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CAPITAL BUDGETING AND LEASING

CAPITAL BUDGETING AND LEASING. Chapter 4. Investment. The addition of durable assets to a business Disinvestment is the withdrawal of durable assets from the business. Investment Opportunities. Maintenance and replacement of depreciable capital items Adoption of cost-reducing investments

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CAPITAL BUDGETING AND LEASING

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  1. CAPITAL BUDGETING ANDLEASING Chapter 4

  2. Investment • The addition of durable assets to a business • Disinvestment is the withdrawal of durable assets from the business

  3. Investment Opportunities • Maintenance and replacement of depreciable capital items • Adoption of cost-reducing investments • Adoption of income-increasing investments • A combination of the above

  4. Investment Analysis • STEPS IN INVESTMENT ANALYSIS: • 1. IDENTIFY POTENTIALLY PROFITABLE INVESTMENT ALTERNATIVES • 2. COLLECT RELEVANT DATA ON: • CAPITAL OUTLAYS • COSTS • RETURNS • 3. USE AN APPROPRIATE METHOD TO ANALYZE THE DATA. • 4. DECIDE WHETHER TO ACCEPT OR REJECT THE INVESTMENT OR SELECT THE TOP RANKING AMONG MUTUALLY EXCLUSIVE PROJECTS.

  5. Capital Budgeting • The process of planning expenditures on assets whose returns will extend beyond one year.

  6. Weighted Average Cost of Capital There are two types of capital invested in a business: • Debt Capital • Equity Capital • What is the cost of debt? • What is the cost of equity?

  7. Weighted Average Cost of Capital • Kc = wd Kd + we Ke • Where: • Kc is the weighted average cost of capital • wd is the proportion of assets financed with debt • Kd is the cost of debt capital • we is the proportion of assets financed with equity • Ke is the cost of equity capital

  8. Payback Method • The payback method gives the number of years necessary to recover the initial investment. • Does not account for the timing of cash flows.

  9. Payback Method P = I / E WHERE: P = PAYBACK PERIOD IN YEARS I= INITIAL INVESTMENT OUTLAY E = ANNUAL NET CASH RETURN

  10. Simple Rate of Return • Expresses the average annual net income as a percentage of the amount invested. • This may be in terms of the initial capital outlay or the average amount invested over the useful life of the investment.

  11. Simple Rate of Return SRR= Y/I Where: SRR = SIMPLE RATE OF RETURN Y = AVERAGE ANNUAL NET CASH RECEIPTS (DEPRECIATION TAKEN INTO ACCOUNT) I = INITIAL INVESTMENT OUTLAY

  12. Calculation of Annual Cash Receipts Y=(E – D) WHERE: Y = AVERAGE ANNUAL NET INCOME E = TOTAL EXPECTED ANNUAL CASH RECEIPTS D= TOTAL ANNUAL DEPRECIATION

  13. Net Present Value (NPV) • With the NPV, the cash flows of the investment are discounted by a minimum acceptable compound annual rate of return. • The investment is judged to be acceptable if the present value of the cash inflows exceeds the investment’s present value of the cash outflows.

  14. Net Present Value (NPV) NPV = ΣPVCashInflows– ΣPVCash Outflows

  15. Benefit Cost Ratio • A ratio that utilizes the same two elements of the Net Present Value. B/C = ΣPV cash inflows / ΣPV cash outflows

  16. Internal Rate of Return (IRR) • The IRR is the compound interest rate that equates the present value of the future net cash inflows with the cash outflows. • Or in other words the discount rate that gives a NPV = Zero. • Both the NPV and IRR take into account the time value of money. • The purpose of these investment analysis techniques is to evaluate the acceptability of investments relative to an acceptable rate of return.

  17. What goes into the Discount Rate? • The discount rate should reflect the cost of capital or the cost of funds used to finance the business. • An investment is not acceptable unless it generates a return sufficient to cover the cost of funds.

  18. What goes into the Discount Rate? The discount rate contains three components: • Real Risk-Free Rate • Risk Premium • Inflation Expectations

  19. Other Considerations Regarding Capital Budgeting • Profitability Index • Used to allocate limited capital among several independent projects. • Present value of the cash inflows divided by the cash outflows.

  20. Other Considerations Regarding Capital Budgeting • Annuity Equivalent • Used to compare NPVs with unequal lives.

  21. Other Considerations Regarding Capital Budgeting • Financial Feasibility • Once you have evaluated an investment, the financing of the project should be determined. • After-tax cash flows may not be sufficient to meet debt repayment requirements.

  22. Comparing Four Methods Among Three Investments

  23. Cash Flows for Three Investments

  24. Payback Method • A 20000/6000 = 3.33 YEARS • B 20000/5800 = 3.45 YEARS • C 20000/5600 = 3.57 YEARS

  25. Simple Rate of Return • A (30000-20000)/5 = 2000 • 2000/20000 = 0.10 10% • B (29000-20000)/5 = 1800 • 1800/20000 = 0.09 9% • C (28000-20000)/5 = 1600 • 1600/20000 = 0.08 8%

  26. Net Present Value • A NPV = -20000 + 2000/(1.08) + 4000/(1.08)2 + 6000/(1.08)3 + 8000/(1.08)4 + 10000/(1.08)5 + 0/(1.08)5 • NPV = -20000 + 1852 + 3429 + 4763 + 5880 + 6806 + 0 • NPV = 2730

  27. Net Present Value and Internal Rate of Return • A NPV = 2730 IRR = 12.01 • B NPV = 3158 IRR = 13.82 • C NPV = 3766 IRR = 17.57

  28. Leasing Versus Owning

  29. Leasing Versus Owning • A lease represents an agreement that gives control over an asset owned by the lessor to the lessee for a specific period of time upon the payment of an agreed upon amount, known as rent.

  30. Types of Leases • IN NON-REAL ESTATE LEASING THERE ARE SEVERAL TYPES OF LEASES: • OPERATING LEASE • CAPITAL (OR FINANCIAL) LEASE • CUSTOM HIRE

  31. Operating Lease • USUALLY A SHORT-TERM RENTAL ARRANGEMENT IN WHICH THE RENTALCHARGE IS CALCULATED ON A TIME BASIS. • SUCH AS THE HOUR OR THE DAY, ETC. • THE LESSEE PAYS THE DIRECT COST SUCH AS FUEL AND LABOR.

  32. Capital or Financial Lease • A LONG - TERM CONTRACTUAL ARRANGEMENT IN WHICH THE LESSEE ACQUIRES CONTROL OF AN ASSET IN RETURN FOR RENTAL PAYMENTS. • USUALLY RUNS FOR SEVEAL YEARS AND CANNOT BE CANCELLED WITHOUT PENALTY. • IS FULLY AMORTIZED, MEANING THAT THE PRESENT VALUE OF THE LEASE PAYMENTS EQUALS THE FULL PRICE OF THE LEASED EQUIPMENT. • MAY HAVE A PRUCHASE OPTION AT THE END OF THE LEASE.

  33. Capital Vs. Operating Lease • Capital lease transfers some of the risks of ownership to the lessee.

  34. Issues in Capital Leasing • Advantages: • CONSERVATION OF WORKING CAPITAL • NEARLY 100% FINANCING • THE USE OF MODERN EQUIPMENT • POSSIBLE TAX BENEFITS

  35. Evaluation of a lease vs. Purchase • May be evaluated by looking at the present value of cash flows for each option.

  36. Sample Problem • $ 30,000 TRUCK • 35% TAX BRACKET • 12% COST OF CAPITAL • PURCHASE • 30% DOWN PAYMENT • LEVEL PAYMENTS • 10% INTEREST • 5 YEARS • LEASE • 5 YEAR LEASE • ANNUAL PAYMENTS OF $7,000

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