Slide 1
8.6 Other Capital Budgeting Approaches
Other Capital budgeting methods
o Internal rate of return
o Payback period
o Simple rate of return
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Slide 2
Internal Rate of Return
o Simply the yield on a project
o Return rate on a project when
net present value is zero
o Where discounted inflows equal
discounted outflows
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Slide 3
Internal Rate of Return
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Calculating the Internal Rate of
Return
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oFinancial calculator
oSpreadsheet software
oBy hand – not recommended
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Slide 4
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Payback Period Method
o Payback period is the time
required to recoup the initial
investment from cash receipts
o Not a true measure of profitability
o Does not take into account future
cash flows
o Payback Period Method Equation
Payback Period Method =
Investment Required
Net Annual Cash Inflows
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Slide 5
Payback Period Method Example
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Cosmos International has decided to update
equipment. Upon review of the specs on a
number of bids, two bids have been identified
as having the necessary attributes to replace
the antiquated equipment.
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o Bid 172a is bare bones. However, because this
equipment will not require constant repair and
maintenance it is calculated that productivity should
increase by 25%
o Bid 274b has some time saving features but is more
expensive
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COSMOS INTL
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Slide 6
Payback Period Method Example
Investment
Investment required
Net cash inflows
Payback period in yrs
Bid 172a
Bid 274b
$175,000
$258,000
$43,750
$52,500
4.0 yrs
4.9 yrs
Based upon the payback method
the bare bones model is the best
decision. It will pay for itself almost
one year earlier than the fancy
model.
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Slide 7
Simple Rate of Return
o Does not involve discounting cash
flows and thus does not consider
the time value of money
o AKA:
o Accounting rate of return
o Unadjusted rate of return
o Focus on incremental net operating
income
o Incremental revenues – incremental
expenses
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2005 KD Hatheway-Dial
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Slide 8
Simple Rate of Return
Two equation variations:
Simple Rate of Return
Simple Rate of Return
=
=
Annual
Incremental
Revenues
Annual Incremental
Expenses including
Depreciation
Initial Investment
Annual
Cost
Savings
Annual
Depreciation on
New Equipment
Initial Investment
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Slide 9
Simple Rate of Return Example 1
Scott Inc. makes widgets and is considering the
addition of a new processing line. The processing
line would increase revenue by $650,000 with
associated expenses of $475,000. The new
processing line would cost $900,000 and have a
useful life of 10 years with no salvage value
$650,000
Simple Rate of Return
=
= 10%
($475,000 + $85,000
depreciation)
$900,000
(850,000 – 0)/10
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Assume straight line depreciation
(Cost – salvage value) / useful life
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Slide 10
Simple Rate of Return Example 2
Dallas John Corp has begun to review automating
the packaging division of their warehouse. Currently
all Doodads are packed for shipping by hand. The
new equipment could save the company $79,000
each year in labor costs. The new equipment costs
$360,000. It has a useful life of 15 years with no
salvage value.
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Simple Rate of Return
=
$80,000
= 20.0%
$20,000
$300,000
(300,000 – 0)/15
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Assume straight line depreciation
(Cost – salvage value) / useful life
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2005 KD Hatheway-Dial
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