CHAPTER THREE

Opportunity Cost of Capital

and Capital Budgeting
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Outline of Chapter 3
Opportunity Cost of Capital and
Capital Budgeting
 Opportunity Cost of Capital
 Interest Rate Fundamentals
 Capital Budgeting: The Basics
 Capital Budgeting: Some Complexities
 Alternative Investment Criteria

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Opportunity Cost of Capital

Opportunity cost of capital: benefits of investing capital in a
bank account that is forgone when that capital is invested
in some other alternative.

Importance for decision making: when expected cash flows

occur in different time periods.

Capital budgeting: analysis of investment alternatives

involving cash flows received or paid over time.

Capital budgeting is used for decisions about replacing

equipment, lease or buy, and plant acquisitions.

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Time Value of Money

A dollar today is worth more than a dollar tomorrow, because you could
invest the dollar today and have your dollar plus interest tomorrow.

Value at end
Alternative of one year
A. Invest $1,000 in bank account earning
5 percent per year $1,050
B. Invest $1,000 in project returning $1,000 in one year $1,000

Alternative B forgoes the $50 of interest that could have been

earned from the bank account. The opportunity cost of
selecting alternative B is $1,050.

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Present Value Concept

Since investment decisions are being made now
at beginning of the investment period, all future
cash flows must be converted to their
equivalent dollars now.

Beginning-of-year dollars  (1  Interest rate) = End-of-year

dollars

Beginning-of-year dollars = End-of-year dollars(1  Interest

rate)

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Interest Rate Fundamentals

FV = Future Value
PV = Present Value
r = Interest rate per period (usually per year)
n = Periods from now (usually years)

Future Value of a single flow: FV = PV (1 + r)n

Present Value of a single flow: PV = FV(1 + r)n

Discount factor = 1 (1 + r)n

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Interest Rate Fundamentals

Present value of a perpetuity (a stream of equal periodic
payments for infinite periods)
PV = FV r

Present value of an annuity (a stream of equal periodic payments

for a fixed number of years)
PV = (FV r ) { 1 – [1 (1 + r)n]}

Multiple cash flows per year - see text.

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NPV Basics
1. Identify after-tax cash flows for each period
2. Determine discount rate
3. Multiply by appropriate present-value factor (single or annuity)
for each cash flow. PV factor is 1.0 for cash invested now
4. Sum of the present values of all cash flows = net present
value (NPV)
5. If NPV 0, then accept project
6. If NPV < 0, then reject project

NPV is also known as discounted cash flow (DCF).

See examples.

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Capital Budgeting - Warnings

1. Discount after-tax cash flows, not accounting earnings
Cash can be invested and earn interest. Accounting earnings
include accruals that estimate future cash flows.

2. Include working capital requirements

Consider cash needed for additional inventory and accounts
receivable.

3. Include opportunity costs but not sunk costs

Sunk costs are not relevant to decisions about future
alternatives.

4. Exclude financing costs

The firm’s opportunity cost of capital is included in the discount
rate.

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Adjustment for Risk

Discount risky projects at a higher discount rate than safe
projects
= Risk-free rate of interest on government bonds
+ Risk premium associated with project i
= Risk-adjusted discount rate for project i
(Determining the appropriate discount rate is covered in a corporate
finance course. In most problems in the managerial accounting course,
the discount rate is given.)

Use expected cash flows rather than highest or lowest cash flow
that could occur
Example: If cash flow could be $100 or $200 with equal
probability, then expected cash flow is $150.

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Adjustment for Inflation

If inflation exists in the economy, then the discount rate should be
adjusted for inflation.
rnominal = nominal interest rate with inflation
i = inflation rate
rreal = real interest rate if no inflation = riskless rate + risk
premium
(1 + rnominal ) = (1 + rreal ) (1 + i)
Solving: rnominal = rreal + i + (rreal  i )

1. Restate future cash flows into nominal dollars (after inflation)

2. Discount cash flows with nominal interest rate

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After-Tax Cash Flow(ATCF) -

Concept
Determine cash flows after taxes
On the firm’s income tax return, they cannot fully deduct the cost of a
capital investment in the year purchased. Instead firms depreciate
the investment over several years at the rate allowed by the tax law.

Time Cash flow

Beginning of project Cash to acquire assets

Future years Depreciation deduction on tax return

reduces future tax payments
(depreciation tax shield)

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ATCF - Definitions
t = Tax rate (tax refund rate if negative income)
R = Revenue in one year (assume all cash)
E = All cash expenses in one year (excludes depreciation)
D = Depreciation allowed in one year on income tax return

Tax expense for one year

TAX = (R - E - D)  t

After-tax cash flow for year

ATCF = R - E - Tax
= R - E - (R - E - D)  t = (R - E)(1 - t) + Dt

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ATCF - Equivalent Methods

1. Separate tax computation
ATCF = (Cash flow before tax) - TAX
= ( R - E ) - (R - E - D)  t

2. Depreciation tax shield

ATCF = (After-tax cash flow without depreciation) + Depreciation
tax
shield
= ( R - E ) (1 - t) + D  t

3. Financial accounting income after tax and add back non-cash

expenses
ATCF = (Accounting income after tax) + (Non-cash expenses)
= (R - E - D) (1 - t) + D

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Alternative Capital
Budgeting Methods
Methods that consider time value of money:
1. Discounted cash flow (DCF), also known as net present value
(NPV) method
2. Internal rate of return (IRR)
Methods that do not consider time value of money:
3. Payback method
4. Accounting rate of return on investment (ROI)

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Alternative: Payback Method

Payback = the time required until cash inflows from a project equal the
initial cash investment.
Rank projects by payback and accept those with shortest payback
period

Advantages of payback method:

 Simple to explain and compute

Disadvantages of payback method:

 Ignores time value of money (when is cash received within
payback period)
 Ignores cash flows beyond end of payback period

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Alternative: Accounting Return

(ROI)
Average annual accounting income from project
 Average annual investment in the project
= Return on investment (ROI)

Average annual investment = (Initial investment + Salvage

value at end) 2

Advantages of ROI method:

 Simple to explain and compute using financial statements

Disadvantages of payback method:

 Ignores time value of money (when is cash received
within payback period)
 Accounting income is often not equal to cash flow

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Alternative: Internal Return

(IRR)
Internal rate of return (IRR) is the interest rate that equates the present
value of future cash flows to the cash outflows.
By definition: PV = FV (1 + irr)
Solution for a single cash flow: irr = (FV PV) - 1

Comparison of IRR and DCF/NPV methods

 Both consider time value of cash flows

 IRR indicates relative return on investment

 DCF/NPV indicates magnitude of investment’s return

 IRR can yield multiple rates of return

 IRR assumes all cash flows reinvested at project’s constant IRR

 DCF/NPV discounts all cash flows with specified discount rate

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Capital Budgeting in Practice

See Table 3-11 .

DCF/NPV has become the most commonly used

capital budgeting method for evaluating new and
replacement projects in large US corporations.

“Urgency,” such as governmental mandates, is still a

significant cause for approving replacement
projects.

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