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Capital InvestmentCapital Investment

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Payback and Accounting Rate of Payback and Accounting Rate of Return: Nondiscounting Return: Nondiscounting MethodsMethods

2

Payback Period: the time required for a firm to recover its original investment.

When the cash flows of a project are assumed to be even, the following formula can be used to compute the

project’s payback period:

Payback period = original investment/annual cash flow

If the cash flows are uneven, the payback period is computed by adding the annual cash flows until such time

as the original investment is recovered.

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Payback and Accounting Rate of Payback and Accounting Rate of Return: Nondiscounting Return: Nondiscounting MethodsMethods

2

• The payback period provides information to managers that can be used as follows:• To help control the risks associated with the

uncertainty of future cash flows.• To help minimize the impact of an investment on a

firm’s liquidity problems.• To help control the risk of obsolescence.• To help control the effect of the investment on

performance measures.

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Payback and Accounting Rate of Payback and Accounting Rate of Return: Nondiscounting Return: Nondiscounting MethodsMethods

2

Accounting Rate of Return (ARR)

Measures the return on a project in terms of income, as opposed to using a project’s cash flow

Accounting rate of return = Average income /Original investment

Where:

Average income = average annual net cash flows less average depreciation

Original investment (or average investment) = (I+S)/2 (I is the original investment and S is the salvage value). Assume that the investment is uniformly consumed.

The major deficiency of the accounting rate of return is that it ignores the time value of money.

19-5

The Net Present Value The Net Present Value MethodMethod 3

• Net Present value is the difference between the present value of the cash inflows and outflows associated with a project:

NPV = P - 1Where:

P = the present value of the project’s future cash inflows

I = the present value of the project’s cost (usually the initial outlay)

NPV measures the profitability of an investment. If the NPV is positive, it measures the increase in wealth

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The Net Present Value The Net Present Value MethodMethod 3

Decision Criteria for NPVIf the NPV is positive, it signals that1) The initial investment has been recovered2) The required rate of return has been recovered3) A return in excess of (1) and (2) has been received

Reinvestment Assumption: The NVP model assumes that all cash flows generated by a project are immediately reinvested to earn the required rate of return throughout the life of the project.

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Internal Rate of ReturnInternal Rate of Return 4

The internal rate of return (IRR) is the interest rate that sets the present value of a project’s cash inflows equal to the present value of the project’s cost.

It is the interest rate that sets the project’s NPV at zero.

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Internal Rate of ReturnInternal Rate of Return 4

Decision Criteria:

If the IRR>Cost of Capital, the project should be accepted.

If the IRR = Cost of Capital, acceptance or rejection is equal.

If the IRR < Cost of Capital, the project should be rejected.

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NPV versus ITT: Mutually NPV versus ITT: Mutually Exclusive ProjectsExclusive Projects 5

There are two major differences between net present value and the internal rate of return:

• NPV assumes cash inflows are reinvested at the required rate of return, whereas the IRR method assumes that the inflows are reinvested at the internal rate of return.

• NPV measures the profitability of a project in absolute dollars, whereas the IRR methods measures it as a percentage.

19-10

Computing After-Tax Computing After-Tax Cash FlowsCash Flows 6

• To analyze tax effects, cash flows are usually broken into three categories:

1. The initial cash outflows needed to acquire the assets of the project

2. The cash flows produced over the life of the project (operating cash flows)

3. The cash flows from the final disposal of the project

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Computing After-Tax Cash FlowsComputing After-Tax Cash Flows6

MACRS Depreciation

The taxpayer can use either the straight-line or the modified accelerated cost recovery system (MACRS) to compute annual

depreciation with a half year convention

The tax laws classify most assets into the following three classes (class = allowable years for depreciation):

Class 3: most small tools

Class 5: cars, light trucks, computer equipment

Class 7: machinery, office equipment

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Capital Investment: Advanced Capital Investment: Advanced Technology and Environmental Technology and Environmental ConsiderationsConsiderations

7

How Estimates of Operating Cash Flows Differ

A company is evaluating a potential investment in a flexible manufacturing system (FMS). The choice is to continue producing with its traditional equipment, expected to last 10 years, or to switch to the new system, which is also expected to have useful life of 10 years. The company’s discount rate is 12 percent.

Present value ($4,000,000 * 5.65) $22,600,000

Investment 18,000,000

Net Present Value $ 4,600,000