Chapter 11 – Capital Budgeting Decisions

Capital investment – company’s contribution of funds toward the acquisition of long-lived (long-term or
capital) assets for further growth.
- Examples include purchase of new equipment, expanding operations into new facilities, expanding
into new products or markets

Steps for captial decision-making:

1. Determine captial needs for both new and existing projects
a. What needs require immediate attention?
i. Old equipment that needs replacement?
ii. Building expansion for increased production?
2. Identify and establish resource limitations
a. Availability of funds and time

3. Establish baseline criteria for alternatives

a. Alternatives – options available for investment
i. Due to many options being available, company must establish baseline criteria
for measurement methods to help choose best investment
1. Methods for calculation of baseline:
a. Payback
b. Rate of Return
c. Time value of money
 4. Evaluate alternatives using screening and preference decisions
a. Screening decision – allows companies to remove alternatives that would be less
desirable to pursue
b. Preference decision – compares potential projects that meet the screening decision
criteria and will rank the alternatives in order of importance, feasibility, or desirability to
differentiate among alternatives

5. Make the decision

Methods to establish criteria

Non-time value methods – methods that do not compare the value of a dollar today to the value of a
dollar in the future

- Payback method – computes the length of time in years that it takes a company to recover their
initial investment

*Formula can only be used if Net Annual Cash Flow is a stream of equal amounts every year

Cash flow – money coming into or out of the company as a result of a business activity
- Cash inflow – money received or cost savings from a capital investment
- Cash outflow – money paid or increased cost expenditures from capital investment
Textbook example – section 11.2

*EA3, EA4

Accounting Rate of Return (ARR)– the return on investment considering changes to net income
- Shows how much extra income the company could expect if it undertakes the proposed project
- Income is compared to initial investment
- Incremental means the difference in either revenue or expense with this proposed investment

OR
 Textbook example – section 11.2 (typo in textbook – modified the data from textbook)

Returning to the BGM example, the company is still considering the metal press machine because it
passed the payback period method of less than 7 years. BGM has s et rate of return of 25% expected for
the metal press machine investment. The expects incremental revenues of $22,000 and incremental
expenses of $12,000. Initial investment cost is $50,000. BGM computes ARR as follows:

*EA7

Time Value-Based Methods - Hopefully, you remember this from Financial Accounting, but if you need
a refresher on what Present Value and Future Values are, please see section 11.3 in textbook

The full Time Value of Money tables are located at the end of your Textbook, see the link on the left
menu when logged into your textbook online.

Net Present Value (NPV) – discounts future cash flows to their present value at the expected rate of
return and compares that to the initial investment
*Remember than an annuity is a stream of equal payments at equal time intervals, so the $10,000 equal
cash flow would be multiplied by the Present Value factor for 7 periods and 5% (expected rate of
return). Since the NPV is positive, this is a valid investment.

*EA15, EA16 – EA16 is not an annuity, so you must discount each of the cash flows back separately using
the PV of $1 table.

Internal Rate of Return (IRR)– compares the profitability or growth potential among alternatives

First find the Present Value factor:

Then you look up that factor with the investments # of periods and find the percentage rate it is closest
to.

Textbook example – section 11.4

*EA19, EA20
Strengths and Weakness of Methods: