed as the average book value of the asset over its life.
  • It assumes that incremental NI is the same each year (because of avg)

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Specific Considerations: Accounting Rate of Return Approach:

Specific Considerations  -- 

  1. Depreciations  --  Depreciation expense is explicitly recognized under the accounting rate of return approach. While all of the other methods of evaluation are based on measuring cash flows, this method is based on expected accounting revenues and expenses, including depreciation expense. Thus, the accounting rate of return approach is the only approach that recognizes depreciation expense per se.
  2. Income Taxes  --  Income tax expenses are explicitly recognized under the accounting rate of return approach. Because it is based on expected accounting revenues and expenses, expected income tax expenses would be taken into account in computing the net increment in accounting income. Because the full amount of expected tax expense enters into determining the net increment in accounting income, the tax effect is taken into account in full; the issue of "tax shield" (a cash flow concept) is not relevant.
  3. Residual (Salvage) Value  --  The residual value associated with a capital project is taken into account to the extent that residual value is expected to generate an increase in accounting income (from a gain) or decrease accounting income (from incurring a loss) upon disposal. 

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ARR Approach Illustration:

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Advantages of ARR Approach:

Advantages of ARR Approach:

  • Easy to use and understand;
  • Consistent with financial statement values;
  • Considers entire life and results of project.

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Disadvantages of ARR Approach:

Disadvantages of ARR Approach:

  • Ignores the time value of money;
  • Uses accrual accounting values, not cash flows.

18

What alternative investment bases can be used in the accounting rate-of-return approach (to capital budgeting)?  

Two alternative investment bases may be used:

  • Initial investment;
  • Average investment (i.e., the average book value of the asset over its life).

19

In computing the accounting rate-of-return approach (to capital budgeting), will using the Initial Investment or the Average Investment give the higher rate of return?

Because the average investment gives a smaller denominator, the accounting rate of return will be higher when the average investment is used, rather than when the initial investment is used

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Question:

Phillips Company is considering the acquisition of a new machine that would cost $66,000, has an expected life of 6 years, and an expected salvage value of $16,000. The company expects the machine to provide annual incremental income before taxes of $7,200. Phillips has a tax rate of 30%. If Phillips uses average values in its calculations, which one of the following will be the average accounting rate of return on the machine?

A.  10.08%
B.  10.90%
C.  12.29%
D.  14.40%

  • ARR = Avg Annual Incremental NI / Initial (or Avg) Investment
  • $7,200x.70 = $5,040 (Avg Annual Inc NI)
  • Avg Investment= $66,000 Beg BV + $16,000 End BV = $82,000 / 2 = $41,000
  • $5,040 / $41,000 = 12.29%

The (average) accounting rate of return is determined by dividing the average annual after-tax net income by the average cost of the investment. The after-tax income would be $7,200 x .70 = $5,040. The average cost of the investment would be beginning book value ($66,000) + ending book value of ($16,000), or $82,000/2 = $41,000. Therefore, the accounting rate of return is: $5,040/$41,000 = 12.29%.  

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Net Present Value Approach: Illustration

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Net Present Value Approach: Specific Considerations

Specific Considerations: 

  1. Depreciations  --  Depreciation expense does not create a cash flow. Because depreciation expense (per se) does not create a cash flow, it is not considered in the determination of the net present value (an approach which is based on cash flows).
    • However, to the extent depreciation expense is deductible for income tax purposes, it saves taxes and the cash outflow to pay those taxes. That cash outflow savings, called a "tax shield," is considered in determining the net present value.
      • For example, if $100 of tax deductible depreciation expense occurs during a year and the firm's tax rate is 30%, the tax shield would be .30 × $100 = $30, the amount of cash that would be saved as a result of the tax deductibility of the depreciation expense. That $30, discounted to its present value, would be recognized as a cash inflow (savings) for each period it occurred.
  2. ​Residual (Salvage) Value  --  The residual value associated with a capital project is considered in the net present value approach. Any residual value expected at the end of the project life would be discounted to its present value and treated as a positive value into the determination of net present value. Conversely, if it is expected that an additional disposal cost would be incurred at the end of the project life, that cost would discounted to its present value and treated as a negative value in the determination of net present value. 

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Net Present Value Approach: Advantages

Advantages:

  1. Recognizes the time value of money (i.e., present value of the future cash flows);
  2. Relates project rate of return to cost of capital; 
  3. Considers the entire life and results of the project; 
  4. Easier to compute than the internal rate of return method (the other discounted cash flow method).
  5. It accounts for compounds of return

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Net Present Value Approach: Disadvantages

Disadvantages: 

  1. Requires estimation of cash flows over the entire life of the project, which could be very long;  
  2. Assumes that the cash flows resulting from new revenues or cost savings are immediately reinvested at the hurdle rate of return. 

25

Question:

A company is considering two projects, which have the following details:

Project A 
Expected sales $1,000 
Cash operating expense 400 
Depreciation 150 
Tax rate 30% 

Project B

Expected sales $1,500
Cash operating expense 700
Depreciation 250
Tax rate 30% 

Which project would provide the largest after-tax cash inflow?

A.  Project A because after-tax cash inflow equals $465.
B.  Project A because after-tax cash inflow equals $315.
C.  Project B because after-tax cash inflow equals $635.
D.  Project B because after-tax cash inflow equals $385. 

C.  Project B because after-tax cash inflow equals $635.

Project A:

  • Expected sales: $1,000 - $400 (cash op exp) = $600
  • $600 x .70 = $420
  • Depreciation= $150x.30 = $45 (tax shield - saving)
  • $420+45 = $465

Project B:

  • Expected sales: $1,500 - $700 (cash op exp) = $800
  • $800 x .70 = $560
  • Depreciation = $250x.30= $75 (tax shield - saving)
  • $560 + $75 = $635

26

Question:

 

A corporation is considering purchasing a machine that costs $100,000 and has a $20,000 salvage value. The machine will provide net annual cash inflows of $25,000 per year and has a six-year life. The corporation uses a discount rate of 10%. The discount factor for the present value of a single sum six years in the future is 0.564. The discount factor for the present value of an annuity for six years is 4.355. What is the net present value of the machine?

A. ($2,405)

B. $ 8,875

C. $20,155

D. $28,875

C. $20,155

  • $25,000 cash inflows x 4.355 = $108,875
  • $20,000 salvage value x .564 = $11,280
  • SUM: $108,875+11,280 = $120,155
  • $120,155 - $100,000 (initial investment) = $20,155

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Question:

The discount rate is determined in advance for which of the following capital budgeting techniques?

A.  Payback.
B.  Accounting rate of return.
C.  Net present value.
D.  Internal rate of return.

C.  Net present value.

The discount rate is determined in advance when using the net present value capital budgeting technique. The net present value technique compares the present value of expected cash inflows with the present value of cash outflows to determine whether or not a capital project is economically feasible. Determining present values requires the use of a predetermined discount rate. Often the firm's cost of capital is used as the discount rate.

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Question:

Given a 10% discount rate with cash inflows of $3,000 at the end of each year for five years and an initial investment of $11,000, what is the net present value?

A.  ($9,500)
B.  $370
C.  $4,000
D.  $11,370

B.  $370

The net present value is $370. The present value (PV) of expected cash inflows is determined by discounting those flows to their present value using the firm's discount rate (also called the hurdle rate). The difference between the resulting PV of cash inflows and the initial cost (which is at present value) is the net present value of the project. Cash inflows are $3,000 at the end of each year for five years, which is an ordinary annuity. If (in the absence of a PV table of factors) you know the formula for the PV of an ordinary annuity it can be used. That would be:

PVoa = C x [(1 - (1 / (1 + i)n)) / i]

Where: C = Cash flow per year; i = interest rate; and n = number of years.

Substituting: PV = $3,000 x [(1 - (1/(1 + .10)5))/.10]; PV = $3,000 x 3.79; PV of cash inflows = $11,370 - initial investment $11,000 = $370 net present value.

Even if you don't have PV factors or don't know the formula for PVoa, you can compute the answer (even easier than using the formula). For each year, discount the $3,000 by the discount rate times the number of years, as follows:

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Question:

 

A project's net present value, ignoring income tax considerations, is normally affected by the:

A.  Proceeds from the sale of the asset to be replaced.
B.  Carrying amount of the asset to be replaced by the project.
C.  Amount of annual depreciation on the asset to be replaced.
D.  Amount of annual depreciation on fixed assets used directly on the project.

A.  Proceeds from the sale of the asset to be replaced.

The net present value approach is based on cash flows. Only the proceeds from sale of the asset to be replaced is a cash flow. The remaining alternatives are not cash flows, and do not cause cash flows to change when income tax effects are ignored. In the equipment replacement decision, the proceeds from the sale of the old asset (not its carrying value) increase the net present value of the replacement alternative. 

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Internal Rate of Return Approach (IRR) Defined:

Internal Rate of Return Approach (IRR): Determines the discount rate that equates the PV of expected cash inflows w the PV of expected cash outflows. 

  • That discount rate is the rate of return on the project.
  • IRR computes the discount rate that maked NPV of cashflows equal to zero.
  • Calculation of the IRR is best done w a financial calculator or computer program.

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IRR Approach Illustration:

 

IRR Approach Illustration:

Equation for NPV=0:

  • Future annual cash inflows x PV factor = Investment Cost

Rearranged Equation:

  • PV factor = Investment Cost / Future annual cash inflows.

Proposed Project:

  • Initial cash outlay = $37,500, no residual value;
  • Expected CF= $10,000 year for 5 yrs
  • PV factor = Initial Cost/Expected Cash = $37,500 / $10,000 = 3.750 (PV factor)
  • See attached: 

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IRR Approach Advantages:

IRR Approach Advantages:

  • Recognizes TMV
  • Considers entire life and results of the project

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IRR Approach Disadvantages:

IRR Approach Advantages:

  • Difficult to compute without a financial calculator; even more difficult when cash flows are uneven
  • Requires estimation of cash flows over entire lifre of project, which could be very long, and that all cash flows be either positive or negative
  • Assumes cash flows are immediately reinvested as internal rate of return

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NPV vc. IRR Approaches:

NPV vc. IRR Approaches:

NPV: Uses a rate of return (hurdle rate) to determine whether or not the PV of net cash flows is positive.

  • If so, the project will earn at least the hurdle rate

IRR: Determines what rate of return makes the NPV of net cash flows equate to zero.

  • That rate of return is the rate earned by the project. 

35

Under what conditions is the internal-rate-of-return approach (to capital budgeting) not appropriate?  

 

When future cash flows of a project are both positive and negative, the internal rate of return method should not be used because it can result in multiple solutions.

36

Profitablity Index and Ranking (PI) Defined:

Profitablity Index (also Cost-Benefit Ratio): Determines project rankings by taking into account both the NPV and the cost of each project. It computes the expected return for each dollar invested.

Profitability Index Calculation:

  • PI: NPV of project inflows (or PV of future CF) / PV of project cost
  • Higher the percentage=higher the rank

 

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PI Approach Illustrated:

PI Approach Illustrated:

Proposed Projects:

Project A: NPV $60,000/Cost = $50,000 = 1.20

Project B: NPV $110,000/Cost = $100,000 = 1.10

Profitability Indexes (PI):

  • Project A: 1.20
  • Project B: 1.10

Based on PI, Project A ranks higher than Project B

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Differences of using PV of Future Cash Inflows or NPV for PI:

PI = PV of Cash Inflows / Project Cost

  • A project would be economically feasible only if PI > or equal to 1.

PI = NPV / Project Cost

  • A project would be economically feasible only if PI is zero or positive. 
  • PI > or equal to zero means project is providing value at least to discount rate used (e.g. WACC). 

39

Will the profitability index and the net-present-value approach (to capital budgeting) result in the same ranking of multiple projects? 

No.

Since the Net Present Value Approach does not explicitly consider the differences in initial cost of one project compared to another project, it does not give the same ranking as the Profitability Index, which considers both the Net Present Value and the initial cost of the project by getting an NPV per dollar invested.

40

Which of the following is a limitation of the profitability index?

A. It uses free cash flows.

B. It ignores the time value of money.

C. It is inconsistent with the goal of shareholder wealth maximization.

D. It requires detailed long-term forecasts of the project's cash flows.

D. It requires detailed long-term forecasts of the project's cash flows.

Because the profitability index is based on cash flow and because projects may be of very long duration, the use of the profitability index requires detailed long-term forecasts (i.e., amount and timing) of projects' cash flows. The longer the projection period, the greater the uncertainty of those cash flows.

41

Capital Project Ranking Decisions: 

Project Ranking Decisions:

A firm is limited in the number of projects it can undertake in the short-run due to resource constraints.

  • Limited capital
  • Limited mgt capability

It needs to allocate resources to the most beneficial projects.

  • Called Capital Rationing

42

Capital Project Ranking Decisions: How does each approach measure up? PPA and Ranking:

PPA and Ranking:

Payback Period Approach (PPA): Ranks projects based on how quickly invested capital is recovered.

  • It uses nominal dollars, not discounted value
  • It does not rank in terms of relative total economicv alue; it only considers outcome up to point at which initial investment is recovered.
  • Useful for ranking when liquidity is a major concern.

43

Capital Project Ranking Decisions: How does each approach measure up? DPP and Ranking:

DPP and Ranking:

Discounted Payback Period Approach (DDP): Ranks projects based on how quickly invested capital is recovered using discounted cash flows.

  • It's better than the undiscounted PPA.
  • It does not rank in terms of relative total economicv alue; it only considers outcome up to point at which initial investment is recovered.

  • Useful for ranking when liquidity is a major concern.

44

Capital Project Ranking Decisions: How does each approach measure up? ARR and Ranking:

ARR and Ranking:

Accounting Rate of Return (ARR): Ranks projects based on annual incremental accrual based NI as a percentage of initial investment.

  • Higher percent = higher ranking
  • It ignores the TMV
  • It uses accrual accounting values, not cash flows. 

45

Capital Project Ranking Decisions: How does each approach measure up? NPV Approach and Ranking:

NPV Approach and Ranking:

Net Present Value (NPV) Approach: Ranks projects based on their relative net present values.

  • Higher NPV = Higher ranking
  • It recognizes TMV -> Rankings in terms of comparable dollars
  • Projects with negative NPV = not considered
  • It fails to consider differences in initial project costs

NPV ranking of projects is a preferred method. 

46

Capital Project Ranking Decisions: How does each approach measure up? IRR Approach and Ranking:

 IRR Approach and Ranking:

Internal Rate of Return (IRR) Approach: Ranks projects based on their relative internal rate of return.

  • Higher IRR=Higher ranking
  • It recognizes TMV -> rankings in terms of comparable dollars
  • Fails to consider differences in initial project costs.

47

NPV vs. IRR Ranking:

NPV vs. IRR Ranking:

IRR and NPV may result in different rakings due to differences in:

  • Project investment cost
  • Timing of cash flows
  • Project life-span

 

48

Capital Project Ranking Decisions: How does each approach measure up? PI Approach and Ranking:

PI Approach and Ranking:

Profitability Index (PI) Approach: Ranks projects based on the NPV of each project as a percentage of initial investment cost of each.

  • Higher PI index= Higher ranking
  • Recognizes TMV -> rankings in terms of comparable dollars
  • Takes into acccount cost of each project.

PI ranking of projects is a preferred method.

49

Project Ranking Methods Summary:

Summary:

  • Methods which use cash flows are better than the accounting rate or retun method.
  • Methods which incorporate TMV are better than those that don't.
  • Profitability Index uses:
    • Cash flows
    • TMV
    • Initial Investment Cost
  • Some degree of subjectivity is likely to enter in to the final selection decision. 

50

 

Which of the following statements is correct regarding financial decision making?

A.  Opportunity cost is recorded as a normal business expense.
B.  The accounting rate of return considers the time value of money.
C.  A strength of the payback method is that it is based on profitability.
D.  Capital budgeting is based on predictions of an uncertain future.

D.  Capital budgeting is based on predictions of an uncertain future.

 

Capital budgeting is the process of measuring, evaluating, and selecting long-term investment opportunities. Inherent in every capital investment opportunity (i.e., capital project) are elements of risk and reward. Risk is the possibility of loss or other unfavorable results that derives from the uncertainty implicit in future outcomes. The time periods, expected costs and savings, and other elements used in capital budgeting are largely estimates or predictions about an uncertain future.   

51

Which one of the following methods of evaluating investment projects is most likely to be used to rank projects competing for limited capital investment funds?

A.  Payback period method.
B.  Net present value method.
C.  Internal rate of return method.
D.  Profitability index method.

D.  Profitability index method.

The profitability index method is specifically designed to rank projects by taking into account both the time value of money and the initial cost of the project. 

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