1. 7 Capital Budgeting Decisions–Part I
Prepared by
Douglas Cloud Pepperdine University

2. After reading this chapter, you should be able to:
Objectives
Explain the concepts of cost of capital and cutoff rates of return.
Calculate cash flows from an investment, including the tax effects of depreciation.
Use the net present value method to evaluate an investment.
Use the internal rate of return method to evaluate an investment.
After reading this chapter, you should be able to:
Continued

3. Objectives
Discuss qualitative reasons for making or not making particular investments.
Use the payback method and accounting rate of return method.
Understand why discounted cash flow methods are superior to non-discounting methods.
Understand why investing in foreign countries poses special risks.

4. Capital budgeting decisions involve long-term commitments, investments made now in the expectation of increased returns in the future.

5. Importance of Capital Budgeting Decisions
Capital budgeting decisions commit companies to courses of action. The success or failure of a particular strategy, or even of the company itself, can hinge on one or a series of such decisions.

6. Why Capital Budgeting Decisions are Riskier Than Short-Term Ones
The company expects to recoup its investment over a longer period. Much time expires between making the expenditure and receiving the cash.
Reversing a capital budgeting decision is much more difficult than reversing a short-term decision.

7. Types of Capital Budgeting Decisions
Investments that increase capacity or reduce costs.
Investments mandated by law or policy.
Investments that advance strategic goals.
Investments made for non-financial reasons.

8. Investments Mandated by Law or Policy
This group includes investments made to comply with environmental, safety, and other laws and regulations. The group also includes investments made because company policy so dictates. In these cases, the organization must do something, so the only question is how to do it.
Example: A company might have three alternatives that will reduce toxic emissions. 20 9

9. Investments Made to Further Strategic Goals
This group comprises investments made for such purposes as securing global distribution of products, increasing quality, and reducing lead time.
Companies need not make these investments, but probably will even if they do not meet normal profitability criteria that we discuss shortly. 21 10

10. Investments Made to Increase Capacity or Reduce Costs
This group constitutes the bulk of investments that managers evaluate with the techniques in the chapter.
Such decisions lend themselves to analytical treatment. These investments aim at increasing profitability. 22 11

11. Investments Made for Non-Financial Reasons
A company might build a fitness center or cafeteria, without much analysis of the potential benefits, because upper level managers believe they should do so.
Such decisions typically cannot show objective measures of profitability sufficient to justify them, though indirect, intangible benefits might be very high.
The decision revolves around how to accomplish the desired result, say, what equipment to purchase for the fitness center. 23 12

12. Cost of capital is the cost, expressed as a percentage, of obtaining the money needed to operate the company.
Capital is obtained from two sources, creditors and owners, corresponding to divisions of liabilities and owners’ equity on the balance sheet.

13. Cutoff Rate
Because of the practical difficulties of determining cost of capital, managers might simply use their judgment to set a minimum acceptable rate, called a cutoff rate, hurdle rate, or target rate. % 25 25 14

14. Methods of Analyzing Investment Decisions
1. Net present value (NPV) method
2. Internal rate of return (IRR) method
3. Discounted cash flow (DCF) method

15. Net Present Value Method
The net present value method (NPV) uses the minimum acceptable rate to find the present value (PV) of the future returns and compares that value with the cost of the investment.
NPV = PV of future returns – Cost of the investment 27 16 27

16. Internal Rate of Return Method
The internal rate of return method (IRR) finds the rate of return associated with the project and compares that rate with the minimum acceptable rate. 28 17 28

17. Capital Budgeting Methods
A company with a cutoff rate of 10 percent has an opportunity to introduce a new product. The firm is expected to sell 4,000 units per year for the next five years at $10 each. Variable costs are expected to be $4 per unit and the machinery required costs $50,000 (five-year life; no salvage value). Annual fixed expenses are expected to be $8,000. 29 18 29

18. Capital Budgeting Methods
Annual Cash Flows Years 1-5
Revenues ($10 x 4,000) $40,000
Variable costs ($4 x 4,000) 16,000
Contribution margin ($6 x 4,000) 24,000
Cash fixed costs 8,000
Net cash flow $16,000

19. Net Present Value Example
Present value of future cash flows ($16,000 x 3.791) $60,656
Investment required 50,000
Net present value $10,656

20. Internal Rate of Return
Present value of future flows
Annual cash flows
Factor for the discount rate and the number of periods =
$50,000
$16,000
3.125 = 32 32 21

21. Taxes and Depreciation
Additional information:
Tax rate is 40 percent.
Straight-line depreciation is used. 33 22 33

22. Annual Incremental After-Tax Cash Inflows
Tax Computation
Cash Flow
Revenues $40,000 $40,000
Cash expenses (variable and fixed) 24, ,000
Cash inflow before taxes $16,000 $16,000
Depreciation 10,000
Increase in taxable income $ 6,000
Income taxes (40 percent) 2, ,400
Net increase in annual cash inflow $13,600

23. Net Present Value of After-Tax Example
Expected increase in net cash inflows $13,600
Times present value factor for 5 years at 10% x 3.791
Present value of future cash flows $51,558
Investment required 50,000
Net present value $ 1,558

24. Uneven Cash Flows
Now, assume that the salvage value in the example is $5,000 at the end of the fifth year. 5 37 37 26

25. Uneven Cash Flows (Salvage Values)
PV of future cash flows ($13,600 x 3.791) $51,558
Salvage value:
Total salvage value $5,000
Tax on salvage value 2,000
After-tax cash inflow on salvage value $3,000
Times PV factor (5 years, 10%)
Present value of salvage value ,863
Total present value $53,421
Investment 50,000
Net present value $ 3,421

26. Decision Rules
Under the NPV method, a project having a positive NPV should be accepted; others should be rejected.
Under the IRR method, a project having an IRR greater than the company’s cost of capital should be accepted. 41 30 41

27. Investment Annual cash return
Payback Period
Payback period
Investment Annual cash return =
The required investment of $50,000 generates annual net cash flows of $13,600.
3.677
Payback period
$50, $13,600 = 42 42 31

28. Advantages of Payback
It is an important method to a company experiencing liquidity problems.
Payback also serves as a rough screening device for investment proposals.

29. Flaws of Payback
It tells nothing about the profitability of the investment.
Payback ignores the return on the investment.

30. Payback Period Consider the following investments: A B
Useful life in years 5 15
Annual cash flows over the useful lives $ 2,500 $ 2,000
Payback period 4 years 5 years

31. Book Rate of Return Average book rate of return
Average annual expected book income
Average book investment =
14.4%
Average book rate of return
$3,600
$50,000 ÷ 2 =
The book rate of return method nearly always misstates the internal rate of return because it ignores the timing of the cash flows. 43 32 43

32. International Aspects of Capital Budgeting
The risk of nationalization is very great in some countries.
Instability in economic, social, and political conditions can cause serious losses.
Astronomical inflation can wipe out the value of an investment.
Continued 46 46 33

33. International Aspects of Capital Budgeting
Restrictions on trade and on repatriation of cash can limit the company’s ability to return its investment to its home country.
Exchange rate fluctuations increase risk because overseas investments might be profitable in the local currency, but unprofitable when translated back to the home currency.
Continued 48 49 34

34. International Aspects of Capital Budgeting
Failure to respect local customs and traditions could jeopardize investments.

35. Chapter 7
The End