Capital Budgeting Decisions

Chapter 14
McGraw-Hill/Irwin
Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Typical Capital Budgeting Decisions
Plant expansion
Equipment selection
Equipment replacement
Lease or buy Cost reduction
14-2
Time Value of Money
A dollar today is
worth more than a
dollar a year from
now. Therefore,
projects that promise
earlier returns are
preferable to those
that promise later
returns.
14-3
The Net Present Value Method
To determine net present value we . . .
Calculate the present value of cash inflows,
Calculate the present value of cash outflows,
Subtract the present value of the outflows
from the present value of the inflows.
14-4
If the Net Present
Value is . . . Then the Project is . . .
Positive . . .
Acceptable because it promises
a return greater than the
required rate of return.
Zero . . .
Acceptable because it promises
a return equal to the required
rate of return.
Negative . . .
Not acceptable because it
promises a return less than the
required rate of return.
The Net Present Value Method
14-5
Typical Cash Outflows
Repairs and
maintenance
Incremental
operating
costs
Initial
investment
Working
capital
14-6
Typical Cash Inflows
Reduction
of costs
Salvage
value
Incremental
revenues
Release of
working
capital
14-7
Recovery of the Original Investment
Depreciation is not deducted in
computing the present value of a
project because . . .

It is not a current cash outflow.

Discounted cash flow methods
automatically provide for a return of the
original investment.
14-8
Recovery of the Original Investment
Carver Hospital is considering the purchase of an
attachment for its X-ray machine.






No investments are to be made unless they have an
annual return of at least 10%.

Will we be allowed to invest in the attachment?
14-9
Item Year(s)
Amount of
Cash Flow
10%
Factor
Present
Value of
Cash
Flows
Initial investment (outflow) Now (3,170) 1.000 (3,170)
Annual cash inflows 1-4 1,000 $ 3.170 3,170 $
Net present value $ -0-
Periods 10% 12% 14%
1 0.909 0.893 0.877
2 1.736 1.690 1.647
3 2.487 2.402 2.322
4 3.170 3.037 2.914
5 3.791 3.605 3.433
Present Value of $1
Present value
of an annuity
of $1 table
Recovery of the Original Investment
14-10
Recovery of the Original Investment
(1) (2) (3) (4) (5)
Year
Investment
Outstanding
during the
year
Cash
Inflow
Return on
Investment
(1) 10%
Recover of
Investment
during the
year
(2) - (3)
Unrecovered
Investment at
the end of the
year
(1) - (4)
1 3,170 $ 1,000 $ 317 $ 683 $ 2,487 $
2 2,487 1,000 249 751 1,736
3 1,736 1,000 173 827 909
4 909 1,000 91 909 0
Total investment recovered 3,170 $
This implies that the cash inflows are sufficient to recover the $3,170
initial investment (therefore depreciation is unnecessary) and to
provide exactly a 10% return on the investment.
14-11
Two Simplifying Assumptions
Two simplifying assumptions are usually made
in net present value analysis:
All cash flows other
than the initial
investment occur at
the end of periods.
All cash flows
generated by an
investment project
are immediately
reinvested at a rate of
return equal to the
discount rate.
14-12
Quick Check
Denny Associates has been offered a four-year contract to
supply the computing requirements for a local bank.
Cash flow information
Cost of computer equipment $ 250,000
Working capital required 20,000
Upgrading of equipment in 2 years 90,000
Salvage value of equipment in 4 years 10,000
Annual net cash inflow 120,000
The working capital would be released at the end of
the contract.
Denny Associates requires a 14% return.
14-13
Quick Check
What is the net present value of the contract with
the local bank?
a. $150,000
b. $ 28,230
c. $ 92,340
d. $132,916
14-14
What is the net present value of the contract with
the local bank?
a. $150,000
b. $ 28,230
c. $ 92,340
d. $132,916
Quick Check
Years
Cash
Flows
14%
Factor
Present
Value
Investment in equipment Now $ (250,000) 1.000 (250,000) $
Working capital needed Now (20,000) 1.000 (20,000)
Annual net cash inflows 1-4 120,000 2.914 349,680
Upgrading of equipment 2 (90,000) 0.769 (69,210)
Salvage value of equip. 4 10,000 0.592 5,920
Working capital released 4 20,000 0.592 11,840
Net present value 28,230 $
14-15
Internal Rate of Return Method
The internal rate of return is the rate of return
promised by an investment project over its useful
life. It is computed by finding the discount rate that
will cause the net present value of a project to be
zero.

It works very well if a projects cash flows are
identical every year. If the annual cash flows are
not identical, a trial and error process must be used
to find the internal rate of return.
14-16
Internal Rate of Return Method
General decision rule . . .
If the Internal Rate of Return is . . . Then the Project is . . .
Equal to or greater than the minimum
required rate of return . . .
Acceptable.
Less than the minimum required rate
of return . . .
Rejected.
When using the internal rate of return,
the cost of capital acts as a hurdle rate
that a project must clear for acceptance.
14-17
Quick Check
The expected annual net cash inflow from a project
is $22,000 over the next 5 years. The required
investment now in the project is $79,310. What is
the internal rate of return on the project?
a. 10%
b. 12%
c. 14%
d. Cannot be determined
14-18
The expected annual net cash inflow from a project
is $22,000 over the next 5 years. The required
investment now in the project is $79,310. What is
the internal rate of return on the project?
a. 10%
b. 12%
c. 14%
d. Cannot be determined
Quick Check
$79,310/$22,000 = 3.605,
which is the present value factor
for an annuity over five years
when the interest rate is 12%.
14-19
Least Cost Decisions
In decisions where revenues are not directly
involved, managers should choose the
alternative that has the least total cost from a
present value perspective.

Lets look at the Home Furniture Company.
14-20
Least Cost Decisions
Home Furniture Company is trying to
decide whether to overhaul an old delivery
truck now or purchase a new one.
The company uses a discount rate of 10%.
14-21
Least Cost Decisions
New Truck
Purchase price 21,000 $
Annual operating costs 6,000
Salvage value in 5 years 3,000
Old Truck
Overhaul cost now 4,500 $
Annual operating costs 10,000
Salvage value in 5 years 250
Salvage value now 9,000
Here is information about the trucks . . .
14-22
Least Cost Decisions
Buy the New Truck
Year
Cash
Flows
10%
Factor
Present
Value
Purchase price Now $ (21,000) 1.000 $ (21,000)
Annual operating costs 1-5 (6,000) 3.791 (22,746)
Salvage value of old truck Now 9,000 1.000 9,000
Salvage value of new truck 5 3,000 0.621 1,863
Net present value
(32,883)
Keep the Old Truck
Year
Cash
Flows
10%
Factor
Present
Value
Overhaul cost Now $ (4,500) 1.000 $ (4,500)
Annual operating costs 1-5 (10,000) 3.791 (37,910)
Salvage value of old truck 5 250 0.621 155
Net present value
(42,255)
14-23
Least Cost Decisions
Home Furniture should purchase the new truck.
Net present value of costs
associated with purchase
of new truck (32,883) $
Net present value of costs
associated with overhauling
existing truck (42,255)
Net present value in favor of
purchasing the new truck 9,372 $
14-24
Preference Decision The Ranking of
Investment Projects
Screening Decisions
Pertain to whether or
not some proposed
investment is
acceptable; these
decisions come first.
Preference Decisions
Attempt to rank
acceptable
alternatives from the
most to least
appealing.
14-25
Internal Rate of Return Method
The higher the internal
rate of return, the
more desirable the
project.
When using the internal rate of return
method to rank competing investment
projects, the preference rule is:
14-26
Net Present Value Method
The net present value of one project cannot
be directly compared to the net present
value of another project unless the
investments are equal.
14-27
Ranking Investment Projects
Project Net present value of the project
profitability Investment required
index
=
Project A Project B
Net present value (a)
1,000 $ 1,000 $
Investment required (b) $ 10,000 $ 5,000
Profitability index (a) (b)
0.10 0.20
The higher the profitability index, the
more desirable the project.
14-28
The Payback Method
The payback period is the length of time that it
takes for a project to recover its initial cost out
of the cash receipts that it generates.
When the annual net cash inflow is the same
each year, this formula can be used to compute
the payback period:


Payback period =
Investment required
Annual net cash inflow
14-29
Payback and Uneven Cash Flows
1 2 3 4 5
$1,000 $0 $2,000 $1,000 $500
When the cash flows associated with an
investment project change from year to year,
the payback formula introduced earlier cannot
be used.
Instead, the un-recovered investment must be
tracked year by year.
14-30
Simple Rate of Return Method
Does not focus on cash flows -- rather it
focuses on accounting net operating income.
The following formula is used to calculate the
simple rate of return:
Simple rate
of return
=
Annual incremental net operating income
-
Initial investment*
*Should be reduced by any salvage from the sale of the old equipment
14-31
Present Value of a Series of Cash Flows
1 2 3 4 5 6
$100 $100 $100 $100 $100 $100
An investment that involves a series of
identical cash flows at the end of each
year is called an annuity.

14-32
Present Value of a Series of Cash Flows
An Example
Lacey Inc. purchased a tract of land on
which a $60,000 payment will be due
each year for the next five years. What
is the present value of this stream of
cash payments when the discount rate
is 12%?
14-33
Present Value of a Series of Cash Flows
An Example
We could solve the problem like this . . .
Periods 10% 12% 14%
1 0.909 0.893 0.877
2 1.736 1.690 1.647
3 2.487 2.402 2.322
4 3.170 3.037 2.914
5 3.791 3.605 3.433
Present Value of an Annuity of $1
$60,000 3.605 = $216,300
14-34
Simplifying Assumptions
Taxable income
equals net income as
computed for
financial reports.
The tax rate is a
flat percentage of
taxable income.
14-35
Concept of After-tax Cost
After-tax cost
(net cash outflow)
= (1-Tax rate) Tax-deductible cash expense
An expenditure net of its tax effect is
known as after-tax cost.

Here is the equation for determining the
after-tax cost of any tax-deductible cash
expense:
14-36
Depreciation Tax Shield
While depreciation is not a cash
flow, it does affect the taxes that
must be paid and therefore has
an indirect effect on a
companys cash flows.
Tax savings from
the depreciation
tax shield
= Tax rate Depreciation deduction
14-37
End of Chapter 14
14-38