LEARNING GOALS
394
C
APITAL
B
UDGETING
T
ECHNIQUES
CHAPTER
Across the Disciplines
WHY THIS CHAPTER MATTERS TO YOU
Accounting:
You need to understand capital budgeting tech-niques in order to help determine the after-tax cash flows asso-ciated with proposed capital expenditures.
Information systems:
You need to understand capital budget-ing techniques in order to design decision modules that helpreduce the amount of work required to analyze proposed capi- tal projects.
Management:
You need to understand capital budgeting tech-niques in order to understand the decision criteria used toaccept or reject proposed projects.
Marketing:
You need to understand capital budgeting techniques in order to understand how proposals for new mar-keting programs for new products, and for the expansion ofexisting product lines will be evaluated by the firm’s decisionmakers.
Operations:
You need to understand capital budgeting tech-niques in order to understand how proposals for the acquisitionof new equipment and plants will be evaluated by the firm’sdecision makers.
Use net present value profiles to compare NPVand IRR techniques.Discuss NPV and IRR in terms of conflicting rank-ings and the theoretical and practical strengthsof each approach.
LG6LG5
Understand the role of capital budgeting tech-niques in the capital budgeting process.Calculate, interpret, and evaluate the paybackperiod.Calculate, interpret, and evaluate the net presentvalue (NPV).Calculate, interpret, and evaluate the internal rateof return (IRR).
LG4LG3LG2LG1
9
395
H
ave you ever been stuck at an airportbecause your flight was late and youmissed your connection? You were frus- trated by the long lines at customer ser-vice counters and pay phones, and whenyou called on your cell phone, you wereplaced on hold for what seemed like for-ever. Wouldn’t it be nice to use yourInternet-capable cell phone or personal digital assistant (PDA) to pull up flight information and timetables and reschedule your flight? Since 2000,
Delta Airlines
passengers have been able todo just that.The airline was one of the first to recognize that it could increase customer loyalty by givingbusiness travelers better flight information more quickly. Before Delta’s e-business unit added this feature, however, the project had to be justified the project on the basis of its economicvalue. Unlike making capital budgeting decisions about whether to buy new aircraft or build main- tenance facilities, decisions that managers had been making for years, this project was moving them into uncharted skies—literally.Delta’scapitalbudgetingmethodologyforthisInternetprojectusedtraditionalnetpresentvalue(NPV)analysistodeveloprelevantcashflows,discountthematthecompany’scostofcapi- tal,andsubtracttheproject’sinitialinvestment.Anticipatedcostsavingswereamajorfactorindevelopingprojectedcashflows.WirelessWebaccessenablescustomerstoobtaininformationandconducttransactionswithoutcallingDelta’scustomerservicerepresentatives,sotheairlinedoesn’thavetoaddemployeestohandlealargercustomerbase.Anotherpotentialsavings:lowerpapercosts,becausemoreticketswillbeissuedelectronically,evenwhenlast-minutechangesareinvolved.Thesystemismorecost-effective,therebyresultinginbetterresourceutilizationandahigherROI.Improved productivity is another benefit to be derived from this wireless project. Deltahopes to add self-service features so that passengers can choose seats, check in, and handleother routine transactions online. This will free reservations agents to handle more calls placed to purchase tickets, thus generating more revenue. Building on its initial success, Delta is ready to expand its wireless applications. A joint project with American Airlines, United Airlines, andBoeing Corporation will equip planes with broadband Internet connections so that the airlinescan sell in-flight wireless services. Delta’s innovative technology initiatives have made it one offive finalists for Computerworld’s 21st Century Achievement Award.Delta based its decision to accept the wireless-communication project on the project’s pos-itive NPV, which indicated that the project would earn a return above its cost of capital. Thischapter focuses on the capital budgeting techniques, including NPV, that companies use toaccept or reject and to rank proposed projects.
D
ELTA
D
ELTA
C
UTSTHE
W
IRES
1. For simplification, these 5-year-lived projects with 5 years of cash inflows are used throughout this chapter. Proj-ects with usable lives equal to the number of years of cash inflows are also included in the end-of-chapter problems.Recall from Chapter 8 that under current tax law, MACRS depreciation results in
n
1 years of depreciation for an
n
-year class asset. This means that projects will commonly have at least 1 year of cash flow beyond their recoveryperiod. In actual practice, the usable lives of projects (and the associated cash inflows) may differ significantly fromtheir depreciable lives. Generally, under MACRS, usable lives are longer than depreciable lives.2. Two other, closely related techniques that are sometimes used to evaluate capital budgeting projects are the
aver-age (or accounting) rate of return (ARR)
and the
profitability index (PI).
The ARR is an unsophisticated techniquethat is calculated by dividing a project’s average profits after taxes by its average investment. Because it fails to con-
TABLE 9.1
Capital ExpenditureData for BennettCompany
Project AProject BInitial investment$42,000$45,000YearOperating cash inflows
1$14,000$28,000214,00012,000314,00010,000414,00010,000514,00010,000
LG1
Hint
Remember that theinitial investment is an
outflow
occurring at time zero.
396
PART 3Long-Term Investment Decisions
9.1Overview of Capital Budgeting Techniques
Whenfirmshavedevelopedrelevantcashflows,asdemonstratedinChapter8,theyanalyzethemtoassesswhetheraprojectisacceptableortorankprojects.Anumberoftechniquesareavailableforperformingsuchanalyses.Thepreferredapproachesintegratetimevalueprocedures,riskandreturnconsiderations,andvaluationconceptstoselectcapitalexpendituresthatareconsistentwiththefirm’sgoalofmaximizingowners’wealth.Thischapterfocusesontheuseofthesetechniquesinanenvironmentofcertainty.Chapter10coversriskandotherrefinementsincapitalbudgeting.We will use one basic problem to illustrate all the techniques described in thischapter. The problem concerns Bennett Company, a medium-sized metal fabrica-tor that is currently contemplating two projects: Project A requires an initialinvestment of $42,000, project B an initial investment of $45,000. The projectedrelevant operating cash inflows for the two projects are presented in Table 9.1and depicted on the time lines in Figure 9.1.
1
The projects exhibit
conventional cash flow patterns,
which are assumed throughout the text. In addition, we ini-tially assume that all projects’ cash flows have the same level of risk, that projectsbeing compared have equal usable lives, and that the firm has unlimited funds.(The risk assumption will be relaxed in Chapter 10.) We begin with a look at thethree most popular capital budgeting techniques: payback period, net presentvalue, and internal rate of return.
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