Capital Budgeting Decisionsf

Capital Budgeting Decisions
Chapter Fourteen
McGrawHill/Irwin
Copyright2008,TheMcGrawHillCompanies,Inc.
Typical Capital Budgeting Decisions

Plant expansion
Equipment selection
Lease or buy
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Equipment replacement
Cost reduction
Typical Capital Budgeting Decisions

Capital budgeting tends to fall into two broad
categories . . .
Screening decisions. Does a proposed project
meet some preset standard of acceptance?
Preference decisions. Selecting from among
several competing courses of action.
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Time Value of Money
A dollar today is worth

more than a dollar a
year from now.
Therefore, investments
that promise earlier
returns are preferable to
those that promise later
returns.
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Time Value of Money

The capital
budgeting
techniques that best
recognize the time
value of money are
those that involve
discounted cash
flows.
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Learning Objective 1
Evaluate the acceptability

of an investment project
using the net present
value method.
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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.
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General decision rule . . .
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Net present value analysis
emphasizes cash flows and not
accounting net income.
The reason is that
accounting net income is
based on accruals that
ignore the timing of cash
flows into and out of an
organization.
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Typical Cash Outflows

Repairs and
maintenance
Working
capital
Initial
investment
Incremental
operating
costs
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Typical Cash Inflows

Salvage
value
Release of
working
capital
Reduction
of costs
Incremental
revenues
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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 return of the original investment.
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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?
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Periods
1
2
3
4
5
McGrawHill/Irwin
Present Value of $1
10%
12%
0.909
0.893
1.736
1.690
2.487
2.402
3.170
3.037
3.791
3.605
14%
0.877
1.647
2.322
2.914
3.433
Present
Present value
value
of
of an
an annuity
annuity
of
of $1
$1 table
table

(1)
(2)
Investment
Outstanding
during the
Cash
Year
year
Inflow
1
$
3,170 $ 1,000
2
$
2,487 $ 1,000
3
$
1,736 $ 1,000
4
$
909 $ 1,000
Total investment recovered
(3)
Return on
Investment
(1) 10%
$
317
$
249
$
173
$
91
(4)
Recover of
Investment
during the
year
(2) - (3)
$
683
$
751
$
827
$
909
$
3,170
(5)
Unrecovered
Investment at
the end of the
year
(1) - (4)
$
2,487
$
1,736
$
909
$
-
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.
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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.
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All cash flows

generated by an
investment project
are immediately
reinvested at a rate of
return equal to the
discount rate.
Choosing a Discount Rate

The firms cost of capital
is usually regarded as the
minimum required rate of
return.
The cost of capital is the
average rate of return the
company must pay to its
long-term creditors and
stockholders for the use of
their funds.
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Lester Company has been offered a five year contract
to provide component parts for a large
manufacturer.
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At the end of five years the working capital
will be released and may be used elsewhere
by Lester.
Lester Company uses a discount rate of
10%.
Should the contract be accepted?
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Annual net cash inflow from operations
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Present value of an annuity of $1

factor for 5 years at 10%.
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Present value of $1
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Present value of $1
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Accept the contract because the project has a

positive net present value.
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Quick Check
Denny Associates has been offered a four-year contract to
supply the computing requirements for a local bank.
The working capital would be released at the end of the

contract.
Denny Associates requires a 14% return.
McGrawHill/Irwin
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
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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
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Evaluate the acceptability

of an investment project
using the internal rate of
return method.
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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.
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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.
McGrawHill/Irwin

Decker Company can purchase a new
machine at a cost of $104,320 that will save
$20,000 per year in cash operating costs.
The machine has a 10-year life.
McGrawHill/Irwin

Future cash flows are the same every year in
this example, so we can calculate the
internal rate of return as follows:
PV factor for the
=
internal rate of return
$104, 320
$20,000
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Investment required
Net annual cash flows
= 5.216

Using the present value of an annuity of $1 table . . .
Find the 10-period row, move across
until you find the factor 5.216. Look
at the top of the column and you
find a rate of 14%.
14%
Periods
1
2
. . .
9
10
McGrawHill/Irwin
10%
0.909
1.736
. . .
5.759
6.145
12%
0.893
1.690
. . .
5.328
5.650
14%
0.877
1.647
. . .
4.946
5.216

Decker Company can purchase a new
machine at a cost of $104,320 that will save
$20,000 per year in cash operating costs.
The machine has a 10-year life.
The internal rate of return on
this project is 14%.
If the internal rate of return is equal to or
greater than the companys required rate of
return, the project is acceptable.
McGrawHill/Irwin
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
McGrawHill/Irwin
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?
$79,310/$22,000 = 3.605,
a. 10%
which is the present value factor
b. 12%
for an annuity over five years
c. 14%
when the interest rate is 12%.
d. Cannot be determined
McGrawHill/Irwin
Net Present Value vs. Internal Rate of Return
NPV is easier to use.

Questionable assumption:
Internal rate of return
method assumes cash
inflows are reinvested at
the internal rate of return.
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Net Present Value vs. Internal Rate of Return
NPV is easier to use.

Questionable assumption:
Internal rate of return
method assumes cash
inflows are reinvested at
the internal rate of return.
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Expanding the Net Present Value Method

To compare competing investment projects we
can use the following net present value
approaches:
Total-cost
Incremental cost
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The Total-Cost Approach

White Company has two alternatives:
(1) remodel an old car wash or,
(2) remove it and install a new one.
The company uses a discount rate of 10%.

New Car
Wash
Annual revenues
$ 90,000
Annual cash operating costs
30,000
Net annual cash inflows
$ 60,000
McGrawHill/Irwin
Old Car
Wash
$ 70,000
25,000
$ 45,000

If White installs a new washer . . .
Cost
Productive life
Salvage value
Replace brushes at
the end of 6 years
Salvage of old equip.
$300,000
10 years
7,000
50,000
40,000
Lets look at the present value

of this alternative.
McGrawHill/Irwin

Install the New Washer
Cash
Year
Flows
Initial investment
Now
$ (300,000)
Replace brushes
6
(50,000)
1-10
60,000
Salvage of old equipment
Now
40,000
Salvage of new equipment
10
7,000
Net present value
10%
Factor
1.000
0.564
6.145
1.000
0.386
Present
Value
$ (300,000)
(28,200)
368,700
40,000
2,702
$
83,202
If we install the new washer, the

investment will yield a positive net
present value of $83,202.
McGrawHill/Irwin

If White remodels the existing washer . . .
Remodel costs
Replace brushes at
the end of 6 years
$175,000
80,000
Lets look at the present value

of this second alternative.
McGrawHill/Irwin

Remodel the Old Washer
Cash
10%
Year
Flows
Factor
Initial investment
Now
$ (175,000)
1.000
Replace brushes
6
(80,000)
0.564
1-10
45,000
6.145
Net present value
Present
Value
$ (175,000)
(45,120)
276,525
$ 56,405
If we remodel the existing washer, we will

produce a positive net present value of
$56,405.
McGrawHill/Irwin

Both projects yield a positive net
present value.
However, investing in the new washer will

produce a higher net present value than
remodeling the old washer.
McGrawHill/Irwin
The Incremental-Cost Approach

Under the incremental-cost approach, only
those cash flows that differ between the two
alternatives are considered.
Lets look at an analysis of the White Company
decision using the incremental-cost approach.
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The Incremental-Cost Approach
Incremental investment
Incremental cost of brushes
Increased net cash inflows
Salvage of old equipment
Salvage of new equipment
Net present value
Year
Now
6
1-10
Now
10
Cash
Flows
$(125,000)
$ 30,000
15,000
40,000
7,000
10%
Factor
1.000
0.564
6.145
1.000
0.386
Present
Value
$(125,000)
16,920
92,175
40,000
2,702
$ 26,797
We get the same answer under either the

total-cost or incremental-cost approach.
McGrawHill/Irwin
Quick Check
Consider the following alternative projects. Each project
would last for five years.
Project A
Project B
Initial investment
$80,000
$60,000
Annual net cash inflows
20,000
16,000
Salvage value
10,000
8,000
The company uses a discount rate of 14% to evaluate
projects. Which of the following statements is true?
a. NPV of Project A > NPV of Project B by $5,230
b. NPV of Project B > NPV of Project A by $5,230
c. NPV of Project A > NPV of Project B by $2,000
d. NPV of Project B > NPV of Project A by $2,000
McGrawHill/Irwin
Quick Check
Consider the following alternative projects. Each project
would last for five years.
Project A
Project B
Initial investment
$80,000
$60,000
Annual net cash inflows
20,000
16,000
Salvage value
10,000
8,000
The company uses a discount rate of 14% to evaluate
projects. Which of the following statements is true?
a. NPV of Project A > NPV of Project B by $5,230
b. NPV of Project B > NPV of Project A by $5,230
c. NPV of Project A > NPV of Project B by $2,000
d. NPV of Project B > NPV of Project A by $2,000
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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.
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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%.
McGrawHill/Irwin

Here is information about the trucks . . .
Old Truck
Overhaul cost now
Annual operating costs
Salvage value in 5 years
Salvage value now
McGrawHill/Irwin
$ 4,500
10,000
250
9,000

Buy the New Truck
Cash
Year
Flows
Purchase price
Now
$ (21,000)
1-5
(6,000)
Salvage value of old truck
Now
9,000
Salvage value of new truck
5
3,000
Net present value
Keep the Old Truck
Cash
Year
Flows
Overhaul cost
Now
$ (4,500)
1-5
(10,000)
Salvage value of old truck
5
250
Net present value
McGrawHill/Irwin
10%
Factor
1.000
3.791
1.000
0.621
10%
Factor
1.000
3.791
0.621
Present
Value
$ (21,000)
(22,746)
9,000
1,863
(32,883)
Present
Value
$ (4,500)
(37,910)
155
(42,255)

Home Furniture should purchase the new truck.
Net present value of costs
associated with purchase
of new truck
Net present value of costs
associated with remodeling
existing truck
Net present value in favor of
purchasing the new truck
McGrawHill/Irwin
$(32,883)
(42,255)
$ 9,372
Quick Check
Bay Architects is considering a drafting machine
that would cost $100,000, last four years, and
provide annual cash savings of $10,000 and
considerable intangible benefits each year. How
large (in cash terms) would the intangible benefits
have to be per year to justify investing in the
machine if the discount rate is 14%?
a. $15,000
b. $90,000
c. $24,317
d. $60,000
McGrawHill/Irwin
Quick Check
Bay Architects is considering a drafting machine
that would cost $100,000, last four years, and
provide annual cash savings of $10,000 and
$70,860/2.914
= each
$24,317
considerable intangible
benefits
year. How
large (in cash terms) would the intangible benefits
have to be per year to justify investing in the
machine if the discount rate is 14%?
a. $15,000
b. $90,000
c. $24,317
d. $60,000
McGrawHill/Irwin
Evaluate an investment
project that has uncertain
cash flows.
McGrawHill/Irwin
Uncertain Cash Flows An Example

Assume that all of the cash flows related to an
investment in a supertanker have been estimated,
except for its salvage value in 20 years.
Using a discount rate of 12%, management has
determined that the net present value of all the
cash flows, except the salvage value is a negative
$1.04 million.
How large would the salvage value need to be to
make this investment attractive?
McGrawHill/Irwin
Uncertain Cash Flows An Example

Net present value to be offset
Present value factor
$1,040,000
= $ 10,000,000
0.104
This equation can be used to determine that

if the salvage value of the supertanker is at
least $10,000,000, the net present value of
the investment would be positive and
therefore acceptable.
McGrawHill/Irwin
Real Options
Delay the start of
a project
Expand a project
if conditions are
favorable
Cut losses if
conditions are
unfavorable
The ability to consider these real options adds value to many
investments. The value of these options can be quantified using
what is called real options analysis, which is beyond the scope of
the book.
McGrawHill/Irwin
Rank investment projects

in order of preference.
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Preference Decision The Ranking of

Investment Projects
Screening Decisions
Preference Decisions
Pertain to whether or
not some proposed
investment is
acceptable; these
decisions come first.
Attempt to rank
acceptable
alternatives from the
most to least
appealing.
McGrawHill/Irwin

When using the internal rate of return
method to rank competing investment
projects, the preference rule is:
The higher the internal

rate of return, the
more desirable the
project.
McGrawHill/Irwin
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.
McGrawHill/Irwin
Ranking Investment Projects

Profitability
=
index
Present value of cash inflows

Investment required
Investment
A
Present value of cash inflows $81,000
Investment required
80,000
Profitability index
1.01
B
$6,000
5,000
1.20
The
The higher
higher the
the profitability
profitability index,
index, the
the
more
more desirable
desirable the
the project.
project.
McGrawHill/Irwin
Other Approaches to
Capital Budgeting Decisions
Other methods of making capital budgeting
decisions include . . .
The Payback Method.
Simple Rate of Return.
McGrawHill/Irwin
Determine the payback

period for an investment.
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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 net annual cash inflow is the same each
year, this formula can be used to compute the
payback period:
Payback period =
McGrawHill/Irwin
Investment required
Net annual cash inflow
The Payback Method

Management at The Daily Grind wants to install an
espresso bar in its restaurant.
The espresso bar:
1. Costs $140,000 and has a 10-year life.
2. Will generate net annual cash inflows of $35,000.
Management requires a payback period of 5 years or

less on all investments.
What is the payback period for the espresso bar?

McGrawHill/Irwin
The Payback Method

Investment required
Payback period =
Net annual cash inflow
Payback period =
$140,000
$35,000
Payback period =
4.0 years
According
According to
to the
the companys
companys criterion,
criterion,
management
management would
would invest
invest in
in the
the
espresso
espresso bar
bar because
because its
its payback
payback
period
period is
is less
less than
than 55 years.
years.
McGrawHill/Irwin
Quick Check
Consider the following two investments:
Project X Project Y
Initial investment
$100,000 $100,000
Year 1 cash inflow
$60,000
$60,000
Year 2 cash inflow
$40,000
$35,000
Year 3-10 cash inflows
$0
$25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined
McGrawHill/Irwin
Quick Check
Consider the following two investments:
Project X Project Y
Initial investment
$100,000 $100,000
Year 1 cash inflow
$60,000
$60,000
Year 2 cash inflow
$40,000
$35,000
Year 3-10 cash inflows
$0
$25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
Project X has a payback period of 2 years.
c. Cannot be determined
Project Y has a payback period of slightly more than 2 years.

Which project do you think is better?
McGrawHill/Irwin
Evaluation of the Payback Method

Ignores the
time value
of money.
Short-comings
of the payback
period.
McGrawHill/Irwin
Ignores cash
flows after
the payback
period.
Evaluation of the Payback Method

Serves as
screening
tool.
Strengths
of the payback
period.
Identifies
investments that
recoup cash
investments
quickly.
Identifies
products that
recoup initial
investment
quickly.
McGrawHill/Irwin
Payback and Uneven Cash Flows

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.
$1,000
1
McGrawHill/Irwin
$0
$2,000 $1,000
$500
Payback and Uneven Cash Flows

For example, if a project requires an initial
investment of $4,000 and provides uneven net
cash inflows in years 1-5 as shown, the
investment would be fully recovered in year 4.
$1,000
1
McGrawHill/Irwin
$0
$2,000 $1,000
$500
Compute the simple rate

of return for an
investment.
McGrawHill/Irwin
Simple Rate of Return Method

Does not focus on cash flows -- rather it
focuses on accounting net operating income.
income
The following formula is used to calculate the
simple rate of return:
Simple rate Annual incremental net operating income
=
of return
Initial investment*
*Should be reduced by any salvage from the sale of the old equipment
McGrawHill/Irwin

Management of The Daily Grind wants to install
an espresso bar in its restaurant.
The espresso bar:
1.
2.
Cost $140,000 and has a 10-year life.

Will generate incremental revenues of $100,000
and incremental expenses of $65,000 including
depreciation.
What is the simple rate of return on the

investment project?
McGrawHill/Irwin
Simple rate
of return
McGrawHill/Irwin
$35,000
$140,000
= 25%
Criticism of the Simple Rate of Return

Ignores the
time value
of money.
Short-comings
of the simple
rate of return.
McGrawHill/Irwin
The same project

may appear
desirable in some
years and
undesirable
in other years.
Postaudit of Investment Projects

A postaudit is a follow-up after the project has
been completed to see whether or not
expected results were actually realized.
McGrawHill/Irwin
The Concept of Present Value
Appendix 14A
McGrawHill/Irwin
(Appendix 14A)
Understand present value
concepts and the use of
present value tables.
McGrawHill/Irwin
The Mathematics of Interest

A dollar received
today is worth more
than a dollar received
a year from now
because you can put
it in the bank today
and have more than a
dollar a year from
now.
McGrawHill/Irwin
The Mathematics of Interest An Example
Assume a bank pays 8% interest on a

$100 deposit made today. How much
will the $100 be worth in one year?
Fn = P(1 + r)
McGrawHill/Irwin
The Mathematics of Interest An Example
Assume a bank pays 8% interest on a

$100 deposit made today. How much
will the $100 be worth in one year?
Fn = P(1 + r)
Fn = $100(1 + .08)1
Fn = $108.00
McGrawHill/Irwin
Compound Interest An Example

What if the $108 was left in the bank for a
second year? How much would the
original $100 be worth at the end of the
second year?
Fn = P(1 + r)
McGrawHill/Irwin
Compound Interest An Example
Fn = $100(1 + .08)
Fn = $116.64
The interest that is paid in the second year on the
interest earned in the first year is known as
compound interest.
McGrawHill/Irwin
Computation of Present Value

An investment can be viewed in two
waysits future value or its present
value.
Present
Value
Future
Value
Lets look at a situation where the

future value is known and the present
value is the unknown.
McGrawHill/Irwin
Present Value An Example

If a bond will pay $100 in two years, what
is the present value of the $100 if an
investor can earn a return of 12% on
investments?
Fn
P=
(1 + r)n
McGrawHill/Irwin
$100
P=
(1 + .12)2
P = $79.72
This process is called discounting. We have discounted
the $100 to its present value of $79.72. The interest rate
used to find the present value is called the discount rate.
McGrawHill/Irwin

Lets verify that if we put $79.72 in the bank
today at 12% interest that it would grow to $100
at the end of two years.
Year
Year
Year11
Year22
Beginning
Beginningbalance
balance $$ 79.72
79.72 $$ 89.29
89.29
Interest
$$ 9.57
Interest@
@12%
12%
9.57 $$ 10.71
10.71
Ending
$$ 89.29
Endingbalance
balance
89.29 $$100.00
100.00
IfIf $79.72
$79.72 is
is put
put in
in the
the bank
bank today
today and
and earns
earns
12%,
12%, itit will
will be
be worth
worth $100
$100 in
in two
two years.
years.
McGrawHill/Irwin

$100 0.797 = $79.70 present value
Periods
Periods
11
22
33
44
55
10%
10%
0.909
0.909
0.826
0.826
0.751
0.751
0.683
0.683
0.621
0.621
Rate
Rate
12%
12%
0.893
0.893
0.797
0.797
0.712
0.712
0.636
0.636
0.567
0.567
14%
14%
0.877
0.877
0.769
0.769
0.675
0.675
0.592
0.592
0.519
0.519
Present value factor of $1 for 2 periods at 12%.

McGrawHill/Irwin
Quick Check
How much would you have to put in the bank today
to have $100 at the end of five years if the interest
rate is 10%?
a. $62.10
b. $56.70
c. $90.90
d. $51.90
McGrawHill/Irwin
Quick Check
How much would you have to put in the bank today
to have $100 at the end of five years if the interest
rate is 10%?
a. $62.10
$100
0.621
=
$62.10
b. $56.70
c. $90.90
d. $51.90
McGrawHill/Irwin
Present Value of a Series of Cash Flows

An investment that involves a series of
identical cash flows at the end of each
year is called an annuity.
annuity
$100
McGrawHill/Irwin
$100
$100
$100
$100
$100

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%?
McGrawHill/Irwin

An Example
We could solve the problem like this . . .
Present
Periods
1
2
3
4
5
Value of an Annuity
10%
12%
0.909
0.893
1.736
1.690
2.487
2.402
3.170
3.037
3.791
3.605
of $1
14%
0.877
1.647
2.322
2.914
3.433
$60,000 3.605 = $216,300

McGrawHill/Irwin
Quick Check
If the interest rate is 14%, how much would you
have to put in the bank today so as to be able to
withdraw $100 at the end of each of the next five
years?
a. $34.33
b. $500.00
c. $343.30
d. $360.50
McGrawHill/Irwin
Quick Check
If the interest rate is 14%, how much would you
have to put in the bank today so as to be able to
withdraw $100 at the end of each of the next five
years?
a. $34.33
b. $500.00
c. $343.30
$100 3.433 = $343.30
d. $360.50
McGrawHill/Irwin
Income Taxes in Capital

Budgeting Decisions
Appendix 14C
McGrawHill/Irwin
(Appendix 14C)
Include income taxes in a
capital budgeting analysis.
McGrawHill/Irwin
Simplifying Assumptions
Taxable income
equals net
income as
computed for
financial reports.
The tax rate is a

flat percentage of
taxable income.
McGrawHill/Irwin
Concept of After-tax Cost

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:
After-tax cost
= (1-Tax rate) Tax-deductible cash expense
(net cash outflow)
McGrawHill/Irwin
After-tax Cost An Example

Assume a company with a 30% tax rate is
contemplating investing in a training program
that will cost $60,000 per year.
We can use this equation to determine that the
after-tax cost of the training program is
$42,000.
After-tax cost
= (1-Tax rate) Tax-deductible cash expense
(net cash outflow)
$42,000 = (1 - .30) $60,000
McGrawHill/Irwin

The answer can also be determined by
calculating the taxable income and income tax
for two alternativeswithout the training
program and with the training program.
The after-tax cost of

the training program is
the same$42,000.
McGrawHill/Irwin

The amount of net cash inflow
realized from a taxable cash
receipt after income tax effects
have been considered is known
as the after-tax benefit.
After-tax benefit
=
(net cash inflow)
McGrawHill/Irwin
(1-Tax rate) Taxable cash receipt
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 rate Depreciation deduction
tax shield
McGrawHill/Irwin
Depreciation Tax Shield An Example

Assume a company has annual cash sales and
cash operating expenses of $500,000 and
$310,000, respectively; a depreciable asset,
with no salvage value, on which the annual
straight-line depreciation expense is $90,000;
and a 30% tax rate.
Tax savings from
the depreciation = Tax rate Depreciation deduction
tax shield
McGrawHill/Irwin

Assume a company has annual cash sales and
cash operating expenses of $500,000 and
$310,000, respectively; a depreciable asset,
with no salvage value, on which the annual
straight-line depreciation expense is $90,000;
and a 30% tax rate.
Tax savings from
the depreciation
tax shield
$27,000
Tax rate Depreciation deduction
.30 $90,000
The depreciation tax shield is $27,000.

McGrawHill/Irwin

The answer can also be determined by
calculating the taxable income and income tax
for two alternativeswithout the depreciation
deduction and with the depreciation deduction.
The depreciation tax

shield is the same
$27,000.
McGrawHill/Irwin
Holland Company An Example

Holland Company owns the mineral
rights to land that has a deposit of ore.
The company is deciding whether to
purchase equipment and open a mine
on the property. The mine would be
depleted and closed in 10 years and
the equipment would be sold for its
salvage value.
More information is provided on the next slide.
McGrawHill/Irwin
Should
Holland open
a mine on
the property?
McGrawHill/Irwin

Step One: Compute the net annual cash
receipts from operating the mine.
Cash receipts from ore sales
Less cash expenses for mining ore
Net cash receipts
McGrawHill/Irwin
$
$
250,000
170,000
80,000

Step Two: Identify all relevant cash flows
as shown.
McGrawHill/Irwin

Step Three: Translate the relevant cash
flows to after-tax cash flows as shown.
McGrawHill/Irwin

Step Four: Discount all cash flows to
their present value as shown.
Items and Computations

Cost of new equipment
Working capital needed
Net annual cash receipts
Road repairs
Annual depreciation deductions
Salvage value of equipment
Release of working capital
Net present value
McGrawHill/Irwin
Holland Company
(1)
(2)
(3)
Tax
Effect
Year
Amount (1) (2)
Now $ (300,000)
0
Now $ (75,000)
0
1-10 $
80,000
1-.30
6
$ (40,000) 1-.30
1-10 $
30,000
.30
10
$ 100,000 1-.30
10
$
75,000
0
(4)
After-Tax
Cash Flows
$ (300,000)
$ (75,000)
$
56,000
$ (28,000)
$
9,000
$
70,000
$
75,000
(5)
(6)
12%
Present
Factor
Value
1.000 $ (300,000)
1.000
(75,000)
5.650
316,400
0.507
(14,196)
5.650
50,850
0.322
22,540
0.322
24,150
$
24,744
End of Chapter 14
McGrawHill/Irwin

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Capital Budgeting Decisionsf

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Capital Budgeting Decisions

Typical Capital Budgeting Decisions

Typical Capital Budgeting Decisions

meet some preset standard of acceptance?

Preference decisions. Selecting from among

several competing courses of action.

Time Value of Money

A dollar today is worth

Time Value of Money

Evaluate the acceptability

The Net Present Value Method

The Net Present Value Method

The Net Present Value Method

Typical Cash Outflows

Typical Cash Inflows

Recovery of the Original Investment

Recovery of the Original Investment

No investments are to be made unless they have

Recovery of the Original Investment

Recovery of the Original Investment

Two Simplifying Assumptions

All cash flows

Choosing a Discount Rate

The Net Present Value Method

The Net Present Value Method

Should the contract be accepted?

The Net Present Value Method

The Net Present Value Method

The Net Present Value Method

Present value of an annuity of $1

The Net Present Value Method

The Net Present Value Method

The Net Present Value Method

Accept the contract because the project has a

The working capital would be released at the end of the

Evaluate the acceptability

Internal Rate of Return Method

Internal Rate of Return Method

Then the Project is . . .

Equal to or greater than the minimum

Less than the minimum required rate

When using the internal rate of return,

Internal Rate of Return Method

Internal Rate of Return Method

Internal Rate of Return Method

Internal Rate of Return Method

Net Present Value vs. Internal Rate of Return

NPV is easier to use.

Net Present Value vs. Internal Rate of Return

NPV is easier to use.

Expanding the Net Present Value Method

The Total-Cost Approach

The company uses a discount rate of 10%.

The Total-Cost Approach

Lets look at the present value

The Total-Cost Approach

If we install the new washer, the

The Total-Cost Approach

Lets look at the present value

The Total-Cost Approach

If we remodel the existing washer, we will

The Total-Cost Approach

However, investing in the new washer will

The Incremental-Cost Approach