Capital Budgeting Decisions
What types of business decisions
require capital budgeting analysis?
• Business decisions that require capital
budgeting analysis are decisions that
involve in outlay now in order to obtain
some return in the future.
• Cost reduction decisions. Should new
equipment be purchased to reduce costs?
• Expansion decisions. Should a new
plant, warehouse, or other facility be
acquired to increase capacity and sales?
• Equipment selection decision. Which of
several available machines should be the
most cost effective to purchase?
• Lease or buy decisions. Should new
equipment be leased or purchased?
• Equipment replacement decisions.
Should old equipment be replaced now or
later?
Methods of Ranking Investment
Proposals
• Payback Method
• Internal Rate of Return
• Net Present Value
Payback Method
• The payback method focuses on the payback
period. The payback period is the length of time
that it takes for a project to recoup its initial cost
out of the cash receipts that it generates. This
period is some times referred to as" the time that
it takes for an investment to pay for itself." The
basic premise of the payback method is that the
more quickly the cost of an investment can be
recovered, the more desirable is the investment.
The payback period is expressed in years.
Payback Method
The formula or equation for the calculation of payback period is as
follows:
Payback period = Investment required ÷
Net annual cash inflow*
*If new equipment is replacing old equipment, this becomes
incremental net annual cash inflow.
Payback Method
• Smart Globe Company needs a new milling machine.
The company is considering two machines. Machine A
and machine B. Machine A costs $15,000 and will
reduce operating cost by $5,000 per year. Machine B
costs only $12,000 but will also reduce operating costs
by $5,000 per year.
Required:
– Calculate payback period.
– Which machine should be purchased according to
payback method?
Payback Method
Calculation:
• Machine A payback period = $15,000 / $5,000 = 3.0 years
• Machine B payback period = $12,000 / $5,000 = 2.4 years
– According to payback calculations, Smart Globe Company
should purchase machine B, since it has a shorter payback
period than machine A.
Payback Method
• Payback and Uneven Cash Flows:
Payback Method
• Payback and Uneven Cash Flows:
Internal Rate of Return
• The internal rate of return (IRR) is the rate of
return promised by an investment project over its
useful life. It is some time referred to simply as
yield on project. The internal rate of return is
computed by finding the discount rate that
equates the present value of a project's cash out
flow with the present value of its cash inflow In
other words, the internal rate of return is that
discount rate that will cause the net present
value of a project to be equal to zero.
Internal Rate of Return
• Compute the IRR for an investment of $1,000
returning an annuity of $244 per year for five
years.
– Investment ÷ Annuity = $1,000/$244 = 4.1
– PVA indicates that a factor of 4.1 for 5 years has a
yield of 7%
Net Present Value
• Under the net present value method, the present
value of a project's cash inflows is compared to
the present value of the project's cash
outflows. The difference between the present
value of these cash flows is called "the net
present value". This net present value
determines whether or not the project is an
acceptable investment. To illustrate consider the
following data.
Net Present Value
Net Present Value
• Harper company is contemplating the purchase
of a machine capable of performing certain
operations that are now performed manually.
The machine will cost $5,000, and it will last for
five years. At the end of five-years period the
machine will have a zero scrap value. Use of the
machine will reduce labor costs by $1,800 per
year. Harper company requires a minimum
pretax return of 20% on all investment projects.
Net Present Value
• Should the machine be purchased? Harper
company must determine whether a cash
investment now of $5,000 can be justified if it will
result in an $1,800 reduction in cost each year over
the next five years. It may appear that the answer is
obvious since the total cost savings is $9,000 (5 ×
$1800). However, the company can earn a 20%
return by investing its money elsewhere. It is not
enough that the cost reductions cover just the
original cost of the machine. they must also yield at
least 20% return or the company would be better off
investing the money elsewhere.
Net Present Value
• To determine whether the investment is desirable,
the stream of annual $1,800 cost savings is
discounted to its present value and then compared
to the cost of the new machine. Since Harper
company requires a minimum return of 20% on all
investment projects, this rate is used in the
discounting process and is called the discount rate.
Net Present Value
Net Present Value
• According to this analysis, Harper company should
purchase the new machine. The present value of the
cost savings is $5,384, as compared to a present
value of only $5,000 for the required investment
(cost of the machine). Deducting the present value
of the required investment from the present value of
the cost savings a net value of $384. Whenever the
net present value is zero or greater, as in our
example, an investment project is acceptable.
Whenever the net present value is negative an
investment project is not acceptable.