Capital Budgeting Decisions

Chapter 3

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 Capital Budgeting Decisions

expansion

Equipment selection Equipment replacement

Lease or buy Cost reduction

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 Capital Budgeting Decisions

Capital
Capital budgeting
budgeting tends
tends to
to fall
fall into
into two
two broad
broad
categories
categories .. .. ..
Screening
Screening decisions
decisions.. Does
Does aa proposed
proposed project
project
meet
meet some
some present
present standard
standard of
of acceptance?
acceptance?
Preference
Preference decisions
decisions.. Selecting
Selecting from
from among
among
several
several competing
competing courses
courses of
of action.
action.

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 Time Value of Money

A dollar today is worth

more than a dollar a
year from now.
Therefore, investments
that promise earlier
returns are preferable to
those that promise later
returns.

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 Time Value of Money

The capital
budgeting
techniques that best
recognize the time
value of money are
those that involve
discounted cash
flows.
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 The Net Present Value Method

To determine net present value we . . .

Calculate the present value of cash inflows,
Calculate the present value of cash outflows,
Subtract the present value of the outflows from the
present value of the inflows.

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 The Net Present Value Method

General decision rule . . .

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 The Net Present Value Method

Net present value analysis

emphasizes cash flows and not
accounting net income.

The reason is that

accounting net income is
based on accruals that
ignore the timing of cash
flows into and out of an
organization.
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 Typical Cash Outflows

Repairs and
maintenance

Working Initial
capital investment

Incremental
operating
costs

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 Typical Cash Inflows

Salvage
value

Release of
Reduction
working
of costs
capital

Incremental
revenues

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 Recovery of the Original Investment

Carver company is considering the purchase of an

attachment for its X-ray machine.

No investments are to be made unless they have

an annual return of at least 10%.

Will we be allowed to invest in the attachment?

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 Recovery of the Original Investment

Present Value of $1
Periods 10% 12% 14%
1 0.909 0.893 0.877 Present
Present value
value
2 1.736 1.690 1.647
3 2.487 2.402 2.322
of
of an
an annuity
annuity
4 3.170 3.037 2.914 of
of $1
$1 table
table
5 3.791 3.605 3.433

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 Choosing a Discount Rate

• The firm’s cost of capital is

usually regarded as the
minimum required rate of
return.

• The cost of capital is the

average rate of return the
company must pay to its
long-term creditors and
stockholders for the use of
their funds.

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 The Net Present Value Method

Let’s look at
how we use the net
present value
method to make
business
decisions.

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 The Net Present Value Method

Lester Hospital has been offered a five year contract to

provide medical services for a large company’ employees
Cost of special equipment $160,000

Working capital required 100,000

Relining equipment in 3 years 30,000

Salvage value of equipment in 5 years 5,000

Annual revenues and costs

Services revenue 750,000
Services cost 400,000
Salaries 270,000

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 The Net Present Value Method

• At
At the
the end
end of
of five
five years
years the
the working
working capital
capital
will
will be
be released
released and
and may
may bebe used
used elsewhere
elsewhere
by
by Lester.
Lester.
• Lester
Lester uses
uses aa discount
discount rate
rate of
of 10%.
10%.
Should the contract be accepted?

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 The Net Present Value Method

Annual net cash inflows from operations

Services Revenue $750,000

Services cost (400,000)

Salaries (270,000)

Annual Net Cash inflows $80,000

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 The Net Present Value Method

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 The Net Present Value Method

Present value of an annuity of $1

factor for 5 years at 10%.

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 The Net Present Value Method

Present value of $1
factor for 3 years at 10%.

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 The Net Present Value Method

Present value of $1
factor for 5 years at 10%.

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 The Net Present Value Method

Accept the contract because the project has a

positive net present value.

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 Internal Rate of Return Method

• The internal rate of return is the rate of return

promised by an investment project over its
useful life. It is computed by finding the discount
rate that will cause the net present value of a
project to be zero.
• It works very well if a project’s cash flows are
identical every year. If the annual cash flows
are not identical, a trial and error process must
be used to find the internal rate of return.

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 Internal Rate of Return Method

General decision rule . . .

If the Internal Rate of Return is . . . Then the Project is . . .

Equal to or greater than the minimum

Acceptable.
required rate of return . . .

Less than the minimum required rate

Rejected.
of return . . .

When using the internal rate of return,

the cost of capital acts as a hurdle rate
that a project must clear for acceptance.
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 Internal Rate of Return Method

• Decker
Decker hospital
hospital can
can purchase
purchase aa new
new
machine
machine at
at aa cost
cost of
of $104,320
$104,320 that
that will
will save
save
$20,000
$20,000 per
per year
year in
in cash
cash operating
operating costs.
costs.
• The
The machine
machine has
has aa 10-year
10-year life.
life.

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 Internal Rate of Return Method

Future
Future cash
cash flows
flows are
are the
the same
same every
every year
year in
in
this
this example,
example, soso we
we can
can calculate
calculate the
the
internal
internal rate
rate of
of return
return as
as follows:
follows:

PV factor for the Investment required

=
internal rate of return Net annual cash flows

$104, 320
= 5.216
$20,000

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 Internal Rate of Return Method

Using the present value of an annuity of $1 table . . .

Find the 10-period row, move
across until you find the factor
5.216. Look at the top of the column
and you find a rate of 14%.
14%

Periods 10% 12% 14%

1 0.909 0.893 0.877
2 1.736 1.690 1.647
. . . . . . . . . . . .
9 5.759 5.328 4.946
10 6.145 5.650 5.216

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 Internal Rate of Return Method

• Decker hospital can purchase a new machine

at a cost of $104,320 that will save $20,000 per
year in cash operating costs.
• The machine has a 10-year life.

The internal rate of return on

this project is 14%.

If the internal rate of return is equal to or

greater than the company’s required rate of
return, the project is acceptable.
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 Quick Check 

The expected annual net cash inflow from a

project is $22,000 over the next 5 years. The
required investment now in the project is
$79,310. What is the internal rate of return
on the project?
a. 10%
b. 12%
c. 14%
d. Cannot be determined

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 Quick Check 

The expected annual net cash inflow from a

project is $22,000 over the next 5 years. The
required investment now in the project is
$79,310. What is the internal rate of return
on the project?
a. 10% $79,310/$22,000 = 3.605,
b. 12% which is the present value factor
c. 14% for an annuity over five years
when the interest rate is 12%.
d. Cannot be determined

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 Other Approaches to
Capital Budgeting Decisions
Other
Other methods
methods of
of making
making capital
capital budgeting
budgeting
decisions
decisions include
include .. .. ..
The
The Payback
Payback Method.
Method.
Simple
Simple Rate
Rate of
of Return.
Return.

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 The Payback Method

The
The payback
payback period
period is
is the
the length
length of of time
time that
that itit
takes
takes for
for aa project
project to
to recover
recover its its initial
initial cost
cost
out
out of
of the
the cash
cash receipts
receipts that
that itit generates.
generates.
When
When the
the net
net annual
annual cash
cash inflow
inflow is
is the
the same
same each
each
year,
year, this
this formula
formula can
can be
be used
used toto compute
compute the
the
payback
payback period:
period:

Investment required
Payback period =
Net annual cash inflow

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 The Payback Method

Management
Management at at The
The Daily
Daily hospital
hospital wants
wants to
to
install
install an
an equipment
equipment ..
The
The equipment
equipment information
information ::
1.
1. Costs
Costs $140,000
$140,000 and
and has
has aa 10-year
10-year life.
life.
2.
2. Will
Will generate
generate net
net annual
annual cash
cash inflows
inflows ofof
$35,000.
$35,000.
Management
Management requires
requires aa payback
payback period
period of
of 55
years
years or
or less
less on
on all
all investments.
investments.
What
What is
is the
the payback
payback period
period for
for the
the Equipment?
Equipment?

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 The Payback Method

Investment required
Payback period =
Net annual cash inflow

$140,000
Payback period = $35,000

Payback period = 4.0 years

According
According toto the
the hospital’s
hospital’s criterion,
criterion,
management
management would
would invest
invest in
in the
the
Equipment
Equipment because
because itsits payback
payback period
period
is
is less
less than
than 55 years.
years.

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 Evaluation of the Payback Method

Ignores the
time value
of money.

Short-comings
of the payback
period. Ignores cash
flows after
the payback
period.

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 Evaluation of the Payback Method

Serves as
screening
tool.

Identifies
Strengths investments that
of the payback recoup cash
period. investments
quickly.
Identifies
products that
recoup initial
investment
quickly.
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 Simple Rate of Return Method

• Does not focus on cash flows -- rather it

focuses on accounting net operating income.
income
• The following formula is used to calculate the
simple rate of return:

Incremental Incremental expenses,

-
Simple rate revenues including depreciation
of return =
Initial investment*

*Should be reduced by any salvage from the sale of the old equipment
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 Simple Rate of Return Method

Management of The Daily hospital wants to

install an equipment.
The equipment information:
1. Cost $140,000 and has a 10-year life.
2. Will generate incremental revenues of $100,000
and incremental expenses of $65,000 including
depreciation.
What is the simple rate of return on the
investment project?

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 Simple Rate of Return Method

Simple rate $100,000 - $65,000

= = 25%
of return $140,000

The
The simple
simple rate
rate of
of return
return method
method isis
not
not recommended
recommended because
because itit
ignores
ignores the
the time
time value
value of
of money
money
and
and the
the simple
simple rate
rate of
of return
return can
can
fluctuate
fluctuate from
from year
year to
to year.
year.

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 End of Chapter 3

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