Chapter

McGraw-Hill/IrwinCopyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Capital Budgeting Decision12

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Chapter 12 - Outline

• What is Capital Budgeting?• 5 Methods of Evaluating

Investment Proposals

• Average Accounting Return

• Payback Period• Net Present Value• Internal Rate of Return• Profitability index

PPT 12-2

• Accept/Reject Decision• Capital Rationing• Net Present Value Profile• Capital Cost Allowance• Determining Whether to

Purchase a Machine• Summary and Conclusions

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What is Capital Budgeting?

Capital Budgeting:– represents a long-term investment decision

• for example, buy a new computer system or build a new plant

– involves the planning of expenditures for a project with a life of 1 or more years

– emphasizes amounts and timing of cash flows and opportunity costs and benefits

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

– considers only those cash flows that will change as a result of the investment

• all cash flows are calculated aftertax

PPT 12-3

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Administrative Considerations

• Steps in the decision-making process:– Search for and discovery of investment

opportunities– Collection of data– Evaluation and decision making– Reevaluation and adjustment

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Capital Budgeting Procedures

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Accounting Flows versus Cash Flow

• The capital budgeting process focuses on cash flows rather than income on an aftertax basis.

• Evaluation involves the incorporation of all incremental cash flows in the capital budgeting analysis. Sunk costs are ignored. Opportunity costs included.

• Accounting flows are not totally disregarded in the capital budgeting process.– Investors’ emphasis on EPS.– Top management may elect to glean the short-term personal

benefits of income effect.

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Earnings before amortization and taxes (cash inflow) . . . $20,000

Amortization (non-cash expense). . . . . . . . 5,000

Earnings before taxes . . . . . . . . . . . . 15,000

Taxes (cash outflow) . . . . . . . . . . . .7,500

Earnings aftertaxes . . . . . . . . . . . .7,500

Amortization . . . . . . . . . . . . . . + 5,000

Cash flow . . . . . . . . . . . . . . . $12,500

Alternative method of cash flow calculation

Cash inflow (EBAT) . . . . . . . . . . . . $20,000

Cash outflow (taxes) . . . . . . . . . . . .- 7,500

Cash flow . . . . . . . . . . . . . . . $12,500

PPT 12-5Table 12-1

Cash flow for Alston Corporation

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Earnings before amortization and taxes . . . . .$20,000

Amortization . . . . . . . . . . . . .20,000

Earnings before taxes . . . . . . . . . . 0

Taxes . . . . . . . . . . . . . . . 0

Earnings aftertaxes . . . . . . . . . . . 0

Amortization . . . . . . . . . . . . . + 20,000

Cash flow . . . . . . . . . . . . .$20,000

PPT 12-6Revised cash flow for Alston Corporation

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5 Methods of Evaluating Investment Proposals

• Average Accounting Return (AAR)

• Payback Period (PP)

• Internal Rate of Return (IRR)

• Net Present Value (NPV)

• Profitability Index (PI)

PPT 12-7

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Average Accounting Return

AAR Equals:

Average Earnings Aftertax

Average Book Value of Investment

Advantage: Relatively easy to calculate

Disadvantages:Uses accounting earnings, not cash flows

Ignores the timing of the earnings

Uses book value, not market value of investment

Does not suggest an an evaluation yardstick

PPT 12-8

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Payback Period

Payback Period (PP):– 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– one measure of the risk of an investment

• Disadvantages:– ignores inflows after the cutoff period and fails to consider the

time value of money– better measures of risk

PPT 12-9

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Net Present Value

Net Present Value (NPV):– the present value of the cash inflows

minus the present value of the cash outflows

– the future cash flows are discounted back over the life of the investment

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

PPT 12-11

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Internal Rate of Return

Internal Rate of Return (IRR):– represents a yield on an investment or an

interest rate

– requires calculating the discount rate that equates the initial cash outflow (cost) with the future cash inflows (benefits)

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

PPT 12-12

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Accept/Reject Decision

Payback Period (PP):– if PP < cutoff period, accept the project

– if PP > 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

PPT 12-14

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Net Cash Inflows (of a $10,000 investment)

Year Investment A Investment B

1 $5,000 $1,500

2 5,000 2,000

3 2,000 2,500

4 5,000

5 5,000

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

PPT 12-10Table 12-3

Investment alternatives

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Investment A Investment B Selection

Payback period . . . . 2 years 3.8 years Quickest payback: Investment A

Net present value . . . $180 $1,414 Highest net present value:

Investment B

Internal rate of return 11.16% 14.33% Highest yield: Investment B

Profitability Index . .1.0180 1.1414 Highest relativeprofitability:Investment B

PPT 12-13Table 12-4

Capital budgeting results

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NPV method versus IRR method

• The NPV method and the IRR method always agree on the accepted-reject decision on a capital proposal. ( a project having a NPV>=0 also means IRR> or =cost of capital)

• A disagreement may arise between the NPV and IRR methods when a choice must be made from mutually exclusive proposals or all acceptable proposals cannot be taken due to capital rationing.– The primary cause of disagreement is the differing discounting

assumptions. The NPV method of discounts cash flows at the cost of capital. The IRR method discounts of cash flows at the internal rate of return.

– The more conservative NPV technique is usually the recommended approach when a conflict in ranking arises.

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Investment A (11.16% IRR) Investment A

Year Cash Flow Year Cash Flow

1 . . . $5,000 1 . . . $5,000 10%

2 . . . 5,000 2 . . . 5,000 11%

3 . . . 2,000 3 . . . 2,000 12%

discounted at discounted

11.16% at various rates if desired

NPV = 0 NPV = $27

PPT 12-15Internal rate of return and net present value ($10,000 investment)

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Table 12-6

Multiple IRRsCash Flow @20% @500%

0 . . . . . . . . . . . . . -1,528 -1,528 -1,528

1 . . . . . . . . . . . . . 11,000 9,167 1,833

2 . . . . . . . . . . . . . -11,000 -7,639 -305

NPV 0 0

PPT 12-16

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Modified Internal Rate of Return (MIRR)

• Combines reinvestment assumption of the net present value method with the internal rate of return

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Modified Internal Rate of Return (MIRR) (cont’d)

• Assuming $10,000 produces the following inflows for the next three years:

• The cost of capital is 10%• Determining the terminal value of the inflows at a growth rate equal to

the cost of capital:

• To determine the MIRR:

PVIF = PV = $10,000 = .641 (Appendix B)

FV $15,610

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Capital Rationing

• Artificial restraint set on the usage of funds that can be invested in a given period– May be adopted because of:

• Fear of too much growth• Hesitation to use external sources of funding

– Hinders a firm from achieving maximum profitability

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Capital Rationing

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Net Present Value Profile

• Allows graphical representation of net present value of a project at different discount rates

• To apply the net present value profile, three characteristics need to be looked into:– The net present value at a zero discount rate– The net present value as determined by a

normal discount rate (such as cost of capital)– The internal rate of return for the investments

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Net Present Value Profile – Graphic Representation

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Net Present Value Profile with Crossover

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The Rules of Depreciation

• Assets are classified according to nine categories– Determine the allowable rate of depreciation

write-off– Modified accelerated cost recovery system

(MACRS) represent the categories– Asset depreciation range (ADR) is the expected

physical life of the asset or class of assets

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Categories for Depreciation Write-Off

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Depreciation Percentages(Expressed in Decimals)

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Depreciation Schedule

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The Tax Rate

• Corporate tax rates are subject to changes– Maximum quoted federal corporate tax rate is

now in the mid-30 percent range– Smaller corporations and others may pay taxes

only between 15 – 20%– Larger corporations with foreign tax obligations

and special state levies may pay effective taxes of 40% or more

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Actual Investment Decision

• Assumption: – $50,000 depreciation analysis allows purchase of machinery with a

six-year productive life– Produces an income of $18,500 for first three years before

deductions for depreciation and taxes– In the last three years, income before depreciation and taxes will be

$12,000– Corporate tax rate taken at 35% and cost of capital 10%

– For each year:• The depreciation is subtracted from “earnings before

depreciation and taxes” to arrive at earnings before taxes• Taxes then subtracted to determine earnings after taxes• Depreciation is added to earnings to arrive at cash flow

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Cash Flow Related to the Purchase of Machinery

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Net Present Value Analysis

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The Replacement Decision

• Investment decision for new technology

• Includes several additions to the basic investment situation– The sale of the old machine– Tax consequences

• Decision can be analyzed by using a total or an incremental analysis

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Book Value of Old Computer

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Net Cost of New Computer

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Analysis of Incremental Depreciation Benefits

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Analysis of Incremental Cost Savings Benefits

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Present Value of the Total Incremental Benefits

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Elective Expensing

• Businesses can write off tangible property, in the purchased year for up to $100,000– Includes: equipment, furniture, tools, computers

etc.

• Beneficial to small businesses: – Allowance is phased out dollar for dollar when

total property purchases exceed $200,000 in a year