#26.2 -- Payback Period and Average Rate of Return (10.54)

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Capital Budgeting:

Capital Budgeting Chapter 26

Chapter 26 & Appendix B Outcomes: Capital Budgeting:

Chapter 26 & Appendix B Outcomes: Capital Budgeting Explain the concept of time value of money. Describe the difference between present value and future value of money. Describe the process of capital budgeting. Use the Payback Period method of capital budgeting to determine length of time needed to recover investment. Use the Average Rate of Return to make long-term business decisions. Use Discounted Cash Flows (Net Present Value) to make long-term business decisions.

Capital Investment Decisions:

Capital budgeting: Analyzing alternative long-term investments and deciding which assets to acquire or sell. Outcome is uncertain. Large amounts of money are usually involved. Investment involves a long-term commitment. Decision may be difficult or impossible to reverse. Capital Investment Decisions

Capital Investment Decisions:

? ? ? Plant Expansion New Equipment Office Renovation Which project will provide the most profitable return on available funds? Capital Investment Decisions Limited Investment Funds

Capital Investment Decisions: Typical Cash Outflows:

Incremental operating costs Initial investment Repairs and maintenance Capital Investment Decisions: Typical Cash Outflows

Capital Investment Decisions: Typical Cash Inflows:

Incremental revenues Cost savings Salvage value Capital Investment Decisions: Typical Cash Inflows

Evaluating Capital Investment Proposals: An Illustration:

Stars’ Stadium is considering purchasing vending machines with a 5-year life. The cost is $75,000 with a salvage value of $5,000. ($75,000 - $5,000) ÷ 5 years Evaluating Capital Investment Proposals: An Illustration

Evaluating Capital Investment Proposals: An Illustration:

Most capital budgeting techniques use annual net cash flow . Depreciation is not a cash outflow. Depreciation usually is added back in to determine cash flow. Evaluating Capital Investment Proposals: An Illustration

Capital Budgeting Method #1: Payback Period:

The payback period of an investment is the time expected to recover the initial investment amount. Managers prefer investing in projects with shorter payback periods. Capital Budgeting Method #1: Payback Period Payback period = Amount to Be Invested Estimated Annual Net Cash Flow

Payback Period:

Payback period = $75,000 $24,000 = 3.125 years Payback Period The payback period of an investment is the time expected to recover the initial investment amount. Payback period = Amount to Be Invested Estimated Annual Net Cash Flow

Weaknesses of Payback Period:

Weaknesses of Payback Period Ignores the time value of money. Ignore the cash flows after the payback period. Because of these weaknesses, the payback period is usually just an initial method used to determine capital budgeting.

Payback Period:

Consider two projects, each with a five-year life and each costing $6,000. Would you invest in Project One just because it has a shorter payback period? Payback Period

Capital Budgeting Method #2: Return on Average Investment (ROI):

ROI = Average estimated net income Average investment Original cost + Salvage value 2 Capital Budgeting Method #2: Return on Average Investment (ROI) ROI focuses on annual income instead of cash flows (so depreciation does need to be considered).

Evaluating Capital Investment Proposals: An Illustration:

Stars’ Stadium is considering purchasing vending machines with a 5-year life. The cost is $75,000 with a salvage value of $5,000. ($75,000 - $5,000) ÷ 5 years Evaluating Capital Investment Proposals: An Illustration ROI = = 25% $10,000 $40,000 $75,000 + $5,000 2 ROI focuses on annual income instead of cash flows.

Weakness of Return on Average Investment (ROI):

Weakness of Return on Average Investment (ROI) Income may vary from year to year. Time value of money is ignored. So the preferred method for capital budgeting is to use the time value of money, which we will discuss in our next video lecture.

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