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CAPITALBUDGETING

Chapter

26

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Capital budgeting:Analyzing alternative long-

term investments and deciding which assets to acquire or sell.

Outcomeis uncertain.

Large amounts ofmoney are usually

involved.

Investment involves along-term commitment.

Decision may bedifficult or impossible

to reverse.

Capital Investment DecisionsCapital Investment Decisions

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?

?

?

PlantExpansion

NewEquipment

OfficeRenovation

I will choose theproject with the mostprofitable return on

available funds.

Capital Investment DecisionsCapital Investment Decisions

LimitedInvestment

Funds

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Incrementaloperating

costs

Initialinvestment

Repairs andmaintenance

Capital Investment Decisions:Typical Cash Outflows

Capital Investment Decisions:Typical Cash Outflows

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Costsavings

Salvagevalue

Incrementalrevenues

Capital Investment Decisions:Typical Cash Inflows

Capital Investment Decisions:Typical Cash Inflows

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Employee morale

Environmental concerns Corporate image

Employee working conditions

Product quality

Capital Investment Decisions:Nonfinancial Considerations

Capital Investment Decisions:Nonfinancial Considerations

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Let’s look atmethods used

to make capitalinvestmentdecisions.

Evaluating Capital Investment Proposals: An Illustration

Evaluating Capital Investment Proposals: An Illustration

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Stars’ Stadium is considering purchasingvending machines with a 5-year life.

Cost and revenue informationCost of vending machines $ 75,000

Revenue 84,375$ Cost of goods sold 50,625 Gross profit 33,750$ Cash operating costs 3,350$ Depreciation 14,000 17,350 Pretax income 16,400$ Income tax 6,400 After-tax income 10,000$

($75,000 - $5,000) ÷ 5 years

Evaluating Capital Investment Proposals: An Illustration

Evaluating Capital Investment Proposals: An Illustration

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Most capital budgeting techniques use annual net cash flow.

Depreciation is not a cash outflow.

Annual net income 10,000$ Add annual depreciation 14,000 Annual net cash flow 24,000$

Evaluating Capital Investment Proposals: An Illustration

Evaluating Capital Investment Proposals: An Illustration

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The payback period of an investmentis the time expected to recoverthe initial investment amount.

The payback period of an investmentis the time expected to recoverthe initial investment amount.

Paybackperiod

= Cost of Investment Annual Net Cash Flow

Managers prefer investing in projects with shorter payback periods.

Payback PeriodPayback Period

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The payback period of an investmentis the time expected to recoverthe initial investment amount.

The payback period of an investmentis the time expected to recoverthe initial investment amount.

Paybackperiod

= Cost of Investment Annual Net Cash Flow

Paybackperiod

=$75,000$24,000

= 3.125 years

Payback PeriodPayback Period

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Ignores the time valueof money.

Ignores cashflows after the payback

period.

Payback PeriodPayback Period

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Consider two projects, each with afive-year life and each costing $6,000.

Project One Project TwoNet Cash Net Cash

Year Inflows Inflows

1 2,000$ 1,000$ 2 2,000 1,000 3 2,000 1,000 4 2,000 1,000 5 2,000 1,000,000

Would you invest in Project One just because it has a shorter payback period?

Payback PeriodPayback Period

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ROI = Average estimated net income Average investment

Original cost + Salvage value2

Return on Average Investment (ROI)Return on Average Investment (ROI)

ROI focuses on annual incomeinstead of cash flows.

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ROI = = 25%$10,000$40,000

ROI focuses on annual incomeinstead of cash flows.

$75,000 + $5,0002

Return on Average Investment (ROI)Return on Average Investment (ROI)

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Income may vary from year to year.

Time value ofmoney is ignored.

Income may vary from year to year.

Time value ofmoney is ignored.

So why would I ever want to use this method

anyway?

Return on Average Investment (ROI)Return on Average Investment (ROI)

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Now let’s look at a capital budgeting model that considers the time value of cash flows.

Now let’s look at a capital budgeting model that considers the time value of cash flows.

Discounting Future Cash FlowsDiscounting Future Cash Flows

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A comparison of the present value of cash inflows with the present value of cash

outflows

A comparison of the present value of cash inflows with the present value of cash

outflows

Net Present Value (NPV)Net Present Value (NPV)

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Chose a discount rate – the minimum required rate of return.

Calculate the presentvalue of cash inflows.

Calculate the presentvalue of cash outflows.

NPV = –

Net Present Value (NPV)Net Present Value (NPV)

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General decision rule . . .If the Net Present

Value is . . . Then the Project is . . .

Positive . . . Acceptable, since it promises a return greater than the required

rate of return.

Zero . . . Acceptable, since it promises a return equal to the required rate

of return.

Negative . . . Not acceptable, since it

promises a return less than the required rate of return.

Net Present Value (NPV)Net Present Value (NPV)

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Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in

operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent,

what is the NPV? Ignore taxes.

a. $ 4,300

b. $12,700

c. $11,000

d. $17,000

Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in

operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent,

what is the NPV? Ignore taxes.

a. $ 4,300

b. $12,700

c. $11,000

d. $17,000

Net Present Value (NPV)Question

Net Present Value (NPV)Question

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Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in

operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent,

what is the NPV? Ignore taxes.

a. $ 4,300

b. $12,700

c. $11,000

d. $17,000

Savak Company can buy a new machine for $96,000 that will save $20,000 cash per year in

operating costs. If the machine has a useful life of 10 years and Savak’s required return is 12 percent,

what is the NPV? Ignore taxes.

a. $ 4,300

b. $12,700

c. $11,000

d. $17,000

Using the present value of an annuity (table 2)

PV of inflows = $20,000 × 5.650 = $113,000

NPV = $113,000 - $96,000 = $17,000

Net Present Value (NPV)Question

Net Present Value (NPV)Question

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Calculate the NPV if Savak Company’s required return is 15 percent instead of 12 percent.

Calculate the NPV if Savak Company’s required return is 15 percent instead of 12 percent.

Note that the NPV is smallerusing the larger interest rate.

Using the present value of an annuity (table 2)

PV of inflows = $20,000 × 5.019 = $100,380

NPV = $100,380 - $96,000 = $4,380

Net Present Value (NPV)Question

Net Present Value (NPV)Question

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Now that you have mastered the basic concept of net present value, it’s time

for a more sophisticated checkup!

Let’s return to Stars’ Stadium.

Net Present Value (NPV)Net Present Value (NPV)

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Stars’ Stadium is considering purchasingvending machines with a 5-year life.

Cost and revenue informationCost of vending machines $ 75,000

Revenue 84,375$ Cost of goods sold 50,625 Gross profit 33,750$ Cash operating costs 3,350$ Depreciation 14,000 17,350 Pretax income 16,400$ Income tax 6,400 After-tax income 10,000$

($75,000 - $5,000) ÷ 5 years

Evaluating Capital Investment Proposals: An Illustration

Evaluating Capital Investment Proposals: An Illustration

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Most capital budgeting techniques use annual net cash flow.

Depreciation is not a cash outflow.

Annual net income 10,000$ Add annual depreciation 14,000 Annual net cash flow 24,000$

Evaluating Capital Investment Proposals: An Illustration

Evaluating Capital Investment Proposals: An Illustration

© The McGraw-Hill Companies, Inc., 2005McGraw-Hill/Irwin

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Stars’ Stadium Net Present Value Analysis

Year(s) Cash Flow PV factor PVVending mach. Now (75,000)$ 1.000 (75,000)$

Stars uses a 15% discount rate.

Net Present Value (NPV)Net Present Value (NPV)

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Year(s) Cash Flow PV factor PVVending mach. Now (75,000)$ 1.000 (75,000)$ Annual inflow 1 - 5 24,000 3.352 80,448

Present value of an annuity of $1 factor for 5 years at 15%.

Stars’ Stadium Net Present Value Analysis

$24,000 × 3.352 = $80,448

Net Present Value (NPV)Net Present Value (NPV)

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Year(s) Cash Flow PV factor PVVending mach. Now (75,000)$ 1.000 (75,000)$ Annual inflow 1 - 5 24,000 3.352 80,448 Salvage 5 5,000 0.497 2,485

Present value of $1 factor for 5 years at 15%.

Stars’ Stadium Net Present Value Analysis

Net Present Value (NPV)Net Present Value (NPV)

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Since the NPV is positive, we know the rate of return is greater than the 15 percent discount rate.

Year(s) Cash Flow PV factor PVVending mach. Now (75,000)$ 1.000 (75,000)$ Annual inflow 1 - 5 24,000 3.352 80,448 Salvage 5 5,000 0.497 2,485 NPV Now 7,933

Stars’ Stadium Net Present Value Analysis

Net Present Value (NPV)Net Present Value (NPV)

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Let’s use NPVconcepts with

an asset replacement

decision.

Net Present Value (NPV)Replacing Assets

Net Present Value (NPV)Replacing Assets

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The Maine LobStars are considering replacing an old buswith a new bus, each with a 5-year life and zero salvage.

Cost and savings informationCost of new bus $ 65,000

Book value of old bus $ 25,000 Current value of old bus 10,000 Loss if old bus sold $ 15,000

Annual savings of new bus 12,000$ Depreciation - new bus 13,000$

old bus 5,000 8,000 Increase in taxable income 4,000$ Tax @ 40% 1,600 After-tax income 2,400$

Evaluating Capital Investment Proposals: An Illustration

Evaluating Capital Investment Proposals: An Illustration

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Depreciation is not a cash outflow.

Annual net income 2,400$ Add increased depreciation 8,000 Annual net cash flow 10,400$

Tax savings from loss ondisposal of old bus:

$15,000 × 40% = $6,000

Evaluating Capital Investment Proposals: An Illustration

Evaluating Capital Investment Proposals: An Illustration

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Year(s) Cash Flow PV factor PVNew bus Now (65,000)$ 1.000 (65,000)$

LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.

Net Present Value (NPV)Net Present Value (NPV)

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Year(s) Cash Flow PV factor PVNew bus Now (65,000)$ 1.000 (65,000)$ Annual inflow 1 - 5 10,400 3.352 34,861

LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.

Net Present Value (NPV)Net Present Value (NPV)

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Year(s) Cash Flow PV factor PVNew bus Now (65,000)$ 1.000 (65,000)$ Annual inflow 1 - 5 10,400 3.352 34,861 Old bus sale Now 10,000 1.000 10,000

LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.

Net Present Value (NPV)Net Present Value (NPV)

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Since the NPV is negative, we know the rate of return is less than the 15 percent discount rate.

Year(s) Cash Flow PV factor PVNew bus Now (65,000)$ 1.000 (65,000)$ Annual inflow 1 - 5 10,400 3.352 34,861 Old bus sale Now 10,000 1.000 10,000 Tax savings 1 6,000 0.870 5,220 NPV Now (14,919)$

LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.

Net Present Value (NPV)Net Present Value (NPV)

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Capital budgeting involves many estimates.Estimates may be pessimistic or optimistic.Uncertainty about the future may impact

estimates.

Capital budgeting involves many estimates.Estimates may be pessimistic or optimistic.Uncertainty about the future may impact

estimates.

Behavioral Issuesin Capital Budgeting

Behavioral Issuesin Capital Budgeting

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Conflicts may exist between short-run performance measures and long-run capital

budgeting criteria.

Conflicts may exist between short-run performance measures and long-run capital

budgeting criteria.

Behavioral Issuesin Capital Budgeting

Behavioral Issuesin Capital Budgeting

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A follow-up after the project has been approved to see whether or not expected

results are actually realized.

A follow-up after the project has been approved to see whether or not expected

results are actually realized.

Capital Budget AuditCapital Budget Audit

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End of Chapter 26End of Chapter 26