Name: Randrianantenaina Solohery Mampionona Aime

NIM: 041924353041
Chapter 14 Capital Budgeting Decisions
A. Capital Budgeting—An Overview
Typical Capital Budgeting Decisions
Any decision that involves a cash outlay now to obtain a future return is a capital budgeting
decision. Typical capital budgeting decisions include:
1. Cost reduction decisions. Should new equipment be purchased to reduce costs?
2. Expansion decisions. Should a new plant, warehouse, or other facility be acquired to
increase capacity and sales?
3. Equipment selection decisions. Which of several available machines should be
purchased?
4. Lease or buy decisions. Should new equipment be leased or purchased?
5. Equipment replacement decisions. Should old equipment be replaced now or later?
Cash Flows versus Net Operating Income
Net income is the profit a company has earned for a period, while cash flow from operating
activities measures, in part, the cash going in and out during a company's day-to-day
operations. Net income is the starting point in calculating cash flow from operating activities.
However, both are important in determining the financial health of a company.
The Time Value of Money
An amount today is worth more than in a year from now. Projects promising earlier returns
are preferable to those that promise later returns. The time value of money concept
recognizes that a dollar today is worth more than a dollar a year from now. Therefore,
projects that promise earlier returns are preferable to those that promise later returns.
B. The Payback Method
The payback method is a method of evaluating a project by measuring the time it will take to
recover the initial investment. When the annual net cash inflow is the same every year, the
following formula can be used to compute the payback period:
Payback period= investment required/annual net cash inflow
E.g: Machine A $15,000, useful life of ten years, will reduce operating costs by $5,000 per
year. Machine B $12,000, reduce operating costs by $5,000 per year, has a useful life of only
five years. Which machine should be purchased according to the payback method?
Machine A payback Perdio=15000/5000=3years
Machine Bpayback periode=12000/5000=2,4 years
Based on payback calculation Machine B is the best option because it has shorter payback
period than machine A. However a shorter payback period does not always mean that one
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041
investment is more desirable than another. Moreover, it does not consider the time value of
money.
Payback and Uneven Cash Flows: The formula to calculate the payback period of an
investment depends on whether the periodic cash inflows from the project are even
or uneven. Cumulative net cash flow is the sum of inflows to date, minus the initial outflow
C. The Net Present Value Method
Net present value (NPV) measures the net increase in a company’s value resulting from an
investment. It equals the difference between the present value of future cash flows of the
investment estimated based on an appropriate discount rate, and the amount of total initial
investment required. In NPV analysis, there are 2 assumptions: (1) all cash flows other than
the initial investment occur at the end of periods; (2) all cash flows generated by an
investment project are immediately reinvested at a rate of return equal to the rate used to
discount the future cash flows, also known as the discount rate.
Net present value can be calculated using the Excel NPV function or XPNV function or by
manually discounting each cash flow to time zero and subtracting the initial investment. The
manual calculation of NPV is expressed algebraically as follows:
CF 1 CF 2 CF n
NPV = 1
+ 2
+ … .+ n
−1
(1+r ) (1+r ) (1+ r)
Where CF stands for net incremental cash flow in a period, r stands for the discount rate
and I refers to the initial investment.
Recovery of the Original Investment: When an investment is first made in an asset or a
company, the investor initially sees a negative return, until the initial investment is recouped.
The return of that initial investment is known as capital recovery. Capital recovery must
occur before a company can earn a profit on its investment.
D. The internal rate of return
The internal rate of return is a metric used in financial analysis to estimate the profitability of
potential investments. The internal rate of return is a discount rate that makes the net present
value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.
E.g: Glendale school want to purchase a large tractor-pulled lawn mower. Cost:$16.950,
with useful life of 10 years. By using this tractor, the company can save $3000/year Compare
to the old mower. To compute the internal rate of return of the new mower, we must find the
discount rate that will result in a zero net present value. The simplest and most direct
approach when the net cash inflow is the same every year is to divide the investment in the
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041
project by the expected annual net cash inflow. This computation yields a factor from which
the internal rate of return can be determined. The formula is as follows:
Factor of the internal rate of return=investment required/ annual net cash inflow
$16950/$3000= 5650 is the discount factor that will equate a series of $3,000 cash inflows
with a present investment of $16,950. Now we need to compute the the project’s internal rate
of return of 12 percent by using IRR formula. If the internal rate of return is equal to or
greater than the required rate of return, then the project is acceptable. If the internal rate of
return is less than the required rate of return, then the project is rejected.
The Net Present Value vs Internal Rate of Return Methods: NPV and IRR are both used in
the evaluation process for capital expenditures. Net present value (NPV) discounts the stream
of expected cash flows associated with a proposed project to their current value, which
presents a cash surplus or loss for the project. The internal rate of return (IRR) calculates the
percentage rate of return at which those same cash flows will result in a net present value of
zero.
E. Expanding the net present value method
Expanded Net present value factors the value of real options into the valuation of
an Investment. It is equal to the Net present value of an Investment plus the Value of Real
options. In this section we use the total-cost approach to explain how the net present value
method can be used to evaluate two alternative projects.
The net present value approach can be expanded to include two alternatives and to integrate
the concept of relevant costs. Two approaches-the total-cost approach and the incremental-
cost approach-are used to compare competing investment projects. In the total-cost approach
to net present value, all cash inflows and all cash outflows are included in the computation of
net present value for each alternative. The net present value figures for each of the two
alternatives are compared and the alternative with the higher net present value is preferred.
Two points should be noted from the exhibit in the book. First, all cash inflows and all cash
outflows are included in the solution under each alternative. No effort has been made to
isolate those cash flows that are relevant to the decision and those that are irrelevant. The
inclusion of all cash flows associated with each alternative gives the approach its name—the
total-cost approach. Second, notice that a net present value is computed for each alternative.
This is a strength of the total-cost approach because an unlimited number of alternatives can
be compared side by side to determine the best option.
F. Uncertain cash flows
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041
In this section, future cash flows are uncertain or difficult to estimate. At a 20% profit
margin, cash flows occurring 4 years or more into the future are considered so uncertain that
the NCFDFs become negative, meaning that an investor must be paid to be exposed to
the cash flow risk even though the cash flows have a positive expected value. To cope with
this situation, here is a very useful formula to help managers deal with uncertain cash flows
without getting too technical.
Negative net present value/present value factor= $X
If the intangible benefits of a product are worth at least $X a year to the company, then its
net present value would be positive and the investment should be made. Preference decisions
G. Preference Decisions—The Ranking of Investment Projects
When making capital budgeting decisions, projects are first screened into acceptable and
unacceptable groups. Projects in the acceptable group are then ranked in order of preference.
Either the internal rate of return method or the net present value method can be used to make
this ranking.
1. Internal Rate of Return Method. 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.
2. Net Present Value Method. Every project with a positive net present value is
acceptable. However, if investment funds are limited, there needs to be some method of
ranking acceptable projects in order of how well they utilize the available funds. If projects
are not equal in size and there are limited investment funds, then it is necessary to compute
each project's profitability index. The formula for the profitability index (PI) is:
PI = Present value of cash inflows / Investment required
This is actually an application of the idea from Chapter 13 that the possible uses of a scarce
resource should be ranked in order of the contribution margin per unit of the scarce resource.
In this case, the constrained resource is investment funds and the present value of the cash
inflows is analogous to the contribution margin. When using the profitability index, the
preference rule is: the higher the profitability index, the more desirable the project.
H. The simple rate of return method
The simple rate of return method is the final capital budgeting technique discussed in the
chapter. This method also is often referred to as the accounting rate of return or the
unadjusted rate of return. It is calculated by taking the annual incremental net operating
income and dividing by the initial investment. When calculating the annual incremental net
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041
operating income, we need to remember to reduce by the depreciation expense incurred by
the investment.
I. Postaudit of investment projects
Post-audit of an investment project means a follow-up after the project has been approved to
see whether or not expected results are being realized. In a post-audit, actual data (rather than
estimated data) are used in computing the net present value. The net present value based upon
actual data is compared to the net present value based upon estimated data as a way of
gauging the accuracy of the estimated data. Such a post-audit may help refine planning
models and also may help encourage managers to be forthright in their estimates of future
cash flows