ch13 AFM102w2017

13-1
MANAGERIAL
ACCOUNTING
Tenth Canadian Edition
GARRISON, LIBBY, WEBB
Capital Budgeting Decisions
Chapter 13
Robert G. Ducharme, MAcc, CPA, CA

University of Waterloo, School of Accounting and Finance
Managerial Accounting
13-2
Typical Capital Budgeting Decisions

 Production equipment/facilities replacement or
upgrades
 May include alternatives
 Expansion of operations
 Cost reduction alternatives
 Non-manufacturing
 Computer system replacements/upgrades
 lease vs. buy decisions
Capital budgeting tends to fall into two broad categories . . .
 Screening decisions. Does a proposed project meet some
present standard of acceptance?
 Preference decisions. Selecting from among several competing
courses of action.
13-3
Approaches to
Capital Budgeting Decisions
Two
Two methods
methods of
of making
making capital
capital budgeting
budgeting decisions
decisions
include
include .. .. ..
 The
 The Payback
Payback Method.
Method.
 Simple
 Simple Rate
Rate of
of Return.
Return.
13-4
The Payback Method
The payback period is the length of time that it

takes for a project to recover its initial cost
out of the cash receipts that it generates.
When the net annual cash inflow is the same each

year, this formula can be used to compute the
payback period:
Investment required
Payback period =
Net annual cash inflow
13-5
The Payback Method
Management
Management at at The
The Daily
Daily Grind
Grind wants
wants to
to install
install an
an
espresso
espresso barbar inin its
its restaurant.
restaurant.
The
The espresso
espresso bar: bar:
1.
1. Costs
Costs $140,000
$140,000 and and has
has aa 10-year
10-year life.
life.
2.
2. Will
Will generate
generate net net annual
annual cash
cash inflows
inflows ofof $35,000.
$35,000.
Management
Management requires requires aa payback
payback period
period ofof 55 years
years or
or
less
less on
on all
all investments.
investments.
What
What is
is the
the payback
payback period
period for
for the
the espresso
espresso bar?
bar?
13-6
The Payback Method
Investment required _
Payback period =
Net annual cash inflow
$140,000
Payback period = $35,000
Payback period = 4.0 years
According
According to
to the
the company’s
company’s criterion,
criterion,
management
management would
would invest
invest inin the
the
espresso
espresso bar
bar because
because its
its payback
payback
period
period is
is less
less than
than 55 years.
years.
13-7
Evaluation of the Payback Method
 disadvantages
 ignores the time value of money
 ignores cash flows after the payback period
 advantages
 serves as screening tool
 identifies investments that recoup cash investments
quickly
 identifies products that recoup initial investment
quickly
13-8
Payback Period
Consider two projects, each with a

five-year life and each costing $6,000.
Project One Project Two

Net Cash Net Cash
Year Inflows Inflows
1 $ 2,000 $ 1,000
2 2,000 1,000
3 2,000 1,000
4 2,000 1,000
5 2,000 1,000,000
Would you invest in Project One just because

it has a shorter payback period?
13-9
Payback and Uneven Cash Flows
When the cash flows associated with an investment

project change from year to year, the payback formula
introduced earlier cannot be used.
Instead, the un-recovered investment must be tracked
year by year.
$1,000 $0 $2,000 $1,000 $500
1 2 3 4 5
For example, if a project requires an initial investment
of $4,000 and provides uneven net cash inflows in
years 1-5 as shown, the investment would be fully
recovered in year 4.
13-10
Simple Rate of Return Method

 Does not focus on cash flows -- rather it focuses
on accounting net operating income.
income
 The following formula is used to calculate the
simple rate of return:
Incremental Incremental expenses,

–
Simple rate revenues including depreciation
of return =
Initial investment*
*Should be reduced by any salvage from the sale of the old equipment
13-11
Management of The Daily Grind wants to install an

espresso bar in its restaurant.
The espresso bar:
1.
1. Cost $140,000 and has a 10-year life.
2.
2. Will generate incremental revenues of $100,000
and incremental expenses of $65,000 including
depreciation.
What is the simple rate of return on the
investment project?
13-12
Simple rate $100,000 – $65,000

= = 25%
of return $140,000
The
The simple
simple rate
rate of
of return
return method
method isis
not
not recommended
recommended because
because itit
ignores
ignores the
the time
time value
value of
of money
money
and
and the
the simple
simple rate
rate of
of return
return can
can
fluctuate
fluctuate from
from year
year to
to year.
year.
13-13
The Net Present Value Method
To determine net present value we . . .

 Calculate the present value of cash inflows,
 Calculate the present value of cash outflows,
 Subtract the present value of the outflows from the
present value of the inflows.
13-14
General decision rule . . .
13-15
Net present value analysis emphasizes cash

flows and not accounting net income.
The reason is that accounting net income is

based on accruals that ignore the timing of cash
flows into and out of an organization.
Depreciation is not deducted in computing the

present value of a project because . . .
 Itis not a current cash outflow.
 Discounted cash flow methods automatically
provide for return of the original investment.
13-16
Two Simplifying Assumptions
Two simplifying assumptions are usually made

in net present value analysis:
• All cash flows other than the initial investment
occur at the end of periods.
• All cash flows generated by an investment
project are immediately reinvested at a rate of
return equal to the discount rate.
13-17
Choosing a Discount Rate
 The firm’s cost of capital is usually regarded as

the minimum required rate of return.
 The cost of capital is the average rate of return

the company must pay to its long-term creditors
and shareholders for the use of their funds.
13-18
The Net Present Value Method: An Example
Lester Company has been offered a five year

contract to provide component parts for a
large manufacturer.
13-19
 At
At the
the end
end of
of five
five years
years the
the working
working capital
capital will
will
be
be released
released and
and may
may be
be used
used elsewhere
elsewhere byby
Lester.
Lester.
 Lester
Lester Company
Company uses
uses aa discount
discount rate
rate of
of 10%.
10%.
Should
Should the
the contract
contract be
be accepted?
accepted?
13-20
Annual net cash flow from operations
13-21
Accept the contract because the project has a

positive net present value.
13-22
Internal Rate of Return Method
 The internal rate of return is the rate of return

promised by an investment project over its useful life. It
is computed by finding the discount rate that will cause
the net present value of a project to be zero.
 It works very well if a project’s cash flows are identical
every year. If the annual cash flows are not identical, a
trial and error process must be used to find the internal
rate of return.
13-23
Internal Rate of Return Method
General decision rule . . .

If the Internal Rate of Return is . . . Then the Project is . . .
Equal to or greater than the minimum

Acceptable.
required rate of return . . .
Less than the minimum required rate

Rejected.
of return . . .
When using the internal rate of return,

the cost of capital acts as a hurdle rate
that a project must clear for acceptance.
13-24
Internal Rate of Return Method: An Example
 Decker
Decker Company
Company can
can purchase
purchase aa new
new
machine
machine at
at aa cost
cost of
of $104,320
$104,320 that
that will
will save
save
$20,000
$20,000 per
per year
year in
in cash
cash operating
operating costs.
costs.
 The
The machine
machine has
has aa 10-year
10-year life.
life.
13-25
Future
Future cash
cash flows
flows are
are the
the same
same every
every year
year in
in this
this
example,
example, so
so we
we can
can calculate
calculate the
the internal
internal rate
rate ofof
return
return as
as follows:
follows:
PV factor for the Investment required

=
internal rate of return Net annual cash flows
$104, 320
= 5.216
$20,000
13-26
Using the present value of an annuity of $1 table . . .

Find the 10-period row, move
across until you find the factor
5.216. Look at the top of the column
and you find a rate of 14%.
14%
Periods 10% 12% 14%

1 0.909 0.893 0.877
2 1.736 1.690 1.647
. . . . . . . . . . . .
9 5.759 5.328 4.946
10 6.145 5.650 5.216
13-27
 Decker Company can purchase a new machine at a

cost of $104,320 that will save $20,000 per year in
cash operating costs.
 The machine has a 10-year life.
The internal rate of return on

this project is 14%.
If the internal rate of return is equal to

or greater than the company’s required
rate of return, the project is acceptable.
13-28
Net Present Value vs. Internal Rate of Return
 NPV is easier to use.

 Less of an advantage now with the availability
of IRR functions in spreadsheets such as
Excel.
 Questionable assumption with IRR:

 Internal rate of return method assumes cash
inflows are reinvested at the internal rate of
return.
13-29
Expanding the Net Present Value Method
To
To compare
compare competing
competing investment
investment projects
projects we
we
can
can use
use the
the following
following net
net present
present value
value
approaches:
approaches:
 Total-cost
 Incremental cost
13-30
The Total-Cost Approach
 White
White Company
Company has has two
two alternatives:
alternatives:
(1)
(1) remodel
remodel anan old
old car
car wash
wash or,or,
(2)
(2) remove
remove itit and
and install
install aa new
new one.
one.
 The
The company
company usesuses aa discount
discount rate
rate of
of 10%.
10%.
New Car Old Car

Wash Wash
Annual revenues $ 90,000 $ 70,000
Annual cash operating costs 30,000 25,000
Net annual cash inflows $ 60,000 $ 45,000
13-31
If White installs a new washer . . .
Cost $300,000
Productive life 10 years
Salvage value 7,000
Replace brushes at
the end of 6 years 50,000
Salvage of old equip. 40,000
Let’s look at the present value

of this alternative.
13-32
Install the New Washer

Cash 10% Present
Year Flows Factor Value
Initial investment Now $ (300,000) 1.000 $ (300,000)
Replace brushes 6 (50,000) 0.564 (28,200)
Net annual cash inflows 1-10 60,000 6.145 368,700
Salvage of old equipment Now 40,000 1.000 40,000
Salvage of new equipment 10 7,000 0.386 2,702
Net present value $ 83,202
If we install the new washer, the

investment will yield a positive net
present value of $83,202.
13-33
If White remodels the existing washer . . .
Remodel costs $175,000

Replace brushes at
the end of 6 years 80,000
Let’s look at the present value

of this second alternative.
13-34
Remodel the Old Washer

Cash 10% Present
Initial investment Now $ (175,000) 1.000 $ (175,000)
Replace brushes 6 (80,000) 0.564 (45,120)
Net annual cash inflows 1-10 45,000 6.145 276,525
If we remodel the existing washer, we will

produce a positive net present value of
$56,405.
13-35
Both projects yield a positive net

present value.
However, investing in the new washer will

produce a higher net present value than
remodeling the old washer.
13-36
The Incremental-Cost Approach
Under
Under the
the incremental-cost
incremental-cost approach,
approach, only
only
those
those cash
cash flows
flows that
that differ
differ between
between the
the two
two
alternatives
alternatives are
are considered.
considered.
Let’s look at an analysis of the White Company

decision using the incremental-cost
approach.
13-37
The Incremental-Cost Approach
Cash 10% Present

Incremental investment Now $(125,000) 1.000 $(125,000)
Incremental cost of brushes 6 $ 30,000 0.564 16,920
Increased net cash inflows 1-10 15,000 6.145 92,175
Salvage of old equipment Now 40,000 1.000 40,000
Salvage of new equipment 10 7,000 0.386 2,702
We get the same answer under either the

total-cost or incremental-cost approach.
13-38
Least Cost Decisions
In decisions where revenues are not directly

involved, managers should choose the
alternative that has the least total cost from a
present value perspective.
Let’s look at the Home Furniture Company.
13-39

 Home Furniture Company is trying to decide whether to
overhaul an old delivery truck now or purchase a new one.
 The company uses a discount rate of 10%.
Here is information about the trucks . . .

Old Truck
Overhaul cost now $ 4,500
Annual operating costs 10,000
Salvage value in 5 years 250
Salvage value now 9,000
13-40
Buy the New Truck

Cash 10% Present
Purchase price Now $ (21,000) 1.000 $ (21,000)
Annual operating costs 1-5 (6,000) 3.791 (22,746)
Salvage value of old truck Now 9,000 1.000 9,000
Salvage value of new truck 5 3,000 0.621 1,863
Net present value (32,883)
Keep the Old Truck

Cash 10% Present
Overhaul cost Now $ (4,500) 1.000 $ (4,500)
Annual operating costs 1-5 (10,000) 3.791 (37,910)
Salvage value of old truck 5 250 0.621 155
Net present value (42,255)
13-41
Home Furniture should purchase the new truck.
Net present value of costs

associated with purchase
of new truck $(32,883)
Net present value of costs
associated with remodeling
existing truck (42,255)
Net present value in favour of
purchasing the new truck $ 9,372
13-42
Preference Decisions:
Ranking of Capital Projects
 Unless an organization has unlimited funds to invest
in capital projects, a rank ordering of the possibilities
will be required.
 Two approaches to ranking:
 IRR, highest to lowest
 NPV: Profitability index = PV of net cash flows .
net investment required
the higher the profitability index, the better
 Which approach is better & why?
 the profitability index is superior because it will always
give the correct signal as to the relative desirability of
alternatives, even if the alternatives have different lives
and different patterns of earnings (text 9ce pg625)
13-43
Postaudit of Investment Projects
A postaudit is a follow-up after the project has been completed

to see whether or not expected results were actually
realized.
 Many organizations fail to compare the estimates made in
the capital budgeting process with the actual results
 This is a mistake for three reasons:
 By comparing estimates with results, the organizations planners
can identify where their estimates are wrong and try to avoid
making similar mistakes in the future
 By assessing the skill of planners, organizations can identify
and reward those who are good at making capital budgeting
decisions
 By auditing the results of acquiring long-term assets, companies
create an environment in which planners are less tempted to
inflate estimates of the cash benefits associated with their
projects in order to get them approved
13-44
The Concept of Present Value
Appendix 13A
13-45
The Theory of Interest
A dollar received
today is worth more
than a dollar received
a year from now
because you can put
it in the bank today
and have more than a
dollar a year from
now.
13-46
The Theory of Interest – An Example
Assume a bank pays 8% interest on a

$100 deposit made today. How much
will the $100 be worth in one year?
Fn = P(1 + r) n
Fn = $100(1 + .08)1
Fn = $108.00
13-47
The Theory of Interest – An Example
Assume a bank pays 8% interest on a

$100 deposit made today. How much
will the $100 be worth in one year?
Future Value of $1
Periods 8% 10% 12%
1 1.080 1.100 1.120
2 1.166 1.210 1.254
3 1.260 1.331 1.405
4 1.360 1.464 1.574
5 1.469 1.611 1.762
The $108 can also be derived by using the Future Value

of $1 table shown in Exhibit 13-20.
13-48
Compound Interest – An Example
What if the $108 was left in the bank for a second

year? How much would the original $100 be
worth at the end of the second year?
Fn = P(1 + r)n
Fn = $100(1 + .08) 2
Fn = $116.64
The interest that is paid in the second year on the interest
earned in the first year is known as compound interest.
13-49
Compound Interest – An Example
What if the $108 was left in the bank for a

second year? How much would the
original $100 be worth at the end of the
second year?
Future Value of $1
Periods 8% 10% 12%
1 1.080 1.100 1.120
2 1.166 1.210 1.254
3 1.260 1.331 1.405
4 1.360 1.464 1.574
5 1.469 1.611 1.762
The $116.60 can also be derived by using the Future

Value of $1 table shown in Exhibit 13-20.
13-50
Computation of Present Value
An investment can be viewed in two

ways—its future value or its present
value.
Present Future
Value Value
Let’s look at a situation where the

future value is known and the present
value is the unknown.
13-51
Present Value – An Example

If a bond will pay $100 in two years, what is the present value of the
$100 if an investor can earn a return of 12% on investments?
Fn
P=
(1 + r)n
$100
P=
(1 + .12)2
P = $79.72
This process is called discounting. We have discounted the $100 to its
present value of $79.72. The interest rate used to find the present
value is called the discount rate.
13-52
Present Value – An Example
$100 × 0.797 = $79.70 present value

Rate
Rate
Periods
Periods 10%
10% 12%
12% 14%
14%
11 0.909
0.909 0.893
0.893 0.877
0.877
22 0.826
0.826 0.797
0.797 0.769
0.769
33 0.751
0.751 0.712
0.712 0.675
0.675
44 0.683
0.683 0.636
0.636 0.592
0.592
55 0.621
0.621 0.567
0.567 0.519
0.519
Present value factor of $1 for 2 periods at 12%.

13-53
Present Value of a Series of Cash Flows
An investment that involves a series of

identical cash flows at the end of each
year is called an annuity.
annuity
$100 $100 $100 $100 $100 $100
1 2 3 4 5 6
13-54
Present Value of a Series of Cash Flows –

An Example
Lacey Inc. purchased a tract of land on which a

$60,000 payment will be due each year for the
next five years. What is the present value of this
stream of cash payments when the discount rate
is 12%?
13-55
Present Value of a Series of Cash Flows –

An Example
We could solve the problem like this . . .
Present Value of an Annuity of $1

Periods 10% 12% 14%
1 0.909 0.893 0.877
2 1.736 1.690 1.647
3 2.487 2.402 2.322
4 3.170 3.037 2.914
5 3.791 3.605 3.433
$60,000 × 3.605 = $216,300

13-56
Income Taxes in Capital

Budgeting Decisions
Appendix 13B
13-57
Concept of After-tax Cost
An expenditure net of its tax effect is known as

after-tax cost.
Here is the equation for determining the after-

tax cost of any tax-deductible cash expense:
After-tax cost
= (1 – Tax rate)  Tax-deductible cash expense
(net cash outflow)
Simplifying assumptions:
• Taxable income equals net income as computed for
financial reports
• The tax rate is a flat percentage of taxable income
13-58
After-tax Cost – An Example
Assume a company with a 30% tax rate is

contemplating investing in a training program
that will cost $60,000 per year.
We can use this equation to determine that the

after-tax cost of the training program is
$42,000.
After-tax cost
= (1 – Tax rate)  Tax-deductible cash expense
(net cash outflow)
$42,000 = (1 – .30)  $60,000

13-59
The answer can also be determined by

calculating the taxable income and income tax
for two alternatives—without the training
program and with the training program.
The after-tax cost of

the training program is
the same—$42,000.
13-60
The amount of net cash inflow

realized from a taxable cash
receipt after income tax effects
have been considered is known
as the after-tax benefit.
After-tax benefit
= (1 – Tax rate)  Taxable cash receipt
(net cash inflow)
13-61
Capital Cost Allowance (CCA) Tax Shield
While capital cost allowance

(CCA) is not a cash flow, it does
affect the taxes that must be
paid and therefore has an
indirect effect on a company’s
cash flows.
Tax savings from

the CCA tax = Tax rate   CCA deduction
shield
13-62
CCA Tax Shield – An Example
Assume a company has annual cash sales and

cash operating expenses of $500,000 and
$310,000, respectively; a depreciable asset,
with no salvage value, on which the annual
straight-line depreciation expense is $90,000;
and a 30% tax rate.
Tax savings from
shield
13-63
Assume a company has annual cash sales and

cash operating expenses of $500,000 and
$310,000, respectively; a depreciable asset,
with no salvage value, on which the annual
straight-line CCA depreciation expense is
$90,000; and a 30% tax rate.
Tax savings from
shield
$27,000 = .30  $90,000
The CCA tax shield is $27,000.

13-64
The answer can also be determined by

calculating the taxable income and income tax
for two alternatives—without the CCA
depreciation deduction and with the CCA
depreciation deduction.
The CCA tax shield is

the same—$27,000.
13-65
Present Value of CCA Tax Shields

• Capital cost allowance (CCA) is depreciation for tax
purposes
• Tax Shield on CCA = CCA × tax rate
• CCA is calculated on a declining balance basis. Each
year’s CCA is calculated as:
• Undepreciated Capital Cost (UCC) × CCA rate
• UCCt+1 = UCCt – CCAt
• In the year an asset is purchased, only a 1/2 year of CCA
can be deducted
• Present value of CCA tax shields:
• PV = [(Cdt/d + k)/(d + k) × (1 +.5k)/(1 + k)]
• Where: c = capital cost of asset; d = CCA rate; t = tax
rate; k = cost of capital
13-66
• When an asset is sold, and adjustment is needed to the

present value of the CCA tax shields.
• The adjustment is needed because the original calculation
(see previous slide) assumes an infinite stream of CCA
deductions (declining balance basis) and related tax
shields.
• When the asset is sold, the company loses the tax shields
on any proceeds received. The adjustment is:
(Sdt/d + k) × (1+ k)-n
Where, s = salvage value; d = depreciation rate; t = tax
rate; k = cost of capital; n = year of disposal
13-67
Holland Company – An Example

Holland Company owns the mineral rights to
land that has a deposit of ore. The company
is deciding whether to purchase equipment
and open a mine on the property. The mine
would be depleted and closed in 10 years and
the equipment would be sold for its salvage
value (which will be very little, and thus
estimated to be zero). Holland Company uses
a 20% rate, assuming no salvage value, to
compute CCA deductions for tax purposes.
More information is provided on the next slide.
13-68
Cost of equipment $ 300,000

Working capital needed $ 75,000 Should
Estimated annual cash $ 250,000
receipts from ore sales
Holland open
Estimated annual cash a mine on
expenses for mining ore $ 170,000 the property?
Cost of road repairs
needed in 6 years $ 40,000
Salvage value of the
equipment in 10 years $ -
After-tax cost of capital 12%
Tax rate 30%
13-69
Step One: Compute the net annual cash

receipts from operating the mine.
Cash receipts from ore sales $ 250,000

Less cash expenses for mining ore 170,000
Net cash receipts $ 80,000
13-70
Step Two: Identify all relevant cash flows

as shown.
Holland Company
(1) (2)
Items and Computations Year Amount

Cost of new equipment Now $ (300,000)
Working capital needed Now $ (75,000)
Net annual cash receipts 1-10 $ 80,000
Road repairs 6 $ (40,000)
Salvage value of equipment 10 $ -
Release of working capital 10 $ 75,000
Present value of CCA tax shield

Net present value
13-71
Step Three: Translate the relevant cash

flows to after-tax cash flows as shown.
Holland Company
(1) (2) (3) (4)
Tax
Effect After-Tax
Items and Computations Year Amount (1)  (2) Cash Flows
Cost of new equipment Now $ (300,000) – $ (300,000)
Working capital needed Now $ (75,000) – $ (75,000)
Net annual cash receipts 1-10 $ 80,000 1-.30 $ 56,000
Road repairs 6 $ (40,000) 1-.30 $ (28,000)
Salvage value of equipment 10 $ - – $ -
Release of working capital 10 $ 75,000 – $ 75,000
Present value of CCA tax shield

Net present value
13-72
CCA Instead of Depreciation
• Capital cost allowance (CCA) is essentially

depreciation for tax purposes
• For each income tax year, the tax shield on CCA =
CCA tax deduction × tax rate
• CCA is calculated on a declining balance basis. Each
year’s CCA is calculated as:
• Undepreciated Capital Cost (UCC) × CCA rate
• In the year an asset is purchased, only one-half of the
prescribed rate is permitted to be deducted.
13-73
The present value of this perpetual stream of tax

savings from a declining balance CCA is calculated by
using the CCA tax shield formula:
PV = [(Cdt)/(d + k)] × [(1 + 0.5k)/(1 + k)]
Where: c = capital cost of the asset added to the asset pool;
d = CCA rate; t = marginal income tax rate; k = cost of
capital.
In the case of Holland Company:

PV = [(Cdt)/(d + k)] × [(1 + 0.5k)/(1 + k)]
PV = [($300,000×0.2×0.3)/(0.2+0.12)] × [(1 + 0.5×0.12)/(1+0.12)]
PV = [$18,000/0.32] × [1.06/1.12]
PV = $56,250 × 0.946429
PV = $53,237
13-74
Step Four: Discount all cash flows to

their present value as shown.
Holland Company
(1) (2) (3) (4) (5) (6)
Tax
Effect After-Tax 12% Present
Items and Computations Year Amount (1)  (2) Cash Flows Factor Value
Cost of new equipment Now $ (300,000) – $ (300,000) 1.000 $ (300,000)
Working capital needed Now $ (75,000) – $ (75,000) 1.000 (75,000)
Net annual cash receipts 1-10 $ 80,000 1-.30 $ 56,000 5.650 316,400
Road repairs 6 $ (40,000) 1-.30 $ (28,000) 0.507 (14,196)
Salvage value of equipment 10 $ - – $ - 0.322 -
Release of working capital 10 $ 75,000 – $ 75,000 0.322 24,150
(48,646)
Present value of CCA tax shield 53,237
13-75
End of Chapter 13

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13-1

Capital Budgeting Decisions

Robert G. Ducharme, MAcc, CPA, CA

Typical Capital Budgeting Decisions

The Payback Method

The payback period is the length of time that it

When the net annual cash inflow is the same each

The Payback Method

The Payback Method

Payback period = 4.0 years

Evaluation of the Payback Method

Consider two projects, each with a

Project One Project Two

Would you invest in Project One just because

Payback and Uneven Cash Flows

When the cash flows associated with an investment

Simple Rate of Return Method

Incremental Incremental expenses,

Simple Rate of Return Method

Management of The Daily Grind wants to install an

Simple Rate of Return Method

Simple rate $100,000 – $65,000

The Net Present Value Method

To determine net present value we . . .

The Net Present Value Method

General decision rule . . .

The Net Present Value Method

Net present value analysis emphasizes cash

The reason is that accounting net income is

Depreciation is not deducted in computing the

Two Simplifying Assumptions

Two simplifying assumptions are usually made

Choosing a Discount Rate

 The firm’s cost of capital is usually regarded as

 The cost of capital is the average rate of return

The Net Present Value Method: An Example

Lester Company has been offered a five year

The Net Present Value Method: An Example

The Net Present Value Method: An Example

Annual net cash flow from operations

The Net Present Value Method: An Example

Accept the contract because the project has a

Internal Rate of Return Method

 The internal rate of return is the rate of return

Internal Rate of Return Method

General decision rule . . .

Equal to or greater than the minimum

Less than the minimum required rate

When using the internal rate of return,

Internal Rate of Return Method: An Example

Internal Rate of Return Method: An Example

PV factor for the Investment required

Internal Rate of Return Method: An Example

Using the present value of an annuity of $1 table . . .

Periods 10% 12% 14%

Internal Rate of Return Method: An Example

 Decker Company can purchase a new machine at a

The internal rate of return on

If the internal rate of return is equal to

Net Present Value vs. Internal Rate of Return

 NPV is easier to use.

 Questionable assumption with IRR: