Chapter 12

The Capital BudgetingDecision

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PPT 12-1

FIGURE 12-1Capitalbudgeting procedures

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PPT 12-2

TABLE 12-1Cash flow forAlston Corporation

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PPT 12-2

TABLE 12-2Revised cash flow forAlston Corporation

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PPT 12-3

TABLE 12-3Investment alternatives

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PPT 12-3

TABLE 12-4Capital budgetingresults

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PPT 12-4

TABLE 12-6The reinvestment assumption−net present value ($10,000 investment)

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PPT 12-5

TABLE 12-7Capital rationing

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PPT 12-6

FIGURE 12-2Net presentvalueprofile

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PPT 12-7

FIGURE 12-3Net presentvalue profilewithcrossover

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PPT 12-8TABLE 12-8Categories for depreciation write-off

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PPT 12-9TABLE 12-9Depreciationpercentages(expressed indecimals)

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PPT 12-10

TABLE 12-10Depreciation schedule

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PPT 12-11

TABLE 12-11Cash flow related to thepurchase of machinery

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PPT 12-12

TABLE 12-12Net present valueanalysis

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PPT 12-13

TABLE 12-15Analysis of incrementaldepreciation benefits

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PPT 12-14

TABLE 12-16Analysis of incrementalcost savings benefits

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PPT 12-15

TABLE 12-17Present value of the totalincremental benefits

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Chapter 12 - Outline LT 12-1

What is Capital Budgeting? 3 Methods of Evaluating Investment Proposals Accept/Reject Decision Capital Rationing Net Present Value Profile Determining Whether to Purchase a Machine

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What is Capital Budgeting? LT 12-2

Capital Budgeting:

– represents a long-term investment decision

– involves the planning of expenditures for a project with a life of many years

– usually requires a large initial cash outflow with the expectation of future cash inflows

– uses present value analysis

– emphasizes cash flows rather than income

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3 Methods of Evaluating Investment Proposals LT 12-3

There are 3 widely used methods of evaluating investment proposals:

Payback Method (PB)Internal Rate of Return (IRR)Net Present Value (NPV)

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Payback Method LT 12-4

Payback Method (PB):

– computes the amount of time required to recoup the initial investment

– a cutoff period is established

Advantages:

– easy to use (“quick and dirty” approach)

– emphasizes liquidity

Disadvantages:

– ignores inflows after the cutoff period and fails to consider the time value of money

– is inferior to the other 2 methods

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Internal Rate of Return LT 12-5

Internal Rate of Return (IRR):

– represents a yield on an investment or an interest rate

– requires calculating the interest rate that equates the cash outflows (cost) with the cash inflows

– is the interest rate where the cash outflows equal the cash inflows (or NPV = 0)

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Net Present Value LT 12-6

Net Present Value (NPV):

– the present value of the cash inflows minus the present value of the cash outflows

– the cash inflows are discounted back over the life of the investment

– the basic discount rate is usually the firm’s cost of capital (WACC)

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Accept/Reject Decision LT 12-7

Payback Method (PB):–if PB period < cutoff period, accept the project

– if PB period > cutoff period, reject the project

Internal Rate of Return (IRR):– if IRR > cost of capital, accept the project

– if IRR < cost of capital, reject the project

Net Present Value (NPV):– if NPV > 0, accept the project

– if NPV < 0, reject the project

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Capital Rationing

A limit or constraint on the amount of funds that can be invested

Firm must rank investments based on their NPVs

Those with positive NPVs are accepted until all funds are exhausted

LT 12-8

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Net Present Value Profile LT 12-9

Net Present Value Profile:– a graph of the NPV of a project at 3 different

discount rates: a zero discount rate the normal discount rate (or cost of capital) the IRR for the investment

– allows an easy way to visualize whether or not an investment should be undertaken

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Determining Whether to Purchase a Machine LT 12-10

To make the actual investment decision:– calculate a depreciation schedule using the

appropriate MACRS class

– figure earnings and cash flow (CF)

– discount the cash flows back to the present to determine whether the machine should be purchased (only if NPV > 0)