12

The Capital
Budgeting Decision

Chapter

McGraw-Hill/Irwin
Copyright 2009 by The McGraw-Hill Companies, Inc. All

Chapter Outline
Capital budgeting decision
Cash flows and capital budgeting
Methods for ranking investments
Payback methods
Internal rate of return
Net present value

Discount or cutoff rate

Aftertax operating benefits and tax shield
benefits of depreciation
12-2

Capital Budgeting Decision

Involves planning of expenditures for a
project with a minimum period of a year or
longer
Capital expenditure decision requires:
Extensive planning and coordination of different
departments

Uncertainties are common in areas such as:

Annual costs and inflows, product life, interest
rates, economic conditions, and technological
changes
12-3

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

12-4

Capital Budgeting Procedures

12-5

Accounting Flows versus

Cash Flows
Capital budgeting decisions - emphasis
remains on cash flow
Depreciation (noncash expenditure) is added
back to profit to determine the amount of cash
flow generated
Example shown in the next slide

Emphasis is on use of proper evaluation

techniques to make best economic choices
and assure long term wealth
12-6

Cash Flow for Alston Corporation

12-7

Revised Cash Flow

for Alston Corporation

12-8

Methods of Ranking
Investment Proposals
Three methods used:
Payback method although not sound
conceptually, is often used
Internal rate of return - more acceptable and
commonly used
Net present value - more acceptable and
commonly used

12-9

Payback Method
Time required to recoup initial investment
Table 12-3, using Investment A:
There is no consideration of inflows after the cutoff
period
The method fails to consider the concept of the time
value of money
Year
1..
2..
3..

Early Returns
$9,000
$1,000
$1,000

Late Returns
$1,000
$9,000
$1,000

12-10

Investment Alternatives

12-11

Payback Method (contd)

Advantages:
Easy to understand and emphasizes liquidity
Must recoup initial investment quickly or it will
not qualify
Rapid payback preferred in industries
characterized by dynamic technological
developments

Shortcomings:
Fails to discern optimum or most economic
solution to capital budgeting problem
12-12

Internal Rate of Return

Requires the determination of the yield on an
investment with subsequent cash inflows
Assuming that a $1,000 investment returns an annuity of
$244 per annum for five years, provides an internal rate
of return of 7%:
Dividing the investment (present value) by the annuity:
(Investment) = $1,000 = 4.1 (PVIFA)
(Annuity)

$244

The present value of an annuity (given in Appendix D) shows

that the factor of 4.1 for five years indicates a yield of 7%

12-13

Determining Internal Rate of Return

Year
1
2
3
4
5

Cash Inflows (of $10,000 investment)

Investment A
Investment B
$5,000
$1,500
$5,000
$2,000
$2,000
$2,500
$5,000
$5,000

To find a beginning value to start the first trial, the inflows are averaged
out as though annuity was really being received
$5,000
$5,000
$2,000
$12,000 3 = $4,000
12-14

Determining Internal Rate of Return

(contd)

Dividing the investment by the assumed annuity value in the previous

step, we have:
(Investment) = $10,000 = 2.5 (PVIFA)
(Annuity)
$4,000
The first approximation (derived from Appendix D) of the internal rate of
return using:
PVIFA factor = 2.5
n (period) = 3
The factor falls between 9 and 10 percent
Averaging understates actual IRR, same method would overstate IRR
for Investment B
Cash flows in early years are worth more and increase the return,
possible to gauge whether first approximation is overstated or
understated
12-15

Determining Internal Rate of Return

(contd)

Using the trial and error approach, we use both 10% and 12% to arrive
at the answer:
Year
10%
1.$5,000 X 0.909 = $4,545
2.$5,000 X 0.826 = $4,130
3.$2,000 X 0.751 = $1,502
$10,177

(At 10%, the present value of the inflows exceeds $10,000 we therefore use a higher discount
rate)

Year
12%
1.$5,000 X 0.893 = $4,465
2.$5,000 X 0.797 = $3,985
3.$2,000 X 0.712 = $1,424
$9,874

(At 12%, the present value of the inflows is less than $10,000 thus the discount rate is too
high)
12-16

Interpolation of the Results

The internal rate of return is determined when the present value of the
inflows (PVI) equals the present value of the outflows (PVO)
The total difference in present values between 10% and 12% is $303
$10,177 PVI @ 10%
- $9,874....PVI @ 12%
$303

$10,177.PVI @ 10%
- $10,000(cost)
$177

The solution is ($177/$303) percent of the way between 10 and 12

percent. Due to a 2% difference, the fraction is multiplied by 2% and the
answer is added to 10% for the final answer of:
10% + ($177/$303) (2%) = 11.17% IRR

The exact opposite of this conclusion is yielded for Investment B

(14.33%)
12-17

Interpolation of the Results (contd)

Use of internal rate of return requires calculated selection of Investment

B in preference to Investment A, the conclusion being exactly the
opposite under the payback method
The final selection of any project will also depend on yield exceeding
some minimum cost standard, such as cost of capital to the firm
Investment A

Payback
method..2 years
Internal
Rate of
Return11.17%

Investment B

3.8 years

14.33%

Selection

Quicker payback: Investment A

Higher yield: Investment B

12-18

Net Present Value

Discounting back the inflows over the life of
the investment to determine whether they
equal or exceed the required investment
Basic discount rate is usually the cost of the
capital to the firm
Inflows must provide a return that at least equals
the cost of financing those returns

12-19

Net Present Value (contd)

$10,000 Investment, 10% Discount Rate
Year
Investment A
Year
Investment B
1 $5,000 X 0.909 = $4,545
1. $1,500 X 0.909 = $1,364
2 $5,000 X 0.826 = $4,130
2. $2,000 X 0.826 = $1,652
3 $2,000 X 0.751 = $1,502
3. $2,500 X 0.751 = $1,878
$10,177
4. $5,000 X 0.683 = $3,415
5. $5,000 X 0.621 = $3,105
$11,414
Present value of inflows..$10,177
Present value of outflows -$10,000
Net present value..$177

Present value of inflows..$11,414

Present value of outflows -$10,000
Net present value...$1,414

12-20

Capital Budgeting Results

12-21

Selection Strategy
For a project to be potentially accepted:
Profitability must equal or exceed cost of capital
Projects that are mutually exclusive:
Selection of one alternative will preclude selection of
any other alternative

Projects that are not mutually exclusive:

Alternatives that provide a return in excess of cost of
capital will be selected

12-22

Selection Strategy (contd)

In the case of the prior Investment A and B, assuming a capital of 10%,

Investment B would be accepted if the alternatives were mutually
exclusive, while both would clearly qualify if they were not so

12-23

Selection Strategy (contd)

Assumption used:
Internal rate of return and net present value
methods call for the same decision
Exceptions to these generally common scenario
are:
Both methods will accept or reject the same
investments
The two methods may give different answers in
selecting the best investment from a range of
acceptable alternatives
12-24

Reinvestment Assumption
All inflows can be reinvested at the yield
from a given investment
Investments with very high IRR
May be unrealistic to assume that reinvestment can
occur at a equally high rate

Under the net present value method:

Allows for certain consistency

12-25

The Reinvestment Assumption Net

Present Value ($10,000 Investment)

12-26

Modified Internal Rate of Return

(MIRR)
Combines reinvestment assumption of the
net present value method with the internal
rate of return

12-27

Modified Internal Rate of Return

(MIRR) (contd)

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 = .641 (Appendix B)
FV

$15,610
12-28

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

12-29

Capital Rationing

12-30

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
12-31

Net Present Value Profile

Graphic Representation

12-32

Net Present Value Profile

with Crossover

12-33

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

12-34

Categories for
Depreciation Write-Off

12-35

Depreciation Percentages
(Expressed in Decimals)

12-36

Depreciation Schedule

12-37

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

12-38

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
12-39

Cash Flow Related

to the Purchase of Machinery

12-40

Net Present Value Analysis

12-41

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

12-42

Book Value of Old Computer

12-43

Net Cost of New Computer

12-44

Analysis of Incremental
Depreciation Benefits

12-45

Analysis of Incremental
Cost Savings Benefits

12-46

Present Value of the

Total Incremental Benefits

12-47

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

12-48