Capital budgeting- involves evaluating and ranking alternative future investments to eff ectively and effi -

ciently allocate limited capital.

Why do most capital budgeting methods focus on cash flows?

All investments undertaken by organizations are expected to earn some type of return. n general, such interest and
dividends are cash returns. Similarly, investments in capital assets are evaluated from a financial perspective based
on their cash costs and cash benefit. Using cash fl ow information puts all investment returns on an equivalent basis.

Do not mix financing decision to investment decision.

Including financing receipts and disbursements with other project cash flows confuses the evaluation of a project’s
profitability because financing costs relate to all projects of an entity rather than to a specific project. Company
management must justify an asset’s acquisition and use prior to justifying the method of financing that asset.

How is payback period computed, and what does it measure?

 measures the time required for a project’s cash inflows to equal the original investment.
 payback for a project is complete when the organization has recouped its investment.
 dimension of project risk by focusing on the timing of cash flows. The assumption is that the longer it takes
to recover the initial investment, the greater is the project’s risk, because cash flows in the more distant
future are more uncertain than relatively near-term cash flows.

Most companies use payback period in conjunction with other quantitative criteria. After being found acceptable in
terms of payback period, a project is then evaluated using other capital budgeting criteria. A second evaluation is
usually necessary because the payback period method ignores three things:
• cash inflows occurring after the payback period has been reached,
• the company’s desired rate of return, and
• the time value of money.
These issues are considered in the decision process using discounted cash flow techniques.

TIME VALUE OF MONEY.

For example, $1 received today has more value than $1 received 1 year from today because money
received today can be invested to generate a return that will cause it to accumulate to more
than $1 over time; this eff ect is referred to as the time value of money.

COST OF CAPITAL
The discount rate should equal or exceed the company’s cost of capital
(COC), which is the weighted average cost of the various sources of funds (debt and
equity) that compose a fi rm’s fi nancial structure.
For example, if a company has a COC
of 10 percent, then each year 10 percent of each capital dollar is required to fi nance
investment projects. To determine whether a capital project is a worthwhile investment,
this company should generally use a minimum rate of 10 percent to discount its projects’
future cash fl ows

A return of capital is the recovery of the original

investment (or the return of principal), whereas a return on capital is income and equals
the discount rate multiplied by the investment amount.
For example, $1.00 invested in a
project that yields a 10 percent rate of return will grow to a sum of $1.10 in 1 year. Of the
$1.10, $1.00 represents the return of capital and $0.10 represents the return on capital.

How are the

net present value and
profi tability index of a
project computed, and
what do they measure?
If the NPV is positive, the actual rate of return is more
than the required rate of return.
Th e information in Exhibit 15–4 indicates that the NPV is not a single, unique amount,
but is a function of two factors:
• Changing the discount rate while holding the amounts and timing of cash fl ows constant
aff ects the NPV. Increasing the discount rate causes NPV to decrease; decreasing
the discount rate causes NPV to increase.
Changing the estimated amounts or timing of cash infl ows and outfl ows aff ects a project’s
net present value. Eff ects of cash fl ow changes on NPV depend on the changes
themselves. For example, decreasing the estimate of cash outfl ows causes NPV to increase;
reducing the stream of cash infl ows causes NPV to decrease.

PROFITABILTY INDEX
Although the net present value of the warehouse is higher, the profi tability index indicates
that the distribution equipment is a more effi cient use of corporate capital.3 Th e higher
PI refl ects a higher rate of return on the distribution equipment than on the warehouse. Th e
higher a project’s PI, the more profi table that project is per investment dollar.
If a capital investment is to provide a return on capital, the PI should be equal to
or greater than 1.00. Th is criterion is the equivalent of an NPV equal to or greater than
zero. Like the NPV method, the PI does not indicate the project’s expected rate of return.
However, another discounted cash fl ow method, the internal rate of return, provides the
expected rate of return to be earned on an investment.

How is the internal

rate of return on a project
computed, and what does
that rate measure?
Th e project’s IRR is then compared with management’s preestablished hurdle rate,
which is the rate of return specifi ed as the lowest acceptable return on investment. Like
the discount rate mentioned earlier, this rate should generally be at least equal to the cost
of capital. In fact, the hurdle rate is commonly the discount rate used in computing NPV.

How do taxation and

depreciation aff ect project
cash fl ows?

Depreciation expense is not a cash fl ow item: no funds are paid or received for it. However,
depreciation on capital assets, similar to interest on debt, aff ects cash fl ows by reducing a
company’s income tax expense. Th us, depreciation provides a tax shield against the payment
of taxes. Th e tax shield produces a tax benefi t equal to the amount of taxes saved (the
depreciation amount multiplied by the tax rate). Th e concepts of tax shield and tax benefi t
are shown on the following income statements. Th e tax rate is assumed to be 40 percent.

In this example, the tax shield is the $75,000 depreciation expense and the tax benefi t is
$30,000 (the diff erence between $30,000 of tax expense on the fi rst income statement
and $0 of tax expense on the second income statement). Th e tax benefi t also equals
the depreciation tax shield of $75,000 multiplied by the 40 percent tax rate. Because
taxes are reduced by $30,000 when depreciation is accrued, the pattern of cash fl ows is
improved.

It is the depreciation taken for income tax purposes rather than the depreciation taken
for financial accounting purposes that is relevant in discounted cash flow analysis.

What are the

underlying assumptions
and limitations of each
capital project evaluation
method?