1. The Capital Budgeting Decision12

2. Chapter 12 - Outline What is Capital Budgeting?
PPT 12-2
Accept/Reject Decision
Capital Rationing
Net Present Value Profile
Capital Cost Allowance
Determining Whether to Purchase a Machine
Summary and Conclusions
What is Capital Budgeting?
5 Methods of Evaluating Investment Proposals
Average Accounting Return
Payback Period
Net Present Value
Internal Rate of Return
Profitability index

3. What is Capital Budgeting?
PPT 12-3
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 change as a result of the investment
all cash flows are calculated aftertax

4. 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

5. Capital Budgeting Procedures

6. Accounting Flows versus Cash Flow
The capital budgeting process focuses on cash flows rather than income on an aftertax basis.
Evaluation involves the incorporation of all incremental cash flows in the capital budgeting analysis. Sunk costs are ignored. Opportunity costs included.
Accounting flows are not totally disregarded in the capital budgeting process.
Investors’ emphasis on EPS.
Top management may elect to glean the short-term personal benefits of income effect.

7. Table 12-1 Cash flow for Alston Corporation
PPT 12-5
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) ,500
Earnings aftertaxes ,500
Amortization ,000
Cash flow $12,500
Alternative method of cash flow calculation
Cash inflow (EBAT) $20,000
Cash outflow (taxes) ,500

8. Revised cash flow for Alston Corporation
PPT 12-6
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
PPT 12-7
5 Methods of Evaluating Investment Proposals
Average Accounting Return (AAR)
Payback Period (PP)
Internal Rate of Return (IRR)
Net Present Value (NPV)
Profitability Index (PI)

10. Average Accounting Return
PPT 12-8
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 an evaluation yardstick

11. Payback Period Payback Period (PP): Advantages: Disadvantages:
PPT 12-9
Payback Period (PP):
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
one measure of the risk of an investment
Disadvantages:
ignores inflows after the cutoff period and fails to consider the time value of money
better measures of risk

12. Net Present Value Net Present Value (NPV):
PPT 12-11
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)

13. Internal Rate of Return
PPT 12-12
Internal Rate of Return (IRR):
represents a yield on an investment or an interest rate
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)

14. Accept/Reject Decision
PPT 12-14
Payback Period (PP):
if PP < cutoff period, accept the project
if PP > 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

15. Table 12-3 Investment alternatives
PPT 12-10
Table 12-3 Investment alternatives
Net Cash Inflows
(of a $10,000 investment)
Year Investment A Investment B
$5, $1,500
, ,000
, ,500
,000
,000

16. Table 12-4 Capital budgeting results
PPT 12-13
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

17. NPV method versus IRR method
The NPV method and the IRR method always agree on the accepted-reject decision on a capital proposal. ( a project having a NPV>=0 also means IRR> or =cost of capital)
A disagreement may arise between the NPV and IRR methods when a choice must be made from mutually exclusive proposals or all acceptable proposals cannot be taken due to capital rationing.
The primary cause of disagreement is the differing discounting assumptions. The NPV method of discounts cash flows at the cost of capital. The IRR method discounts of cash flows at the internal rate of return.
The more conservative NPV technique is usually the recommended approach when a conflict in ranking arises.

18. Internal rate of return and net present value ($10,000 investment)
PPT 12-15
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

19. PPT 12-16
Table 12-6 Multiple IRRs

20. Modified Internal Rate of Return (MIRR)
Combines reinvestment assumption of the net present value method with the internal rate of return

21. 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 = (Appendix B)
FV $15,610

22. 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

23. Capital Rationing

24. 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

25. Net Present Value Profile – Graphic Representation

26. Net Present Value Profile with Crossover

27. 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

28. Categories for Depreciation Write-Off

29. Depreciation Percentages (Expressed in Decimals)

30. Depreciation Schedule

31. 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

32. 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

33. Cash Flow Related to the Purchase of Machinery

34. Net Present Value Analysis

35. 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

36. Book Value of Old Computer

37. Net Cost of New Computer

38. Analysis of Incremental Depreciation Benefits

39. Analysis of Incremental Cost Savings Benefits

40. Present Value of the Total Incremental Benefits

41. 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