Capital Expenditure Decisions
16
Chapter Sixteen
Discounted-Cash-Flow Analysis
Cost reduction
Plant expansion
Equipment selection
Lease or buy
Equipment replacement
Net-Present-Value Method
Prepare a table showing cash flows for each year,
Calculate the present value of each cash flow using a discount rate,
present value,
If present value (NPV) is positive, accept the investment proposal. Otherwise, reject it.
Internal-Rate-of-Return Method
The internal rate of return is the true economic return earned by the asset over its life.
The internal rate of return puted by finding the discount rate that will cause present value of a project to be zero.
Comparing the NPV and IRR Methods
Internal Rate of Return
The cost of capital pared to the internal rate of return on a project.
To be acceptable, a project’s rate of return must be greater than the cost of capital.
Net Present Value
The cost of capital is used as the actual discount rate.
Any project with a present value is rejected.
Comparing the NPV and IRR Methods
present value method has the following advantages over the internal rate of return method . . .
Easier to use.
Easier to adjust for risk.
Provides more usable information.
Assumptions Underlying Discounted-Cash-Flow Analysis
All cash flows are
treated as though
they occur at year end.
Cash flows are
treated as if
they are known
with certainty.
Cash inflows are
immediately
reinvested at
the required
rate of return.
Assumes a
perfect
capital
market.
e Taxes and Capital Budgeting
Cash flows from an investment proposal affect pany’s profit and its e tax liability.
e = Revenue - Expenses + Gains - Losses
After-Tax Cash Flows
The tax rate is 28%, so e taxes are
$525,000 × 28% = $147,000
Investment in Working Capital
Some investment proposals require additional outlays for working capital such as increases in cash, accounts receivable, and inventory.
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