Capital Budgeting

Chapter 12
 Capital budgeting: process by which
organization evaluates and selects long-term
investment projects
Ex. Investments in capital equipment, purchase or
lease of buildings, purchase or lease of vehicles,
etc.
There are various techniques used to make
capital budgeting decisions.
 Payback
Small businesses use this method because it is
simple
Requires calculation of number of years required
to pay back original investment
Payback-based decisions:
Between two mutually exclusive investment projects,
choose project with shortest payback period
Set a predetermined standard
Ex. Accept all projects with payback of less than 5 years and
reject all others
 Payback
Poor method on which to rely for allocation of scarce capital
resources because:
1. Payback ignores time value of money
2. Payback ignores expected cash flows beyond payback period.
Ex.: PROJECT A PROJECT B
Cost = $100,000 Cost = $100,000
Expected Future Cash Flow: Expected Future Cash Flow:
Year 1 $50,000 Year 1 $100,000
Year 2 $50,000 Year 2 $5,000
Year 3 $110,000 Year 3 $5,000
Year 4 and thereafter: None Year 4 and thereafter: None
Total = $210,000 Total = $110,000
Payback = 2 years Payback = 1 year
-Payback period for Project B is shorter, but Project A provides higher return
-Project A is superior to Project B.
 Net Present Value
Difference between present value of expected
future benefits of project to present value of
expected cost of project
If NPV is positive (if present value of benefits exceeds
present value of cost), then project is accepted.
If NPV is negative (if present value of costs exceeds
present value of benefits), then project is rejected.
NPV = PVB PVC
Where NPV = net present value
PVB = present value of benefits
PVC = present value of costs
 Net Present Value
Between two mutually exclusive projects, choose project
with highest net present value.
Ex.: Consider Project A and Project B and 12% discount rate

PVBa = ($50,000)(0.893) + ($50,000)(0.797) + ($110,000)(0.712)

PVBa = $162,820
PVBb = ($100,000)(0.893) + ($5,000)(0.792) + ($5,000)(0.712)
PVBb = $96,820
PVCa = PVCb = $100,000

NPVa = $162,000 $100,000 = $62,800

NPVb = $96,820 $100,000 = ($3,180)

Project A is superior to Project B because PVBa > PVCa and

PVBb < PVCb
Return on Project B is insufficient to justify investment
given firms cost of capital.
 Net Present Value
Selection of a Discount Rate
To find discounted present value of sum of
money to be received in future, choose rate at
which money in hand may be invested
between now and future period in which
money is to be received.
This rate represents individuals opportunity
cost, or cost of next-best opportunity.
 Internal Rate of Return
Discount rate that exactly equates present value of
expected benefits to cost (drives NPV to zero)
Find this discount rate by trial and error
Ex.:
Use discount rate of 20% as first estimate of IRR on Project
A.
NPVa = PVBa PVCa
NPVa = $40,040
Since NPV is too high, use higher estimate of 40%.
NPVa = $1,240
Use estimate of 41% to get closer to zero.
NPVa = $290
 Internal Rate of Return
Investment of $100,000 at 41% annual compound rate of
return allows withdrawal of that investment as a cash flow of
$50,000 at end of 1 year, $50,000 at end of 2nd year, and
$110,000 at end of 3rd year.

Project A Cash Flow Schedule

Year
1 2 3
Beginning investment $100,000 $91,000 $78,310
Annual earnings at 41% 41,000 37,310 _32,107
Subtotal $141,000 $128,310 $110,417
Annual cash flow (50,000) (50,000) (110,417)
Ending investment $91,000 $78,310 $-0-
 Internal Rate of Return
In general, any project with IRR greater than
or equal to cost of capital should be
accepted. Any project with IRR less than cost
of capital should be rejected.
In this case, Project A would be accepted.
 Internal Rate of Return
Ex. (continued):
IRR for Project B is approximately 8.75%.
NPVb = $120
8.75% per year is less than cost of capital of
12%. Achieved rate of return on Project B falls
short of attainable rate of return on other
opportunities.
 Internal Rate of Return
IRR of an Annuity
Project A and Project B do not provide benefits in form of annuity
(constant annual cash flow).
If project costing $100,000 and returning $25,000 per year for 5
years is available, calculate appropriate annuity factor:
$100,000 = $25,000X
X = 4.0
X represents annuity factor that will cause $25,000, 5-year annuity
to have present value of $100,000.
Refer to table of annuity factors in Exhibit 11.4 to find discount rate
that has present value of annuity factor equal to 4.00 after 5 years.
 Internal Rate of Return
Personal Computer Applications
Most basic business-oriented electronic
calculators, personal computers, business-
oriented spreadsheet applications, special-
purpose capital budgeting software packages
can do actual calculations or be programmed
to solve capital budgeting problems.
 Profitability Index
Also benefit/cost ratio
Calculated as ratio of present value of benefits of
investment to cost of investment
PI = NPV(benefits)/NPV(costs)
General rule: All projects with PI > 1.0 should be
accepted.
Between two or more mutually exclusive projects
having different costs, choose project with highest
profitability index.
 Profitability Index
Investment decisions based on profitability
index will be same as decisions made using
net present value.
All projects having positive net present value
have profitability index larger than 1.0 and
therefore are acceptable.
 Selection of Method
All 3 methods (net present value, internal rate
of return, profitability index) result in same
accept-reject decision for given investment
opportunity.
There are three important circumstances
under which methods may yield conflicting
decisions.
 Selection of Method
1. Choosing from among mutually exclusive
investment projects with similar costs, but
radically differing time patterns of cash inflows.
Ex. One project provides large cash flows in early
years and small cash flows in later years
compared with another project providing small
cash flows in early years but large cash flows in
later years.
Project having highest net present value and
profitability may have lowest internal rate of return.
 Selection of Method
1. (continued)
Choice of method depends on which assumption
is closest to reality.
Choice should be based on which reinvestment
rate is closest to rate that firm will be able to
earn on cash flows generated by project.
If cash flows can be reinvested at cost of capital, select
project with higher net present value.
If cash inflows can be reinvested at IRR of project,
select project with higher IRR.
 Selection of Method
1. (continued)
General rule: NPV method should be preferred if
conflict arises because projects with very high
IRRs relative to firms cost of capital are rare. In
most cases, reinvestment rate will be closer to
cost of capital than to IRR and thus, NPV method
is normally preferred to IRR method.
 Selection of Method
2. Choosing from among mutually exclusive
projects with widely differing costs.
If project with highest NPV has lowest PI and IRR,
in general, give preference to project with highest
NPV since this will maximize value of firm.
If project with highest PI and IRR is substantially
less expensive than competing project, former is
selected because lower-cost project may be
perceived as less risky than higher-cost project.
 Selection of Method
3. Capital rationing where insufficient capital is
available to accept all projects having
positive NPVs.
Rank-order projects from highest IRR to lowest
and select projects that firm has sufficient capital
to accept.

In general, NPV method preferred over IRR and PI

methods.
 Dealing With Uncertainty
In practice, uncertainty is often dealt with
through simple mechanism of assigning
higher discount rate to riskier projects.
How much higher depends on managements
perception of degree of risk and additional
compensation required because of that risk
 Case Study
Droppitt Parcel Company is considering purchasing new equipment to
replace existing equipment that has book value of zero and market
value of $15,000.
New equipment costs $90,000 and is expected to provide production
savings and increased profits of $20,000 per year for the next 10 years.
New equipment has expected useful life of 10 years, after which its
estimated salvage value would be $10,000.
Straight-line depreciation
Effective tax rate: 34%
Cost of capital: 12%
Machinery Replacement Problem: Should Droppitt replace current
equipment?
 Case Study
See Exhibit 12.4
1. Effective cost of new equipment: $80,100
Droppits trades its old equipment in for new
equipment by selling it and applying sale
proceeds to new equipment.
 Case Study
2. Calculate present value of expected benefits
of new equipment.
All benefits have been converted to after-tax basis before
present values are calculated.
Profit increase is multiplied by 0.66 (1.00 tax rate) to
determine increased profit remaining after tax.
Calculate tax benefit resulting from effect of depreciation by
multiplying annual depreciation deduction by effective tax rate.
Reflects salvage value of new equipment at end of its expected
useful life.
No tax effect here because there is no profit or loss involved.
 Case Study
3. NPV: $13,068
4. IRR (solved by trial and error using electronic
calculator): 15.7%
New machine should be purchased to
replace old machine since NPV is positive
and IRR exceeds cost of capital.