1. Capital Budgeting Decisions
Chapter 26

2. Capital Budgeting Budgeting for the acquisition of “capital assets”
Capital budgeting techniques
(a) Payback period
(b) Accounting Rate of Return
(c) Net Present Value
(d) Internal Rate of Return

3. Capital Budgeting Outcome is uncertain.
Large amounts of money involved.
Investment involves long-term commitment.
Decision may be difficult or impossible to reverse.
Analyzing alternative long- term investments and deciding which assets to acquire or sell.

4. Example
Casey Co. is considering an investment of $130,000 in new equipment. The new equipment is expected to last 10 years. It will have zero salvage value at the end of its useful life. The straight-line method of depreciation is used for accounting purposes. The expected annual revenues and costs of the new product that will be produced from the investment are:
Sales $200,000
Cost of goods sold $145,000
Depreciation expense 13,000
Selling & Admin expense 22, ,000
Income before income tax $20,000
Income tax expense 7,000
Net Income $13,000

5. Expected annual net cash inflow
Payback Period
Time period required to recover the cost of the investment from the annual cash inflow produced by the investment.
Amount invested
Expected annual net cash inflow

6. Computation of Annual Cash Inflow
Expected annual net cash inflow =
Net income $13,000
Depreciation expense 13,000
$26,000

7. Cash Payback Period /
5 years
$130,000
$26,000 =

8. Payback Period – Uneven Cash Flows
Casey Co. wants to install a machine that costs $16,000 and has an 8-year useful life with zero salvage value. Annual net cash flows are:

9. Payback Period – Uneven Cash Flows
We recover the $16,000
purchase price between
years 4 and 5, about 4.2 years for the payback period.
4.2

10. Using the Payback Period
Payback = 5 years
Payback = 3 years
Consider two projects, each with a 5-year life and each costing $6,000.
Would you invest in Project One just because it has a shorter payback period?

11. Accounting Rate of Return
Average annual operating income from asset
Average amount invested in asset
Compare accounting rate of return to company’s required minimum rate of return for investments of similar risk.
The minimum return is based on the company’s cost of capital.
Cost of Capital - rate of return that management expects to pay on all borrowed and equity funds.

12. Accounting Rate of Return
Average Investment =
Original Investment + Residual Value 2
For Casey, average investment =
($130,000 + $0)/ 2 = $65,000

13. Solution to Accounting Rate of Return Problem
Average annual operating income from asset
Average amount invested in asset
$13, / $65, = %

14. Accounting Rate of Return
The decision rule is:
A project is acceptable if its rate of return is greater than management’s minimum rate of return.
The higher the rate of return for a given risk, the more attractive the investment.

15. Discounted Cash Flows
Considers both the estimated total cash inflows and the time value of money.
Two methods
1) net present value
2) internal rate of return
The discounted cash flows technique is generally recognized as the best conceptual approach to making capital budgeting decisions.

16. Net Present Value Method
Find PV of future cash flows and compare with capital outlay
Interest rate used = required minimum rate of return
Proposal is acceptable when NPV is zero or positive.
The higher the positive NPV, the more attractive the investment.

17. Net Present Value
We will assume that Casey Co’s annual cash inflows of $26,000 are uniform over the asset’s useful life.
The present value of the annual cash inflows can be computed by using the present value of an annuity of 1 for 10 periods. Assume the company requires a minimum return of 12%.

18. Present value of cash flows
Net Present Value
Cash Flow
When?
Type of cash flow
Present value factor
Present value of cash flows
(130,000)
Now
($130,000)
NPV
26,000
Yrs 1-10
Annuity
5.650
146,900
$16,900
Analysis of the proposal: The proposed capital expenditure
is acceptable at a required rate of return of 12% because the net present value is positive

19. Net Present Value
When annual cash inflows are unequal, use present value of one tables.

20. Net Present Value Cash Flow When? Type of cash flow PV factor
(130,000)
Now
($130,000)
36,000 1
Lump sum
.893
32,148
32,000 2 “
.797
25,504
29,000 3
.712
20,648
27,000 4
.636
17,172
26,000 5
.567
14,742
24,000 6
.507
12,168
23,000 7
.452
10,396
22,000 8
.404
8,888
21,000 9
.361
7,581
20,000 10
.322
6,440
NPV
$25,687 ,,

21. Internal Rate of Return
Interest yield of the potential investment
The interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows.

22. Internal Rate of Return
STEP 1.Compute the internal rate of return factor using this formula:
Capital Investment
Annual Cash Inflows
$130,000 / $26, =

23. Internal Rate of Return Method
STEP 2. Use the factor and the present value of an annuity of 1 table to find the internal rate of return.
Locate the discount factor that is closest to 5.0 on the line for 10 periods.

24. Internal Rate of Return Decision Criteria
The decision rule is:
Accept when internal rate of return is equal to or greater than the required rate of return
Reject when internal rate of return is less than required rate

25. Internal Rate of Return – Uneven Cash Flows
If cash inflows are unequal, trial and error solution will result if present value tables are used.
Use business calculators and electronic spreadsheets

26. Comparing Methods