CHAPTER 12

Planning for Capital Investments

ASSIGNMENT CLASSIFICATION TABLE

Brief A B
Study Objectives Questions Exercises Exercises Problems Problems

1. Discuss capital budgeting 1

evaluation, and explain
inputs used in capital
budgeting.

2. Describe the cash 2, 3 1 1, 2, 7, 8 1A, 2A 1B, 2B

payback technique.

3. Explain the net present 4, 5, 6, 7 2, 3, 4, 5 1, 2, 3, 8 1A, 2A, 3A, 1B, 2B, 3B,
value method. 4A, 5A 4B, 5B

4. Identify the challenges 8, 9 4 4A 4B

presented by intangible
benefits in capital
budgeting.

5. Describe the profitability 10 5 3 3A 3B

index.

6. Indicate the benefits of 11 6

performing a post-audit.

7. Explain the internal rate 12, 13, 16 7, 8 4, 5 3A, 5A 3B, 5B

of return method.

8. Describe the annual 3, 14, 15 9 6, 7, 8 1A, 2A 1B, 2B

rate of return method.

12-1
ASSIGNMENT CHARACTERISTICS TABLE

Problem Difficulty Time

Number Description Level Allotted (min.)

1A Compute annual rate of return, cash payback, and net Moderate 30–40
present value.

2A Compute annual rate of return, cash payback, and net Complex 30–40
present value.

3A Compute net present value, profitability index, and Moderate 20–30

internal rate of return.

4A Compute net present value considering intangible Moderate 20–30

benefits.

5A Compute net present value and internal rate of return Moderate 30–40
with sensitivity analysis.

1B Compute annual rate of return, cash payback, and net Moderate 30–40
present value.

2B Compute annual rate of return, cash payback, and net Complex 30–40
present value.

3B Compute net present value, profitability index, and Moderate 20–30

internal rate of return.

4B Compute net present value considering intangible Moderate 30–40

benefits.

5B Compute net present value and internal rate of return Moderate 30–40
with sensitivity analysis.

12-2
 Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

Study Objective Knowledge Comprehension Application Analysis Synthesis Evaluation

1. Discuss capital budgeting evaluation, Q12-1

and explain inputs used in capital
budgeting.

2. Describe the cash payback technique. Q12-2 BE12-1 E12-1 P12-2A

Q12-3 E12-7 E12-2 P12-1B
E12-8 P12-1A P12-2B

3. Explain the net present value method. Q12-5 Q12-4 BE12-3 BE12-4 BE12-2 P12-3A
Q12-6 Q12-7 E12-8 P12-5A BE12-5 P12-4A
P12-5B E12-1 P12-1B
E12-2 P12-2B
E12-3 P12-3B
BLOOM’S TAXONOMY TABLE

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

4. Identify the challenges presented Q12-9 Q12-8 BE12-4 P12-4A

by intangible benefits in capital P12-4B
budgeting.

12-3
5. Describe the profitability index. Q12-10 BE12-5 P12-3A
E12-3 P12-3B

6. Indicate the benefits of performing a Q12-11 BE12-6

post-audit.

7. Explain the internal rate of return Q12-12 Q12-16 BE12-7 P12-5A BE12-8 P12-3A
method. Q12-13 P12-5B E12-4 P12-3B
E12-5

8. Describe the annual rate of return Q12-14 Q12-3 BE12-9 E12-7 P12-1A P12-2A
method. Q12-15 E12-6 E12-8 P12-1B P12-2B

Broadening Your Perspective Real-World Focus Exploring the Web All About Managerial Analysis
Decision Making You Decision Making
Across the Across the
Organization Organization
Ethics Case
Communication
 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 INTAN-

GIBLE BENEFITS IN CAPITAL BUDGETING.

5. DESCRIBE THE PROFITABILITY INDEX.

6. INDICATE THE BENEFITS OF PERFORMING A POST-

AUDIT.

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 company’s 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 capital—that 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 Profitability

÷ =
Future Cash Flows Investment 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 project’s 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 decision—for 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
2 Investment

20. The annual rate of return is compared with management’s 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 company’s cost of capital. The decision rule is: A project is acceptable if its rate of
return is greater than management’s 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 company’s 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 recom-
mends 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 profit-
ability 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.

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.

C. 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

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 conserva-
tive estimates, the net present value is positive, the project should
be accepted.

E. Mutually Exclusive Projects.

1. Proposals are often mutually exclusive—if 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 project’s 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 company’s 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 company’s

cost of capital.

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

greater than management’s 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 management’s 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 False

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

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

4. A company’s cost of capital is the rate that it must pay to obtain funds from creditors and
stockholders.
True False

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

capital budgeting decisions.
True False

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

7. 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 False

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

9. 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. True 6. True
2. False 7. True
3. True 8. False
4. True 9. True
5. False 10. False

Multiple Choice

1. b.
2. c.
3. c.
4. d.
5. 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 Cost of Capital Net Annual

Period* = Investment 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 = 4 years

12-20
ILLUSTRATION 12-3
NET PRESENT VALUE METHOD DECISION CRITERIA

Present Value of
Net Cash Flows

Less

Capital
Investment

Equals

Net
Present Value

If Zero If
or Positive Negative

Accept Reject
Proposal 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) 8% 10% 15%
1 .93 .91 .87
2 1.78 1.74 1.63
3 2.58 2.49 2.28
4 3.31 3.17 2.85
5 3.99 3.79 3.35
Cash 10% Present
Event Period Flow Factor Value
Investment 0 $83,750 1.00 $(83,750)
Annual net cash inflow 1 – 5 25,000 3.79 94,750
Net present value $11,000
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 Present Value of Initial

Index = Net Cash Flows 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 $80,000 = 1.25

12-23
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 If less
or greater than: than:

Accept Reject
Proposal Proposal

12-24
ILLUSTRATION 12-7
ANNUAL RATE OF RETURN

A company wishes to invest $160,000 and provides the following

projected cost data:
Sales $250,000
Manufacturing costs
(exclusive of depreciation) (150,000)
Depreciation expense ($160,000 ÷ 10 years) (16,000)
Selling and administrative expenses (56,000)
Income tax expense (8,000)
Net income $ 20,000
Provide the formula and computation for the (a) average investment,
and (b) annual rate of return.

Compute average investment (assume no salvage value)

Investment at End
Average Original Investment + of Useful Life
Investment =
2

$160,000 + 0
= $80,000
2

Compute annual rate of return

Expected Annual
Net Income
÷ Average
Investment
= Annual Rate
of Return
$20,000 ÷ $80,000 = 25%

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

return, then the project may be accepted.

12-25