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CHAPTER 12

CAPITAL BUDGETING UNDER CERTAINTY

1. Shareholder wealth maximization occurs when projects are chosen with a rate of
return greater than the market-determined rate of return or the cost of capital of
the firm. Stated in other words, profit maximization occurs when the firm’s
marginal costs equal its marginal revenue. Shareholder wealth maximization and
profit maximization are synonymous with maximizing the value of the firm.
The relevant cash flows to examine are the expected cash inflows from the
project over time and the initial and continuing outflows or costs associated with
the project. The future cash flows that are incremental to the project or that accrue
to the firm only as a result of the specific project in question should be examined.
In addition, any decrease in cash flows to the company caused by the project in
question, e.g., the tax depreciation benefit when old equipment is replaced by
equipment, must be considered as well.
Accounting regulations attempt to adjust cash flows over several periods; e.g.,
the expense of an asset is depreciated over several time periods. Hence, project
costs associated with the project are matched with the project revenues in the
periods in which those revenues are expected to accrue. Because this time frame
may span the life of the project, accounting for cash flows at a given point in time
for capital budgeting purposes is accomplished by using economic cash flows.
Economic cash flows are calculated as they occur to the firm.
2.
a. The incremental after-tax operating cash flow (net cash inflow) in a given
period t is defined as the after tax incremental operating cash flow, (1 – τt)COt
plus the incremental depreciation tax subsidy, τtdept, where COt represents the
pretax incremental operating cash flow, τt represents the marginal tax rate, and
dept represents the incremental depreciation. Incremental means the change in
a particular item as a result of the firm undertaking the project.

b. A mutually exclusive project is one whose acceptance precludes the
acceptance of another project while an independent project can be accepted
even other projects are also accepted.

c. The opportunity cost of a new investment is the yield that is given up to
invest in the new project. The cost of capital is the rate of return required by
an investor to invest in a project which means that another investment must be
given up. Thus, the cost of capital is the investor's opportunity cost.

d. The accounting rate of return (ARR) method is the ratio of the investment's
annual net income after taxes to either total outlay or average outlay. (See page
462 of text.)

e. The reinvestment rate is that rate at which cash flows from a project are
reinvested.

f. The profitability index, often referred to as the benefit/cost ratio, is defined as
the present value of (incremental) net cash inflows over the life of the project
divided by the initial outlay for the project.

g. Capital rationing refers to the scenario where a firm sets limits on the amount
of funds it will spend on fixed assets due to the large number of available
(profitable) investments.
3. In estimating cash flows without debt, the following equation expresses the
necessary tax adjustments:

A disadvantage of both the IRR and the NPV is that they do not explicitly account for the risk of the project. Both the IRR and the NPV have advantages relative to the ARR and the PBP in that they account for the time value of money. T = corporate tax rate. the IRR and NPV can give conflicting accept/reject decisions 6.476-480 7. It is the point in time at which the cumulative net cash flow from the project equals the initial investment. respectively. D = incremental annual change in depreciation (DEP) (i. and salvage value. are the increase in income due to the new project. adjustments to the CF for additional taxes due to the increased income and due to the difference in DEP per year. Included in the CF. Identification of areas of opportunity b.CF = ICFBT (1 – T) + TD. and d. For a detailed discussion of capital rationing with linear programming. Furthermore. The annual cash inflows are . 4. Professor Pinches suggests the following process: a. see pp. Control or feedback of the degree of success or failure of both the project and the decision process itself 5. DEP of new- DEP of old). Development of information c.e. where ICFBT = incremental CF before tax. With debt financing we must also adjust the increased interest payments per year. a) The payback method calculates the time period required for the firm to recover the cost of its investment. Selection of the best alternative or courses of action to be implemented. The first and last year CF will include investment.. then. net of tax savings. Linear programming can be used to solve the capital rationing problem by formulating an objective function which maximizes the NPV of the set of projects selected subject to constraints representing the scarcity of resources. set-up costs.

c) The internal rate-of-return is that discount rate which equates the discounted cash flows from a project to the initial investment cost. e) The profitability index is calculated by dividing the discounted cash flows by the initial investment to arrive at the present value per dollar of outlay: . (1  IRR) where CFt = cash flow (positive or negative) in period t I = initial investment. N = the life of the project. b) The accounting rate-of-return method averages the after-tax profit from an investment for every period over the initial outlay. IRR must be solved iteratively as follows: N NPV   t 0 CFt  I. d) The net present value of a project is computed by discounting the cash flows to the present by the appropriate cost of capital. N ARR   t 0 APt N I. where APt = after tax profit in period t I = initial investment N = the life of the project. Thus. N NPV   t 0 CFt I (1  K)t where k = the appropriate discount rate. The cumulative time period is calculated at the point where the sum of annual cash inflows equals the initial investment.estimated for the project’s life. The time period is the payback period. The IRR is then compared with the cost of capital of the firm to determine whether the project will return benefits greater than its cost. A net present value greater than one means that undertaking the project will increase the value of the firm.

N PI   t 0 CFt (1  K)t I. In contrast. Thus the conflict . note that the NPV of each project falls. and internal rate-of-return methods are theoretically and empirically more acceptable than the accounting rate-ofreturn and net payback period methods in that they explicitly consider the cost of capital and the time value of money. in some instances the two methods will provide different rankings for capital investment projects. The net present value method assumes reinvestment of intermediate funds at a single discount rate. The points at which NPV = 0 are the projects’ IRR’s.1%. The ranking derived from the NPV differs from that of the IRR if the discount rate used in the NPV calculation is below point C or 7. Moving along the horizontal axis to larger discount rates in the above diagram. In addition. 8. the IRR method assumes that intermediate net cash flows are reinvested to earn a rate equal to the internal rate of return. the NPV of the project with larger future cash flows will be affected more severely by the increasing discount rate and thus the NPV of project A decreases more rapidly than that of project B. however. Projects result in different rankings if the cost of one project is greater than that of another or if the timing of cash flow differs among projects. The net present value. The NPV and IRR methods may lead to similar accept/reject decisions. profitability index. The project should be undertaken if the PI is greater than 1.

Although there are drawbacks implicit in the assumptions of IRR in real-world problems. Given this constraint. For example. it is illogical to assume that shareholders can invest funds for instance at both 14% and 25% depending on the IRR of the two projects. a) Multiple rates of return can occur using IRR if the cash flows change sign. Ideally. in considering two mutually exclusive projects. the IRR is most appropriate. IRR is often used in conjunction with other capital budgeting methods so that these assumptions are somewhat counterbalanced. Inflation has a major impact upon all financial decisions of the firm mainly because tax deductibility of depreciation charges is based upon historical costs. and constraints. IRR can lead to conflicting capital budgeting solutions. goals. Although these arguments are valid. This causes two problems: (1) it divorces the discounting process from the cost of capital and (2) it implies that reinvestment rates are contingent on individual projects. b) IRR calculations use the assumption that the shareholder can reinvest the cash flows at the IRR. the IRR’s legitimacy is weakened. there will be a new root solution to the IRR problem. regardless of what the length of the project’s useful life is. When this occurs. Multiple or imaginary roots make interpretation of the capital budgeting solution difficult. The IRR may be the most appropriate return measure depending upon the firm’s specific policies. c) When groups of projects are considered. It is also possible for the IRR solution to be imaginary. 10. 9. Nelson goes on to isolate 5 areas in which inflation has impact on capital budgeting decisions: a) The optimal level of capital investment will typically decrease as the rate of . In a world of certainty where each project has the same risk. the viability of using the IRR method should be evaluated only within the corporate or business context.between the NPV and IRR rankings depends on whether the discount rate used by the firm is less than the cross-over rate (point C) or the rate that equates the projects NPV’s. firm policy may set a planning horizon of 4 to 5 years. depending on what combination of projects are considered. a decision rule should allow the manager to choose projects independently of one another. With this in mind.

but the standard error of the estimate of the project’s IRR exceeds the firm’s standard error. higher inflation will work against current replacement. risk-averse investors. 11. Practitioners face the problem of managing uncertainty when performing capital budgeting. and influences the chosen amount of each factor. and thus the lower the marginal present value for successive dollars invested. b) High rates of inflation result in lower capital/labor ratios and thus influence the firm’s choice of technology. the price of the firm’s common stock (its market trade-off point) is a function of its expected rate of return and estimated standard error of return. c) Inflation’s impact on mutually exclusive projects deals with depreciation in the sense that depreciation rates are based on historical costs and the distribution of these charges over the life span of the projects determines the net present value. the larger the discount rate. acceptance criteria are obvious with two exceptions. d) When inflation is high. Tuttle and Litzenberger suggest that returns on investment projects can be made risk-equivalent to the firm’s cost of equity capital by financing the projects with the proper amount of borrowing or lending.inflation increases. the return is made “risk-equivalent” by neutralizing the . With perfect correlation of projected returns. In these cases. These occur when the expected IRR of project i exceeds the firm’s equity capitalization rate. Thus the level of inflation corresponds to different price ratios between labor and capital. or when IRRi < Ri. Assuming a competitive market with many small. whereas the “price” of investment does depend on inflation. The higher the rate of inflation. In these instances. e) This proposition relates to those projects whose lifetime is influenced by managerial decisions about replacement. This occurs because the present value of the replacement is directly influenced by the effect of inflation on future tax savings from depreciation. Then capital budgeting decision is not so clear. but Si < Sf. although with low inflation an investment may be replaced because of high operating costs. Thus. with high inflation the present value of the old project may be higher than that of the replacement project. The “price” of labor does not depend on the rate of inflation. projects with shorter life spans will be favored over those with longer expected lives because those with shorter life spans will have their depreciation costs restated in current dollars more frequently as they are replaced.

the relevant discount rate can be determined to make projects “risk-equivalent. Hastie feels the major problems for practitioners include capital rationing. and the quality of analytic support. allowing for net present value analysis in the risk-equivalent context. If the perfect correlation assumption is removed. and the failure of the financial analyst to be objective or realistic. The analytic techniques employed should be well understood by all who work with them and should generate the relevant information a firm uses in its decision making.risk inherent in the project through a specific debt-equity ratio or through longterm borrowing and lending. In this framework. . and implementation and review stages should be considered more by theoreticians. strategic purposes. estimation of CF. judgment errors in estimation. systematic risk is the relevant risk measure. Errors in judgment in estimating uncertain future profits may come from excessive pessimism or optimism or just bad judgment in general. the new cost of financing is determined through the financing ratio that equates the estimated standard error of returns after acceptance of the project with the error calculated before acceptance. In dealing with these problems. The two methods most commonly used to quantify risk in this context are the certainty equivalent approach and the risk-adjusted discount rate approach. This then becomes the discount rate that reflects the risk-adjusted cost of financing the project. overall corporate strategy should be clear and communicated to all involved planners and analysts. The risk-adjusted rate of return equals the yield to maturity of the firms’ long-term debt plus the financing mix factor multiplied by the expected IRR less the yield to maturity. Perhaps academicians should place more attention on the non-quantitative aspects of the problem. Probability of excess returns is not considered “risk” in this case. That is. the project definition.” Semi-variance is also used as a risk measure in capital budgeting because many managers are concerned only with downside risk. Capital rationing may be caused by limits on borrowing. In markets dominated by large institutional investors. but theory does not offer a method of ranking projects with different risks.

The adjustment to compensate for projects with unequal lives can be carried out using either equation (12. NPV in break-even analysis uses the following model: t NPV ( k )    R (t )  C (t )  e  dt 0 where NPV(k) = net present value of the project discounted at the cost-of-capita1 rate. This is followed by defining the constraints and expressing them as linear equations or inequalities of the decision variables. Traditional NPV techniques may not be appropriate to select a project from mutually exclusive investment alternatives. if the projects have different lives. Besides this infinite replication method the manager can also use the finite replication method. 12. The first step is to model the problem in linear programming form. consideration must be given to non-quantifiable factors such as human dedication to the project. . If these assumptions are not valid. we can compute NPV of infinite replications of the investment project. In order to compare projects with different lives. To employ the latter approach the following formula should be used: NPV ( N )(1  H t 1 ) 1 H Definitions and interpretation for this formula’s components can be found on page 473-474. NPV ( N . Linear programming can be used in capital rationing when the objective of the firm is to be maximized or minimized and the constraints limiting the firm’s actions are linear functions of the decision variables involved. integer and stochastic programming can be used. t )  14. This is done by a) identifying the controllable decision variables and b) defining the objective to be maximized or minimized and representing it as a linear function of the controllable decision variables.13). The following assumptions are made: (1) the solution values of the decision variables are divisible. 13. Such factors are important in determining risk associated with projects in real-world applications. The reason is that a short-lived project can be replicated more quickly than a longlived project. and (2) the constant coefficients are assumed known and deterministic.12) or (12.Although in theory a project’s coavariance with other projects is the relevant risk measure. k.

443)=$24.000 = $ 198.216)=$22.990)(3. Project B should be accepted.18) NPV(B) = ($6.95 b) NPB(A) = ($4. Here the break-even sales levels are 287.89 NPV(B) = ($6.990)(3.066. average ρ = 15. In this model. t = the investment time horizon.09 – 25. C(t) = the stream of cash outlays at time t. development and initial investment phase = 42 months. 15. and in Cash (c) project A should be accepted.47 – 25.605)=$25. equal to log (1 + k). p = the continuously compounded discount rate. Discount rates are an important factor in dynamic break-even analysis. 360 and 510 units. in Cash (a). accounting information and mathematical tools are incorporated to make the project decision analysis more acceptable.000 =$1.000 =$1. Various discount rates are used to determine various breakeven plots.650)=$24. Curves are drawn on the assumptions that total nonrecurring costs are (R + I) = $900mm. corporate tax rate = 50%.694.791)=$26.305. Once the NPV of various projects is determined.736.000 =$2.499.89 – 25.853.990)(3. the values are plotted against units sold.000 = $(933.351)(5.43) c) NPV(A) = ($4.95 – 25.82 – 25.145)=$26. a) NPV(A) = ($4. 3 products/month are produced and sold.15 – 25.09 Since the initial cost for both projects is $25. in Cash (b) neither project should be accepted. .736. finance theory. and that costs will always have positive revenues.351)(5.R(t) = the stream of cash revenues at time t.5.000.198.85) NPV(B) = ($6.000 = $(146.499.351)(6.

55 or 55% 4 400 Project B (10  50  60  80) 100 200  . 17. Project A (50  50  60  60) 100 220  .50 or 50% 4 400 Project C (120  40  30  10) 100 200  . 18.(d) Using the information from (a). Project A: PBP = 2 years Project B: PBP = 2 + (40/60) = 2 Project C: PBP = 100/120 = 2 years 3 5 years 6 C is the best project if the payback method is adopted. (b). and (c). students can graph the NPV profiles following the example given on page 467of the text. 200  40 60 50 100 1000     2 3 4 (1  rA ) (1  rA ) (1  rA ) (1  rA ) (1  rA )5 200  100 100 50 60 40     2 3 4 (1  rB ) (1  rB ) (1  rB ) (1  rB ) (1  rB )5 .50 or 50% 4 400 A is the best project. 16.

Infinite Replication NPVX  30.84)[ (1 1.1) (1.683 ) 0.1)4  30.57  68.58 1.58)(4.84  (48.16 NPVY  48.1)2 a. 80 70   100  72.1)4  30.58)[ (1 1.84)( 0.1) (1.1)4  0 ] 1  (1 1.1 (1.1)2  30.1)2  0 ] 1  (1 1.07 .58)( 1 1  K K ) 2 (1. the IRR’s of projects A and B are given as follows: rA = 53.1 (1.73  57.1) (1  .84[ 1 1  K K ] 4 (1  . NPVX  100  NPVY  100  20 30 50 100    2 3 1.58  K K (1.Using the trial and error method.63% rB = 27.09% 19.1)4  100  18.58  (30.84  48.85  30.78  37.1)4  48.58 30.30  $48.58  (30.7606)  $176.84 b.1)2 (1.1)8  48.1) (1.18  24.317  $154.58  30.84  (48.58  (30.

08 (1.1 (1.85  103.33 NPVB = –5.08)2 Since the NPV of B is less than the NPV of A.1)2 IRRA = 10% Project B’s IRR 200  121 108.1)2 IRRB = 10% CASE 1: If the discount rate is 8%.1 (1.08 (1. NPVA  200  110 121   200  101. For example: Project A’s IRR 200  110 121  1. which is less than the IRR of 10%.59 1.20. CASE 2 If the discount rate is 12% which is larger than the IRR of 10%. then the projects are unacceptable. then the projects are both acceptable.9  1.08)2 NPVB  200  121 108.90   200  112.74  5.39 1. project A is the better of the two. Whether project A or B is better depends on whether the appropriate discount rate is less than or greater than the IRR.36  5.03  93. NPVA = –5.15 .

000 12.6  99. a. 632. 22.000 $92.000 $173.000 $ 80.000) $150.000 (1 – .8  956.000 per year Savings in Operating Expenses Salaries (10 × $15. 000  357.000 12.000 3.000 – 92. 200.000 Net Operating Cash flow = $81.4 1.000 50. 000  400.12)2 ZZZ should reject this project.000) Production Delays Lost Sales Timely Billing Additional Expenses: Salaries of Specialists Maintenance Expenses Incremental Cash flow (173.40) + (.40)(50.000 b.000/5 = $50. 000 1.000 .000 8.000 $250.12 (1. NPV  500.000) = $81. 21.142.NPVA < NPVB but both projects have negative) NPV’s and are therefore unacceptable. because the NPV is negative. Operating Cash Flows Net Operating Cash Flow = Ct = CFt(1 – T) + (Td) Depreciation: $250. Initial Net Cash Outlay Cost of System Installation Expenses Net Cash Outlay $200. 490. 000   500.

000 t t 1 (1  .72 d.56% is slightly higher than 11. Thus. 000 t t 1 (1  . 600 (3.5%. Payback Period = 3 2 Years 3 .6045)  250.115) 5  = 68. 000 The PI is less than 1. 600  250. However. Thus. f. NPV    68.383. the project is unacceptable.5% results in the following NPV: 68. the IRR is still less than the required rate of return of 12%.12) 5 c.600 (3.6499) – 250.= 48. e. 600  250.600 + 20. 710.14 – 250.000 = 250.000 = $383.000 = $68. IRR (r): 68. PI  PV of Future Cash Flows 247. 000  $2.14 The actual IRR of 11. 000  0 t t 1 (1  r ) 5 NPV   A value of r = 11.0.600 68. 600  250. the project should be rejected. 289   0.989 IO 250.

60 + 4539.000 (1 – .000 10.000) = $67. $ 20.6048) + 8000 (0.000 – 20.000 per year Operating Cash Flows = 81.289.000 Terminal Cash Flow: Book Value Market Value Loss Tax Credit from loss on sale of asset (@ 40%) Thus.000 $8.800.000 $15.28 + 8511 – 250.12) (1  .20 – 250.5674) – 250.000 0 $20.12)5 5 NPV  68.000 = $5.5674) – 250.000.28 Project is acceptable. The project should be rejected.20 The NPV is negative. the terminal value = $8.4) + (.000 (3. 600 = 68.000(0.000 . Terminal Cash Flow: Sale Price (t = 5) Tax on gains @ 40 % Net TCF % $25.000 = –$3939.40) (46.000 = $241521. 000   250.000) / 5 = $46. NPV = 67. 000 t t 1 (1  .6045) + 15.000 1 15.000 = 247. Depreciation = (250.600(3. h.g. 23.

Initial Net Cash Outlay: Cashflow from Sale of Old Vehicle: Book Value Market Value Tax Credit on Loss (30.000/5 = $18.000 Breakdowns 15.000 14.400 Initial Outlay Cost of New Truck $90.800 + 3.000 Net Annual Operating Cash Flow = CFt(1 – T) + Td = 23.40)(8.000 Cash Flow From Sale of Old Truck $20.400 $20.000 8.000/3 = $10.000 .000 Terminal Cash Flow: Sale Price Tax on gain @ 40% $20.600 Depreciation on new = $90.400 Net Outlay $69.40) + (.000 Total Savings $23.000 per year Depreciation on old = $30. Operating and Terminal Cash flows: Savings: Maintenance $ 8.000 6.a.000 – 14.200 = $17.000)(.000) = 13.000 per year b.000(1 – .40) Total Inflow $ 30.

000(0. NPV  17. 600  $64.$12.7908)  12.10) (1  .6209)  69. 000  17. 443.60  7450.10)t 5 c. e.000 is not considered) 24.0941 (assuming the terminal value of $12.1%.0) I = (2 – 1)(5000) = $5000 25. Initial Cash Outlay : . 000(3. NPV = (PI – 1. 600 t t 1 (1  . PI  71. Payback Period = 4.80  69. The IRR is approximately 11. 294.000 1 12000   69. 600  $71894.40 d.40  69600  $2.0 f. 600 The project is acceptable because: NPV > 0 IRR > required rate of return PI > 1.0329 69.40  1.894.

000 b.40) = $22.479.000 27.000 = $26. 000 t t 1 (1  .000(1 – .000)(.58 $95.2697) – 140. Operating and Terminal Cash flows: Depreciation = (80.000 + 20.000 22.000 .000 20.000 $55.000 per year Cash flow from Operations: Annual Revenues Variable Costs Fixed Costs Annual Cash Flow $ 90.000 25.10)10 10 c.2161) + 73.000 $140. NPV  26.800(5.000 40.10) (1  .000(0.800 + 4.800 Terminal Cash Flow: Sale Value of land and Building Book Value Gain on Sale Tax on Gain (@ 40%) Net Terminal Cash Flow 1 73.000 Annual Operating Cash Flow = CFt(1 – T) + dT = 38.800 = 26.000 = $19.000 80. 000   140.000)/10 = $10.Land Building Equipment Total Outlay $ 40.000 $95.000 = $159.000 $73.40) + (10.479.000 $38.58 – 140.

000 The project is acceptable based on the NPV. the operating cashflows would be reduced by $13. The terminal value cash flow would not change either. 000 t t 1 (1  . IRR.2161) + 73. 794  0.000(5. This would not affect the initial cash outlay.000. No.17) (1  . and PI.17)10  26. 000 IRR equals approximately 10.The IRR is approximately 17% as shown below: 1 73.2697) – 140.000(0.2080)  140. The project should be rejected. 479.000 = $118. 000   140. 000  $34 10 26. NPV = 19.66 %.40) = $78.58  1. However.206 PI  118.000 resulting in annual operating cash flows of $19.800(4.6586)  73.000(1 – . 000(0.800 PI  159. The allocation of existing overhead to the new facility is an accounting .139 140.794 – 140. d.000 = –$21. e.8485 140.

000(1 –.000 = –$101.000/10 = $9. 000  $117.000 Annual Net Cash Flows: Project A: = –10.1446)  105.000 –$ 9.000 105.060.100 Project B: = –9.10)  2100(6. Initial Outlay Depreciation Cash flow/year Alpha (A) $105. .40)(10. 26.000 90.800 1  105.903.66 10 NPVA  2100 NPVB = –1800(6.500(1 – .1446) – 90.000) = –$1.500 –$10.000/10 = $10.28 Project Gamma should be selected because it has a lower negative NPV.40) + (. 000 t t 1 (1  .40) + (.500 Gamma (B) $ 90.adjustment only.40)( 9.500) = –$2.