# AEC 422 Fall 2013

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AEC 422 Fall 2013. Unit 2 Financial Decision Making. Capital Budgeting. Defined as process by which a firm decides which long term investments to make Decision to accept or reject a capital budgeting project depends on an analysis of the cash flows generated by the project and its cost. - PowerPoint PPT PresentationTRANSCRIPT

AEC 422Fall 2013Unit 2Financial Decision Making

Capital BudgetingDefined as process by which a firm decides which long term investments to make

Decision to accept or reject a capital budgeting project depends on an analysis of the cash flows generated by the project and its cost

Five Capital Budgeting Performance Measures1.Payback

2.Average Rate of Return

3.Net Present Value

4.Profitability Index

5.Internal Rate of Return

Starting with Net Cash Flow StatementCash Flow Statement: sources and uses of cash for a business over a certain period of time.

Period coincides with the reporting period of the income statement.

Cash Flow Statement is basic to calculating performance measures

Cash Flow StatementA cash flow statement shows how your business is performing on a cash basis

The income statement shows how your business performs on an accrual basis while the cash flow statement provides a source of cash receipts shown in the income statement

Cash Versus Accrual Accounting Methods

Basic difference between the two is the timing of the income and expense recording.

Cash versus AccrualCash accounting is based on real time cash flow. Revenues (expenses) are reported when received (paid).

Accrual accounting reports income (expenses) when earned (or received) and expenses when earned and not necessarily when received (or paid).

Three General Categories of a Cash Flow StatementNet flows from operations activities

Net flows from investing activities consisting primarily of purchase or sale of equipment

Net flows from financing activities such as issuing and borrowing funds.

Steps in Preparing a Cash Flow Budget1.Prepare a sales forecast

2.Project anticipated cash inflows

3.Project anticipated cash outflows

4. Putting the projections together to come up with your cash flow bottom line

Capital Budgeting Decision Rules1.You must consider all the projects cash flows

2.Must consider time value of money. Dollar earned next year is not the same as a dollar earned today

3.Must always lead to the correct decision when choosing among mutually exclusive projects

Time Value of MoneyAt its most basic level, the time value of money demonstrates that it is better to have money now rather than later.

Would you rather have $10,000 today or receive it next year?

Why?

Would You Rather Receive $10,000 Today or Next Year?

Inflation

Could have it invested and earning money

Project ClassificationProjects being considered and evaluated can be divided into two categories:

1. Independent projects

2. Mutually exclusive projects

Independent Projects

A project whose cash flows are not affected by the accept or reject decision of other projects.

Mutually Exclusive ProjectsDefined as a set of projects from which at most one will be accepted.

All the projects being considered may be acceptable, but well choose the best one.

Cant always do everything often have a budget constraint

Capital/Investment Projects in AgribusinessWind turbineNew ag chemicalPlastic reusable containers vs cardboardHigh speed wine bottling equipmentFlash freezer vs IQF freezer for fruitElectronic Point of Sale systems for retail storeEmployee health insurance plan A vs BNew line of equipment for a farm supply storeNew service division for a bank

Cash Flow ReturnsBased on project outcomes that either lead toNew net revenueNew net cost savingsTypically over a period of time

The Discount RateIts the firms cost of capital. The latter reflects the firms cost of acquiring capital to invest in long term assets.

Discount rate reflects future value of money. Has two components:An adjustment for inflationA risk-adjusted return on the use of the money

Investment ExampleInitial Investment: $400,000Cash Flow ReturnsYear 1: $115,000Year 2: $115,000Year 3: $115,000Year 4: $115,000Year 5: $115,000Salvage Value: $50,000

Payback PeriodA capital budget performance measure

Defined as the length of time it takes for a capital budgeting project to recover its initial cost

Calculating Payback

Net Investment Average Annual Net Cash Flow

*Note that net cash flow is after taxesPayback =

Calculating Payback

Using the Net Cash Flow example provided, what is the payback period?

Example Calculating Payback Net Investment Average Annual Net Cash Flow

$400,000 $115,000

Decision Rule: The lower the better!

Payback === 3.48 Years

PaybackAdvantages: Easy to calculate Give you a rough idea of liquidity

Disadvantages:Ignores time value of moneyIgnores project profitability

Average Rate of ReturnA second capital budgeting performance measure

Defined as:

Average Annual Net Cash Flow Average Annual Depreciation Net Investment

Average ROR

Calculate the Average ROR using the example net cash flow statement

Calculating Average ROR

$115,000 - $70,000 $400,000

Decision Rule: Must be positive and the higher the better!ROR = = 11.25%

Average RORAdvantages:Again, simple to calculateDoes account for salvage value Begins to consider profitability

Disadvantages:Ignores time value of money

Net Present Value

A third capital budgeting performance measure concept

Net Present Value is a measure of how much value is created or added today by undertaking an investment.

Net Present ValueIt does this by accounting for the time value of money. A $ today is worth more than a $ tomorrow because of the erosive effects of inflation

Net Present ValueIt is the present (discounted) value of future cash inflows minus the present value of the investment and any associated future cash outflows

Its the net result of a multiyear investment expressed in todays dollars

Net Present Value

T NCFt t=1(1 + r)t - NINV

Net Present Value KeyNCFtNet Cash Flow in Year t

Tis the life of the project

ris the discount rate or cost of capital

NINV is the net investment of the project

Note that in year T, Net Cash Flow must include the salvage value of the initial investment

Calculate Net Present Value

Using the example provided, how would you structure the equation for calculating net present value?

Assume Discount Rate = 10%

Calculating Net Present Value

$115,000 $115,000 $115,000 $115,000 $115,000 + $50,000 (1.1)1 (1.1)2 (1.1)3 (1.1)4 (1.1)5

$115,000 $115,000 $115,000 $115,000 $165,000 1.1 1.21 1.331 1.4641 1.61051

$104,545 + $95,041 + $86,401 + $78,547 + $102,452 - $400,000

$466,984 - $400,000

$66,987- $400,000++++- $400,000++ ++

Net Present ValueDecision Rule: Accept project if NPV > 0

$66,987 > 0 so we accept the project given its the only one were considering

Note if mutually exclusive projects being considered, accept the one with the highest NPV

NPVAdvantages:-Accounts for time value of money correctly-Considers firm profitability-Consistent with notion of maximizing owner wealth

NPVDisadvantages:

-More complex to calculate-Difficult to explain to non-financial managers-Not always easy to determine the correct discount rate

Profitability Index (PI)or Benefit Cost Ratio (BCR)

Defined as the present value of the future cash flows divided by the initial investment

Profitability Index

NCFt (1 + r)t NINV T t = 1

Profitability Index--WhereNCFt=Net Cash Flow in Year t

T=Life of the Project

r=Discount Rate

NINV=Net investment of Project

Note that Net Cash flow must include the salvage value of the initial investment

Calculating PIUsing the example provided, what is the profitability index?

Calculate PIFor our example:

$466,987 $400,000 PI = = 1.17

Calculate PIDecision Rule: Accept if PI >1.0But the bigger the PI the better

Hence, we accept this project

Note: PI is a unit free performance measure

Pros and Cons of PIAdvantages:Accounts for time value of moneyConsiders project profitabilityConsiders owner wealth maximization

Disadvantages:Complex to calculateDifficult to explain to non-financial typesMay not pick project with largest NPV

Internal Rate of Return (IRR)The IRR on an investment is the required return that results in a zero NPV when it is used as the discount rate

In some ways its an alternative to NPV

Internal Rate of ReturnNote that NPV is some mathematical function of r (the discount rate)

So IRR is the level of r (call it r*) such that the NPV = 0

Thus,

Internal Rate of Return

NCFt (1 + r*)t

- NINV = 0 T t = 1

Internal Rate of ReturnUnfortunately, one cannot solve for IRR using algebra.

Rather we must solve by trial and error

Calculating IRR-Using Exampler % NPV ($)PI6121,7851.3893,1911.231066,9871.171242,9211.111420,7731.05163491.018-18,520.9520-35,986.9122-52,181.8724-67,225.83

Calculating IRRFrom previous table we note that NPV = 0 somewhere between r = 16% and r = 18%.

Bit more trial and error and we can discover that IRR = 16.04%

Plug 16.04% into NPV formula and you get NPV = 0

Calculating IRRDecision Rule says that for a single project accept if IRR > 0.

The higher the better.

Pros and Cons of IRRAdvantages:Accounts for time value of moneyConsiders profitabilityConsistent with maximizing wealthDoesnt require analyst to specify r

Disadvantages:Complex to calculateDifficult to explainMay not pick project with largest NPV

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