Chapter Title - North Seattle College

Chapter Title - North Seattle College

Capital Budgeting Decisions Chapter 14 2010 The McGraw-Hill Companies, Inc. Typical Capital Budgeting Decisions Plant expansion Equipment selection Lease or buy McGraw-Hill/Irwin Cost reduction Slide 2 Typical Capital Budgeting Decisions Capital budgeting tends to fall into two broad categories . . . Screening decisions. Does a proposed project meet some preset standard of acceptance?

Preference decisions. Selecting from among several competing courses of action. McGraw-Hill/Irwin Slide 3 Time Value of Money A dollar today is worth more than a dollar a year from now. Therefore, projects that promise earlier returns are preferable to those that promise later returns. McGraw-Hill/Irwin

Slide 4 Time Value of Money The capital budgeting techniques that best recognize the time value of money are those that involve discounted cash flows. McGraw-Hill/Irwin Slide 5 Learning Objective 1 Evaluate the acceptability of an investment project using the net present

value method. McGraw-Hill/Irwin Slide 6 The Net Present Value Method To determine net present value we . . . Calculate the present value of cash inflows, Calculate the present value of cash outflows, Subtract the present value of the outflows from the present value of the inflows. McGraw-Hill/Irwin Slide 7 The Net Present Value Method

McGraw-Hill/Irwin Slide 8 The Net Present Value Method Net present value analysis emphasizes cash flows and not accounting net income. The reason is that accounting net income is based on accruals that ignore the timing of cash flows into and out of an organization. McGraw-Hill/Irwin Slide 9 Typical Cash Outflows Repairs and

maintenance Working capital Initial investment Incremental operating costs McGraw-Hill/Irwin Slide 10 Typical Cash Inflows Salvage value Release of working

capital Reduction of costs Incremental revenues McGraw-Hill/Irwin Slide 11 Recovery of the Original Investment Depreciation is not deducted in computing the present value of a project because . . . It is not a current cash outflow. Discounted cash flow methods automatically provide for a return of the original investment.

McGraw-Hill/Irwin Slide 12 Recovery of the Original Investment Carver Hospital is considering the purchase of an attachment for its X-ray machine. No investments are to be made unless they have an annual return of at least 10%. Will we be allowed to invest in the attachment? McGraw-Hill/Irwin Slide 13 Recovery of the Original Investment Periods 1 2

3 4 5 McGraw-Hill/Irwin Present Value of $1 10% 12% 0.909 0.893 1.736 1.690 2.487 2.402 3.170 3.037 3.791 3.605 14% 0.877

1.647 2.322 2.914 3.433 Present Present value value of of an an annuity annuity of of $1 $1 table table Slide 14 Recovery of the Original Investment (1)

(2) (3) Investment Outstanding Return on during the Cash Investment Year year Inflow (1) 10% 1 $ 3,170 $ 1,000 $ 317 2 2,487

1,000 249 3 1,736 1,000 173 4 909 1,000 91 Total investment recovered (4) (5) Recover of Unrecovered Investment Investment at during the the end of the year year (2) - (3) (1) - (4)

$ 683 $ 2,487 751 1,736 827 909 909 0 $ 3,170 This implies that the cash inflows are sufficient to recover the $3,170 initial investment (therefore depreciation is unnecessary) and to provide exactly a 10% return on the investment. McGraw-Hill/Irwin Slide 15 Two Simplifying Assumptions Two simplifying assumptions are usually made

in net present value analysis: All cash flows other than the initial investment occur at the end of periods. McGraw-Hill/Irwin All cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate. Slide 16 Choosing a Discount Rate

The firms cost of capital is usually regarded as the minimum required rate of return. The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds. McGraw-Hill/Irwin Slide 17 The Net Present Value Method Lester Company has been offered a five year contract to provide component parts for a large manufacturer.

McGraw-Hill/Irwin Slide 18 The Net Present Value Method At the end of five years the working capital will be released and may be used elsewhere by Lester. Lester Company uses a discount rate of 10%. Should the contract be accepted? McGraw-Hill/Irwin Slide 19 The Net Present Value Method Annual net cash inflow from operations

McGraw-Hill/Irwin Slide 20 The Net Present Value Method McGraw-Hill/Irwin Slide 21 The Net Present Value Method McGraw-Hill/Irwin Slide 22 The Net Present Value Method McGraw-Hill/Irwin Slide 23

The Net Present Value Method Present value of $1 factor for 5 years at 10%. McGraw-Hill/Irwin Slide 24 The Net Present Value Method Accept the contract because the project has a positive net present value. McGraw-Hill/Irwin Slide 25 Quick Check Denny Associates has been offered a four-year contract to

supply the computing requirements for a local bank. The working capital would be released at the end of the contract. Denny Associates requires a 14% return. McGraw-Hill/Irwin Slide 26 Quick Check What is the net present value of the contract with the local bank? a. $150,000 b. $ 28,230 c. $ 92,340 d. $132,916 McGraw-Hill/Irwin Slide 27

Quick Check What is the net present value of the contract with the local bank? a. $150,000 b. $ 28,230 c. $ 92,340 d. $132,916 McGraw-Hill/Irwin Slide 28 Learning Objective 2 Evaluate the acceptability of an investment project using the internal rate of return method. McGraw-Hill/Irwin

Slide 29 Internal Rate of Return Method The internal rate of return is the rate of return promised by an investment project over its useful life. It is computed by finding the discount rate that will cause the net present value of a project to be zero. It works very well if a projects cash flows are identical every year. If the annual cash flows are not identical, a trial and error process must be used to find the internal rate of return. McGraw-Hill/Irwin Slide 30

Internal Rate of Return Method General decision rule . . . If the Internal Rate of Return is . . . Then the Project is . . . Equal to or greater than the minimum required rate of return . . . Acceptable. Less than the minimum required rate of return . . . Rejected. When using the internal rate of return, the cost of capital acts as a hurdle rate that a project must clear for acceptance. McGraw-Hill/Irwin

Slide 31 Internal Rate of Return Method Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life. McGraw-Hill/Irwin Slide 32 Internal Rate of Return Method Future Future cash cash flows flows are are the

the same same every every year year in in this this example, example, so so we we can can calculate calculate the the internal internal rate rate of of return return as as follows: follows: PV factor for the

= internal rate of return Investment required Annual net cash flows $104, 320 = 5.216 $20,000 McGraw-Hill/Irwin Slide 33 Internal Rate of Return Method Using the present value of an annuity of $1 table . . . Find the 10-period row, move across until you find the factor 5.216. Look at the top of the column and you find a rate of 14%. 14% Periods

1 2 . . . 9 10 McGraw-Hill/Irwin 10% 0.909 1.736 . . . 5.759 6.145 12% 0.893 1.690 . . . 5.328 5.650

14% 0.877 1.647 . . . 4.946 5.216 Slide 34 Internal Rate of Return Method Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life. The internal rate of return on this project is 14%. If the internal rate of return is equal to or greater than the companys required

rate of return, the project is acceptable. McGraw-Hill/Irwin Slide 35 Quick Check The expected annual net cash inflow from a project is $22,000 over the next 5 years. The required investment now in the project is $79,310. What is the internal rate of return on the project? a. 10% b. 12% c. 14% d. Cannot be determined McGraw-Hill/Irwin Slide 36 Quick Check The expected annual net cash inflow from a project

is $22,000 over the next 5 years. The required investment now in the project is $79,310. What is the internal rate of return on the project? a. 10% b. 12% $79,310/$22,000 = 3.605, c. 14% which is the present value factor d. Cannot be determined for an annuity over five years when the interest rate is 12%. McGraw-Hill/Irwin Slide 37 Comparing the Net Present Value and Internal Rate of Return Methods NPV is often simpler to use. Questionable assumption:

Internal rate of return method assumes cash inflows are reinvested at the internal rate of return. McGraw-Hill/Irwin Slide 38 Comparing the Net Present Value and Internal Rate of Return Methods NPV is often simpler to use. Questionable assumption: Internal rate of return method assumes cash inflows are reinvested at the internal rate of return. McGraw-Hill/Irwin Slide 39

Expanding the Net Present Value Method To compare competing investment projects we can use the following net present value approaches: Total-cost Incremental cost McGraw-Hill/Irwin Slide 40 The Total-Cost Approach White Company has two alternatives: (1) remodel an old car wash or, (2) remove it and install a new one. The company uses a discount rate of 10%. New Car Wash Annual revenues $ 90,000

Annual cash operating costs 30,000 Annual net cash inflows $ 60,000 McGraw-Hill/Irwin Old Car Wash $ 70,000 25,000 $ 45,000 Slide 41 The Total-Cost Approach If White installs a new washer . . . Cost $ 300,000

Productive life Salvage value 10 years $ 7,000 Replace brushes at the end of 6 years $ 50,000 Salvage of old equip. $ 40,000 Lets look at the present value of this alternative. McGraw-Hill/Irwin Slide 42 The Total-Cost Approach Install the New Washer Cash

10% Year Flows Factor Initial investment Now $ (300,000) 1.000 Replace brushes 6 (50,000) 0.564 Annual net cash inflows 1-10 60,000 6.145 Salvage of old equipment Now 40,000 1.000 Salvage of new equipment

10 7,000 0.386 Net present value Present Value $ (300,000) (28,200) 368,700 40,000 2,702 $ 83,202 If we install the new washer, the investment will yield a positive net present value of $83,202. McGraw-Hill/Irwin Slide 43

The Total-Cost Approach If White remodels the existing washer . . . Remodel costs Replace brushes at the end of 6 years $175,000 80,000 Lets look at the present value of this second alternative. McGraw-Hill/Irwin Slide 44 The Total-Cost Approach Remodel the Old Washer Cash 10% Year

Flows Factor Initial investment Now $ (175,000) 1.000 Replace brushes 6 (80,000) 0.564 Annual net cash inflows 1-10 45,000 6.145 Net present value Present Value $ (175,000) (45,120) 276,525

$ 56,405 If we remodel the existing washer, we will produce a positive net present value of $56,405. McGraw-Hill/Irwin Slide 45 The Total-Cost Approach Both projects yield a positive net present value. However, investing in the new washer will produce a higher net present value than remodeling the old washer. McGraw-Hill/Irwin Slide 46

The Incremental-Cost Approach Under Under the the incremental-cost incremental-cost approach, approach, only only those those cash cash flows flows that that differ differ between between the the two two alternatives alternatives are are considered. considered.

Lets look at an analysis of the White Company decision using the incrementalcost approach. McGraw-Hill/Irwin Slide 47 The Incremental-Cost Approach Incremental investment Incremental cost of brushes Increased net cash inflows Salvage of old equipment Salvage of new equipment Net present value Year Now 6 1-10 Now

10 Cash Flows $(125,000) $ 30,000 15,000 40,000 7,000 10% Factor 1.000 0.564 6.145 1.000 0.386 Present Value $(125,000)

16,920 92,175 40,000 2,702 $ 26,797 We get the same answer under either the total-cost or incremental-cost approach. McGraw-Hill/Irwin Slide 48 Quick Check Consider the following alternative projects. Each project would last for five years. Project A Project B Initial investment $80,000 $60,000

Annual net cash inflows 20,000 16,000 Salvage value 10,000 8,000 The company uses a discount rate of 14% to evaluate projects. Which of the following statements is true? a. NPV of Project A > NPV of Project B by $5,230 b. NPV of Project B > NPV of Project A by $5,230 c. NPV of Project A > NPV of Project B by $2,000 d. NPV of Project B > NPV of Project A by $2,000 McGraw-Hill/Irwin Slide 49 Quick Check Consider the following alternative projects. Each project would last for five years. Project A

Project B Initial investment $80,000 $60,000 Annual net cash inflows 20,000 16,000 Salvage value 10,000 8,000 The company uses a discount rate of 14% to evaluate projects. Which of the following statements is true? a. NPV of Project A > NPV of Project B by $5,230 b. NPV of Project B > NPV of Project A by $5,230 c. NPV of Project A > NPV of Project B by $2,000 d. NPV of Project B > NPV of Project A by $2,000 McGraw-Hill/Irwin Slide 50

Least Cost Decisions In decisions where revenues are not directly involved, managers should choose the alternative that has the least total cost from a present value perspective. Lets look at the Home Furniture Company. McGraw-Hill/Irwin Slide 51 Least Cost Decisions Home Furniture Company is trying to decide whether to overhaul an old delivery truck now or purchase a new one. The company uses a discount rate of 10%. McGraw-Hill/Irwin Slide 52

Least Cost Decisions Here is information about the trucks . . . Old Truck Overhaul cost now Annual operating costs Salvage value in 5 years Salvage value now McGraw-Hill/Irwin $ 4,500 10,000 250 9,000 Slide 53 Least Cost Decisions Buy the New Truck Cash

Year Flows Purchase price Now $ (21,000) Annual operating costs 1-5 (6,000) Salvage value of old truck Now 9,000 Salvage value of new truck 5 3,000 Net present value Keep the Old Truck Cash Year Flows Overhaul cost Now

$ (4,500) Annual operating costs 1-5 (10,000) Salvage value of old truck 5 250 Net present value McGraw-Hill/Irwin 10% Factor 1.000 3.791 1.000 0.621 10% Factor 1.000 3.791

0.621 Present Value $ (21,000) (22,746) 9,000 1,863 (32,883) Present Value $ (4,500) (37,910) 155 (42,255) Slide 54 Least Cost Decisions Home Furniture should purchase the new truck. Net present value of costs

associated with purchase of new truck $(32,883) Net present value of costs associated with overhauling existing truck (42,255) Net present value in favor of purchasing the new truck $ 9,372 McGraw-Hill/Irwin Slide 55 Quick Check Bay Architects is considering a drafting machine that would cost $100,000, last four years, provide annual cash savings of $10,000, and considerable intangible benefits each year. How large (in cash

terms) would the intangible benefits have to be per year to justify investing in the machine if the discount rate is 14%? a. $15,000 b. $90,000 c. $24,317 d. $60,000 McGraw-Hill/Irwin Slide 56 Quick Check Bay Architects is considering a drafting machine that would cost $100,000, , last four years, provide annual cash savings $70,860/2.914 = $24,317intangible of $10,000, and considerable benefits each year. How large (in cash terms) would the intangible benefits

have to be per year to justify investing in the machine if the discount rate is 14%? a. $15,000 b. $90,000 c. $24,317 d. $60,000 McGraw-Hill/Irwin Slide 57 Learning Objective 3 Evaluate an investment project that has uncertain cash flows. McGraw-Hill/Irwin Slide 58 Uncertain Cash Flows An Example

Assume that all of the cash flows related to an investment in a supertanker have been estimated, except for its salvage value in 20 years. Using a discount rate of 12%, management has determined that the net present value of all the cash flows, except the salvage value is a negative $1.04 million. How large would the salvage value need to be to make this investment attractive? McGraw-Hill/Irwin Slide 59 Uncertain Cash Flows An Example Net present value to be offset Present value factor $1,040,000 = $ 0.104

10,000,000 This equation can be used to determine that if the salvage value of the supertanker is at least $10,000,000, the net present value of the investment would be positive and therefore acceptable. McGraw-Hill/Irwin Slide 60 Real Options Delay the start of a project Expand a project if conditions are favorable Cut losses if

conditions are unfavorable The ability to consider these real options adds value to many investments. The value of these options can be quantified using what is called real options analysis, which is beyond the scope of the book. McGraw-Hill/Irwin Slide 61 Learning Objective 4 Rank investment projects in order of preference. McGraw-Hill/Irwin Slide 62 Preference Decision The Ranking of Investment Projects

Screening Decisions Preference Decisions Pertain to whether or not some proposed investment is acceptable; these decisions come first. Attempt to rank acceptable alternatives from the most to least appealing. McGraw-Hill/Irwin Slide 63 Internal Rate of Return Method

When using the internal rate of return method to rank competing investment projects, the preference rule is: The higher the internal rate of return, the more desirable the project. McGraw-Hill/Irwin Slide 64 Net Present Value Method The net present value of one project cannot be directly compared to the net present value of another project unless the investments are equal. McGraw-Hill/Irwin

Slide 65 Ranking Investment Projects Project = profitability index Net present value of the project Investment required Project A Net present value (a) Investment required (b) Profitability index (a) (b) $ $ 1,000 10,000

0.10 Project B $ $ 1,000 5,000 0.20 The The higher higher the the profitability profitability index, index, the the more more desirable desirable the the project.

project. McGraw-Hill/Irwin Slide 66 Other Approaches to Capital Budgeting Decisions Other methods of making capital budgeting decisions include . . . 1. The Payback Method. 2. Simple Rate of Return. McGraw-Hill/Irwin Slide 67 Learning Objective 5 Determine the payback period for an investment.

McGraw-Hill/Irwin Slide 68 The Payback Method The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates. When the annual net cash inflow is the same each year, this formula can be used to compute the payback period: Payback period = McGraw-Hill/Irwin Investment required Annual net cash inflow Slide 69 The Payback Method

Management Management at at The The Daily Daily Grind Grind wants wants to to install install an an espresso espresso bar bar in in its its restaurant. restaurant. The The espresso espresso bar: bar: 1.

1. 2. 2. Costs Costs $140,000 $140,000 and and has has aa 10-year 10-year life. life. Will Will generate generate annual annual net net cash cash inflows inflows of of $35,000. $35,000.

Management Management requires requires aa payback payback period period of of 55 years years or or less less on on all all investments. investments. What What is is the the payback payback period period for for the the espresso

espresso bar? bar? McGraw-Hill/Irwin Slide 70 The Payback Method Payback period = Investment required Annual net cash inflow Payback period = $140,000 $35,000 Payback period = 4.0 years

According According to to the the companys companys criterion, criterion, management management would would invest invest in in the the espresso espresso bar bar because because its its payback payback period period is is less

less than than 55 years. years. McGraw-Hill/Irwin Slide 71 Quick Check Consider the following two investments: Project X Project Y Initial investment $100,000 $100,000 Year 1 cash inflow $60,000 $60,000 Year 2 cash inflow $40,000 $35,000 Year 14-10 cash inflows

$0 $25,000 Which project has the shortest payback period? a. Project X b. Project Y c. Cannot be determined McGraw-Hill/Irwin Slide 72 Quick Check Consider the following two investments: Project X Project Y Initial investment $100,000 $100,000 Year 1 cash inflow $60,000 $60,000 Year 2 cash inflow

$40,000 $35,000 Year 14-10 cash inflows $0 $25,000 Which project has the shortest payback period? a. Project X b. Project Project X has aYpayback period of 2 years. c. Cannot determined Project Y has abe payback period of slightly more than 2 years. Which project do you think is better? McGraw-Hill/Irwin Slide 73

Evaluation of the Payback Method Ignores the time value of money. Short-comings of the payback period. McGraw-Hill/Irwin Ignores cash flows after the payback period. Slide 74 Evaluation of the Payback Method Serves as screening

tool. Strengths of the payback period. Identifies investments that recoup cash investments quickly. Identifies products that recoup initial investment quickly. McGraw-Hill/Irwin Slide 75 Payback and Uneven Cash Flows

When the cash flows associated with an investment project change from year to year, the payback formula introduced earlier cannot be used. Instead, the un-recovered investment must be tracked year by year. $1,000 1 McGraw-Hill/Irwin $0 $2,000 $1,000 2 3 4

$500 5 Slide 76 Payback and Uneven Cash Flows For example, if a project requires an initial investment of $4,000 and provides uneven net cash inflows in years 1-5 as shown, the investment would be fully recovered in year 4. $1,000 1 McGraw-Hill/Irwin $0 $2,000 $1,000 2

3 4 $500 5 Slide 77 Learning Objective 6 Compute the simple rate of return for an investment. McGraw-Hill/Irwin Slide 78 Simple Rate of Return Method Does not focus on cash flows -- rather it focuses

on accounting net operating income. The following formula is used to calculate the simple rate of return: Simple rate Annual incremental net operating income = of return Initial investment* *Should be reduced by any salvage from the sale of the old equipment McGraw-Hill/Irwin Slide 79 Simple Rate of Return Method Management of The Daily Grind wants to install an espresso bar in its restaurant. The espresso bar: 1. Cost $140,000 and has a 10-year life.

2. Will generate incremental revenues of $100,000 and incremental expenses of $65,000 including depreciation. What is the simple rate of return on the investment project? McGraw-Hill/Irwin Slide 80 Simple Rate of Return Method Simple rate of return McGraw-Hill/Irwin = $35,000 $140,000

= 25% Slide 81 Criticism of the Simple Rate of Return Ignores the time value of money. Short-comings of the simple rate of return. McGraw-Hill/Irwin The same project may appear desirable in some years and undesirable in other years.

Slide 82 Postaudit of Investment Projects A A postaudit postaudit is is aa follow-up follow-up after after the the project project has has been been completed completed to to see see whether whether or or not

not expected expected results results were were actually actually realized. realized. McGraw-Hill/Irwin Slide 83 The Concept of Present Value Appendix 14A 2010 The McGraw-Hill Companies, Inc. Learning Objective 7 (Appendix 14A) Understand present value

concepts and the use of present value tables. McGraw-Hill/Irwin Slide 85 The Mathematics of Interest A dollar received today is worth more than a dollar received a year from now because you can put it in the bank today and have more than a dollar a year from now. McGraw-Hill/Irwin Slide 86

The Mathematics of Interest An Example Assume a bank pays 8% interest on a $100 deposit made today. How much will the $100 be worth in one year? Fn = P(1 + r) n F = the balance at the end of the period n. P = the amount invested now. r = the rate of interest per period. n = the number of periods. McGraw-Hill/Irwin Slide 87 The Mathematics of Interest An Example Assume a bank pays 8% interest on a $100 deposit made today. How much

will the $100 be worth in one year? Fn = P(1 + r) n F1 = $100(1 + .08)1 F1 = $108.00 McGraw-Hill/Irwin Slide 88 Compound Interest An Example What if the $108 was left in the bank for a second year? How much would the original $100 be worth at the end of the second year? Fn = P(1 + r) n

F = the balance at the end of the period n. P = the amount invested now. r = the rate of interest per period. n = the number of periods. McGraw-Hill/Irwin Slide 89 Compound Interest An Example F2 = $100(1 + .08) 2 F2 = $116.64 The interest that is paid in the second year on the interest earned in the first year is known as compound interest. McGraw-Hill/Irwin

Slide 90 Computation of Present Value An investment can be viewed in two waysits future value or its present value. Present Value Future Value Lets look at a situation where the future value is known and the present value is the unknown. McGraw-Hill/Irwin Slide 91 Present Value An Example

If a bond will pay $100 in two years, what is the present value of the $100 if an investor can earn a return of 12% on investments? Fn P= n (1 + r) F = the balance at the end of the period n. P = the amount invested now. r = the rate of interest per period. n = the number of periods. McGraw-Hill/Irwin Slide 92 Present Value An Example $100 P= (1 + .12)2

P = $79.72 This process is called discounting. We have discounted the $100 to its present value of $79.72. The interest rate used to find the present value is called the discount rate. McGraw-Hill/Irwin Slide 93 Present Value An Example Lets verify that if we put $79.72 in the bank today at 12% interest that it would grow to $100 at the end of two years. Year Year Year11 Year22 Beginning Beginningbalance balance $$ 79.72 79.72 $$ 89.29

89.29 Interest 9.57 10.71 [email protected] @12% 12% 9.57 10.71 Ending $$ 89.29 Endingbalance balance 89.29 $$100.00 100.00 IfIf $79.72 $79.72 is is put put in in the the bank

bank today today and and earns earns 12%, 12%, itit will will be be worth worth $100 $100 in in two two years. years. McGraw-Hill/Irwin Slide 94 Present Value An Example $100 0.797 = $79.70 present value Periods

Periods 11 22 33 44 55 10% 10% 0.909 0.909 0.826 0.826 0.751 0.751 0.683 0.683 0.621 0.621 Rate

Rate 12% 12% 0.893 0.893 0.797 0.797 0.712 0.712 0.636 0.636 0.567 0.567 14% 14% 0.877 0.877 0.769 0.769 0.675

0.675 0.592 0.592 0.519 0.519 Present value factor of $1 for 2 periods at 12%. McGraw-Hill/Irwin Slide 95 Quick Check How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62.10 b. $56.70 c. $90.90 d. $51.90 McGraw-Hill/Irwin

Slide 96 Quick Check How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%? a. $62.10 $100 0.621 = $62.10 b. $56.70 c. $90.90 d. $51.90 McGraw-Hill/Irwin Slide 97 Present Value of a Series of Cash Flows An investment that involves a series of identical cash flows at the end of each year is called an annuity.

annuity $100 1 McGraw-Hill/Irwin $100 $100 2 $100 3 $100 4

$100 5 6 Slide 98 Present Value of a Series of Cash Flows An Example Lacey Inc. purchased a tract of land on which a $60,000 payment will be due each year for the next five years. What is the present value of this stream of cash payments when the discount rate is 12%? McGraw-Hill/Irwin Slide 99

Present Value of a Series of Cash Flows An Example We could solve the problem like this . . . Present Periods 1 2 3 4 5 Value of an Annuity 10% 12% 0.909 0.893 1.736 1.690 2.487 2.402 3.170

3.037 3.791 3.605 of $1 14% 0.877 1.647 2.322 2.914 3.433 $60,000 3.605 = $216,300 McGraw-Hill/Irwin Slide 100 Quick Check If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five

years? a. $34.33 b. $500.00 c. $343.30 d. $360.50 McGraw-Hill/Irwin Slide 101 Quick Check If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years? a. $34.33 b. $500.00 c. $343.30 $100 3.433 = $343.30 d. $360.50

McGraw-Hill/Irwin Slide 102 Income Taxes in Capital Budgeting Decisions Appendix 14C 2010 The McGraw-Hill Companies, Inc. Learning Objective 8 (Appendix 14C) Include income taxes in a capital budgeting analysis. McGraw-Hill/Irwin Slide 104 Simplifying Assumptions

Taxable income equals net income as computed for financial reports. The tax rate is a flat percentage of taxable income. McGraw-Hill/Irwin Slide 105 Concept of After-tax Cost An expenditure net of its tax effect is known as after-tax cost. Here is the equation for determining the after-tax cost of any tax-deductible cash expense: After-tax cost = (1-Tax rate)Tax-deductible cash expense (net cash outflow)

McGraw-Hill/Irwin Slide 106 After-tax Cost An Example Assume a company with a 30% tax rate is contemplating investing in a training program that will cost $60,000 per year. We can use this equation to determine that the after-tax cost of the training program is $42,000. After-tax cost = (1-Tax rate)Tax-deductible cash expense (net cash outflow) $42,000 = (1 - .30)$60,000 McGraw-Hill/Irwin Slide 107 After-tax Cost An Example

The answer can also be determined by calculating the taxable income and income tax for two alternativeswithout the training program and with the training program. The after-tax cost of the training program is the same$42,000. McGraw-Hill/Irwin Slide 108 After-tax Cost An Example The amount of net cash inflow realized from a taxable cash receipt after income tax effects have been considered is known as the after-tax benefit. After-tax benefit =

(net cash inflow) McGraw-Hill/Irwin (1-Tax rate)Taxable cash receipt Slide 109 Depreciation Tax Shield While depreciation is not a cash flow, it does affect the taxes that must be paid and therefore has an indirect effect on a companys cash flows. Tax savings from the depreciation = Tax rate Depreciation deduction tax shield McGraw-Hill/Irwin Slide 110

Depreciation Tax Shield An Example Assume a company has annual cash sales and cash operating expenses of $500,000 and $310,000, respectively; a depreciable asset, with no salvage value, on which the annual straight-line depreciation expense is $90,000; and a 30% tax rate. Tax savings from the depreciation = Tax rate Depreciation deduction tax shield McGraw-Hill/Irwin Slide 111 Depreciation Tax Shield An Example Assume a company has annual cash sales and cash operating expenses of $500,000 and $310,000, respectively; a depreciable asset, with no salvage value, on which the annual straight-line depreciation expense is $90,000;

and a 30% tax rate. Tax savings from the depreciation tax shield $27,000 = = Tax rate Depreciation deduction .30$90,000 The depreciation tax shield is $27,000. McGraw-Hill/Irwin Slide 112 Depreciation Tax Shield An Example The answer can also be determined by calculating the taxable income and income tax for two alternativeswithout the depreciation

deduction and with the depreciation deduction. The depreciation tax shield is the same $27,000. McGraw-Hill/Irwin Slide 113 Holland Company An Example Holland Company owns the mineral rights to land that has a deposit of ore. The company is deciding whether to purchase equipment and open a mine on the property. The mine would be depleted and closed in 10 years and the equipment would be sold for its salvage value. More information is provided on the next slide.

McGraw-Hill/Irwin Slide 114 Holland Company An Example Cost of equipment Working capital needed Estimated annual cash receipts from ore sales Estimated annual cash expenses for mining ore Cost of road repairs needed in 6 years Salvage value of the equipment in 10 years After-tax cost of capital Tax rate McGraw-Hill/Irwin $

$ 300,000 75,000 $ 250,000 $ 170,000 $ 40,000 $ 100,000 12%

30% Should Holland open a mine on the property? Slide 115 Holland Company An Example Step One: Compute the annual net cash receipts from operating the mine. Cash receipts from ore sales Less cash expenses for mining ore Net cash receipts McGraw-Hill/Irwin $

$ 250,000 170,000 80,000 Slide 116 Holland Company An Example Step Two: Identify all relevant cash flows as shown. Holland Company (1) (2) Items and Computations Cost of new equipment Working capital needed Annual net cash receipts Road repairs

Annual depreciation deductions Salvage value of equipment Release of working capital Net present value McGraw-Hill/Irwin Year Now Now 1-10 6 1-10 10 10 Amount $ (300,000) $ (75,000) $ 80,000 $ (40,000)

$ 30,000 $ 100,000 $ 75,000 Slide 117 Holland Company An Example Step Three: Translate the relevant cash flows to after-tax cash flows as shown. (1) Items and Computations Cost of new equipment Working capital needed Annual net cash receipts Road repairs Annual depreciation deductions Salvage value of equipment Release of working capital Net present value

McGraw-Hill/Irwin Year Now Now 1-10 6 1-10 10 10 Holland Company (2) (3) Tax Effect Amount (1)(2) $ (300,000) 0 $ (75,000)

0 $ 80,000 1-.30 $ (40,000) 1-.30 $ 30,000 .30 $ 100,000 1-.30 $ 75,000 0 (4) After-Tax Cash Flows $ (300,000) $ (75,000) $ 56,000 $ (28,000) $

9,000 $ 70,000 $ 75,000 Slide 118 Holland Company An Example Step Four: Discount all cash flows to their present value as shown. (1) Items and Computations Cost of new equipment Working capital needed Annual net cash receipts Road repairs Annual depreciation deductions Salvage value of equipment

Release of working capital Net present value McGraw-Hill/Irwin Year Now Now 1-10 6 1-10 10 10 Holland Company (2) (3) (4) (5) (6) Tax

Effect After-Tax Cash Amount (1) (2) Flows 12% Factor Present Value $ (300,000) 0 $ (300,000) 1.000 $ (300,000) $ (75,000) 0 $ (75,000) 1.000 (75,000) $ 80,000 1-.30 $

56,000 5.650 316,400 $ (40,000) 1-.30 $ (28,000) 0.507 (14,196) $ 30,000 .30 $ 9,000 5.650 50,850 $ 100,000 1-.30 $ 70,000 0.322 22,540 $ 75,000 0

$ 75,000 0.322 24,150 $ 24,744 Slide 119 End of Chapter 14 McGraw-Hill/Irwin Slide 120

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