Capital Budgeting Techniques part- 1.pdf

Capital Budgeting Techniques part- 1.pdf

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  Copyright © 2009Pearson Prentice Hall. All rightsreserved. Chapter 9 Capital Budgeting Techniques
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  Copyright © 2009Pearson Prentice Hall. All rights reserved. 9-2 Learning Goals 1. Understand the role of capital budgeting techniques in the capital budgeting process. 2. Calculate, interpret, and evaluate the payback period. 3. Calculate, interpret, and evaluate the net present value (NPV).
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  Copyright © 2009Pearson Prentice Hall. All rights reserved. 9-3 Learning Goals (cont.) 4. Calculate, interpret, and evaluate the internal rate of return (IRR). 5. Use net present value profiles to compare NPV and IRR techniques. 6. Discuss NPV and IRR in terms of conflicting rankings and the theoretical and practical strengths of each approach.
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  Copyright © 2009Pearson Prentice Hall. All rights reserved. 9-4 Bennett Company is a medium sized metal fabricator that is currently contemplating two projects: Project A requires an initial investment of $42,000, project B an initial investment of $45,000. The relevant operating cash flows for the two projects are presented in Table 9.1 and depicted on the time lines in Figure 9.1. Capital Budgeting Techniques • Chapter Problem
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  Copyright © 2009Pearson Prentice Hall. All rights reserved. 9-5 Capital Budgeting Techniques (cont.) Table 9.1 Capital Expenditure Data for Bennett Company
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  Copyright © 2009Pearson Prentice Hall. All rights reserved. 9-6 Capital Budgeting Techniques (cont.) Figure 9.1 Bennett Company’s Projects A and B
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  Copyright © 2009Pearson Prentice Hall. All rights reserved. 9-7 Payback Period • The payback method simply measures how long (in years and/or months) it takes to recover the initial investment. • The maximum acceptable payback period is determined by management. • If the payback period is less than the maximum acceptable payback period, accept the project. • If the payback period is greater than the maximum acceptable payback period, reject the project.
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  Copyright © 2009Pearson Prentice Hall. All rights reserved. 9-8 Pros and Cons of Payback Periods • The payback method is widely used by large firms to evaluate small projects and by small firms to evaluate most projects. • It is simple, intuitive, and considers cash flows rather than accounting profits. • It also gives implicit consideration to the timing of cash flows and is widely used as a supplement to other methods such as Net Present Value and Internal Rate of Return.
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  Copyright © 2009Pearson Prentice Hall. All rights reserved. 9-9 Pros and Cons of Payback Periods (cont.) • One major weakness of the payback method is that the appropriate payback period is a subjectively determined number. • It also fails to consider the principle of wealth maximization because it is not based on discounted cash flows and thus provides no indication as to whether a project adds to firm value. • Thus, payback fails to fully consider the time value of money.
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  9–1 Payback periodJordan Enterprises is considering a capital expenditure that requires an initial investment of $42,000 and returns after-tax cash inflows of $7,000 per year for 10 years. The firm has a maximum acceptable payback period of 8 years. a. Determine the payback period for this project. b. Should the company accept the project? Why or why not? Answer: (a) $42,000  $7,000 = 6 years (b) The company should accept the project.
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  9–2 Payback comparisons NovaProducts has a 5-year maximum acceptable payback period. The firm is considering the purchase of a new machine and must choose between two alternative ones. The first machine requires an initial investment of $14,000 and generates annual after-tax cash inflows of $3,000 for each of the next 7 years. The second machine requires an initial investment of $21,000 and provides an annual cash inflow after taxes of $4,000 for 20 years. a. Determine the payback period for each machine. b. Comment on the acceptability of the machines, assuming that they are independent projects. c. Which machine should the firm accept? Why? d. Do the machines in this problem illustrate any of the weaknesses of using payback? Discuss.
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  Answer: (a) Machine 1:$14,000  $3,000 = 4 years, 8 months Machine 2: $21,000  $4,000 = 5 years, 3 months (b) Only Machine 1 has a payback faster than 5 years and is acceptable. (c) The firm will accept the first machine because the payback period of 4 years, 8 months is less than the 5-year maximum payback required by Nova Products. (d) Machine 2 has returns which last 20 years while Machine 1 has only seven years of returns. Payback cannot consider this difference; it ignores all cash inflows beyond the payback period.
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  9–3 choosing betweentwo projects with acceptable payback periods Shell Camping Gear, Inc. is considering two mutually exclusive projects. Each requires an initial investment of $100,000. John Shell, president of the company, has set a maximum payback period of 4 years. The after-tax cash inflows associated with each project are as follows: a. Determine the payback period of each project. b. Because they are mutually exclusive, Shell must choose one. Which should the company invest in? c. Explain why one of the projects is a better choice than the other.