5-money in organizations

7/28/2019 5-Money in Organizations

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1-Capital budgeting

Capital budgeting is the making of long-run planning decisions for

investments in projects and programs

It is a decision-making and control tool that focuses primarily on projectsor programs that span multiple years

Capital budgeting is a six-stage process:

1. Identification stage

2. Search stage

3. Information-acquisition stage

4. Selection stage5. Financing stage

6. Implementation and control stage

2ULF-Spring 2012-Industrial Management By Georges Abboudeh


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1.1-Payback Method Definition

Paybackmeasures the time it will take to recoup, in the form ofexpected future cash flows, the initial investment in a project.Orit calculates how long it takes to recover the initial investment

Advantages It is simple Focus on cash flow

Disadvantages

Ignore investment after payback period Ignore time value of money Does not account properly for risk Does not lead to value-maximizing decisions



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1.1-Payback Method example 1

An assisted Living is considering buying a machine 1Initial investment is $210,000

Useful life is eleven years

Estimated residual value is zero

Net cash inflows is $35,000 per year

How long would it take to recover the investment?

$210,000 $35,000 = 6 years

Six years is the payback period



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1.1-Payback Method example 2

Suppose that as an alternative to the $210,000 piece of equipment, thereis another one (Machine 2) that also costs $210,000 but will save$42,000 per year during itsfive-year life

What is the payback period?

$210,000 $42,000 = 5 yearsFive years is the payback period

Machine 2 is more preferable than machine 1



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1.1-Payback Method example 3 Assisted Living is considering buying Machine 3

Initial investment is $250,000 Useful life is eleven years

Cash savings are $160,000, $180,000 for year 1 and 2 respectively

and $110,000 over its life

What is the payback period?Year 1 brings in $160,000, Recovery of the amount invested occurs in Year 2.

Payback = 1 year

+ $ 90,000 needed to complete recovery

/ 180,000 net cash inflow in Year 2

= 1 year + 0.5 year

= 1.5 years or 1 year and 6 months



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1.2-Discounted cash flow (DCF)

FV= PV( 1 + r)n

PV= FV/( 1 + r)n

Where

Investment of 10.000 with 10% interest rate

Future value

Year1 : (1+ 0.1) x10.000

Year2 : (1+ 0.1)2

x10.000Year3 : (1+ 0.1)3 x10.000

Year4 : (1+ 0.1)4x10.000

Year5 : (1+ 0.1)5x10.000

FV : future valuePV : Present valuer: Interest raten: number of periods (years usually)



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1.2-Discounted cash flow (DCF)

The discounted cash flow technique compare the value of the future costflows of the project to todays dollars

DCF is calculated for the project for comparing alternative ways of doing it

Example

Project A is expected to make 100.000 $ in 2 yearsProject B is expected to make 120.000 $ in 3 years

The cost of capital is 12%

PV for A = 79.719

PV for B = 85.414

Project B is the project that will return highest investment



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1.3-Net present value (NPV) Based on the dollar amount of cash f lows

The dollar amount of value added by a project

NPV equals the present value of cash inflows minus initial investment

NPV = Pvi - Investment

If NPV >0 accept the project

Projects with high return early are better than with lower return early.

Project A r=12%

Year Inflow PV

1 10.000 8.929

2 15.000 11.958

3 5.000 3.559Total 30.000 24.446

Investment 24.000

NPV 446

Project B r=12%

Year Inflow PV

1 7.000 6.250

2 13.000 3.364

3 10.000 7.118Total 30.000 24.732

Investment 24.000

NPV - 268

N

N

r

CF

r

CF

r

CF

r

CFCFNPV

)1(...

)1()1()1()(

3

3

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210



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1.3-Net present value (NPV)

Initial investment is $245,000.

Investment in working capital is $5,000. Working capital will be recovered.

Useful life is three years.

Estimated residual value is $4,000.

Net cash savings is $80,000 per year.

Expected return is 10%.

Net Cash NPV of NetYears 10% Col. Inflows Cash Inflows

1-3 2.487 $80,000 $198,960

3 0.751 9,000 6,759

Total PV of net cash inflows $205,719

Net initial investment 250,000

Net present value of project ($ 44,281)



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1.3-Net present value (NPV)

Advantages Focuses on cash flows, not accounting earnings Makes appropriate adjustment for time value of money

Can properly account for risk differences between projects

Disadvantages Lacks the intuitive appeal of payback, and

Doesnt capture managerial f lexibility (option value) well.



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1.4-Internal rate of return (IRR)IRR is the discount rate when the present value of the cash

inflows equal to the original investment.

IRR: the discount rate that results in a zero NPV for a project

If IRR is greater than the cost of capital, accept the project.

If IRR is less than the cost of capital, reject the project.

Projects with higher IRR are better

N

N

r

CF

r

CF

r

CF

r

CF

CFNPV )1(...)1()1()1()( 33

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21

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1.4-Internal rate of return (IRR)

Advantages Properly adjusts for time value of money

Uses cash flows rather than earnings

Accounts for all cash flows

Project IRR is a number with intuitiveappeal

Disadvantages Mathematical problems: multiple IRRs, no real solutions

Scale problem Timing problem



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Comparison of NPV and IRR

NPV The NPV method has the advantage that the end result of the computations is

expressed in dollars and not in a percentage

Individual projects can be added

It can be used in situations where the required rate of return varies over the life ofthe project.

IRR The IRR of individual projects cannot be added or averaged to derive the IRR of a

combination of projects.

IRR and NPV conflict, use NPV approach



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1.5-Accrual Accounting Rate-of-Return MethodThe accrual accounting rate-of-return (AARR) method divides an accounting measure of

income by an accounting measure of investment

Does not track cash flows Ignores time value of money

AARR= (Increase in expected average annual operating income)/(Initial required investment)

Initial investment is $303,280

Useful life is five years Net cash inflows is $80,000 per year IRR is 10%

What is the average operating income?Straight-line depreciation is $60,656 per year ( = 303,280/5)

Average operating income is $80,000 $60,656 = $19,344What is the AARR?

AARR= ($80,000 $60,656) $303,280

= .638, or 6.4%



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Which technique is superior?

Although our decision should be based on NPV, but eachtechnique contributes in its own way

Payback period is a rough measure of riskiness. The longerthe payback period, more risky a project is

IRR is a measure of safety margin in a project. Higher IRR

means more safety margin in the projects estimated cashflows


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