Introduction to Advanced Capital Budgeting Tools

What you will learn to do: use time value of money to analyze investment options

Let’s take a look at JuxtaPos again, but in this case, management is considering adding a line of puzzles that necessitates a new machine that will cost $230,000 with an estimated useful life of six years and a residual value of $40,000.

Estimated net cash inflows are as follows:

Description Amount
Year 1 $         60,000
Year 2             60,000
Year 3               55,000
Year 4               55,000
Year 5             50,000
Year 6             65,000
Single Line$        345,000Double line

 

You have calculated the payback at four years:

Description Amount
Cost of new machine $      230,000
Recaptured YR 1 $     (60,000)
Left to recapture Single Line$      170,000
Recaptured YR 2 $     (60,000)
Left to recapture Single Line$      110,000
Recaptured YR 3 $     (55,000)
Left to recapture Single Line$       55,000
Recaptured YR 4 $     (55,000)
Left to recapture Single Line$            –

 

And the accounting rate of return:

Accounting Rate of Return (ARR)
Description Amount
Total net cash inflows $      345,000
Depreciation on machine $      190,000
Accounting income Single Line$      155,000
Operating life in years 6
Average annual operating income Single Line$       25,833
Investment $      230,000
Residual value $       40,000
Net investment (depreciable value) Single Line$      190,000
Divided by: 2
Average amount invested Single Line$       95,000
Accounting rate of return 27.19%

 

So far, this project has made it through all of the internal screening processes and is now at the highest levels for approval. Upper management is asking for a more sophisticated analysis. The CEO and CFO and the capital planning team would like to know the net present value of the project as well as the internal rate of return, along with a profitability index. They have set a hurdle rate of 15% based on the company’s WACC (weighted average cost of capital). Let’s walk through creating this analysis.

When you are done with this section, you will be able to:

  • Calculate the net present value of a capital project
  • Calculate the internal rate of return
  • Calculate the profitability index

Learning Activities

The learning activities for this section include the following:

  • Reading: Net Present Value
  • Self Check: Net Present Value
  • Reading: Internal Rate of Return
  • Self Check: Internal Rate of Return
  • Reading: Profitability Index
  • Self Check: Profitability Index