12

The Capital
Budgeting Decision

Chapter
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline
• Capital budgeting decision
• Cash flows and capital budgeting
• Methods for ranking investments
– Payback methods
– Internal rate of return
– Net present value
• Discount or cutoff rate
• Aftertax operating benefits and tax shield
benefits of depreciation
12-2
 Capital Budgeting Decision
• Involves planning of expenditures for a
project with a minimum period of a year or
longer
• Capital expenditure decision requires:
– Extensive planning and coordination of different
departments
• Uncertainties are common in areas such as:
– Annual costs and inflows, product life, interest
rates, economic conditions, and technological
changes
12-3
 Administrative Considerations
• Steps in the decision-making process:
– Search for and discovery of investment
opportunities
– Collection of data
– Evaluation and decision making
– Reevaluation and adjustment

12-4
Capital Budgeting Procedures

12-5
 Accounting Flows versus
Cash Flows
• Capital budgeting decisions - emphasis
remains on cash flow
– Depreciation (noncash expenditure) is added
back to profit to determine the amount of cash
flow generated
• Example shown in the next slide
• Emphasis is on use of proper evaluation
techniques to make best economic choices
and assure long term wealth

12-6
Cash Flow for Alston Corporation

12-7
 Revised Cash Flow
for Alston Corporation

12-8
 Methods of Ranking
Investment Proposals
• Three methods used:
– Payback method – although not sound
conceptually, is often used
– Internal rate of return - more acceptable and
commonly used
– Net present value - more acceptable and
commonly used

12-9
 Payback Method
• Time required to recoup initial investment
– Table 12-3, using Investment A:
• There is no consideration of inflows after the cutoff
period
• The method fails to consider the concept of the time
value of money
Year Early Returns Late Returns
1……….. $9,000 $1,000
2……….. $1,000 $9,000
3……….. $1,000 $1,000

12-10
Investment Alternatives

12-11
 Payback Method (cont’d)
• Advantages:
– Easy to understand and emphasizes liquidity
– Must recoup initial investment quickly or it will
not qualify
– Rapid payback preferred in industries
characterized by dynamic technological
developments
• Shortcomings:
– Fails to discern optimum or most economic
solution to capital budgeting problem
12-12
 Internal Rate of Return
• Requires the determination of the yield on an
investment with subsequent cash inflows
– Assuming that a $1,000 investment returns an annuity of
$244 per annum for five years, provides an internal rate
of return of 7%:
• Dividing the investment (present value) by the annuity:
(Investment) = $1,000 = 4.1 (PVIFA)
(Annuity) $244

• The present value of an annuity (given in Appendix D) shows

that the factor of 4.1 for five years indicates a yield of 7%

12-13
Determining Internal Rate of Return
Cash Inflows (of $10,000 investment)
Year Investment A Investment B
1……………… $5,000 $1,500
2……………… $5,000 $2,000
3……………… $2,000 $2,500
4……………… $5,000
5……………… $5,000

• To find a beginning value to start the first trial, the inflows are averaged
out as though annuity was really being received
$5,000
$5,000
$2,000
$12,000 ÷ 3 = $4,000

12-14
Determining Internal Rate of Return
(cont’d)
• Dividing the investment by the ‘assumed’ annuity value in the previous
step, we have:
(Investment) = $10,000 = 2.5 (PVIFA)
(Annuity) $4,000
• The first approximation (derived from Appendix D) of the internal rate of
return using: PVIFA factor = 2.5
n (period) = 3
The factor falls between 9 and 10 percent
• Averaging understates actual IRR, same method would overstate IRR
for Investment B
• Cash flows in early years are worth more and increase the return,
possible to gauge whether first approximation is overstated or
understated

12-15
 Determining Internal Rate of Return
(cont’d)
• Using the trial and error approach, we use both 10% and 12% to arrive
at the answer:
Year 10%
1…….$5,000 X 0.909 = $4,545
2…….$5,000 X 0.826 = $4,130
3…….$2,000 X 0.751 = $1,502
$10,177
• (At 10%, the present value of the inflows exceeds $10,000 – we therefore use a higher discount
rate)
Year 12%
1…….$5,000 X 0.893 = $4,465
2…….$5,000 X 0.797 = $3,985
3…….$2,000 X 0.712 = $1,424
$9,874
• (At 12%, the present value of the inflows is less than $10,000 – thus the discount rate is too
high)

12-16
 Interpolation of the Results
• The internal rate of return is determined when the present value of the
inflows (PVI) equals the present value of the outflows (PVO)
• The total difference in present values between 10% and 12% is $303

$10,177…… PVI @ 10% $10,177…….PVI @ 10%

- $9,874…....PVI @ 12% - $10,000……(cost)
$303 $177

• The solution is ($177/$303) percent of the way between 10 and 12

percent. Due to a 2% difference, the fraction is multiplied by 2% and the
answer is added to 10% for the final answer of:

10% + ($177/$303) (2%) = 11.17% IRR

• The exact opposite of this conclusion is yielded for Investment B

(14.33%)
12-17
 Interpolation of the Results (cont’d)
• Use of internal rate of return requires calculated selection of Investment
B in preference to Investment A, the conclusion being exactly the
opposite under the payback method
• The final selection of any project will also depend on yield exceeding
some minimum cost standard, such as cost of capital to the firm

Investment A Investment B Selection

Payback
method……..2 years 3.8 years Quicker payback: Investment
A
Internal
Rate of
Return………11.17% 14.33% Higher yield: Investment B

12-18
 Net Present Value
• Discounting back the inflows over the life of
the investment to determine whether they
equal or exceed the required investment
– Basic discount rate is usually the cost of the
capital to the firm
– Inflows must provide a return that at least equals
the cost of financing those returns

12-19
 Net Present Value (cont’d)
$10,000 Investment, 10% Discount Rate
Year Investment A Year Investment B
1……… $5,000 X 0.909 = $4,545 1………. $1,500 X 0.909 = $1,364
2……… $5,000 X 0.826 = $4,130 2………. $2,000 X 0.826 = $1,652
3……… $2,000 X 0.751 = $1,502 3………. $2,500 X 0.751 = $1,878
$10,177 4………. $5,000 X 0.683 = $3,415
5………. $5,000 X 0.621 = $3,105
$11,414

Present value of inflows…..$10,177 Present value of inflows…..$11,414

Present value of outflows -$10,000 Present value of outflows -$10,000
Net present value……………..$177 Net present value…………...$1,414

12-20
Capital Budgeting Results

12-21
 Selection Strategy
• For a project to be potentially accepted:
– Profitability must equal or exceed cost of capital
– Projects that are mutually exclusive:
• Selection of one alternative will preclude selection of
any other alternative
– Projects that are not mutually exclusive:
• Alternatives that provide a return in excess of cost of
capital will be selected

12-22
 Selection Strategy (cont’d)

• In the case of the prior Investment A and B, assuming a capital of 10%,

Investment B would be accepted if the alternatives were mutually
exclusive, while both would clearly qualify if they were not so

12-23
 Selection Strategy (cont’d)
• Assumption used:
– Internal rate of return and net present value
methods call for the same decision
– Exceptions to these generally common scenario
are:
• Both methods will accept or reject the same
investments
• The two methods may give different answers in
selecting the best investment from a range of
acceptable alternatives

12-24
 Reinvestment Assumption
• All inflows can be reinvested at the yield
from a given investment
– Investments with very high IRR
• May be unrealistic to assume that reinvestment can
occur at a equally high rate
– Under the net present value method:
• Allows for certain consistency

12-25
The Reinvestment Assumption – Net
Present Value ($10,000 Investment)

12-26
 Modified Internal Rate of Return
(MIRR)
• Combines reinvestment assumption of the
net present value method with the internal
rate of return

12-27
 Modified Internal Rate of Return
(MIRR) (cont’d)
• Assuming $10,000 produces the following inflows for the next three years:

• The cost of capital is 10%

• Determining the terminal value of the inflows at a growth rate equal to the
cost of capital:

• To determine the MIRR:

PVIF = PV = $10,000 = .641 (Appendix B)
FV $15,610

12-28
 Capital Rationing
• Artificial restraint set on the usage of funds
that can be invested in a given period
– May be adopted because of:
• Fear of too much growth
• Hesitation to use external sources of funding
– Hinders a firm from achieving maximum
profitability

12-29
Capital Rationing

12-30
 Net Present Value Profile
• Allows graphical representation of net
present value of a project at different
discount rates
• To apply the net present value profile, three
characteristics need to be looked into:
– The net present value at a zero discount rate
– The net present value as determined by a
normal discount rate (such as cost of capital)
– The internal rate of return for the investments
12-31
Net Present Value Profile –
Graphic Representation

12-32
Net Present Value Profile
with Crossover

12-33
 The Rules of Depreciation
• Assets are classified according to nine
categories
– Determine the allowable rate of depreciation
write-off
– Modified accelerated cost recovery system
(MACRS) represent the categories
– Asset depreciation range (ADR) is the expected
physical life of the asset or class of assets

12-34
 Categories for
Depreciation Write-Off

12-35
Depreciation Percentages
(Expressed in Decimals)

12-36
Depreciation Schedule

12-37
 The Tax Rate
• Corporate tax rates are subject to changes
– Maximum quoted federal corporate tax rate is
now in the mid-30 percent range
– Smaller corporations and others may pay taxes
only between 15 – 20%
– Larger corporations with foreign tax obligations
and special state levies may pay effective taxes
of 40% or more

12-38
 Actual Investment Decision
• Assumption:
– $50,000 depreciation analysis allows purchase of machinery with a
six-year productive life
– Produces an income of $18,500 for first three years before
deductions for depreciation and taxes
– In the last three years, income before depreciation and taxes will be
$12,000
– Corporate tax rate taken at 35% and cost of capital 10%
– For each year:
• The depreciation is subtracted from “earnings before
depreciation and taxes” to arrive at earnings before taxes
• Taxes then subtracted to determine earnings after taxes
• Depreciation is added to earnings to arrive at cash flow
12-39
 Cash Flow Related
to the Purchase of Machinery

12-40
Net Present Value Analysis

12-41
 The Replacement Decision
• Investment decision for new technology
• Includes several additions to the basic
investment situation
– The sale of the old machine
– Tax consequences
• Decision can be analyzed by using a total or
an incremental analysis

12-42
Book Value of Old Computer

12-43
Net Cost of New Computer

12-44
Analysis of Incremental
Depreciation Benefits

12-45
Analysis of Incremental
Cost Savings Benefits

12-46
 Present Value of the
Total Incremental Benefits

12-47
 Elective Expensing
• Businesses can write off tangible property, in
the purchased year for up to $100,000
– Includes: equipment, furniture, tools, computers
etc.
• Beneficial to small businesses:
– Allowance is phased out dollar for dollar when
total property purchases exceed $200,000 in a
year

12-48