Chapter 11

Capital Budgeting
ACCT 2200
PROFESSOR THOMAS BOURVEAU
 Capital Budgeting
An important element of capital budgeting involves choosing which investment
opportunity to undertake and how to finance it.
◦ From financial economics we know that, in general, the investment decision
can and should be separated from the financing decision.
And, we are concerned only with the former.

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 Capital Budgeting Process
Plant expansion

Equipment selection Equipment replacement

Capital budgeting is a decision-making approach

aimed at helping managers make decisions about
investments in major capital assets, such as new
facilities, equipment, new products, and research and
development projects.

Lease or buy Cost reduction

 Capital Investment Decisions
There are two main types of
capital investment decisions.

Screening Decisions Preference Decisions

Pertain to whether or Attempt to rank

not some proposed acceptable alternatives
investment is from the most to least
acceptable; these appealing.
decisions come first.
 Capital Investment Decisions
Capital budgeting decisions can
be placed into two categories.

Independent Projects Mutually Exclusive Projects

Projects are unrelated, Investment choices are

so investing in one does competing alternatives, so
not preclude or accepting one leads to
eliminate investing in rejection of the others.
the other projects.
Capital Budgeting Methods
 Capital Budgeting Methods
To illustrate how the five capital budgeting methods work, assume that managers in
Apple’s iPod division are considering producing a special version of the iPod Touch
that would be marketed to children and their parents.The new device, called the
iKids Touch, would be designed to appeal to children, with durable components,
“kid friendly” controls, and bright colors.

The basic question that

managers must answer
is whether this
proposed project is
worth the $1 million
up-front investment.
Learning Objective 11-1

Calculate the accounting rate of

return and describe its major
weaknesses.
 Accounting Rate of Return

Annual Accounting
Net
Income
÷ Initial
Investment = Rate of
Return

$108,000 ÷ $1,000,000 = 10.8%

 Accounting Rate of Return
Shortcoming and Criticisms
 The time value of money is ignored.
 The accounting rate of return is based on accounting
net income instead of cash flow.
 Depreciation may be calculated several ways
and, in addition, other accounting method
alternatives may have an impact on reported
net income.
 Net Cash Flow versus Net Income

To convert from net income to net cash flow, we must

add back the depreciation that was deducted in the
computation of net income, as shown below.
Learning Objective 11-2

Calculate the payback period and

describe its major weaknesses.
 Payback Period
Annual
Initial
Investment ÷ Net Cash = Payback
Period
Flow

Net Income + Depreciation

$1,000,000 ÷ $308,000 = 3.25 years

$108,000 + $200,000
 Payback Period
When annual cash flows are unequal, the payback period must
be computed on a year by year basis by subtracting the net cash
flow from the unpaid investment balance each year.

Starting Annual Net Unpaid

Year Investment Cash Flow Investment
1 $ 1,000,000 – $ 250,000 = $ 750,000
2 750,000 – 300,000 = $ 450,000
3 450,000 – 340,000 = $ 110,000
4 110,000 – 375,000 = $ (265,000)
5 N/A N/A N/A

The payback period is somewhere

between 3 and 4 years.
 Payback Period
Shortcoming and Criticisms
 The time value of money is ignored.
 The payback period ignores cash flows
after the payback period.
 Exercise
Bark Company is considering buying a machine for HKD120,000 with an
estimated life of ten years and no salvage value. The straight-line
method of depreciation will be used. The machine is expected to
generate net income of HKD8,000 after taxes each year. What is the
cash payback period on this investment?
 Solutions
Bark Company is considering buying a machine for HKD120,000 with an
estimated life of ten years and no salvage value. The straight-line
method of depreciation will be used. The machine is expected to
generate net income of HKD8,000 after taxes each year. What is the
cash payback period on this investment?

Payback = Investment / Annual Net Cash flows

Net Income = HKD8,000
Dep = 120,000 / 10 = HKD12,000
Payback = 120,000 / 20,000 = 6 years
 Time Value of Money
One dollar received today is worth more than one dollar
received a year from now because the dollar can be invested
to earn interest.
 Time Value of Money
Two main amounts you will use
◦ Present value
◦ Future value

Which do we likely want to figure out for capital budgeting purposes?

◦ The present value of a project
◦ The future value of a project

Relation: Future value = f(Present value, discount rate)

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 Time Value of Money
Basic FV calculation:

Annuity calculation:
◦ Annuities grant you periodical payments for a set period
of time
◦ FV of Annuity (FVA) with periodical payment (PR):

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 Time Value of Money
Example #1:
Bank deposit of $100,000 with r = 8%; then after 12
years, your account will have:

Example #2:
You put in $5,000 per year into a retirement fund for 45
years. Assume r = 10%. 45 years later, your account will
have:

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Time Value of Money
Present Value Calculation:

PV of Annuity (PVA) with periodical payment (PR):

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 Time Value of Money
Example #3:
If you need $100,000 in 3 years, assuming r = 9%, how much to
deposit today?

Example #4:
At the age of 65, you have $3,500,000 in retirement fund and r =
8%. You believe you will live for 20 more years. How much can be
withdrawn on 66th birthday and the following 19 years?

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 Exercise E11-10
You are saving for a Porsche Carrera Cabriolet, which currently sells for nearly half a
million USD. Your plan is to deposit $15,000 at the end of each year for the next ten
years. You expect to earn 8 percent each year.
1/ Determine how much you will have saved after 10 years.
2/ Determine the amount saved if you were able to deposit $17,500 each year
3/ Determine the amount saved if you deposit $15,000 each year but with a 10
percent interest rate.
 Solutions

1/ FVA = 15,000 * ((1.08)^10-1)/0.08 = 217,299

2/ FVA = 17,500 * ((1.08)^10-1)/0.08 = 253,514
3/ FVA = 15,000 * ((1.1)^10-1)/0.1 = 278,904
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 Time Value of Money
Discounting is exactly the opposite of compounding. Just as
interest builds up over time through compounding,
discounting involves backing out the interest to determine the
equivalent value in today’s present value dollars.
 Time Value of Money
Discounted Cash Flow Methods
Net Present Value
Internal Rate of Return
Profitability Index
Assumptions:
1.All future cash flows happen at the end of the year.
2.Cash inflows are immediately reinvested in another
project.
3.All cash flows can be projected with 100 percent
certainty.
Learning Objective 11-3

Calculate net present value and

describe why it is superior to the
other capital budgeting techniques.
 Net Present Value (NPV)
The net present value (NPV) method compares the
present value (PV) of a project’s future cash inflows
to the PV of the cash outflows.

The reason is that accounting

net income is based on
accruals that ignore the timing
of cash flows into and out of
an organization.
Net Present Value (NPV)
Chose a discount rate – the
minimum required rate of return.

Calculate the present

value of cash inflows.

Calculate the present

value of cash outflows.

NPV = –
 Net Present Value (NPV)
Relationship Between NPV and
the Required Rate of Return
If the Net Present
Value is . . . Then the Project is . . .
Acceptable, since it promises a
Positive . . . return greater than the required
rate of return (discount rate).

Acceptable, since it promises a

Zero . . . return equal to the required rate of
return (discount rate).

Not acceptable, since it promises

Negative . . . a return less than the required rate
of return (discount rate).
 Net Present Value (NPV)
Let’s return to iKids Touch’s proposal. Recall that the up-front
investment is $1,000,000, and the product’s estimated life is 5
years. iKids Touch’s required rate of return is 12%. iKids Touch
estimates the new product will generate $308,000 in cash
flow for each of the next five years.

Since the NPV is positive, we know the rate of return

is greater than the 12 percent discount rate.
 Net Present Value (NPV)
Assume that the expected cash flows for the iKids Touch
project for years 1 to 5 are $250,000, $300,000, $340,000,
$375,000, and $300,000, respectively. The project will still
require an investment of $1,000,000 and the cost of capital
is still 12 percent.
Relationship Between NPV and
Discount Rates
Example: A project has an initial cash outflow of $90. It’s expected to yield cash
inflows of $55 at the end of the first year and $60.50 at the end of the second
year. The firm's cost of capital is 10%. Should the firm accept the project?

Using the firm’s cost of capital as the discount rate, the NPV for the
project is

– 90 55 60.50
NPV = + +
(1 +0.10)0 (1 +0.10)1 (1 +0.10)2

= 10 >0

Accept project

The fact that the NPV is greater than zero means that if the firm
accepts the project it can expect to earn a return in excess of
the cost of capital (i.e. greater than 10%).
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 Exercise PA11-1
Balloons By Sunset is considering the purchase of two new hot air balloons so that it can expand its
desert sunset tours. Various information about the proposed investment follows:
Initial investment $420,000
Useful life = 10 years
Salvage value = $50,000
Annual net income generated = $37,800
Cost of capital = 11%

Required
1/ Accounting rate of return
2/ Payback period
3/ Net present value (NPV)
 Solutions
Req. 1
Accounting Rate of Return = Annual Net Income / Initial Investment
= $37,800 / $420,000
= 9.0%
Req. 2
Payback Period = Initial Investment / Annual Net Cash Flow
= Initial Investment / (Net Income + Depreciation)
= $420,000 / ($37,800 + [($420,000 - $50,000) / 10]
= $420,000 / $74,800
= 5.62 years
 Solutions
Req. 3

Year Annual Cash PV Factor Present Value

Flow 11%
0 (420,000) (420,000)
1-10 74,800* 5.8891 440,512
10 50,000 0.3522 17,610
NPV 38,122

*74,800 = 37,800 + (420,000-50,000)/10