CHAPTER

11

Capital Budgeting

Central Focus and Learning Objectives

This chapter is devoted to a discussion of the decision making process
for investment in capital assets. After studying this chapter students
should be able to:
1. Recognize the nature and importance of long-term (capital) assets
2. Understand why organizations control long-lived assets and short-
term assets differently
3. Use the basic tools and concepts of financial analysis: investment,
return on investment, future value, present value, annuities, and
required rate of return
4. Use capital budgeting to evaluate investment proposals and
recognize how the concepts of payback, accounting rate of return,
net present value, internal rate of return, and economic value added
relate to investing in long term assets
5. Incorporate the effect of taxes and inflation in evaluating
investments in long term assets
6. Use what-if, sensitivity, and basic options analyses to deal with
decision making and uncertainty issues that arise in evaluating
investments in long term assets
7. Recognize what, and how to include, strategic considerations in long
term investment decisions
8. Use post-implementation audits to evaluate past long term
investment decisions

Capital Budgeting 1
Chapter overview This chapter discusses investment decisions related to capital
assets. The chapter begins with a discussion of the importance of
long-term or capital assets and the importance of the relationship
between acquisition, investment decision, and rate of return.
The central concept underlying decisions about investment in long-
term assets is the time value of money. This chapter discusses core
concepts related to the time value of money such as future value,
effective and nominal rates of interest, present value, annuities, the
cost of capital, net present value, how to evaluate an investment
proposal, internal rate of return, and the effect of taxes.
The text discusses the importance of strategic considerations in
capital budgeting. Other topics include the use of what-if and
sensitivity analysis and the role of post implementation audits for
capital budgeting decisions.

Teaching tips • Since the notion of the time value of money is central to
understanding capital budgeting decisions, students must
understand this concept clearly in order to master the material
in this chapter. Many students may already have studied time
value concepts. However, my experience suggests that many
students will need a thorough review to solidify their
understanding.
• Students may be confused by the concept of return on
investment. In the context of capital budgeting, return on
investment refers to the increased future cash flows resulting
from the long-term asset acquired. More generally, return on
investment (ROI) is net income divided by equity.

Recommended 1. There is an excellent series of cases on capital budgeting in the

cases Rotch, Allen and Brownlee casebook including:
a. Lake Erie Corporation (basic case on cash flow analysis)
b. East Tacoma Works (a decision to purchase a new crane)
c. Prillman Lumber Company (more advanced case)
d. Southern Railway: Verta-Pak (advanced case).
2. Del Norte Paper Co. (C) (HBS case 9-177-036). A
comprehensive description of an on-going capital budgeting
system and problems that it faces from foreign subsidiaries.
3. Burlington Northern: The ARES Decision (A) and (B) (HBS
case 9-191-122 (A) [teaching note 5-193-034] and 9-191-123
(B) [teaching note 5-193-034]. This is an advanced case set in
the railroad industry.
4. Wilmington Tap and Die (HBS no. 9-185-124; TN is 5-188-
019) provides an excellent opportunity to review a post
implementation audit on a large capital investment decision
with significant strategic implications.

Capital Budgeting 2
Chapter outline I.
Learning Objective 1:
Recognize the nature
and importance of
long-term (capital)
assets.
The importance of long-term (capital) assets
A. Long-term or capital assets are equipment or facilities
that provide productive services to the organization for
more than one fiscal period.
B. Long-term assets create the committed costs that we have
called batch-related, product-related, process-related, and
facility-sustaining.
C. The acquisition of long-term assets is important because:
D. organizations commit to long-term assets for long periods
of time,
E. the amount of capital committed is usually very large, and
F. the long-term nature of capital assets creates
technological risk for organizations.
G. Capital budgeting is the process that planners use to
evaluate the acquisition of long-term assets based on the
above considerations.

Learning Objective 2: II. Organizations use different mechanisms to control long-lived

Understand why
organizations control
long-lived assets and
short-term assets
differently.
assets and short-term assets.
A. The acquisition rate of short-term assets can be changed
quickly, almost daily if necessary, in response to market,
financial, or other conditions.
B. Long-term assets typically represent committed costs
which cannot be avoided or adjusted in the short run in
response to financial adversity or changes in market
conditions.
C. Capital assets are usually extremely costly.

Learning Objective 3: III. The basic tools and concepts of financial analysis
Use the basic tools A. Investment is the monetary value of the assets that the
and concepts of organization gives up to acquire a long-term asset.
financial analysis: B. Return is the increased cash flows in the future resulting
investment, return on
from the long-term asset acquired.
investment, future
value, present value,
C. Future value is the amount to which a sum invested
annuities, and today will accumulate over a stated number of periods at
required rate of a stated rate of interest.
return. D. Present value is the current monetary worth of an
amount to be paid in the future under stated conditions of
interest and compounding.
E. An annuity is a contract that promises to pay a fixed
amount each period for a stated number of periods.
F. In the context of chapter 11, an annuity is simply a
constant stream of cash flows for a period of years.
G. Required rate of return (also known as discount rate
and the cost of capital) is the interest rate used to
compute present values. It is useful to point out to the
students that they will study, if they have not already,

Capital Budgeting 3
 how to compute the required rate of return in their
Finance courses.

Learning Objective 4: IV. Some Alternative Approaches to Capital Budgeting

Use capital budgeting A. The payback period is the length of time needed to
to evaluate recover the initial investment. Despite the fact that this
investment proposals concept ignores the time value of money, it is, by most
and recognize how
accounts, the most popular approach to capital budgeting.
the concepts of
payback, accounting
It is useful to ask the students to speculate why this may
rate of return, net be so. (Probable answer: it is easily calculated and it tells
present value, internal how fast we are going to get our money back.)
rate of return, and B. Accounting rate of return is average income divided by
economic value added average net book value.
relate to investing in C. Net present value is the algebraic sum of the present
long term assets. values of all the cash inflows and cash outflows
associated with a project. This is the most widely
recommended approach to capital budgeting since it
specifically considers the time value of money and
provides a basis to value the firm. (The value of the firm
is the present value of all its net cash flows.)
1. Under the net present value method, six steps are used
to determine the desirability of an investment
proposal. These are:
a. Choose the period length
b. Identify the firm’s cost of capital
c. Identify the incremental cash flows for each
period
d. Compute the present value of each period’s cash
flows
e. Sum the project’s cash inflows and outflows and
determine the net present value
f. If the net present value is positive, then the project
is acceptable from an economic perspective.
D. Internal rate of return is the discount rate that makes a
project’s net present value equal zero.
1. Note that the firm’s overall objective should be to
choose projects that maximize the NPV, not projects
that maximize the overall IRR.
2. The internal rate of return criterion assumes that
investments of the cash flows from the initial
investment will earn the same rate of return as the
initial investment. This assumption is not likely to be
met in real world situations.
E. Economic value added is the organization’s GAAP
income, adjusted to eliminate biases introduced by the
conservative nature of GAAP, minus the organization’s
cost of capital multiplied by the investment in the

Capital Budgeting 4
 organization. This idea is related in purpose to the older
concepts of residual income (which is simply GAAP
income minus the cost of capital multiplied by the
investment base) and economic income (which is cash
flow minus the cost of capital multiplied by the
investment base). The students should understand that
organizations use economic value added to make
managers aware that assets must provide a minimum
return to justify holding them. The economic value added
criterion is intended to motivate managers to improve the
performance of underperforming assets or to sell them
off. Students should also understand that the adjustment
process for economic value added can be quite complex
and affect both income and the asset base.

Learning Objective 5: V. The effect of taxes on the capital budgeting decision

Incorporate the effect A. The effect of taxes on the organization is two-fold:
of income taxes and 1. The organization must pay taxes on periodic net
inflation in evaluating benefits (which is called taxable income).
investments in long
2. Taxable income is defined by the tax jurisdiction and
term assets.
includes, among other things, a specification relating
to how the organization is to depreciate capital assets
for tax purposes.
B. Review the example in Exhibit 11-17.
C. Inflation requires the adjustment of future cash flows so
that dollars of similar purchasing power can be compared
at time zero.
D. Review the illustration in Exhibits 11-19 and 11-20.

Learning Objective 6: VI. What-If and Sensitivity Analysis

Use what-if, A. What-if analysis is the process of varying the
sensitivity, and basis assumptions underlying a forecasting model to determine
options analyses to the effects of those assumptions on the forecasted
deal with decision
amounts.
making and
uncertainty issues that
B. Sensitivity analysis is the process of varying the
arise in evaluating assumptions underlying a decision to determine the
investments in long decision’s sensitivity to those assumptions.
term assets. C. Students should understand that what-if analysis and
sensitivity analysis are important because all decisions are
based on estimates. What-if and sensitivity analysis
provide the decision maker with an opportunity to
estimate the opportunity cost of the imperfect information
upon which the decision is based.

Learning Objective 7: VII. Strategic considerations in capital budgeting

Recognize what, and A. The key benefits provided by a long-term asset are:
how to include, 1. production of a product or provision of a service that

Capital Budgeting 5
strategic competitors cannot provide.
considerations in 2. improvement in the quality of a product by reduction
long-term investment of the potential to make mistakes.
decisions. 3. reduction in the cycle time needed to make a product.
B. Students should understand that strategic considerations
are important because they provide important competitive
benefits. To be recognized in capital budgeting analysis,
these benefits must be expressed in dollar terms. This is
difficult, subjective, and controversial. However, if this is
not done, the organization may make investments which
are inconsistent with, or inappropriate for, the
organization’s mission and strategy.

Learning Objective 8: VIII. Post-implementation Audits and Capital Budgeting

Use post- A. A post-implementation audit is an opportunity to
implementation reevaluate a past decision to purchase a long-lived asset
audits in capital by comparing expected and actual inflows and outflows.
budgeting.
The audit provides the following benefits:
1. By comparing estimates with results, planners can
determine why their estimates were incorrect and
avoid making the same mistakes in the future.
2. Rewards can be given to those who make good capital
budgeting decisions.
3. If the audit is not done, there are no controls on
planners who might be tempted to inflate the benefits
to get their projects approved.

Capital Budgeting 6
Chapter quiz

1. Which of the following statements is FALSE about long-term assets?

a. Long-term assets are committed for extended periods of time.
b. Acquiring long-term assets creates significant financial risks for organizations.
c. Acquiring long-term assets creates technological risks for organizations.
d. Flexible budgeting is the primary tool that planners use in evaluating the financial
desirability of long-term assets.

2. Although it ignores the time value of money, what is the most common method used
in practice for capital budgeting?
a. internal rate of return
b. net present value
c. payback
d. accounting rate of return

3. What is the present value of $1 received five years from now if the annual rate of
return is 12%?
a. $1.76
b. $0.57
c. $1.00
d. $1.60

4. You have borrowed $150,000 to buy a house. The mortgage holder requires that you
make monthly payments over a period of 25 years to repay the mortgage. The
mortgage rate is 0.60% monthly. What will be the required monthly mortgage
payment?
a. $1,079.38
b. $1,072.63
c. $500.00
d. none of the above

5. You are considering an investment opportunity that requires an investment of

$100,000 in a piece of capital equipment. The salvage value of the equipment in 10
years will be $10,000, at which time it will be liquidated. The project will provide
you with a net income of $12,000 per year for ten years. What is the accounting rate
of return on this investment?
a. 12%
b. 13.3%
c. 26.67%
d. none of the above

6. Organizations use economic value added to:

a. make managers more aware of the assets they are using.
b. increase owners’ wealth.
c. neither (a) nor (b)
d. both (a) and (b)

Capital Budgeting 7
7. The internal rate of return criterion is best used for:
a. evaluating the return provided by an existing project.
b. evaluating the performance of a manager.
c. choosing among competing investment opportunities.
d. effective public relations with owners.

8. Napanee Electronics has a pre-tax cash flow of $1,200,000 in 1996. It is allowed to

claim $500,000 in depreciation expense for the year. The marginal tax rate on income
is 26%. What is the after-tax cash flow for 1996?
a. $700,000
b. $1,018,000
c. $182,000
d. $370,000

9. What-if analysis is most useful to:

a. make sure that a manager is doing a good job.
b. test the effect of an estimate on a forecasted amount.
c. make sure that owners receive their required return.
d. provide a strong basis for financial reporting.

10. Which of the following is NOT one of the more common strategic benefits provided
by acquiring long-term assets?
a. being able to deliver a product that competitors cannot
b. improving product quality
c. reducing cycle time
d. reducing the number of short-term decisions made about operations

Capital Budgeting 8
Solutions to chapter quiz

1. d
2. c
3. b
4. a
5. c
6. d
7. a
8. b
9. b
10. d

Capital Budgeting 9