Note

Salvage value is the estimated resale value at the end of its useful life.

Capital Investment (Present Value)

Capital Budgeting use annual net cash flow: Depreciation is not a cash outflow.

Depreciation

The straight-line depreciation method allocates an equal amount of depreciation expense each year over the useful life of the asset.

$\text{Annual Depreciation}=\frac{\text{Initial Investment}-\text{Salvage Value}}{\text{Useful Life (years)}}$

Payback Period

The payback period is the length of time required to recover the cost of an investment.

$\text{Payback Period}=\frac{\text{Initial Investment}}{\text{Annual Net Cash Inflow}}$

Return on Average Investment

The return on average investment measures the profitability of an investment as a percentage of the average investment over its useful life.

$\text{ROI}=\frac{\text{Average Annual Net Income}}{\text{Average Investment}}$ where:

• $\text{Average Investment}=(\text{Initial Investment}+\text{Salvage Value})/2$

Discounting Future Cash Flows

To account for the time value of money, future cash flows are discounted to their present value using a discount rate. Then calculate the present value of cash inflows and cash outflows. Net present value (NPV) is the difference between the present value of cash inflows and outflows.

$\text{NPV}=\text{Present Value of Cash Inflows}-\text{Present Value of Cash Outflows}$

When NPV is :

• positive: Accept the project
• zero: Indifferent
• negative: Reject the project

PV Factor

For Salvage Value, it tells you what $1received$n$ years from now is worth today.

Ex. with 15% interest rate

$\text{PV Factor}=\frac{1}{(1+r{)}^n}$

where:

• $r$ = discount rate (15% = 0.15)
• $n$ = number of years

Year	PV Factor (15%)
1	0.8696
2	0.7561
3	0.6575
4	0.5718
5	0.4972

Annuity Factor

For Annual Net Cash Inflow, it tells you what a series of $1paymentsreceivedover$n$ years is worth today.

Ex. with 15% interest rate

$\text{Annuity Factor}=\frac{1-(1+r{)}^{-n}}{r}$ where:

• $r$ = discount rate (15% = 0.15)
• $n$ = number of years

Year	Annuity Factor (15%)
1	0.8696
2	1.5887
3	2.2832
4	2.8550
5	3.3522