1. 12 The Capital Budgeting Decision Prepared by: Michel Paquet
SAIT Polytechnic
©2009 McGraw-Hill Ryerson Limited

2. Chapter 12 - Outline Definition of Capital Budgeting
Methods of Evaluating Investment Proposals
Accept/Reject Decision
Capital Rationing
Cash Flow Analysis and Capital Cost Allowance (CCA)
Making Investment Decisions
Summary and Conclusions

3. Learning Objectives
Define capital budgeting decisions as long-run investment decisions. (LO1)
Explain that cash flows rather than accounting earnings are evaluated in the capital budgeting decision. (LO2)
Evaluate investments by the average accounting return, the payback period, the internal rate of return, the net present value and the profitability index. (LO3)

4. Learning Objectives
Discuss the use of the cost of capital as the discount rate in capital budgeting analysis. (LO4)
Identify the cash flows that result from an investment decision, including the aftertax operating benefits and the tax shield benefits of capital cost allowance (amortization). (LO5)
Perform NPV analysis to assist in the decision-making process concerning long-run investments. (LO6)

5. What is Capital Budgeting?
LO1
What is Capital Budgeting?
Capital Budgeting:
represents a long-term investment decision
for example, buy a new computer system or build a new plant
involves the planning of expenditures for a project with a life of 1 or more years
emphasizes amounts and timing of cash flows and opportunity costs and benefits
investment usually requires a large initial cash outflow with the expectation of future cash inflows
considers only those cash flows that will occur as a result of the investment (resultant cash flows)
all cash flows are calculated aftertax

6. LO1
FIGURE 12-1
Capital budgeting procedures

7. Accounting Flows Versus Cash Flows
Table 12-1 Cash flow for Alston Corporation
Earnings before amortization and taxes (cash inflow) $20,000
Amortization (non-cash expense) ,000
Earnings before taxes ,000
Taxes (cash outflow) 40% ,000
Earnings aftertaxes ,000
Amortization ,000
Cash flow $14,000
Alternative method of cash flow calculation
Cash inflow (EBAT) $20,000
Cash outflow (taxes) ,000

8. Table 12-2 Revised cash flow for Alston Corporation
Earnings before amortization and taxes $20,000
Amortization ,000
Earnings before taxes
Taxes
Earnings aftertaxes
Amortization ,000
Cash flow $20,000

9. 5 Methods of Evaluating Investment Proposals
LO3
5 Methods of Evaluating Investment Proposals
Average Accounting Return (AAR)
Payback Period (PB)
Internal Rate of Return (IRR)
Net Present Value (NPV)
Profitability Index (PI)

10. Average Accounting Return (AAR)
LO3
Average Accounting Return (AAR)
AAR Equals:
Average Earnings Aftertax
Average Book Value of Investment
Advantage: Relatively easy to calculate
Disadvantages:
Uses accounting earnings, not cash flows
Ignores the timing of the earnings
Uses book value, not market value of investment
Does not suggest an objective evaluation yardstick

11. Average Accounting Return: An Example
LO1
Average Accounting Return: An Example
Earnings Aftertax Amortized Capital Cost
Capital Cost $30,000*
Year $2, ,500
Year , ,000
Year , ,500
Year ,
Average $16,000/4 = $4, $75,000/5 = $15,000**
Average Accounting Return $4,000/$15,000 = 26.7%
*Straight-line depreciation
**Also, Average Book Value = ($15,000 + $0)/2 = $15,000

12. Payback Period Payback Period (PB): LO3
computes the amount of time required to recoup the initial investment
a cutoff period is arbitrarily established
Advantages:
easy to use (“quick and dirty” approach)
emphasizes liquidity
one measure of the risk of an investment
Disadvantages:
ignores inflows after the cutoff period and
fails to consider the time value of money
does not have an objective yardstick
not a good measures of risk

13. Net Present Value Net Present Value (NPV):
LO3
Net Present Value
Net Present Value (NPV):
the present value of the cash inflows minus the present value of the cash outflows
the future cash flows are discounted back over the life of the investment
the basic discount rate is usually the firm’s cost of capital (WACC) (assuming similar risk)

14. Internal Rate of Return
LO3
Internal Rate of Return
Internal Rate of Return (IRR):
represents a yield on an investment or a rate of return
requires calculating the discount rate that equates the initial cash outflow (cost) with the future cash inflows (benefits)
is the discount rate where the cash outflows equal the cash inflows (or NPV = 0)

15. Profitability Index Profitability Index (PI) =
LO3
Profitability Index
Profitability Index (PI) =
– an alternative presentation of the NPV method
– used to compare investments of different sizes especially in a capital rationing situation
Present value of the inflows
Present value of the outflows

16. Capital Budgeting: An Example
LO3
Capital Budgeting: An Example
TABLE 12-3
Investment alternatives

17. Evaluating These 2 Investments
LO3
Evaluating These 2 Investments
Payback Period:
Investment A: $5,000 + $5,000 = $10,000 (2 years)
Investment B: $1,500 + $2,000 + $2,500 + $4,000 ( = 0.8 of $5,000) =
$10,000 (3.8 years)
Net Present Value:
Investment A:
$5, $5, $2,000
| | | |
PV = -$10, n = 3
%i = 10%
Using the NPV function in a financial calculator:
CF0= ; C01 = 5000; F01 = 2; C02 = 2000; F02 = 1; I = 10;
Compute NPV =

18. Evaluating These 2 Investments
LO3
Evaluating These 2 Investments
Net Present Value:
Investment B:
$1, $2, $2, $5, $5,000
| | | | | |
PV= -$10, n = 5
i% = 10
Using the NPV function in a financial calculator:
CF0= ; C01 = 1500; F01 = 1; C02 = 2000; F02 = 1; C03 = 2500; F03 = 1; C04 = 5000; F04 = 2; I = 10; Compute NPV =

19. Evaluating These 2 Investments
LO3
Evaluating These 2 Investments
Internal Rate of Return:
Investment A:
Investment B:
Profitability Index:
A: PI = $10,180/$10,000 = ;
B: PI = $11,414/$10,000 =
Using the IRR function in a financial calculator:
CF0= ; C01 = 5000; F01 = 2; C02 = 2000; F02 = 1;
Compute IRR = 11.16(%)
Using the IRR function in a financial calculator:
CF0= ; C01 = 1500; F01 = 1; C02 = 2000; F02 = 1; C03 = 2500; F03 = 1; C04 = 5000; F04 = 2; Compute IRR = (%)

20. Table 12-4 Capital budgeting results
LO3
Table 12-4 Capital budgeting results
Investment A Investment B Selection
Payback period years years Quickest payback:
Investment A
Net present value $ $1,414 Highest net present value: Investment B
Internal rate of return % % Highest yield:
Investment B
Profitability Index Highest relative profitability: Investment B

21. Accept/Reject Decision
LO3
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
Profitability Index (PI):
– if PI > 1, accept the project
– if PI < 1, reject the project

22. Comparing Methods PI is a variation of NPV method.
LO3
Comparing Methods
PI is a variation of NPV method.
IRR and NPV methods are superior to PB and AAR methods, because
– IRR and NPV evaluate all the resultant cash flows
– they employ the time value of money
– they have an objective yardstick – the cost of capital
IRR method has some flaws:
– inconsistency with NPV for some mutually exclusive projects
– discounting considerations
– multiple IRRs
NPV is the best methodology.

23. LO4
Table 12-5 Internal rate of return and net present value ($10,000 investment)
Investment A (11.16% IRR) Investment A
Year Cash Flow Year Cash Flow
$5, $5, %
, , %
, , %
discounted at discounted
11.16% at various rates if desired
NPV = NPV = $27

24. Modified Internal Rate of Return
LO3
Modified Internal Rate of Return
The reinvestment assumption of the IRR method may be unrealistic.
To remedy this flaw, the more realistic reinvestment assumption of the NPV method is combined with the IRR method, producing the modified internal rate of return (MIRR).
MIRR is the discount rate that will equate the initial investment with the future value of inflows.
Each of these inflows grows at the cost of capital.

25. Modified Internal Rate of Return
LO3
Modified Internal Rate of Return
Cost of capital = 10%
$6, FV = $7,260
$5, FV = $5,500
$2, FV = $2,850
FV = $15,610
PV = -$10,000
Using the PV function in a financial calculator
N= 3; PV= ; PMT= 0; FV=15,610; Compute I = 16(%)
MIRR = 16%

26. LO3
Table 12-6 Multiple IRRs

27. LO3
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

28. Table 12-7 Capital rationing
LO3
Table 12-7 Capital rationing
Net
Total Present
Project Investment Investment Value
Capital A $2,000,000 $400,000
rationing B 2,000, ,000
solution C 1,000,000 $5,000, ,000
D 1,000, ,000
Best E 800,000 6,800, ,000
solution F 800,000 (30,000.)

29. Net Present Value Profile
LO4
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

30. Figure 12-2 Net Present Value Profile
LO4
Figure 12-2 Net Present Value Profile
6,000
4,000
2,000
Net present value ($) 5%
10%
15%
20%
25%
IRRB = 14.33%
IRRA = 11.16%
Discount rate (percent)
Investment B
Investment A B A A B

31. Figure 12-3 Net Present Value Profile With Crossover
LO4
Figure 12-3 Net Present Value Profile With Crossover
6,000
4,000
2,000
Net present value ($) 5%
10%
15%
20%
25%
IRRC = 22.49%
IRRB = 14.33%
Discount rate (percent)
Crossover point
Investment C
Investment B B C B C

32. Capital Cost Allowance
Amortization for income tax purposes
Capital Cost Allowance (CCA) is the maximum amount of amortization allowable under the tax act
Capital assets are divided into a number of classes (pools)
Each class is assigned a CCA rate;
ex. Class 8 is Machinery with a rate of 20%
CCA is calculated on the Un-depreciated Capital Cost (UCC) in the pool (declining balance)
CCA provides a tax shield over the life of the investment
A formula provides the present value of the CCA tax shield

33. Capital Cost Allowance: tax savings
Before CCA Expense After CCA Expense
Income (cash flow) . . $12, Income (cash flow) $12,000
CCA ,000
Taxable income ,000
40% ,800 40% ,800
Income (cash flow) Income aftertaxes $4,200 aftertaxes ,200
Add back CCA ,000
Income/cash flow
aftertax $9,200
Aftertax expense $5,000 (1 - T) = $3,000
Tax savings $5,000 (T) = $2,000
Before-tax expense $5,000

34. Table 12-8 Some declining balance CCA classes
LO5
Table 12-8 Some declining balance CCA classes

35. Table 12-9 Capital Cost Allowance for investment A or B
Year 1:
Net original cost $10,000
Less: capital cost allowance 1/2($10,000 x .20) ,000
Undepreciated capital cost* $ 9,000
Year 2:
Less: capital cost allowance ($9,000 x .20) ,800
Undepreciated capital cost ,200
Year 3:
Less: capital cost allowance ($7,200 x .20) ,440
Undepreciated capital cost $ 5,760
Year 4:
Less capital cost allowance $(5,760 x .20) ,152
Undepreciated capital cost $ 4,608
Year n:
Undepreciated capital cost (for year n - 1)
Less capital cost allowance (UCC in year n - 1 x .20)
Equals: undepreciated capital cost (for year n)
*UCC for short
UCCn = (1-d/2)(1 - d)n-1

36. Table 12-10 Liquidation of Asset Pool
LO5
Table Liquidation of Asset Pool

37. Making Investment Decisions
LO6
Making Investment Decisions
When estimating cash flows for an investment proposal, remember that only those cash flows resulting from the potential acceptance decision are relevant and should be included in your estimation.
For example, a proposal of purchasing a new van to replace an old van should only include the net cost of the new van, that is, the difference between the cost of the new van and the sale price of the old van.
The present value of CCA tax shield =

38. Table 12-13 Net present value of resultant cash flows at 12%

39. Table 12-14 IRR solution framework using 25%
LO6
Table IRR solution framework using 25%

40. Making Investment Decisions
LO6
Making Investment Decisions
To make the actual investment decision:
(1) determine the net cash outflow arising from the initial investment
(2) estimate the amounts and timing of net future cash inflows (aftertax)
(3) discount the future cash flows back to the present
(4) add the present value of the Capital Cost Allowance shield, using the formula and appropriate CCA rate
(5) determine whether the machine should be purchased (if NPV > 0)

41. Table 12-15 Net price of the new computer
LO6
Table Net price of the new computer
Price of the new computer $150,000
- Investment tax credit (15%) or $22, ,737*
Net price of new computer ,263
- Cash inflow from sale of old computer ,000
Net cost of new computer $ 90,263
*Our assumption about cash flows (revenues, expenses) and tax-initiated cash flows is that they occur at the end of the year. Therefore, the tax credit of $22,500 is discounted one year. The CCA pool is affected in the year after acquisition. The CCA tax shield formula is constructed assuming tax savings effects occur at the end of the year

42. Table 12-16 Differential analysis of new computer
LO6
Table Differential analysis of new computer
Present
( After-tax Value
Year Cash Flow Amount (tax rate) Cash Flow
New computer –$90,623 — — –$90,623
Working capital
investment –5,000 — — –5,000
Cost savings 20, , ,702
Cost savings 38, , ,836
Cost savings 40, , ,469
Cost savings 45, , ,253
Cost savings 45, , ,257*
Salvage 30,000 — — ,581
Working capital
recovery 5,000 — — ,597
Present value of CCA tax shield benefits. . . (from calculation) ,490
Net present value $18,922
*The present value of all the cost savings may be handled in one output from the calculator, particularly if it is an annuity

43. Summary and Conclusions
The capital budgeting decision deals with the planning of expenditures for a project with a life of at least one year.
Five methods are used to analyze capital investment proposals: average accounting return (AAR), payback period (PB), net present value (NPV), internal rate of return (IRR), and profitability index (PI).
NPV, IRR and PI are more complete methods for assessing capital budgeting decision, because they consider timing and overall amount of cash flows and have an objective yardstick.

44. Summary and Conclusions
A capital budgeting decision should consider cash flows on an aftertax basis not accounting flows and should only consider those cash flows as a direct result of the decision.
Capital cost allowance (CCA) would affect the cash flows from a project because it may save a firm some tax dollars.
A positive NPV project will increase the shareholders’ wealth by that amount.