26-1

CHAPTER 26

CAPITAL BUDGETING
LONG-RANGE PLANNING
 26-2

Capital Budgeting
 It is the process of considering alternative
capital projects and selecting those
alternatives that provide the most
profitable return on available funds.
 Examples of capital projects include land,
buildings, equipment and other major
fixed asset items.
 26-3

Capital Budgeting
I will choose the
Alternatives:
project with the most
profitable return on
available funds. Plant
Expansion
?
Limited
New
Investment ? Equipment
Funds
?
Office
Renovation
 26-4

Capital Budgeting
Implementation of a capital project
involves . . .
 a large commitment of money in
the decision period.
 a large increase in fixed costs
for a number of years.
 potential returns in future years.

 an opportunity cost because of

the rejection of other projects.
 26-5

Project Selection:
A General View
 Analysis of cash inflows and cash
outflows
 Net cash inflow is the net cash benefit
expected from a capital project in a period.
 Time value of money
 Cash received today is
worth more than the
same amount received
in the future.
.
 26-6

Capital Budgeting
Cash Flow Analysis
Initial
Investment

Incremental Repairs
Typical
Operating and
Costs Cash Outflows Maintenance

Increased
Working Capital
 26-7

Capital Budgeting
Cash Flow Analysis
Incremental
Revenues

Reduced Released
Typical
Operating Working
Costs Cash Inflows Capital

Salvage
Value .
 26-8

Capital Budgeting
Terminology
Out-of-pocket Cost of Sunk
costs capital costs

Future cash Interest rate Past cash

outflows indicating the outflows
cost of debt
and equity
investment
Avoided by Not avoided
funds
not selecting by current
a project decision
 26-9

Depreciation and Taxes

Depreciation itself is not a cash flow.

However, depreciation results in a

reduction of cash outflows by reducing
federal income taxes.
 26-10

Depreciation and Taxes

Example
Apex Company is considering the purchase of
new equipment. Given the following information,
and a tax rate of 40 percent, compute the:
 Tax savings due to depreciation.
 After-tax net cash inflow.
Asset cost $ 72,000
Asset life 10 years
Asset salvage value $ 12,000
Straight-line depreciation 6,000
Annual cash inflows 90,000
Annual cash outflows 70,000
 26-11

Depreciation and Taxes

Example
 Tax savings With
Depreciation
Without
Depreciation
Net cash inflow from project $ 20,000 $ 20,000
Depreciation 6,000 -
Amount subject to tax $ 14,000 $ 20,000

Tax at 40% $ 5,600 $ 8,000

Tax savings = $2,400

(.40 × $6,000 depreciation = $2,400)
 26-12

Depreciation and Taxes

Example
 After-tax net cash inflow
Income Cash Flow
Net cash inflow from project $ 20,000 $ 20,000
Depreciation 6,000 -
Income subject to tax $ 14,000 $ 20,000
Tax at 40% 5,600 5,600
After-tax amount $ 8,400 $ 14,400

Alternatively, reducing this analysis to a formula yields:

After-tax net Before-tax net Tax Depreciation Tax
cash inflow = [ cash inflow (
× 1- rate )] + [ expense × rate
. ]
[$20,000 × (1 - .4)] + [$6,000 × .4] = $14,400
 26-13

Project Selection Methods

Payback Period
Unadjusted Rate of Return
Net Present Value (NPV)
Profitability Index
Time Adjusted Rate of Return
i.e., Internal Rate of Return (IRR)
 26-14

Project Selection Method 1:

Payback Period

Time required for the sum

of the annual net cash
inflows to equal the
initial cash outlay.
 26-15

Payback Period

When the annual net cash inflows are

equal, use the following formula:

Initial cash outlay

Payback period =
Annual net cash inflow
 26-16

Payback Period
Example
 Gators wants to install a separate seafood
bar in its pub.
 The seafood bar will . . .
 cost $150,000 and has a 10-year life with zero
salvage value.
 generate net annual cash inflows of $30,000.
 Gators requires a payback period of 6 years
or less on all investments.
Should Gators invest in the seafood bar?
 26-17

Payback Period
Example
Initial cash outlay
Payback period =
Annual net cash inflow

$150,000
Payback period = = 5.0 years
$30,000 per year

Gators should invest in the seafood bar

because the payback period is less than 6 years.
 26-18

Payback Period Limitations

Ignores cash Ignores the

flows after time value
the payback of money.
period.
 26-19

Payback Period Limitations

Example
Consider two projects, each with a five-year
life and each costing $6,000.
Project One Project Two
Net Cash Net Cash
Year Inflows Inflows
1 $ 2,000 $ 1,000
2 2,000 1,000
3 2,000 1,000
4 2,000 1,000
5 2,000 1,000,000

Which project has the better payback period?

 26-20

Payback Period Limitations

Example
 Project one returns the $6,000 investment
faster -- shorter payback period of three
years ($6,000 ÷ $2,000 per year = 3 years).
 Project two is clearly superior because of
the large cash inflow in the last year.
 Can you see the limitations of the
payback period?
 26-21

Project Selection Method 2:

Unadjusted Rate of Return
The unadjusted rate of return focuses on
annual income instead of cash flows.
Unadjusted Average annual income
=
rate of return Average amount of investment

Beginning balance + Ending balance

2
 26-22

Unadjusted Rate of Return

Example
Reconsider the Gators example:

 The seafood bar will . . .

 cost $150,000 and has a 10-year life with zero salvage
value.
 generate net annual cash inflows of $30,000.
 Gators requires a payback period of 6 years or
less on all investments and pays tax at 40%.

What is the the unadjusted

rate of return on the seafood bar?
 26-23

Unadjusted Rate of Return

Example
Annual net cash inflows $ 30,000
Depreciation ($150,000 ÷ 10 years) 15,000
Annual income before tax $ 15,000

Unadjusted Average annual income after tax

=
rate of return Average amount of investment
.
Unadjusted Average annual before-
( - Average annual) × (1 - Tax
)
Rate of tax net cash inflow depreciation rate
return
= Average amount of investment

Unadjusted (30,000 - 15,000) x (1 - .40)

= = 12.0%
rate of return (150,000 + 0) ÷ 2
 26-24

Unadjusted Rate of Return

Limitations

 Depreciation may
be calculated
several ways
thereby giving
different results.
 Time value of
money is ignored.
 26-25

Project Selection Method 3:

Net Present Value (NPV) Method

A comparison of the present value of

cash inflows with the present value of
cash outflows
 26-26

Net Present Value

Procedure
Chose a minimum rate of return
(cost of capital).
Calculate the present value of cash
inflows.
Calculate the present value of cash
outflows.
NPV = –
 26-27

Net Present Value

Interpretation
 If NPV is positive, the investment yields a
higher return than the cost of capital.
 Decision rule: Invest if NPV is positive.
 26-28

Net Present Value

Question
Savak Company can buy a new machine for
$96,000 which will save $20,000 cash per year
in operating costs. If the machine has a useful
life of 10 years and Savak’s required return is
12 percent, what is the NPV (rounded)?

a. $ 4,306
b. $12,721
c. $11,553
d. $17,004
 26-29

Net Present Value

Question
Savak Company can buy a new machine for
$96,000 which will save $20,000 cash per year
in operating costs. If the machine has a useful
life of 10 years and Savak’s required return is
12 percent, what is the NPV (rounded)?
Use present value of annuity table (A.4)
a. $ 4,306
PV of inflows = $20,000 × 5.65022 = $113,004
b. $12,721
NPV = $113,004 - $96,000 = $17,004
c. $11,553
d. $17,004
 26-30

Net Present Value

Question
Calculate the NPV if Savak Company’s required
return is 14 percent instead of 12 percent.
 26-31

Net Present Value

Question
Calculate the NPV if Savak Company’s required
return is 14 percent instead of 12 percent.

Use present value of annuity table (A.4)

PV of inflows = $20,000 × 5.21612 = $104,322
NPV = $104,322 - $96,000 = $8,322

Note that the NPV is smaller

using the larger interest rate.
 26-32

Net Present Value

Now that you have mastered the basic
concept of net present value, it’s time
for a more sophisticated checkup!
 26-33

Net Present Value

Example
Harper Co. has been offered a five-year contract
to provide parts for a large manufacturer,
requiring an investment in new equipment.

 The new equipment will . . .

 cost $160,000, have a five-year useful life, and
a $5,000 salvage value.
 need an overhaul at the end of three years
costing $30,000.
 Initial working capital requirement is $100,000.
 26-34

Net Present Value

Example
The contract is expected to produce the
following annual cash flows:
Revenues $ 750,000
Less: Cost of goods sold 400,000
Gross margin $ 350,000
Less: Other cash expenses 270,000
Annual net cash inflow $ 80,000

Harper uses a 10 percent discount rate.

Ignoring income taxes, compute the net
present value of the contract.
 26-35

Net Present Value

Example
Harper Company Net Present Value Analysis
Year(s) Cash Flow PV factor PV(rounded)
Equipment Now $ (160,000) 1.00000 $ (160,000)
 26-36

Net Present Value

Example
Harper Company Net Present Value Analysis
Year(s) Cash Flow PV factor PV(rounded)
Equipment Now $ (160,000) 1.00000 $ (160,000)
Working capital Now (100,000) 1.00000 (100,000)
 26-37

Net Present Value

Example
Harper Company Net Present Value Analysis
Year(s) Cash Flow PV factor PV(rounded)
Equipment Now $ (160,000) 1.00000 $ (160,000)
Working capital Now (100,000) 1.00000 (100,000)
Annual inflow 1-5 80,000 3.79079 303,263

Present value of an annuity of $1

factor for 5 years at 10%.
 26-38

Net Present Value

Example
Harper Company Net Present Value Analysis
Year(s) Cash Flow PV factor PV(rounded)
Equipment Now $ (160,000) 1.00000 $ (160,000)
Working capital Now (100,000) 1.00000 (100,000)
Annual inflow 1-5 80,000 3.79079 303,263

$80,000 × 3.79079 = $303,263

 26-39

Net Present Value

Example
Harper Company Net Present Value Analysis
Year(s) Cash Flow PV factor PV(rounded)
Equipment Now $ (160,000) 1.00000 $ (160,000)
Working capital Now (100,000) 1.00000 (100,000)
Annual inflow 1-5 80,000 3.79079 303,263
Overhaul 3 (30,000) 0.75131 (22,539)

Present value of $1
factor for 3 years at 10%.
 26-40

Net Present Value

Example
Harper Company Net Present Value Analysis
Year(s) Cash Flow PV factor PV(rounded)
Equipment Now $ (160,000) 1.00000 $ (160,000)
Working capital Now (100,000) 1.00000 (100,000)
Annual inflow 1-5 80,000 3.79079 303,263
Overhaul 3 (30,000) 0.75131 (22,539)
Working capital 5 100,000 0.62092 62,092
Salvage value 5 5,000 0.62092 3,105
NPV $ 85,921

Present value of $1
factor for 5 years at 10%.
 26-41

Net Present Value

Example
Harper Company Net Present Value Analysis
Year(s) Cash Flow PV factor PV(rounded)
Equipment Now $ (160,000) 1.00000 $ (160,000)
Working capital Now (100,000) 1.00000 (100,000)
Annual inflow 1-5 80,000 3.79079 303,263
Overhaul 3 (30,000) 0.75131 (22,539)
Working capital 5 100,000 0.62092 62,092
Salvage value 5 5,000 0.62092 3,105
NPV $ 85,921

Since the contract has positive NPV, we know the rate

of return is greater than the 10 percent discount rate.
 26-42

Project Selection Method 4:

Profitability Index
Present value of net cash inflows
Profitability index =
Present value of cash outflows

 Provides a means of ranking projects that

have different initial investments.
 Decision rule: consider only those projects
with a profitability index of 1.00 or more.

.
 26-43

Project Selection Method 5:

Time Adjusted Rate of Return
The interest rate that makes . . .
 Present Present
=
value of value of
cash inflows cash outflows

 The net present value equal zero.

Also known as the internal rate of return.

 26-44

Internal Rate of Return (IRR)

Procedure

For projects with equal annual cash

flows (i.e., annuities)
Determine the payback period.
Use the present value of annuity table
to determine the IRR.
 26-45

Internal Rate of Return (IRR)

Procedure

Project life = 4 years

Initial cost = $42,523
Annual net cash inflows = $14,000
Determine the IRR for this project.

1. Determine the payback period.

($42,523 ÷ $14,000 per year = 3.03736 years)
 26-46

Internal Rate of Return (IRR)

Procedure
1. Determine the payback period.
($42,523 ÷ $14,000 per year = 3.03736 years)

2. Using present value of annuity table . . .

Periods 10% 12% 14%

Locate the row
1 0.90909 0.89286 0.87719
whose number 2 1.73554 1.69005 1.64666
equals the life 3 2.48685 2.40183 2.32163
of the project. 4 3.16987 3.03735 2.91371
5 3.79079 3.60478 3.43308
 26-47

Internal Rate of Return (IRR)

Procedure
1. Determine the payback period.
($42,523 ÷ $14,000 per year = 3.03736 years)

2. Using present value of annuity table . . .

In that row, Periods 10% 12% 14%

locate the 1 0.90909 0.89286 0.87719
interest factor 2 1.73554 1.69005 1.64666
closest in 3 2.48685 2.40183 2.32163
amount to the 4 3.16987 3.03735 2.91371
5 3.79079 3.60478 3.43308
payback period.
 26-48

Internal Rate of Return (IRR)

Procedure
1. Determine the payback period.
($42,523 ÷ $14,000 per year = 3.03736 years)

2. Using present value of annuity table . . .

IRR is the Periods 10% 12% 14%

interest rate 1 0.90909 0.89286 0.87719
of the column 2 1.73554 1.69005 1.64666
in which the 3 2.48685 2.40183 2.32163
4 3.16987 3.03735 2.91371
interest factor
5 3.79079 3.60478 3.43308
is found.
 26-49

Internal Rate of Return

Example
Decker Company can purchase a new
machine at a cost of $104,322 that will
save $20,000 per year in cash operating
costs. The machine will have a 10-year
life.
What is the internal rate of return on this
investment project?
 26-50

Internal Rate of Return

Example
Initial cash outlay
Payback period =
Annual net cash inflow

$104,322
Payback period = = 5.21610
$20,000 per year

In Table A-4 in the appendix of your textbook, look across

the 10-period row until you find an interest factor of
5.21610 in the 14 percent column. The internal rate of
return is 14 percent.
If 14 percent is greater than Decker’s required rate of
return, Decker should purchase the new machine.
 26-51

Internal Rate of Return

Example
Here’s the proof . . .
14% Present
Year Amount Factor Value
Investment required Now $ (104,322) 1.00000 (104,322)
Annual cost savings 1-10 20,000 5.21610 104,322
Net present value $ 0
 26-52

Internal Rate of Return

Complication #1
If the exact interest rate is not found in the
present value table, an estimate of the
interest rate is required.
Periods 10% 11% 12%
1 0.90909 0.90090 0.89286
2 1.73554 1.71252 1.69005
3 2.48685 2.44371 2.40183
4 3.16987 3.10245 3.03735
5 3.79079 3.69590 3.60478

For a project with a five-year life and a payback period

of 3.65000, the IRR would be approximately 11.5 percent.
 26-53

Internal Rate of Return

Complication #2
If cash inflows involve both annuities and
one-time amounts, a trial and error solution
will result if present value tables are used.
Sophisticated business calculators and
electronic spreadsheets can be used to
easily solve these problems.
 26-54

Net Present Value vs.

Internal Rate of Return
Net Present Value Internal Rate of Return
 The cost of capital is  Compare the cost of
used as the actual capital to the internal
discount rate. rate of return on a
project.
 Any project with a  To be acceptable, a
negative net present project’s rate of return
value is rejected. cannot be less than
the cost of capital.
 26-55

THE END
I’m telling you, that’s the end.
There isn’t any more of this
virtual lecture.