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Final Update Marti Pletch
Transcript of Final Update Marti Pletch
Capital Budgeting Analysis
FNT1 - 319.1.3-01, 2.1-04, 2.5 - 05
Net Cash Flow
Project Analysis - NPV basis
Net Present Value 12% Present
Cash Flows PV Factors Value
year 1 629,375 0.893 561,941.96
year 2 629,375 0.797 501,733.90
year 3 704,375 0.7118 501,360.21
year 4 704,375 0.6355 447,643.05
year 5 779,375 0.5674 442,238.31
year 6 779,375 0.5066 394,855.63
year 7 929,375 0.4524 420,402.05
year 8 929,375 0.4039 375,358.98 Working Capital Return 220,000 0.4039 88,854.31
Salvage Return 60,000 0.4039 24,232.99
Building restoration costs (140,000) 0.4039 (56,543.65)
Net Present Value
Project Analysis - IRR basis
Internal Rate of Return
Year 1 629,375
Year 2 629,375
Year 3 704,375
Year 4 704,375
Year 5 779,375
Year 6 779,375
Year 7 929,375
Year 8 + Working Cap + SV - Remodeling 1,069,375
Internal Rate of Return Using Excel 12.59%
Explanation of Capital Budgeting Analysis Methods
B4: Accounting Rate of Return vs IRR
B5 Significance of Payback period
B6 WACC use in Capital Budgeting with NPV
B7 WACC use in Capital Budgeting with IRR
Yr 2 with Yr 2 without Dollar Amt
Depreciation Depreciation Difference
Expected annual sales of new product $3,100,000 $3,100,000
Expected costs of new product
Cash expenses $2,400,000 $2,400,000
Depreciation expense $417,500 0
Income before taxes $282,500 $700,000 $417,500
Income tax at marginal rate $70,625 $175,000 $104,375
Net income $211,875 $525,000 $313,125
Net cash flow for one year $629,375 $525,000
*Depreciation was calculated on a straight line basis by dividing the total equipment cost by the number of useful years the product would have.
Depreciation causes net cash flow to increase because it is added back into the CF equation at a before tax rate, thus increasing cash flow.
- NPV is positive, based upon the cash flow analysis and the Net Present Value at year 8, the investor should go ahead with project because it has proven that it will yield a positive return.
Net Present Value is found by subtracting the present value of cash inflows minus cash outflows and is used for capital budgeting projects to analyze profitability
Rule: ACCEPT If
IRR > Required Rate of Return (Cost of Capital)
Cost Of Capital
Recommendation = ACCEPT
IRR > Cost of Capital
NPV is Positive
ARR vs IRR
Year 0 -3,620,000
Year 1 -2,990,625
Year 2 -2,361,250
Year 3 -1,656,875
Year 4 -952,500
Year 5 -173,125
Year 6 606,250
Year 7 Year 8
WACC used with NPV
For Capital Budgeting
WACC used with IRR
For Capital Budgeting
Accounting Rate of Return
"The average annual income from a project divided by the initial investment" (investopedia)
Internal Rate of Return
"The interest rate at which the present value of the dollars invested in a particular project would equal the present value of the cash inflows from the project." (investopedia)
IRR is the only method that uses the time value of money to account for the future growth of the money
ARR uses accounting profits while IRR uses cash inflows
Definition: The length of time that it takes for a Project to recoup its initial cost out of the cash receipts that it generates.
- Should NOT be sole criterion for analyzing an investment because it does NOT consider time value of money. IRR and NPV are better methods of analysis
Uses with NPV:
Represents the average risk of project
Used to find NPV factors that help adjust cash flows to present values
To find NPV Factors
WACC is the average weighted cost of all sources of capital.
WACC used in conjunction with IRR to determine whether a project should be accepted or rejected
Accept If IRR > WACC
Reject if IRR < WACC
Payback period is used in capital budgeting analysis to determine how long it will take to break even which allows investors to know how long they need they need to get a loan for.
1. Does not take into consideration the time value of money
2. Does not consider the cash flows after payback period.
3. Should not be used as stand alone criteria for investment decision
1. Simplicity of formula
2. Measures risk inherent in a project.
3. Is good for companies that have liquidity problems.