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CHAPTER 12

Planning for Capital Investments


ASSIGNMENT CLASSIFICATION TABLE
Exercises

A
Problems

B
Problems

1, 2, 7, 8

1A, 2A

1B, 2B

4, 5, 6, 7

2, 3, 4, 5

1, 2, 3, 8

1A, 2A, 3A,


4A, 5A

1B, 2B, 3B,


4B, 5B

Identify the challenges


presented by intangible
benefits in capital
budgeting.

8, 9

4A

4B

5.

Describe the profitability


index.

10

3A

3B

6.

Indicate the benefits of


performing a post-audit.

11

7.

Explain the internal rate


of return method.

12, 13, 16

7, 8

4, 5

3A, 5A

3B, 5B

8.

Describe the annual


rate of return method.

3, 14, 15

6, 7, 8

1A, 2A

1B, 2B

Brief
Exercises

2, 3

Explain the net present


value method.

4.

Study Objectives

Questions

1.

Discuss capital budgeting


evaluation, and explain
inputs used in capital
budgeting.

2.

Describe the cash


payback technique.

3.

12-1

ASSIGNMENT CHARACTERISTICS TABLE


Problem
Number

Description

Difficulty
Level

Time
Allotted (min.)

1A

Compute annual rate of return, cash payback, and net


present value.

Moderate

3040

2A

Compute annual rate of return, cash payback, and net


present value.

Complex

3040

3A

Compute net present value, profitability index, and


internal rate of return.

Moderate

2030

4A

Compute net present value considering intangible


benefits.

Moderate

2030

5A

Compute net present value and internal rate of return


with sensitivity analysis.

Moderate

3040

1B

Compute annual rate of return, cash payback, and net


present value.

Moderate

3040

2B

Compute annual rate of return, cash payback, and net


present value.

Complex

3040

3B

Compute net present value, profitability index, and


internal rate of return.

Moderate

2030

4B

Compute net present value considering intangible


benefits.

Moderate

3040

5B

Compute net present value and internal rate of return


with sensitivity analysis.

Moderate

3040

12-2

12-3

Describe the cash payback technique.

Explain the net present value method.

Identify the challenges presented


by intangible benefits in capital
budgeting.

Describe the profitability index.

Indicate the benefits of performing a


post-audit.

Explain the internal rate of return


method.

Describe the annual rate of return


method.

2.

3.

4.

5.

6.

7.

8.

Broadening Your Perspective

Discuss capital budgeting evaluation,


and explain inputs used in capital
budgeting.

1.

Study Objective

Q12-14
Q12-15

Q12-12
Q12-13

Q12-11

Q12-8

Q12-9

BE12-9
E12-6

Q12-3

E12-7
E12-8
Real-World Focus Exploring the Web
Decision Making
Across the
Organization

BE12-7

BE12-3
E12-8

BE12-1
E12-7
E12-8

Application

Q12-16

Q12-10

Q12-4
Q12-7

Q12-5
Q12-6

Q12-2
Q12-3

Q12-1

Knowledge Comprehension

P12-5A
P12-5B

BE12-4

BE12-4
P12-5A
P12-5B

P12-1A
P12-1B

BE12-8
E12-4
E12-5

BE12-6

BE12-5
E12-3

P12-4A
P12-4B

BE12-2
BE12-5
E12-1
E12-2
E12-3
P12-1A
P12-2A

E12-1
E12-2
P12-1A

P12-2A
P12-2B

P12-3A
P12-3B

P12-3A
P12-3B

P12-3A
P12-4A
P12-1B
P12-2B
P12-3B
P12-4B

P12-2A
P12-1B
P12-2B

Evaluation

All About Managerial Analysis


Decision Making
You
Across the
Organization
Ethics Case
Communication

Analysis Synthesis

Correlation Chart between Blooms Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

BLOOMS TAXONOMY TABLE

STUDY OBJECTIVES
1. DISCUSS CAPITAL BUDGETING EVALUATION, AND
EXPLAIN INPUTS USED IN CAPITAL BUDGETING.
2. DESCRIBE THE CASH PAYBACK TECHNIQUE.
3. EXPLAIN THE NET PRESENT VALUE METHOD.
4. IDENTIFY THE CHALLENGES PRESENTED BY INTANGIBLE BENEFITS IN CAPITAL BUDGETING.
5. DESCRIBE THE PROFITABILITY INDEX.
6. INDICATE THE BENEFITS OF PERFORMING A POSTAUDIT.
7. EXPLAIN THE INTERNAL RATE OF RETURN METHOD.
8. DESCRIBE THE ANNUAL RATE OF RETURN METHOD.

12-4

CHAPTER REVIEW
The Capital Budgeting Evaluation Process
1.

(S.O. 1) The capital budgeting evaluation process generally has the following steps:
a. Project proposals are requested from departments, plants, and authorized personnel.
b. Proposals are screened by a capital budget committee.
c. Officers determine which projects are worthy of funding; and
d. Board of directors approves capital budget.

Cash Flow Information


2.

While accrual accounting has advantages over cash accounting in many contexts, for purposes of
capital budgeting, estimated cash inflows and outflows are preferred for inputs into the capital
budgeting decision tools.

3.

Sometimes cash flow information is not available, in which case adjustments can be made to
accrual accounting numbers to estimate cash flows.

4.

The capital budgeting decision, under any technique, depends in part on a variety of considerations:
a. The availability of funds;
b. Relationships among proposed projects;
c. The companys basic decision-making approach; and
d. The risk associated with a particular project.

Cash Payback
5.

(S.O. 2) The cash payback technique identifies the time period required to recover the cost of
the capital investment from the net annual cash inflow produced by the investment. The formula
for computing the cash payback period is:
Cost of Capital Investment Net Annual Cash Flow = Cash Payback Period
Net annual cash flow can be approximated by adding depreciation expense to net income.

6.

The evaluation of the payback period is often related to the expected useful life of the asset.
a. With this technique, the shorter the payback period, the more attractive the investment.
b. This technique is useful as an initial screening tool.
c. This technique ignores both the expected profitability of the investment and the time value of
money.

Net Present Value Method


7.

(S.O. 3) Under the net present value (NPV) method, cash flows are discounted to their present
value and then compared with the capital outlay required by the investment. The difference
between these two amounts is the net present value (NPV).
a. The interest rate used in discounting the future net cash flows is the required minimum
rate of return.
b. A proposal is acceptable when NPV is zero or positive.
c. The higher the positive NPV, the more attractive the investment.

12-5

8.

When there are equal annual cash inflows, the table showing the present value of an annuity of
1 can be used in determining present value. When there are unequal annual cash inflows, the
table showing the present value of a single future amount must be used in determining present
value.

9.

The discount rate used by most companies is its cost of capitalthat is, the rate that the
company must pay to obtain funds from creditors and stockholders.

10.

The net present value method demonstrated in the text requires the following assumptions:
a. All cash flows come at the end of each year;
b. All cash flows are immediately reinvested in another project that has a similar return; and
c. All cash flows can be predicted with certainty.

Intangible Benefits
11.

(S.O. 4) By ignoring intangible benefits, such as increased quality or improved safety, capital
budgeting techniques might incorrectly eliminate projects that could be financially beneficial to the
company. To avoid rejecting projects that actually should be accepted, two possible approaches
are suggested;
a. Calculate net present value ignoring intangible benefits, and then, if the NPV is negative, ask
whether the intangible benefits are worth at least the amount of the negative NPV.
b. Project rough, conservative estimates of the value of the intangible benefits, and incorporate
these values into the NPV calculation.

Mutually Exclusive Projects


12.

(S.O. 5) In theory, all projects with positive NPVs should be accepted. However, companies
rarely are able to adopt all positive-NPV proposals because (1) the proposals are mutually
exclusive (if the company adopts one proposal, it would be impossible to also adopt the other
proposal), and (2) companies have limited resources.

13.

In choosing between two projects, one method that takes into account both the size of the original
investment and the discounted cash flows is the profitability index. The profitability index
formula is as follows:

Present Value of
Initial

Investment
Future Cash Flows

Profitability
Index

The project with the greater profitability index should be the one chosen.
14.

Another consideration made by financial analysts is uncertainty or risk. One approach for
dealing with uncertainty is sensitivity analysis. Sensitivity analysis uses a number of outcome
estimates to get a sense of the variability among potential returns. In general, a higher risk project
should be evaluated using a higher discount rate.

Post-Audit of Investment Projects


15.

(S.O. 6) A post-audit is a thorough evaluation of how well a projects actual performance


matches the projections made when the project was proposed. Performing a post-audit is
beneficial for the following reasons:
a. Management will be encouraged to submit reasonable and accurate data when they make
investment proposals;
b. A formal mechanism is used for determining whether existing projects should be supported or
terminated;
c. Management improves their estimation techniques by evaluating their past successes and
failures.
12-6

16.

A post-audit involves the same evaluation techniques that were used in making the original capital
budgeting decisionfor example, use of the net present value method. The difference is that, in
the post-audit, actual figures are inserted where known, and estimation of future amounts is
revised based on new information.

Internal Rate of Return Method


17.

(S.O. 7) The internal rate of return method results in finding the interest yield of the potential
investment. This is the interest rate that will cause the present value of the proposed capital
expenditure to equal the present value of the expected annual cash inflows.
Determining the internal rate of return can be done with a financial (business) calculator,
computerized spreadsheet, or by employing a trial-and-error procedure.

18.

The decision rule is: Accept the project when the internal rate of return is equal to or greater than
the required rate of return, and reject the project when the internal rate of return is less than the
required rate.

Annual Rate of Return Method


19.

(S.O. 8) The annual rate of return method indicates the profitability of a capital expenditure and
its formula is:
Expected Annual Net Income Average Investment = Annual Rate of Return
Average investment is based on the following:

Original investment + Value at end of usefull life


= Average
Investment
2
20.

The annual rate of return is compared with managements required minimum rate of return for
investments of similar risk. The minimum rate of return (the hurdle rate or cutoff rate) is generally
based on the companys cost of capital. The decision rule is: A project is acceptable if its rate of
return is greater than managements minimum rate of return; it is unacceptable when the reverse
is true.

21.

When the rate of return technique is used in deciding among several acceptable projects, the
higher the rate of return for a given risk, the more attractive the investment.

12-7

LECTURE OUTLINE
A.

Capital Budgeting Evaluation Process


1. The process of making capital expenditure decisions in business is
referred to as capital budgeting.
2. Capital budgeting involves choosing among various projects to find the
one(s) that will maximize a companys return on its financial investment.

TEACHING TIP

ILLUSTRATION 12-1 presents the steps involved in the capital budgeting


evaluation process.
3. Top management requests proposals for projects from each department
and a capital budgeting committee screens the proposals and recommends worthy projects to company officers.
4. Company officers decide which projects to fund and submit this list of
projects to the board of directors for approval.
5. For purposes of capital budgeting, estimated cash inflows and outflows
are the preferred inputs.

B.

Cash Payback.
1. The cash payback technique identifies the time period required to
recover the cost of the capital investment from the net annual cash flow
produced by the investment.
2. Net annual cash flow is computed by adding back depreciation expense
to net income. Depreciation expense is added back because it is an
expense that does not require an outflow of cash.
12-8

TEACHING TIP

ILLUSTRATION 12-2 provides an example of calculating the cash payback


period on an investment project. Point out that cash payback is easy to compute
and is often used to screen projects for risk, but it does not consider the profitability of the project.
Also available as teaching transparency.
a.

The formula when net annual cash flows are equal is: Cost of
Capital Investment Net Annual Cash FIow = Cash Payback
Period.

b.

The shorter the payback period, the more attractive the investment.

c.

The cash payback technique recognizes that:


(1) The earlier the investment is recovered, the sooner the company
can use the cash funds for other purposes.
(2) The risk of loss from obsolescence and changed economic
conditions is less in a shorter payback period.

C.

d.

In the case of uneven net annual cash flows, the company determines
the cash payback period when the cumulative net cash flows from
the investment equal the cost of the investment.

e.

The cash payback technique is relatively easy to compute and


understand.

f.

It should not ordinarily be the only basis for the capital budgeting
decision because it ignores the expected profitability of the project.

Net Present Value Method.


1. Discounted cash flow techniques are generally recognized as the most
informative and best conceptual approaches to making capital budgeting
decisions.
12-9

2. These techniques consider both the time value of money and the
estimated net cash flow from the investment.
3. The primary discounted cash flow technique is the net present value
method.
4. The net present value method in values discounting net cash flows to
their present value and then comparing that present value with the
capital outlay required by the investment. The difference between these
two amounts is referred to as net present value (NPV).

TEACHING TIP

ILLUSTRATION 12-3 presents a diagram of the decision criteria for the net
present value method.
a.

Company management determines what interest rate to use in


discounting the future net cash flows. This rate is often referred to
as the discount rate or required rate of return.

b.

A proposal is acceptable when net present value is zero or positive,


because this means the rate of return on the investment equals or
exceeds the discount rate (required rate of return).

c.

The higher the positive net present value, the more attractive the
investment.

TEACHING TIP

ILLUSTRATION 12-4 provides a short example of applying the net present value
method.
Also available as teaching transparency.

12-10

D.

Intangible Benefits.
1. Intangible benefits, such as increased quality, improved safety, or
enhanced employee loyalty, are difficult to quantify, and thus often are
ignored in capital budgeting decisions.
2. To avoid rejecting projects that should actually be accepted, managers
can either

E.

a.

Calculate the net present value (NPV) ignoring intangible benefits,


and if the resulting NPV is negative, evaluate whether the intangible
benefits are worth at least the amount of the negative NPV.

b.

Incorporate intangible benefits into the NPV calculation by projecting


rough, conservative estimates of their value. If, after using conservative estimates, the net present value is positive, the project should
be accepted.

Mutually Exclusive Projects.


1. Proposals are often mutually exclusiveif the company adopts one
proposal, it would be impossible to also adopt the other proposal.
2. The profitability index is a method that compares the relative merits of
alternative capital investment projects.
3. This method takes into account both the size of the original investment
and its discounted future cash flows.
4. It is computed by dividing the present value of net cash flows by the
initial investment.
TEACHING TIP

ILLUSTRATION 12-5 provides an example of calculating the profitability index.


Point out that any project with a positive NPV will have a profitability index
greater than 1.
Also available as teaching transparency.
5. The higher the profitability index, the more desirable the project.
12-11

F.

Post-Audit of Investment Projects.


1. A post-audit is a thorough evaluation of how well a projects actual
performance matches the original projections.
2. Performing a post-audit is important for several reasons.
a.

Since managers know that their results will be evaluated, there is


an incentive for them to make accurate estimates rather than
presenting overly optimistic estimates in an effort to get projects
approved.

b.

A post-audit provides a formal mechanism for determining whether


existing projects should be continued, expanded, or terminated.

c.

Post-audits improve future investment proposals because managers


improve their estimation techniques by evaluating past successes
and failures.

3. A post-audit involves the same evaluation techniques used in making


the original capital budgeting decision. In the post-audit, managers use
actual figures where known, and they revise estimates of future amounts
based on new information.
G.

Internal Rate of Return.


1. The internal rate of return method differs from the net present value
method in that it finds the interest yield of the potential investment.
a.

The internal rate of return is the interest rate that will cause the
present value of the proposed capital expenditure to equal the
present value of the expected net annual cash flows.

TEACHING TIP

Use ILLUSTRATION 12-4 to calculate the internal rate of return on an investment


project. Compare the net present value method and the internal rate of return
method for the same investment proposal.
Also available as teaching transparency.
12-12

b.

The determination of the internal rate of return involves the use of a


financial calculator or computerized spreadsheet to solve for the
rate (if the cash flows are uneven).

c.

If the net annual cash flows are equal, an easier approach to


solving for the internal rate of return can be used. This approach
involves two steps:
(1) Compute the internal rate of return factor.
(2) Use the factor and the present value of an annuity of 1 table to
find the internal rate of return.

d.

The formula for determining the internal rate of return factor is:
Capital Investment Net Annual Cash Flows = Internal Rate of
Return Factor.

e.

Once managers know the internal rate, of return, they compare it to


the companys required rate of return (the discount rate).

f.

The decision rule is: Accept the project when the internal rate
of return is equal to or greater than the required rate of return.
Reject the project when the internal rate of return is less than the
required rate.

TEACHING TIP

ILLUSTRATION 12-6 provides a diagram of the decision criteria for the internal
rate of return method.
2. The two discounted cash flow methods differ as follows:
a.

Objective:
(1) Net present value: compute net present value (a dollar amount).
(2) Internal rate of return: compute internal rate of return
(a percentage).
12-13

b.

Decision rule:
(1) Net present value (NPV): If NPV is zero or positive, accept the
proposal. If NPV is negative, reject the proposal.
(2) Internal rate of return (IRR): If IRR is equal to or greater than
the required rate of return, accept the proposal. If IRR is less
than the required rate of return, reject the proposal.

H.

Annual Rate of Return Method.


1. The annual rate of return method is based directly on accounting data
rather than on cash flows.

TEACHING TIP

ILLUSTRATION 12-7 provides an example of calculating the annual rate of


return on an investment project. Point out that this is the only approach that uses
accrual accounting data, and it ignores the time value of money.
Also available as teaching transparency.
a.

Annual rate of return is obtained from the following formula:


Expected Annual Net Income Average Investment.

b.

Management compares the annual rate of return with its required


rate of return for investments of similar risk.

c.

The required rate of return is generally based on the companys


cost of capital.

d.

The decision rule is: A project is acceptable if its rate of return is


greater than managements required rate of return. It is unacceptable
when the reverse is true.

12-14

e.

The higher the rate of return for a given risk, the more attractive the
investment.

f.

The principal advantages of this method are the simplicity of its


calculation and managements familiarity with the accounting terms
used in the computation.

g.

A major limitation of this method is that it does not consider the time
value of money.

12-15

20 MINUTE QUIZ
Circle the correct answer.
True/False
1.

For purposes of capital budgeting, estimated cash inflows and outflows are the preferred
inputs.
True

2.

The cash payback technique is relatively easy to compute and considers the expected
profitability of the project.
True

3.

False

The internal rate of return method does not recognize the time value of money.
True

9.

False

Performing a post-audit is important because if managers know their estimates will be


compared to actual results they will be more likely to submit reasonable and accurate
data when they make investment proposals.
True

8.

False

The profitability index takes into account both the size of the original investment and the
discounted cash flows.
True

7.

False

Intangible benefits, such as increased quality or improved safety, should be ignored in


capital budgeting decisions.
True

6.

False

A companys cost of capital is the rate that it must pay to obtain funds from creditors and
stockholders.
True

5.

False

The primary discounted cash flow technique is the net present value method.
True

4.

False

False

The internal rate of return is the interest rate that will cause the present value of the
proposed capital expenditure to equal the present value of the expected net annual cash
flows.
True

False

12-16

10.

The annual rate of return is computed by dividing net annual cash flow by the average
investment.
True

False

Multiple Choice
1.

All of the capital budgeting methods use cash flow except the
a. cash payback method.
b. annual rate of return method.
c. internal rate of return method.
d. profitability index method.

2.

The cash payback period is computed by dividing the


a. cost of the capital investment by the annual net income.
b. cost of the capital investment by the present value of the cash flows.
c. cost of the capital investment by the net annual cash flow.
d. present value of the cash flows by the cost of the capital investment.

3.

The primary discounted cash flow technique is the


a. Annual rate of return method.
b. Cash payback method.
c. Net present value method.
d. None of the above.

4.

A company is considering investing in a project that costs $780,000 and is expected to


generate net annual cash flows of $315,000 each year for 3 years. The company has a
required rate of return of 9%. The present value of an annuity of 1 for 3 periods at 9% is
2.531. The net present value of this project is
a. $797,265.
b. $465,000.
c. $797,725.
d. $17,265.

5.

If capital investment is $800,000 and equal annual cash inflows are $200,000, the
internal rate of return factor is
a. 25.0.
b. 4.0.
c. 5.0.
d. .25.

12-17

ANSWERS TO QUIZ
True/False
1.
2.
3.
4.
5.

True
False
True
True
False

6.
7.
8.
9.
10.

True
True
False
True
False

Multiple Choice
1.
2.
3.
4.
5.

b.
c.
c.
d.
b.

12-18

ILLUSTRATION 12-1
CAPITAL BUDGET AUTHORIZATION PROCESS

1. Project proposals are requested from departments,


plants, and authorized personnel.
2. Proposals are screened by a capital budget committee.
3. Officers determine which projects are worthy of
funding.
4. Board of directors approves capital budget.

12-19

ILLUSTRATION 12-2
CASH PAYBACK PERIOD

Cash Payback
Period*

Cost of Capital
Investment

Net Annual
Cash Flow

Assuming net annual cash flows are equal.

A company wishes to invest $200,000 in a project that has a


10-year life, expected annual net income of $35,000, and
annual net cash flow of $50,000.
Compute the cash payback period.
Cash Payback
Period

$200,000

$50,000

12-20

4 years

ILLUSTRATION 12-3
NET PRESENT VALUE METHOD DECISION CRITERIA

Present Value of
Net Cash Flows
Less
Capital
Investment
Equals
Net
Present Value
If Zero
or Positive

If
Negative

Accept
Proposal

Reject
Proposal

12-21

ILLUSTRATION 12-4
DISCOUNTED CASH FLOWS

A company is considering an investment of $83,750 for equipment


that is expected to provide a net cash flow of $25,000 each year
for the five years of the equipment's life. The equipment will have
no salvage value at the end of five years.
Compute the net present value of this investment if the
company requires a 10% rate of return on its investments.
Present Value of an Annuity of I
(n)
1
2
3
4
5

8%
.93
1.78
2.58
3.31
3.99

10%
.91
1.74
2.49
3.17
3.79
Cash
Flow
$83,750
25,000

15%
.87
1.63
2.28
2.85
3.35
10%
Factor
1.00
3.79

Present
Value
$(83,750)
94,750
$11,000

Event
Period
Investment
0
Annual net cash inflow 1 5
Net present value
The project is acceptable because it has a positive net present
value and therefore earns more than the 10% required rate of
return.

Compute the internal rate of return on the project


if management has a required rate of 10% on investment projects.
1. Compute the internal rate of return factor.
$83,750 $25,000 = 3.35
2. Use the factor and the present value of an annuity of I table
to find the internal rate of return.
n = 5; IRR = 15%

12-22

ILLUSTRATION 12-5
PROFITABILITY INDEX

Profitability
Index

Present Value of
Net Cash Flows

Initial
Investment

A company wishes to invest $80,000 in a project that


has a present value of net cash flows of $100,000.
Compute the profitability index.

Profitability
Index

= $100,000

12-23

$80,000 =

1.25

ILLUSTRATION 12-6
INTERNAL RATE OF RETURN METHOD DECISION CRITERIA

Internal
Rate of Return
Compared to
Required
Rate of Return
(the Discount Rate)
If equal to
or greater than:

If less
than:

Accept
Proposal

Reject
Proposal

12-24

ILLUSTRATION 12-7
ANNUAL RATE OF RETURN
A company wishes to invest $160,000 and provides the following
projected cost data:
$250,000
Sales
Manufacturing costs
(150,000)
(exclusive of depreciation)
(16,000)
Depreciation expense ($160,000 10 years)
(56,000)
Selling and administrative expenses
(8,000)
Income tax expense
$ 20,000
Net income
Provide the formula and computation for the (a) average investment,
and (b) annual rate of return.
Compute average investment (assume no salvage value)

Average
Investment

Investment at End
of Useful Life
Original Investment +
2

$160,000 + 0
2

= $80,000

Compute annual rate of return


Expected Annual
Net Income
$20,000

Average
Investment
$80,000

=
=

Annual Rate
of Return
25%

If the project's rate of return exceeds the required rate of


return, then the project may be accepted.

12-25