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 • 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 • 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.