7-1

Capital
Budgeting
DecisionsPart I
Prepared
Preparedby
by

Douglas
DouglasCloud
Cloud

Pepperdine
PepperdineUniversity
University

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Objectives
Objectives
Explain the concepts of cost of capital and
After
reading
this
After
reading
this
cutoff rates of return.
chapter,
you
should
chapter,
you
Calculate cash
flows fromshould
an investment,
be
able
to:
be
able
to:depreciation.
including the tax effects of
Use the net present value method to evaluate
an investment.
Use the internal rate of return method to
evaluate an investment.
Continued
Continued

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Objectives
Objectives
Discuss qualitative reasons for making or not
making particular investments.
Use the payback method and accounting rate of
return method.
Understand why discounted cash flow methods
are superior to non-discounting methods.
Understand why investing in foreign countries
poses special risks.

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Capital
Capital budgeting
budgeting decisions
decisions
involve
involve long-term
long-term
commitments,
commitments, investments
investments
made
made now
nowin
in the
theexpectation
expectation of
of
increased
increased returns
returns in
in the
the future.
future.

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Importance
Importance of
of Capital
Capital
Budgeting
Budgeting Decisions
Decisions
Capital budgeting
decisions commit
companies to courses of
action. The success or
failure of a particular
strategy, or even of the
company itself, can hinge
on one or a series of such
decisions.

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Why
Why Capital
Capital Budgeting
Budgeting
Decisions
Decisions are
are Riskier
Riskier Than
Than
Short-Term
Short-Term Ones
Ones

The company expects to recoup its investment over

a longer period. Much time expires between
making the expenditure and receiving the cash.

Reversing a capital budgeting decision is much

more difficult than reversing a short-term decision.

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Types
Types of
of Capital
Capital
Budgeting
Budgeting Decisions
Decisions
Investments that increase capacity or reduce
costs.
Investments mandated by law or policy.
Investments that advance strategic goals.
Investments made for non-financial reasons.

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Investments
Investments Mandated
Mandated
by
by Law
Law or
or Policy
Policy
This group includes investments made to comply with
environmental, safety, and other laws and regulations.
The group also includes investments made because
company policy so dictates. In these cases, the
organization must do something, so the only question
is how to do it.
Example: A company might have three
alternatives that will reduce toxic
emissions.

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Investments
Investments Made
Made to
to Further
Further
Strategic
Strategic Goals
Goals
This group comprises investments made for such
purposes as securing global distribution of products,
increasing quality, and reducing lead time.
Companies need not make these investments, but
probably will even if they do not meet normal
profitability criteria that we discuss shortly.

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Investments
Investments Made
Made to
to Increase
Increase
Capacity
Capacity or
or Reduce
Reduce Costs
Costs
This group constitutes the bulk of investments
that managers evaluate with the techniques in
the chapter.
Such decisions lend themselves to analytical
treatment. These investments aim at
increasing profitability.

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Investments
Investments Made
Made for
for
Non-Financial
Non-Financial Reasons
Reasons
A company might build a fitness center or cafeteria,
without much analysis of the potential benefits,
because upper level managers believe they should
do so.
Such decisions typically cannot show objective
measures of profitability sufficient to justify them,
though indirect, intangible benefits might be very high.
The decision revolves around how to accomplish the
desired result, say, what equipment to purchase for the
fitness center.

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Cost
Cost of
of capital
capital isis the
the cost,
cost,
expressed
expressed as
as aa percentage,
percentage, of
of
obtaining
obtaining the
the money
money needed
needed to
to
operate
operate the
the company.
company.

Capital is obtained from two

sources, creditors and owners,
corresponding to divisions of
liabilities and owners equity on
the balance sheet.

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Cutoff
Cutoff Rate
Rate
Because of the practical
difficulties of
determining cost of
capital, managers might
simply use their judgment
to set a minimum
acceptable rate, called a
cutoff rate, hurdle rate,
or target rate.

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Methods
Methods of
of Analyzing
Analyzing
Investment
Investment Decisions
Decisions
1. Net present value (NPV) method
2. Internal rate of return (IRR)
method
3. Discounted cash flow (DCF)
method

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Net Present
Present Value
Value Method
Method
Net
The net present value method (NPV) uses the
minimum acceptable rate to find the present
value (PV) of the future returns and compares
that value with the cost of the investment.
NPV = PV of future returns Cost of the
investment

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Internal
Internal Rate
Rate of
of Return
Return Method
Method
The internal rate of
return method (IRR)
finds the rate of return
associated with the
project and compares that
rate with the minimum
acceptable rate.

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Capital
Capital Budgeting
Budgeting Methods
Methods
A company with a cutoff rate of 10 percent
has an opportunity to introduce a new
product. The firm is expected to sell 4,000
units per year for the next five years at $10
each. Variable costs are expected to be $4 per
unit and the machinery required costs $50,000
(five-year life; no salvage value). Annual
fixed expenses are expected to be $8,000.

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Capital
Capital Budgeting
Budgeting Methods
Methods
Revenues ($10 x 4,000)

Annual Cash Flows

Years 1-5
$40,000

Variable costs ($4 x 4,000)

16,000

Contribution margin ($6 x 4,000)

24,000

Cash fixed costs

Net cash flow

8,000
$16,000

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Net
Net Present
Present Value
Value Example
Example
Present value of future cash flows
($16,000 x 3.791)
Investment required
Net present value

$60,656
50,000
$10,656

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Internal
Internal Rate
Rate of
of Return
Return
Present value of future flows
Annual cash flows
$50,000
$16,000

= 3.125

Factor for the

= discount rate and
the number of
periods

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Taxes
Taxes and
and Depreciation
Depreciation
Additional information:
Tax rate is 40 percent.
Straight-line depreciation is used.

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Annual
Annual Incremental
Incremental After-Tax
After-Tax
Cash
Cash Inflows
Inflows
Tax
Cash
Computation Flow
Revenues
$40,000 $40,000
Cash expenses (variable and fixed)
24,000 24,000
Cash inflow before taxes
$16,000 $16,000
Depreciation
10,000
Increase in taxable income
$ 6,000
Income taxes (40 percent)
2,400
2,400
Net increase in annual cash inflow
$13,600

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Net
Net Present
Present Value
Value of
of
After-Tax
After-Tax Example
Example
Expected increase in net cash inflows

$13,600

Times present value factor for 5 years

at 10%

x 3.791

Present value of future cash flows

$51,558

Investment required
Net present value

50,000
$ 1,558

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Uneven
Uneven Cash
Cash Flows
Flows
Now, assume that the
salvage value in the
example is $5,000 at
the end of the fifth
year.

Uneven
Uneven Cash
Cash Flows
Flows
(Salvage
(Salvage Values)
Values)

PV of future cash flows ($13,600 x 3.791)

$51,558
Salvage value:
Total salvage value
$5,000
Tax on salvage value
2,000
After-tax cash inflow on
salvage value
$3,000
Times PV factor (5 years, 10%)
0.621
Present value of salvage value
1,863
Total present value
$53,421
Investment
50,000
Net present value
$ 3,421

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Decision
Decision Rules
Rules
Under the NPV method, a project having a
positive NPV should be accepted; others
should be rejected.
Under the IRR method, a project having an
IRR greater than the companys cost of
capital should be accepted.

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Payback
Payback Period
Period
Payback
period

Investment
=
Annual cash return

The required investment of $50,000 generates

annual net cash flows of $13,600.
Payback
3.677
period

$50,000
$13,600

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Advantages
Advantages of
of Payback
Payback
It is an important method to a company
experiencing liquidity problems.
Payback also serves as a rough screening
device for investment proposals.

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Flaws
Flaws of
of Payback
Payback
It tells nothing about the profitability of
the investment.
Payback ignores the return on the
investment.

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Payback
Payback Period
Period
Consider the following investments:
A
Investment
$10,000
Useful life in years
5
Annual cash flows over the
useful lives
$ 2,500
Payback period
4 years

B
$10,000
15
$ 2,000
5 years

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Book
Book Rate
Rate of
of Return
Return
Average
Average annual expected book income
book rate =
Average book investment
of return
Average
$3,600
book
rate =
14.4%
$50,000 2
of return
The book rate of return method nearly always
misstates the internal rate of return because it
ignores the timing of the cash flows.

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International
International Aspects
Aspects of
of
Capital
Capital Budgeting
Budgeting
The risk of nationalization is very great in
some countries.
Instability in economic, social, and political
conditions can cause serious losses.
Astronomical inflation can wipe out the
value of an investment.
Continued
Continued

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International
International Aspects
Aspects of
of
Capital
Capital Budgeting
Budgeting
Restrictions on trade and on repatriation of
cash can limit the companys ability to
return its investment to its home country.
Exchange rate fluctuations increase risk
because overseas investments might be
profitable in the local currency, but
unprofitable when translated back to the
home currency.
Continued
Continued

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International
International Aspects
Aspects of
of
Capital
Capital Budgeting
Budgeting
Failure to respect local customs and
traditions could jeopardize investments.

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Chapter 7
The
The End
End

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