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CAPITAL BUDGETING & COST
ANALYSIS
LECTURE 9
Outline
Capital budgeting
Five stages in capital budgeting
Capital budgeting methods
NPV
IRR
Payback
ARR
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Two Dimension of
Cost Analysis
Project dimension—one
project spans multiple
accounting periods
Accounting period
dimension—one period
contains multiple
projects
Capital Budgeting
Capital budgeting Capital budgeting
is making long-run is a decision-
planning decisions making and control
for investing in tool that spans
projects. multiple years
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Identify projects—determine which types of
Stage capital investments are necessary to
1 accomplish organizational objectives and
strategies.
Five Stages in
Capital Stage Make predictions—forecast all potential cash
2 flows attributable to the alternative projects
Budgeting
Stage3 Obtain information—gather information from
parts of the value chain to evaluate projects
Five Stages in Capital Budgeting
Stage 4 Decision stage—determine which investment yields the greatest benefit
and least cost to the organization
Implementation and evaluate performance:
• Obtain funding.
Stage 5 • Track realized cash flows.
• Compare results to project predictions.
• Revise plans if necessary.
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Four Capital Budgeting Methods
Accrual
Net present Internal rate of accounting rate
Payback period
value (NPV) return (IRR) of return
(AARR)
Discounted Cash Flows
Discounted cash flow (DCF) methods measure all
expected future cash inflows and outflows of a
project as if they occurred at a single point in
time.
The key feature of DCF methods is the
time value of money (interest), meaning
that a dollar received today is worth more
than a dollar received in the future.
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Discounted Cash Flows
DCF methods use the required rate of return (RRR), which is the
minimum acceptable annual rate of return on an investment.
RRR is the return that an organization could expect to receive
elsewhere for an investment of comparable risk.
RRR is also called the discount rate, hurdle rate, cost of capital,
or opportunity cost of capital.
NPV method calculates the expected
monetary gain or loss from a project
by discounting all expected future
Net Present cash inflows and outflows to the
present point in time, using the RRR.
Value (NPV)
Method Based on financial factors alone, only
projects with a zero or positive NPV
are acceptable.
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Draw a sketch of the relevant cash
1. inflows and outflows.
Three-Step Convert the inflows and outflows
NPV Method 2. into present value figures using
tables or a calculator.
Sum the present value figures to
determine the NPV.
3. NPV >0 => accept
NPV < 0 => reject
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Lecture example – E21-22
• Yummy Candy Company is considering purchasing a second chocolate dipping
machine in order to expand their business. The information Yummy has
accumulated regarding the new machine is:
Cost of the machine $80,000
Increased annual contribution margin $15,000
Life of the machine 10 years
Required rate of return 6%
• Yummy estimates they will be able to produce more candy using the second
machine and thus increase their annual contribution margin. They also estimate
there will be a small disposal value of the machine but the cost of removal will
offset that value. Ignore income tax issues in your answers. Assume all cash
flows occur at year-end except for initial investment amounts
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Lecture example – NPV
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The IRR Method calculates the
discount rate at which the present
value of expected cash inflows from
a project equals the present value
Internal Rate of its expected cash outflows.
of Return
(IRR) Method
A project is accepted only if the IRR
equals or exceeds the RRR.
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Analysts use a calculator or computer
program to provide the IRR.
Trial and error approach:
IRR Method • Use a discount rate and calculate the project’s
NPV. Goal: find the discount rate for which
NPV = 0
• If the calculated NPV is greater than zero,
use a higher discount rate.
• If the calculated NPV is less than zero, use a
lower discount rate.
• Continue until NPV = 0.
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Lecture example – IRR
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NPV analysis is generally regarded as
the preferred method.
Comparison NPV expresses the computations in
dollars, not in percentages.
NPV and IRR
The NPV value can always be computed
Methods for a project.
NPV method can be used when the RRR
varies over the life of the project.
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Payback Method
Payback measures the time it will take to recoup, in the form of expected
future cash flows, the net initial investment in a project.
Shorter payback period are preferable.
Organizations choose a project payback period. The greater the risk, the
shorter the payback period.
Easy to understand.
The two weaknesses of the payback Fails to recognize the time value of money
method are: Doesn’t consider the cash flow beyond the payback point
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Payback Method
• With uniform cash flows:
• With non-uniform cash flows: add cash flows period-by-period
until the initial investment is recovered; count the number of
periods included for payback period.
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Lecture example – Payback
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Accounting Rate of Return Method (ARR)
• ARR method divides an accrual accounting measure of average
annual income of a project by an accrual accounting measure of
its investment.
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Firms vary in how they calculate
AARR
Easy to understand, and use
numbers reported in financial
statements
AARR Method
Does not track cash flows
Ignores time value of money
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Lecture example –ARR Method
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Evaluating Managers and
Goal-Congruence Issues
• Some firms use NPV for capital budgeting decisions and a different
method for evaluating performance.
• Managers may be tempted to make capital budgeting decisions on
the basis of short-run accrual accounting results, even though that
would not be in the best interest of the firm.
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Relevant cash flows are the
differences in expected future cash
flows as a result of making an
investment.
Relevant Cash
Flows in
Categories of cash flows:
DCF Analysis
• Net initial investment
• After-tax cash flow from operations
• After-tax cash flow from terminal disposal
of an asset and recovery of working capital
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Three components:
•Initial machine
investment
Net Initial
Investment •Initial working capital
investment
•After-tax cash flow
from current disposal
of old machine
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Cash Flow Two components:
from
Operations Inflows (after-tax) from
producing and selling
additional goods or Income tax cash savings
services, or from savings from annual
in operating costs— depreciation deductions
excludes depreciation,
handled below:
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Two components:
Terminal • After-tax cash flow from terminal
Disposal of disposal of asset (investment)
Investment • After-tax cash flow from recovery of
working capital (liquidating
receivables and inventory once
needed to support the project)
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Managing the Project
• Implementation and control:
• Management of the investment activity itself
• Management control of the project as a whole
• A post-investment audit may be done to provide management
with feedback about the performance of a project, so that
management can compare actual results to the costs and
benefits expected at the time the project was selected
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Strategic Considerations in
Capital Budgeting
• A company’s strategy is the source of its strategic capital
budgeting decisions.
• Some firms regard R&D projects as important strategic
investments.
• Outcomes very uncertain
• Far in the future
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