lecture 14 and 15 wk 9
TRANSCRIPT
-
8/6/2019 Lecture 14 and 15 Wk 9
1/25
-
8/6/2019 Lecture 14 and 15 Wk 9
2/25
CAPITAL BUDGETING
TECHNIQUES
Traditional methods
accounting rate of return (ARR)
payback period (PP)
Discounted cash flow techniques
internal rate of return (IRR)
net present value (NPV)
-
8/6/2019 Lecture 14 and 15 Wk 9
3/25
Lecture example
project cost $28 550
estimated life 4 years
estimated residual value zero
annual net cash inflow $10 000
required rate of return 10%
Average net profit $2862
-
8/6/2019 Lecture 14 and 15 Wk 9
4/25
Traditional methods of
project evaluation
Accounting rate of return
ARR = av net profit
av book value of investment
or = av net profit
total initial investment value
-
8/6/2019 Lecture 14 and 15 Wk 9
5/25
Traditional methods of
project evaluation
Accounting rate of return example
ARR = 2 862 =20%
14 275
or = 2 862 =10%
28 550
-
8/6/2019 Lecture 14 and 15 Wk 9
6/25
Accounting rate of
return (ARR)
advantages
easy to understand
managers are familiar with the
key concepts
-
8/6/2019 Lecture 14 and 15 Wk 9
7/25
-
8/6/2019 Lecture 14 and 15 Wk 9
8/25
Payback period
a risk-related measure used inpractice to supplement othertechniques
payback period
time required to recover the initialinvestment
-
8/6/2019 Lecture 14 and 15 Wk 9
9/25
Payback period
calculated by dividing the initialinvestment by the net cash inflow
project with the lowest payback periodis selected
Payback = initial investment
net cash inflow
-
8/6/2019 Lecture 14 and 15 Wk 9
10/25
Payback period
example
Payb w
Payback = 28 550 = 2.855 years
10 000
-
8/6/2019 Lecture 14 and 15 Wk 9
11/25
Payback period
advantages
easy to understand
provides some assessment of risk
-
8/6/2019 Lecture 14 and 15 Wk 9
12/25
Payback period
disadvantages
ignores cash flows after thepayback period and does notmeasure profitability
ignores time value of moneybecause cash flows are notdiscounted
overcome by using the discountedpayback method
-
8/6/2019 Lecture 14 and 15 Wk 9
13/25
Lecture 15
Capital decision cont
Reference - Chapter 16
-
8/6/2019 Lecture 14 and 15 Wk 9
14/25
Internal rate of
return (IRR)
Rate that equates the resent value
of theexpectedcashoutflowswiththepresent valueof theexpectedcash inflows
Accept projectswhichoffer an IRRaboveacertain ini umdesiredrateof return
-
8/6/2019 Lecture 14 and 15 Wk 9
15/25
IRR
OC = NCF1 + NCF2 ++ NCFn
(1+R)1 (1+R)2 (1+R)n
where
OC = original cost
NCF1 = net cash flow in year 1R = IRR 100
n = number of periods
-
8/6/2019 Lecture 14 and 15 Wk 9
16/25
IRR example
PVF = 28 550 = 2.855
10 000
From Table 4 appendix 2, we need tofind the factor of 2.855 for four periods
it equates to 15%ACCEPT PROJECT since IRR > cost of
capital
To help calculation when the cash flow isuneven, apply the rule
If NPV > 0 then IRR > cost of capital
If NPV < 0 then IRR < cost of capital
-
8/6/2019 Lecture 14 and 15 Wk 9
17/25
-
8/6/2019 Lecture 14 and 15 Wk 9
18/25
Internal rate of return
(IRR)
disadvantages
with certain cash flows there canbe multiple IRRs or no IRR
for mutually exclusive projects,
IRR can provide an incorrectranking of projects
-
8/6/2019 Lecture 14 and 15 Wk 9
19/25
-
8/6/2019 Lecture 14 and 15 Wk 9
20/25
NPV formula
OC = NCF1 + NCF2 ++ NCFn
(1+R)1 (1+R)2 (1+R)n
where
OC = original cost
NCF1 = net cash flow in year 1
R = required rate of return
n = number of periods
-
8/6/2019 Lecture 14 and 15 Wk 9
21/25
NPV example
NPV = -20 000 + 10 000 x PVF (10, 4)
= -20 000 + 10 000 x 3.1698
= $11 698
ACCEPT PROJECT
Decision rule is to accept project if theNPV is positive
-
8/6/2019 Lecture 14 and 15 Wk 9
22/25
Net present value (NPV)
advantages
recognises the time value of money
dollars can be added as they are inpresent valuescorrect ranking of mutually exclusive
projects
dependent on forecast cash flowsand opportunity cost of capital,rather than arbitrary guess bymanagement
-
8/6/2019 Lecture 14 and 15 Wk 9
23/25
Net present value (NPV)
disadvantages
how do we determine theminimum rate of return?
how accurate are forecast cashflows?
-
8/6/2019 Lecture 14 and 15 Wk 9
24/25
Comparison of IRR and NPV
independent projects
mutually exclusive projects
IRR and NPV rankings
reinvestment assumptions
qualitative factors
-
8/6/2019 Lecture 14 and 15 Wk 9
25/25
Group activity for
Tutorial next weekReview exercises:1, 2, &3. Page 500
Example 16.2 page 503
Example 16.3 page 505
Example 16.4 page508
Review Exercise4 page 510Review exercise5 page 510