Chap.

14:
CAPITAL
BUDGETING
DECISIONS
TABLE OF CONTENT
1 OVERVIEW OF CAPITAL BUDGETING

2 PAYBACK METHOD

3 NET PRESENT VALUE METHOD

INTERNAL RATE OF RETURN

4
METHOD

5 SIMPLE RATE OF RETURN

METHOD
1. OVERVIEW OF
CAPITAL BUDGETING
a. Typical Capital Budgeting Decisions
Capital budgeting tends to fall into two broad categories:
• Screening decisions. Does a proposed project meet
some present standard of acceptance?
• Preference decisions. Selecting from among several
competing courses of action.
b. Cash Flows
vs. Net Operating Income
• Payback Method
• Net Present Value
• Internal Rate of Return
→ Focus on analyzing the cash flows
associated with capital investment projects
• Simple Rate of Return Method
→ Focuses on incremental net operating
income

O v e r v i ew of Ca p i t a l Bu d g et i n g
 TYPICAL CASH FLOWS:
Most projects have at least three types of cash outflows / cash inflows

1. Typical Cash Outflows 2. Typical Cash Inflows

Initial Working Release of

Salvage
investment capital working
value
capital

incremental Maintenance Reduction of Incremental

operating and revenues
costs
costs repair
 c. The Time Value of Money

• 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
• Net present value and Internal rate of return are the
capital budgeting methods that best recognize the time
value of money and involve discounted cash flows.

O v e r v i ew of Ca p i t a l Bu d g et i n g
2. PAYBACK METHOD
• The payback method focuses on the payback
period, which is the length of time that it takes for
a project to recoup its initial cost out of the cash
inflows that it generates.
=> The basic premise: “The more quickly the cost of an
investment can be recovered, the more desirable is
the investment”
 2. PAYBACK METHOD
• The payback method analyzes cash flows; however, it
does not consider the time value of money.
• When the annual net cash inflow is the same every year,
the following formula can be used to compute the
payback period:

Investment required
Payback period =
Annual net cash inflow
 2. PAYBACK METHOD
Example A: York Company needs a new milling machine. The
company is considering two machines: machine A and
machine B. Machine A costs $15,000, has a useful life of ten
years, and will reduce operating costs by $5,000 per year.
Machine B costs only $12,000, will also reduce operating costs
by $5,000 per year, but has a useful life of only five years.
 b. Evaluation of the Payback Method
• The payback method only reveals the time needed to
recover the initial investment. A shorter payback period
doesn't always mean one investment is better.
• In Example A, Machine B has a shorter payback period but a
shorter useful life. Machine B would need to be bought
twice, making Machine A potentially better investment, but
the payback method doesn't account for post-payback
period cash flows.
• Another criticism is its disregard for the time value of
money, treating future and present cash inflows equally.
P a y b a c k Met h od
 c. Payback and Uneven Cash Flows
• When the cash flows associated with an investment project
change from year to year, the simple payback formula
outlined earlier cannot be used.
=> Instead, the unrecovered investment must be tracked year
by year.
Payback period = Number of years up to the year in which
the investment is paid off + (Unrecovered investment at the
beginning of the year in which the investment is paid off ÷
Cash inflow in the period in which the investment is paid off)
N e t P re s e n t Va l u e M e t h o d
Payback Method
a. The Net Present Value Method
Illustrated
• The net present value method compares the present
value of a project’s cash inflows to the present value
of its cash outflows.
3. NET PRESENT
• Net present value determines
whether or not a project is an VALUE METHOD
acceptable investment
c. The Net Present Value Method
Illustrated (cont.)
When performing net present value analysis, managers
usually make two important assumptions.
• First, they assume that all cash flows other than the
initial investment occur at the end of periods.
• Second, managers assume that 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.

Ne t Pre s e n t Va l u e M e t h o d
 d. Recovery of the Original
Investment
The net present value method automatically provides
for return of the original investment. Whenever the
net present value of a project is positive, the project will
recover the original cost of the investment plus
sufficient excess cash inflows to compensate the
organization for tying up funds in the project

N e t Pre s e n t Val u e M e t h o d
N e t Pre s e n t Val u e M e t h o d
4. INTERNAL RATE OF
RETURN METHOD
The internal rate of return is the rate of return of an
investment project over its useful life. The internal
rate of return is computed by finding the discount
rate that equates the present value of a project’s
cash outflows with the present value of its cash
inflows.
 a. The Internal Rate of Return
Method Illustrated

Factor of the internal Investment required

=
rate of return Annual net cash inflow

I n t e r n al R at e o f R e t u r n M e t h o d
 b. Comparison of the Net Present Value
and Internal Rate of Return Methods
• First, both methods use the cost of capital to screen out undesirable
investment projects. When the internal rate of return method is used,
the cost of capital is used as the hurdle rate that a project must clear
for acceptance and as the discount rate used to compute the net
present value of a proposed project.
• Second, the internal rate of return method makes a questionable
assumption. However, the two methods make different assumptions
concerning the rate of return that is earned on those cash flows.
I n t e r n al R at e o f R e t u r n M e t h o d
 5. SIMPLE RATE OF
RETURN METHOD
The simple rate of return method is the final capital
budgeting technique. To obtain the simple rate of return,
the annual incremental net operating income generated by
a project is divided by the initial investment in the project,
as shown below.

Annual incremental net operating income

Simple rate of return =
Initial investment
The annual incremental net operating income included in the
numerator should be reduced by the depreciation charges
that result from making the investment. Furthermore, the
initial investment shown in the denominator should be
reduced by any salvage value realized from the sale of old
equipment.

Simple Rate of Return Method

Si mpl e R at e o f R e t u r n M e t h o d
The simple rate of return suffers
from two important limitations:
• First, it focuses on accounting
net operating income rather
than cash flows.
• Second, the simple rate of
return method does not involve
discounting cash flows.

Si m pl e R at e o f R e t u r n M e t h o d
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