1. Capital Budgeting Decisions
Chapter12
Capital Budgeting Decisions

2. Capital Budgeting
How managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment and introduction of new products.

3. Typical Capital Budgeting Decisions
Plant expansion
Equipment selection
Equipment replacement
Lease or buy
Cost reduction

4. Typical Capital Budgeting Decisions
Capital budgeting tends to fall into two broad categories . . .
Screening decisions. Does a proposed project meet some present standard of acceptance?
Preference decisions. Selecting from among several competing courses of action.

5. Time Value of Money
Business investments extend over long periods of time, so we must recognize the time value of money.
Investments that promise returns earlier in time are preferable to those that promise returns later in time.

6. Time Value of Money
A dollar today is worth more than a dollar a year from now since a dollar received today can be invested, yielding more than a dollar a year from now.

7. Interest and the Time Value of Money
If $100 is invested today at 8% interest, how much will you have in two years?
At the end of one year:
$ $100 = (1.08)$100 = $108
At the end of two years:
$ $108 = (1.08)$108
= (1.08)[(1.08)$100]
= (1.08)2 $100 = $116.64

8. Interest and the Time Value of Money
If P dollars are invested today at the annual interest rate r, then in n years you would have Fn dollars computed as follows:
Fn = P(1 + r)n

9. Interest and the Time Value of Money
The present value of any sum to be received in the future can be computed by turning the interest formula around and solving for P:

10. Interest and the Time Value of Money
A bond will pay $100 in two years. What is the present value of the $100 if an investor can earn a return of 12% on investments?
P = $100 (0.797)
P = $79.70

11. Interest and the Time Value of Money
A bond will pay $100 in two years. What is the present value of the $100 if an investor can earn a return of 12% on investments?
Present Value = $79.70
What does this mean?
If $79.70 is put in the bank today, it will be worth $100 in two years.
In that sense, $79.70 today is equivalent to $100 in two years.

12. Interest and the Time Value of Money
Let’s verify that if we put $79.70 in the bank today at 12% interest that it would grow to $100 at the end of two years.

13. We can also determine the present value using present value tables.
Time Value of Money
A bond will pay $100 in two years. What is the present value of the $100 if an investor can earn a return of 12% on investments?
We can also determine the present value using present value tables.

14. Excerpt from Present Value of $1 Table in the Appendix to Chapter 12
Time Value of Money
Excerpt from Present Value of $1 Table in the Appendix to Chapter 12

15. Time Value of Money $100 × 0.797 = $79.70 present value
Present value factor of $1 for 2 periods at 12%.

16. Quick Check 
How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%?
a. $62.10
b. $56.70
c. $90.90
d. $51.90

17. Quick Check 
How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%?
a. $62.10
b. $56.70
c. $90.90
d. $51.90
$100  = $62.10

18. Time Value of Money
An investment that involves a series of identical cash flows at the end of each year is called an annuity. 1 2 3 4 5 6
$100

19. Time Value of Money
Lacey Inc. purchased a tract of land on which a $60,000 payment will be due each year for the next five years. What is the present value of this stream of cash payments when the discount rate is 12%?

20. Time Value of Money We could solve the problem like this . . .
Look in Appendix B of this Chapter for the
Present Value of an Annuity of $1 Table

21. Time Value of Money $60,000 × 3.605 = $216,300
We could solve the problem like this . . .
$60,000 × = $216,300

22. Quick Check 
If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years?
a. $34.33
b. $500
c. $343.30
d. $360.50

23. Quick Check 
If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years?
a. $34.33
b. $500
c. $343.30
d. $360.50
$100  = $343.33

24. Quick Check 
If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years?
a. $866.90
b. $178.60
c. $
d. $300.00

25. Quick Check 
If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years?
a. $866.90
b. $178.60
c. $
d. $300.00
$100( )= $1001.786 = $178.60 or
$100( )= $1001.786 = $178.60

26. Typical Cash Outflows Repairs and maintenance Working capital Initial
investment
Incremental
operating
costs

27. Typical Cash Inflows Salvage value Release of working capital
Reduction
of costs
Incremental
revenues

28. Illustration of the NPV Method
Carver Hospital is considering the purchase of an attachment for its X-ray machine No investments are to be made unless they have an annual return of at least 10%. Will we be allowed to invest in the attachment?

29. Illustration of the NPV Method

30. Illustration of the NPV Method
Present value
of an annuity
of $1 table

31. Illustration of the NPV Method
Because the net present value is equal to zero,
the investment in the attachment for the X-ray
machine provides exactly a 10% return.

32. Quick Check 
Suppose that the investment in the attachment for the X-ray machine had cost $4,000 and generated an increase in annual cash inflows of $1,200. What is the net present value of the investment?
a. $ 800
b. $ 196
c. $(196)
d. $(800)

33. Quick Check 
Suppose that the investment in the attachment for the X-ray machine had cost $4,000 and generated an increase in annual cash inflows of $1,200. What is the net present value of the investment?
a. $ 800
b. $ 196
c. $(196)
d. $(800)
-$4,000+$1,2003.170
= -$4,000 + $3,804
= -$196

34. Choosing a Discount Rate
The firm’s cost of capital is usually regarded as the most appropriate choice for the discount rate.
The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds.

35. The Net Present Value Method
To determine net present value we . . .
Calculate the present value of cash inflows,
Calculate the present value of cash outflows,
Subtract the present value of the outflows from the present value of the inflows.

36. The Net Present Value Method
General decision rule . . .

37. The Net Present Value Method
Let’s look at
how we use
present value to
make business
decisions.

38. The Net Present Value Method
Lester Company has been offered a five year contract to provide component parts for a large manufacturer.

39. The Net Present Value Method
At the end of five years the working capital will be released and may be used elsewhere by Lester.
Lester Company uses a discount rate of 10%. Should the contract be accepted?

40. The Net Present Value Method
Annual net cash inflows from operations

41. The Net Present Value Method

42. The Net Present Value Method
Present value of an annuity of $1
factor for 5 years at 10%.

43. The Net Present Value Method
Present value of $1
factor for 3 years at 10%.

44. The Net Present Value Method
Present value of $1
factor for 5 years at 10%.

45. The Net Present Value Method
Accept the contract because the project has a positive net present value.

46. Quick Check Data
Denny Associates has been offered a four-year contract to supply the computing requirements for a local bank.
The working capital would be released at the end of the contract.
Denny Associates requires a 14% return.

47. Quick Check 
What is the net present value of the contract with the local bank?
a. $150,000
b. $ 28,230
c. $ 92,340
d. $132,916

48. Quick Check 
What is the net present value of the contract with the local bank?
a. $150,000
b. $ 28,230
c. $ 92,340
d. $132,916

49. Expanding the Net Present Value Method
To compare competing investment projects we can use the following net present value approaches:
Total-cost
Incremental cost

50. The Total-Cost Approach
White Co. has two alternatives: (1) remodel an old car wash or, (2) remove it and install a new one.
The company uses a discount rate of 10%.

51. The Total-Cost Approach
If White installs a new washer . . .
Let’s look at the present value of this alternative.

52. The Total-Cost Approach

53. The Total-Cost Approach

54. The Total-Cost Approach

55. The Total-Cost Approach

56. The Total-Cost Approach

57. The Total-Cost Approach
If we install the new washer, the investment will yield a positive net present value of $83,202.

58. The Total-Cost Approach
If White remodels the existing washer . . .
Let’s look at the present value of this second alternative.

59. The Total-Cost Approach

60. The Total-Cost Approach

61. The Total-Cost Approach

62. The Total-Cost Approach
If we remodel the existing washer, we will produce a positive net present value of $56,405.

63. The Total-Cost Approach
Both projects yield a positive net present value.
However, investing in the new washer will produce a higher net present value than remodeling the old washer.

64. The Incremental-Cost Approach
Under the incremental-cost approach, only those cash flows that differ between the two alternatives are considered.
Let’s look at an analysis of the White Co. decision using the incremental-cost approach.

65. The Incremental-Cost Approach
$300,000 new - $175,000 remodel = $125,000

66. The Incremental-Cost Approach
$80,000 remodel - $50,000 new = $30,000

67. The Incremental-Cost Approach
$60,000 new - $45,000 remodel = $15,000

68. The Incremental-Cost Approach
We get the same answer under either the
total-cost or incremental-cost approach.

69. Quick Check 
Consider the following alternative projects. Each project would last for five years.
Project A Project B
Initial investment $80,000 $60,000
Annual net cash inflows 20,000 16,000
Salvage value 10,000 8,000
The company uses a discount rate of 14% to evaluate projects. Which of the following statements is true?
a. NPV of Project A > NPV of Project B by $5,230
b. NPV of Project B > NPV of Project A by $5,230
c. NPV of Project A > NPV of Project B by $2,000
d. NPV of Project B > NPV of Project A by $2,000

70. Quick Check 
Consider the following alternative projects. Each project would last for five years.
Project A Project B
Initial investment $80,000 $60,000
Annual net cash inflows 20,000 16,000
Salvage value 10,000 8,000
The company uses a discount rate of 14% to evaluate projects. Which of the following statements is true?
a. NPV of Project A > NPV of Project B by $5,230
b. NPV of Project B > NPV of Project A by $5,230
c. NPV of Project A > NPV of Project B by $2,000
d. NPV of Project B > NPV of Project A by $2,000

71. Let’s look at the Home Furniture Company.
Least Cost Decisions
In decisions where revenues are not directly involved, managers should choose the alternative that has the least total cost from a present value perspective.
Let’s look at the Home Furniture Company.
Home Furniture

72. Least Cost Decisions
Home Furniture Company is trying to decide whether to overhaul an old delivery truck now or purchase a new one.
The company uses a discount rate of 10%.
Home Furniture

73. Least Cost Decisions
Here is information about the trucks . . .

74. Least Cost Decisions

75. Home Furniture should purchase the new truck.
Least Cost Decisions
Home Furniture should purchase the new truck.

76. Ranking Investment Projects
Profitability Present value of cash inflows index Investment required =
The higher the profitability index, the
more desirable the project.

77. Other Approaches to Capital Budgeting Decisions
Other methods of making capital budgeting decisions include . . .
The Payback Method.
Simple Rate of Return.

78. The Payback Method
The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates.
When the net annual cash inflow is the same each year, this formula can be used to compute the payback period:
Payback period =
Investment required
Net annual cash inflow

79. What is the payback period for the espresso bar?
The Payback Method
Management at The Daily Grind wants to install an espresso bar in its restaurant.
The espresso bar:
Costs $140,000 and has a 10-year life.
Will generate net annual cash inflows of $35,000.
Management requires a payback period of 5 years or less on all investments.
What is the payback period for the espresso bar?

80. The Payback Method
Payback period =
Investment required
Net annual cash inflow
Payback period =
$140,000
$35,000
Payback period =
4.0 years
According to the company’s criterion, management would invest in the espresso bar because its payback period is less than 5 years.

81. Quick Check  Consider the following two investments:
Project X Project Y
Initial investment $100,00 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 3-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined

82. Quick Check  Project X has a payback period of 2 years.
Project Y has a payback period of slightly more than 2 years.
Which project do you think is better?
Quick Check 
Consider the following two investments:
Project X Project Y
Initial investment $100,00 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 3-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined

83. Evaluation of the Payback Method
Ignores the
time value
of money.
Short-comings
of the Payback
Period.
Ignores cash
flows after
the payback
period.

84. The Simple Rate of Return Method
Does not focus on cash flows -- rather it focuses on accounting income.
The following formula is used to calculate the simple rate of return:
Simple rate
of return =
Incremental Incremental expenses,
revenues including depreciation
Initial investment -

85. The Simple Rate of Return Method
Management of The Daily Grind wants to install an espresso bar in its restaurant.
The espresso bar:
Cost $140,000 and has a 10-year life.
Will generate incremental revenues of $100,000 and incremental expenses of $65,000 including depreciation.
What is the simple rate of return on the investment project?

86. The Simple Rate of Return Method
$100, $65,000
$140,000
= 25% =
The simple rate of return method is not recommended for a variety of reasons, the most important of which is that it ignores the time value of money.

87. Quick Check 
Inland Airlines is considering the purchase of an aircraft for $20 million that would last for 10 years and generate incremental revenues of $9 million per year and incremental expenses, excluding depreciation, of $5 million per year. What is the simple rate of return on the aircraft?
a. 10%
b. 15%
c. 20%
d. 25%

88. Quick Check 
Inland Airlines is considering the purchase of an aircraft for $20 million that would last for 10 years and generate incremental revenues of $9 million per year and incremental expenses, excluding depreciation, of $5 million per year. What is the simple rate of return on the aircraft?
a. 10%
b. 15%
c. 20%
d. 25%
[$9 – ($5 + $2)] / $20 = 15%

89. Postaudit of Investment Projects
A postaudit is a follow-up after the project has been approved to see whether or not expected results are actually realized.

90. End of Chapter 12