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CAPITAL BUDGETING AND LEASINGPowerPoint Presentation

CAPITAL BUDGETING AND LEASING

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### CAPITAL BUDGETING ANDLEASING

Chapter 4

Investment

- The addition of durable assets to a business
- Disinvestment is the withdrawal of durable assets from the business

Investment Opportunities

- Maintenance and replacement of depreciable capital items
- Adoption of cost-reducing investments
- Adoption of income-increasing investments
- A combination of the above

Investment Analysis

- STEPS IN INVESTMENT ANALYSIS:
- 1. IDENTIFY POTENTIALLY PROFITABLE INVESTMENT ALTERNATIVES
- 2. COLLECT RELEVANT DATA ON:
- CAPITAL OUTLAYS
- COSTS
- RETURNS

- 3. USE AN APPROPRIATE METHOD TO ANALYZE THE DATA.
- 4. DECIDE WHETHER TO ACCEPT OR REJECT THE INVESTMENT OR SELECT THE TOP RANKING AMONG MUTUALLY EXCLUSIVE PROJECTS.

Capital Budgeting

- The process of planning expenditures on assets whose returns will extend beyond one year.

Weighted Average Cost of Capital

There are two types of capital invested in a business:

- Debt Capital
- Equity Capital
- What is the cost of debt?
- What is the cost of equity?

Weighted Average Cost of Capital

- Kc = wd Kd + we Ke
- Where:
- Kc is the weighted average cost of capital
- wd is the proportion of assets financed with debt
- Kd is the cost of debt capital
- we is the proportion of assets financed with equity
- Ke is the cost of equity capital

Payback Method

- The payback method gives the number of years necessary to recover the initial investment.
- Does not account for the timing of cash flows.

Payback Method

P = I / E

WHERE:

P = PAYBACK PERIOD IN YEARS

I= INITIAL INVESTMENT OUTLAY

E = ANNUAL NET CASH RETURN

Simple Rate of Return

- Expresses the average annual net income as a percentage of the amount invested.
- This may be in terms of the initial capital outlay or the average amount invested over the useful life of the investment.

SRR= Y/I

Where:

SRR = SIMPLE RATE OF RETURN

Y = AVERAGE ANNUAL NET CASH RECEIPTS (DEPRECIATION TAKEN INTO ACCOUNT)

I = INITIAL INVESTMENT OUTLAY

Calculation of Annual Cash Receipts

Y=(E – D)

WHERE:

Y = AVERAGE ANNUAL NET INCOME

E = TOTAL EXPECTED ANNUAL CASH RECEIPTS

D= TOTAL ANNUAL DEPRECIATION

Net Present Value (NPV)

- With the NPV, the cash flows of the investment are discounted by a minimum acceptable compound annual rate of return.
- The investment is judged to be acceptable if the present value of the cash inflows exceeds the investment’s present value of the cash outflows.

Net Present Value (NPV)

NPV = ΣPVCashInflows– ΣPVCash Outflows

Benefit Cost Ratio

- A ratio that utilizes the same two elements of the Net Present Value.
B/C = ΣPV cash inflows / ΣPV cash outflows

Internal Rate of Return (IRR)

- The IRR is the compound interest rate that equates the present value of the future net cash inflows with the cash outflows.
- Or in other words the discount rate that gives a NPV = Zero.
- Both the NPV and IRR take into account the time value of money.
- The purpose of these investment analysis techniques is to evaluate the acceptability of investments relative to an acceptable rate of return.

What goes into the Discount Rate?

- The discount rate should reflect the cost of capital or the cost of funds used to finance the business.
- An investment is not acceptable unless it generates a return sufficient to cover the cost of funds.

What goes into the Discount Rate?

The discount rate contains three components:

- Real Risk-Free Rate
- Risk Premium
- Inflation Expectations

Other Considerations Regarding Capital Budgeting

- Profitability Index
- Used to allocate limited capital among several independent projects.
- Present value of the cash inflows divided by the cash outflows.

Other Considerations Regarding Capital Budgeting

- Annuity Equivalent
- Used to compare NPVs with unequal lives.

Other Considerations Regarding Capital Budgeting

- Financial Feasibility
- Once you have evaluated an investment, the financing of the project should be determined.
- After-tax cash flows may not be sufficient to meet debt repayment requirements.

Payback Method

- A 20000/6000 = 3.33 YEARS
- B 20000/5800 = 3.45 YEARS
- C 20000/5600 = 3.57 YEARS

Simple Rate of Return B (29000-20000)/5 = 1800 C (28000-20000)/5 = 1600

- A (30000-20000)/5 = 2000
- 2000/20000 = 0.10 10%

- 1800/20000 = 0.09 9%

- 1600/20000 = 0.08 8%

Net Present Value

- A NPV = -20000 + 2000/(1.08)
+ 4000/(1.08)2 + 6000/(1.08)3

+ 8000/(1.08)4 + 10000/(1.08)5

+ 0/(1.08)5

- NPV = -20000 + 1852 + 3429
+ 4763 + 5880 + 6806 + 0

- NPV = 2730

Net Present Value and Internal Rate of Return

- A NPV = 2730 IRR = 12.01
- B NPV = 3158 IRR = 13.82
- C NPV = 3766 IRR = 17.57

Leasing Versus Owning

- A lease represents an agreement that gives control over an asset owned by the lessor to the lessee for a specific period of time upon the payment of an agreed upon amount, known as rent.

Types of Leases

- IN NON-REAL ESTATE LEASING THERE ARE SEVERAL TYPES OF LEASES:
- OPERATING LEASE
- CAPITAL (OR FINANCIAL) LEASE
- CUSTOM HIRE

Operating Lease

- USUALLY A SHORT-TERM RENTAL ARRANGEMENT IN WHICH THE RENTALCHARGE IS CALCULATED ON A TIME BASIS.
- SUCH AS THE HOUR OR THE DAY, ETC.
- THE LESSEE PAYS THE DIRECT COST SUCH AS FUEL AND LABOR.

Capital or Financial Lease

- A LONG - TERM CONTRACTUAL ARRANGEMENT IN WHICH THE LESSEE ACQUIRES CONTROL OF AN ASSET IN RETURN FOR RENTAL PAYMENTS.
- USUALLY RUNS FOR SEVEAL YEARS AND CANNOT BE CANCELLED WITHOUT PENALTY.
- IS FULLY AMORTIZED, MEANING THAT THE PRESENT VALUE OF THE LEASE PAYMENTS EQUALS THE FULL PRICE OF THE LEASED EQUIPMENT.
- MAY HAVE A PRUCHASE OPTION AT THE END OF THE LEASE.

Capital Vs. Operating Lease

- Capital lease transfers some of the risks of ownership to the lessee.

Issues in Capital Leasing

- Advantages:
- CONSERVATION OF WORKING CAPITAL
- NEARLY 100% FINANCING
- THE USE OF MODERN EQUIPMENT
- POSSIBLE TAX BENEFITS

Evaluation of a lease vs. Purchase

- May be evaluated by looking at the present value of cash flows for each option.

Sample Problem

- $ 30,000 TRUCK
- 35% TAX BRACKET
- 12% COST OF CAPITAL
- PURCHASE
- 30% DOWN PAYMENT
- LEVEL PAYMENTS
- 10% INTEREST
- 5 YEARS

- LEASE
- 5 YEAR LEASE
- ANNUAL PAYMENTS OF $7,000

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