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PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Capital Budgeting DecisionsChapter 13
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Typical Capital Budgeting Decisions
Plant expansion
Equipment selection
Lease or buy Cost reduction
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Typical Capital Budgeting DecisionsCapital budgeting tends to fall into two broad categories.
1. Screening decisions. Does a proposed project meet some preset standard of acceptance?
2. Preference decisions. Selecting from among several competing courses of action.
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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.
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13-5
Time Value of Money
The capital budgeting
techniques that best recognize the time value of money are those that involve discounted cash
flows.
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Learning Objective 1
Evaluate the acceptability of an
investment project using the net present value
method.
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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.
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The Net Present Value Method
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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.
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Typical Cash Outflows
Repairs andmaintenance
Incrementaloperating
costs
Initialinvestment
Workingcapital
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Typical Cash Inflows
Reductionof costs
Salvagevalue
Incrementalrevenues
Release ofworkingcapital
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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.
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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?
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Present value
of an annuityof $1 table
Recovery of the Original Investment
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Recovery of the Original Investment
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.
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Two Simplifying AssumptionsTwo simplifying assumptions are usually made
in net present value analysis:
All cash flows other than the initial
investment occur at the end of periods.
All cash flows generated by an
investment project are immediately
reinvested at a rate of return equal to the
discount rate.
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Choosing a Discount Rate
• The firm’s 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.
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The Net Present Value Method
Lester Company has been offered a five year contract to provide component parts for a large manufacturer.
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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?
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The Net Present Value Method
Annual net cash inflow from operations
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The Net Present Value Method
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The Net Present Value Method
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The Net Present Value Method
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Present value of $1 factor for 5 years at 10%.
The Net Present Value Method
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Accept the contract because the project has a positive net present value.
The Net Present Value Method
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Quick Check ✓
• The working capital would be released at the end of the contract.
• Denny Associates requires a 14% return.
Denny Associates has been offered a four-year contract to supply the computing requirements for a local bank.
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Quick Check ✓
What is the net present value of the contract with the local bank?
a. $150,000b. $ 28,230c. $ 92,340d. $132,916
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Quick Check ✓
What is the net present value of the contract with the local bank?
a. $150,000b. $ 28,230c. $ 92,340d. $132,916
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Learning Objective 2
Evaluate the acceptability of an
investment project using the internal rate of
return method.
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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 project’s 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.
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Internal Rate of Return MethodGeneral decision rule . . .
When using the internal rate of return, the cost of capital acts as a hurdle rate
that a project must clear for acceptance.
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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.
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Internal Rate of Return Method
Investment required Annual net cash flows
PV factor for theinternal rate of return =
$104, 320 $20,000
= 5.216
Future cash flows are the same every year in this example, so we can calculate the internal rate of
return as follows:
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Internal Rate of Return Method
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%.
Using the present value of an annuity of $1 table . . .
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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 company’s required rate of return, the project is acceptable.
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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
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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
$79,310/$22,000 = 3.605,which is the present value factor
for an annuity over five years when the interest rate is 12%.
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Comparing the Net Present Value andInternal 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.
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•NPV is often simpler to use.
•Questionable assumption:▫ Internal rate of return method assumes cash inflows are reinvested at the internal rate of return.
Comparing the Net Present Value and Internal Rate of Return Methods
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Expanding the Net Present Value Method
To compare competing investment projects we can use the following net present value approaches:
1. Total-cost2. Incremental cost
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The Total-Cost Approach
White Company has two alternatives:1. remodel an old car wash or, 2. remove the old car wash and install a new one.
The company uses a discount rate of 10%.
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The Total-Cost Approach
If White installs a new washer . . .
Let’s look at the present valueof this alternative.
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The Total-Cost Approach
If we install the new washer, the investment will yield a positive net
present value of $83,202.
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The Total-Cost Approach
If White remodels the existing washer . . .
Let’s look at the present valueof this second alternative.
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The Total-Cost Approach
If we remodel the existing washer, we will produce a positive net present
value of $56,405.
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The Total-Cost ApproachBoth 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.
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The Incremental-Cost Approach
Under the incremental-cost approach, only those cash flows that differ between the two alternatives
are considered.
Let’s look at an analysis of the White Company decision using the incremental-cost approach.
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The Incremental-Cost Approach
We get the same answer under either thetotal-cost or incremental-cost approach.
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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 $5,230b. NPV of Project B > NPV of Project A by $5,230c. NPV of Project A > NPV of Project B by $2,000d. NPV of Project B > NPV of Project A by $2,000
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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 $5,230b. NPV of Project B > NPV of Project A by $5,230c. NPV of Project A > NPV of Project B by $2,000d. NPV of Project B > NPV of Project A by $2,000
Quick Check ✓
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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.
Let’s look at the Home Furniture Company.
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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%.
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Least Cost DecisionsHere is information about the trucks . . .
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Least Cost Decisions
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Least Cost Decisions
Home Furniture should purchase the new truck.
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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. $15,000b. $90,000c. $24,317d. $60,000
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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. $15,000b. $90,000c. $24,317d. $60,000
Quick Check ✓
$70,860/2.914 = $24,317
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Learning Objective 3
Evaluate an investment project that has
uncertain cash flows.
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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?
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Uncertain Cash Flows – An Example
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.
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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.
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Learning Objective 4
Rank investment projects in order of
preference.
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Preference Decision – The Ranking of Investment Projects
Screening Decisions
Pertain to whether or not some proposed
investment is acceptable; these
decisions come first.
Preference Decisions
Attempt to rank acceptable
alternatives from the most to least
appealing.
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Internal Rate of Return Method
The higher the internal rate of return, the
more desirable the project.
When using the internal rate of return method to rank competing investment
projects, the preference rule is:
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Net Present Value MethodThe net present value of one project cannot
be directly compared to the net present value of another project unless the
investments are equal.
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Ranking Investment Projects Project Net present value of the project profitability Investment required index
=
The higher the profitability index, themore desirable the project.
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Other Approaches toCapital Budgeting Decisions
Other methods of making capital budgeting decisions include:
1. The Payback Method.2. Simple Rate of Return.
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Learning Objective 5
Determine the payback period for an investment.
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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:
The Payback Method
Payback period = Investment required Annual net cash inflow
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The Payback Method
Management at The Daily Grind wants to install an espresso bar in its restaurant that
1. Costs $140,000 and has a 10-year life.2. Will generate annual net cash inflows of
$35,000.
Management requires a payback period of 5 years or less on all investments.
What is the payback period for the espresso bar?
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The Payback Method
Payback period = Investment required Annual net cash inflow
Payback period = $140,000 $35,000
Payback period = 4.0 years
According to the company’s criterion, management would invest in the espresso bar
because its payback period is less than 5 years.
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Quick Check ✓ Consider the following two investments:
Project X Project YInitial investment $100,000 $100,000Year 1 cash inflow $60,000 $60,000Year 2 cash inflow $40,000 $35,000Year 14-10 cash inflows $0 $25,000Which project has the shortest payback period?
a. Project Xb. Project Yc. Cannot be determined
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Consider the following two investments:Project X Project Y
Initial investment $100,000 $100,000Year 1 cash inflow $60,000 $60,000Year 2 cash inflow $40,000 $35,000Year 14-10 cash inflows $0 $25,000Which project has the shortest payback period?
a. Project Xb. Project Yc. Cannot be determined
Quick Check ✓
•Project X has a payback period of 2 years.•Project Y has a payback period of slightly more than 2 years.•Which project do you think is better?
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Evaluation of the Payback Method
Ignores the time valueof money.
Ignores cashflows after
the paybackperiod.
Short-comingsof the payback
period.
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Evaluation of the Payback MethodServes as screening
tool.Identifies
investments that recoup cash investments
quickly.Identifies
products that recoup initial investment
quickly.
Strengthsof the payback
period.
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Payback and Uneven Cash Flows
1 2 3 4 5
$1,000 $0 $2,000 $1,000 $500
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.
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Payback and Uneven Cash Flows
1 2 3 4 5
$1,000 $0 $2,000 $1,000 $500
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.
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Learning Objective 6
Compute the simple rate of return for an
investment.
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Simple Rate of Return Method
Simple rateof return =
Annual incremental net operating income -
Initial investment*
*Should be reduced by any salvage from the sale of the old equipment
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:
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Simple Rate of Return Method
Management of The Daily Grind wants to install an espresso bar in its restaurant that:
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?
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Simple Rate of Return Method
Simple rateof return
$35,000 $140,000 = 25%=
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Criticism of the Simple Rate of Return
Ignores the time valueof money.
The same project may appear
desirable in some years and
undesirable in other years.
Short-comingsof the simple rate of return.
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Postaudit of Investment Projects
A postaudit is a follow-up after the project has been completed to see whether or not
expected results were actually realized.
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PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
The Concept of Present ValueAppendix 13A
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Learning Objective 7
(Appendix 13A)
Understand present value concepts and the
use of present value tables.
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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.
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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.
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The Mathematics of Interest – An Example
Fn = P(1 + r)n F1 = $100(1 + .08)1
F1 = $108.00
Assume a bank pays 8% interest on a $100 deposit made today. How much
will the $100 be worth in one year?
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Compound Interest – An Example
Fn = P(1 + r)n
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?
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.
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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.
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Computation of Present Value
Present Value
Future Value
An investment can be viewed in two ways—its future value or its present
value.
Let’s look at a situation where the future value is known and the present
value is the unknown.
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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?
(1 + r)nP =Fn
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.
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Present Value – An Example
(1 + .12)2P =$100
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.
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Present Value – An Example Let’s 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.
If $79.72 is put in the bank today and earns 12%, it will be worth $100 in two years.
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Present Value – An Example
$100 × 0.797 = $79.70 present value
Present value factor of $1 for 2 periods at 12%.
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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. $62.10b. $56.70c. $90.90d. $51.90
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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. $62.10b. $56.70c. $90.90d. $51.90
Quick Check ✓
$100 × 0.621 = $62.10
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Present Value of a Series of Cash Flows
1 2 3 4 5 6
$100 $100 $100 $100 $100 $100
An investment that involves a series of identical cash flows at the end of each year is
called an annuity.
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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%?
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Present Value of a Series of Cash Flows – An Example
We could solve the problem like this . . .
$60,000 × 3.605 = $216,300
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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. $34.33b. $500.00c. $343.30d. $360.50
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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. $34.33b. $500.00c. $343.30d. $360.50
Quick Check ✓
$100 × 3.433 = $343.30
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PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Income Taxes in Capital Budgeting DecisionsAppendix 13C
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Learning Objective 8
(Appendix 13C)
Include income taxes in a capital budgeting
analysis.
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Simplifying Assumptions
Taxable income equals net income as
computed for financial reports.
The tax rate is a flat percentage of taxable income.
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Concept of After-tax CostAn 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:
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After-tax Cost – An ExampleAssume 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.
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After-tax Cost – An ExampleThe answer can also be determined by
calculating the taxable income and income tax for two alternatives—without the training program and with the training program.
The after-tax cost of the training program is
the same—$42,000.
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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.
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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 company’
s cash flows.
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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.
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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.
The depreciation tax shield is $27,000.
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Depreciation Tax Shield – An Example
The answer can also be determined by calculating the taxable income and income tax for two alternatives—without the depreciation
deduction and with the depreciation deduction.
The depreciation tax shield is the
same—$27,000.
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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.
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Holland Company – An Example
Should Holland
open a mine on the
property?
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Holland Company – An Example
Step One: Compute the annual net cash receipts from operating the mine.
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Holland Company – An ExampleStep Two: Identify all relevant cash
flows as shown.
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Holland Company – An ExampleStep Three: Translate the relevant cash
flows to after-tax cash flows as shown.
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Holland Company – An ExampleStep Four: Discount all cash flows to
their present value as shown.
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End of Chapter 13