Chapter 12 The Capital Budgeting Decision

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 12-1 FIGURE 12-1 Capital budgeting procedures

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 12-2 TABLE 12-1 Cash flow for Alston Corporation

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 12-2 TABLE 12-2 Revised cash flow for Alston Corporation

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 12-3 TABLE 12-3 Investment alternatives

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 12-3 TABLE 12-4 Capital budgeting results

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 12-4 TABLE 12-6 The reinvestment assumption− net present value ($10,000 investment)

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 12-5 TABLE 12-7 Capital rationing

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 12-6 FIGURE 12-2 Net present value profile

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 12-7 FIGURE 12-3 Net present value profile with crossover

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 12-8 TABLE 12-8 Categories for depreciation write-off

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 12-9 TABLE 12-9 Depreciation percentages (expressed in decimals)

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT TABLE Depreciation schedule

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT TABLE Cash flow related to the purchase of machinery

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT TABLE Net present value analysis

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT TABLE Analysis of incremental depreciation benefits

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT TABLE Analysis of incremental cost savings benefits

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT TABLE Present value of the total incremental benefits

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 12 - Outline LT 12-1 What is Capital Budgeting? 3 Methods of Evaluating Investment Proposals Accept/Reject Decision Capital Rationing Net Present Value Profile Determining Whether to Purchase a Machine

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. What is Capital Budgeting? LT 12-2 Capital Budgeting: – represents a long-term investment decision – involves the planning of expenditures for a project with a life of many years – usually requires a large initial cash outflow with the expectation of future cash inflows – uses present value analysis – emphasizes cash flows rather than income

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3 Methods of Evaluating Investment Proposals LT 12-3 There are 3 widely used methods of evaluating investment proposals: Payback Method (PB) Internal Rate of Return (IRR) Net Present Value (NPV)

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Payback Method LT 12-4 Payback Method (PB): – computes the amount of time required to recoup the initial investment – a cutoff period is established Advantages: – easy to use (“quick and dirty” approach) – emphasizes liquidity Disadvantages: – ignores inflows after the cutoff period and fails to consider the time value of money – is inferior to the other 2 methods

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Internal Rate of Return LT 12-5 Internal Rate of Return (IRR): – represents a yield on an investment or an interest rate – requires calculating the interest rate that equates the cash outflows (cost) with the cash inflows – is the interest rate where the cash outflows equal the cash inflows (or NPV = 0)

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Net Present Value LT 12-6 Net Present Value (NPV): – the present value of the cash inflows minus the present value of the cash outflows – the cash inflows are discounted back over the life of the investment – the basic discount rate is usually the firm’s cost of capital (WACC)

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Accept/Reject Decision LT 12-7 Payback Method (PB): –if PB period < cutoff period, accept the project – if PB period > cutoff period, reject the project Internal Rate of Return (IRR): – if IRR > cost of capital, accept the project – if IRR < cost of capital, reject the project Net Present Value (NPV): – if NPV > 0, accept the project – if NPV < 0, reject the project

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Capital Rationing A limit or constraint on the amount of funds that can be invested Firm must rank investments based on their NPVs Those with positive NPVs are accepted until all funds are exhausted LT 12-8

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Net Present Value Profile LT 12-9 Net Present Value Profile: – a graph of the NPV of a project at 3 different discount rates: a zero discount rate the normal discount rate (or cost of capital) the IRR for the investment – allows an easy way to visualize whether or not an investment should be undertaken

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Determining Whether to Purchase a Machine LT To make the actual investment decision: – calculate a depreciation schedule using the appropriate MACRS class – figure earnings and cash flow (CF) – discount the cash flows back to the present to determine whether the machine should be purchased (only if NPV > 0)