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Chapter 11

Capital Budgeting
ACCT 2200
PROFESSOR THOMAS BOURVEAU

Capital Budgeting Methods

Learning Objective 11-4


Predict the internal rate of return
and describe its relationship to net
present value.

Internal Rate of Return (IRR)


The internal rate of return is the interest
rate that makes . . .

Present

value of
cash inflows

Present
value of
cash outflows

The net present value equal zero.

Internal Rate of Return (IRR)


The internal rate of return is the discount rate which equates the NPV of a
stream of cash flows to zero.
CFt
0
(1 IRR ) t
If the IRR can be determined, then, in general,
choosing IRR > r often leads to the same decision as choosing NPV > 0.
The IRR criterion is useful for choosing among projects with the same NPV.
Using the cash flows for the preceding example, we get:

90

IRR

18%

55
(1 +

> 10%

IRR)1

60.50

(1 + IRR)2

Accept the project

Computing IRR in Excel

One important note about the IRR function is that you must
include the original cash outflow in the calculation.

Internal Rate of Return (IRR)

Application
A local company, Lester Inc. has a minimum required rate of
return / cost of capital of 8% per year. The company is considering
investing in a robotic project that costs HKD68,337 and is expected
to generate cash flows of approximately HKD 27,000 per year for
the next three years. The approximate internal rate of return of
this project is:
A. 8%
B. 9%
C. 10%
D. Less than the required 8%

Profitability Index
The profitability index is the ratio of a projects benefits (measured
by the present value of the future cash flows) to its costs (or
required investment).

Profitability Index > 1 = Project Acceptable


Profitability Index < 1 = Project Unacceptable

Comparing Capital Budgeting Methods

Learning Objective 11-5


Use the net present value method to
analyze mutually exclusive capital
investments.

Case 1: Lease or Buy Equipment


iKids Touch is trying to decide whether to buy a new copier or
lease it from a copier company, and has gathered the following
information about the two options:

iKids Touch uses net present value to evaluate


investment options. If the discount rate is 10%,
should the company lease or buy?

Case 1: Lease or Buy Equipment


To analyze this decision, we can use the NPV method to
compare the relevant costs (in present dollar values) of
each option.

Lease option costs $1,419 less.

Case 2: Investing in Automation


iKids Touch is thinking of spending $10,000,000 to
automate a production facility. The investment is
expected to have the following effects:
Automation

will increase the capacity of the plant and allow it


to boost production and sales by 20 percent.
The company will be able to reduce packaging labor cost per
unit by 30 percent.
Factory supervision costs will increase by $500,000 per year.
The estimated useful life of the equipment is six years, at which
point it will have a residual value of $1,000,000. Straight-line
depreciation of the assets will be $1,500,000 per year
[($10,000,000 1,000,000) 6 years = $1,500,000].

Case 2: Investing in Automation


This table summarizes the effects on net income. The per-unit costs
in the first column are assumed. Note that automation increases net
income by $1,100,000.

iKids Touch uses net present value to evaluate


investments. If the discount rate is 12%, should
the company make the $10,000,000 investment?

Case 2: Investing in Automation


Remember that the net present value method is based on cash flow
rather than net income. So, we need to add back the depreciation (a
noncash expense) to net income to get net cash flow. We also need
to incorporate the initial investment (at time zero) and the salvage
value of the machinery at the end of six years.

The positive net present value of $1,196,240 means that the


proposed investment in automation will generate a return in excess
of the 12% cost of capital.

Exercise E11-7
Your friend Harrold is trying to decide whether to buy or lease his
next vehicle. He has gathered information about each option but is
not sure how to compare the alternatives. Purchasing a new
vehicle cost $26,500, and Harrold expects to spend about $500 per
year in maintenance costs. He would keep the vehicle for five
years and estimate the salvage value to be $10,500. Alternatively,
he could lease the same vehicle for five years at a cost of $3,480
per year, including maintenance. Assume a discount rate of 10
percent.

Learning Objective 11-6


Use the profitability index to
prioritize independent capital
investment projects.

Prioritizing Independent
Projects
The profitability index is used to prioritize
capital investment projects.

Profitability
Index

Present Value of
Future Cash flows

Initial
Investment

When using the profitability index to prioritize projects,


the preference rule is: the higher the profitability index,
the more desirable the project.

Prioritizing Independent
Projects

iKids Touch is trying to decide how to prioritize their limited


research and development budget. They are
considering these three independent projects.

How should iKids Touch prioritize these three projects?


A, then B, then C

Application
Lester Inc. just raised HKD1,000,000 from investors in Hong Kong to
fund the creation of a new robot with a cost of capital of 10%. The CEO
of the company hesitates between two different mutually exclusive
projects. Both of them requires an initial cash outflow of HKD1,000,000
but have the following cash flow patterns:
Year 1

Year 2

Year 3

Year 4

Year 5

Total

Project A

800,000

600,000

400,000

200,000

100,000

2,100,000

Project B

100,000

200,000

400,000

600,000

800,000

2,100,000

Which one should the firm opt for?

Application
Sai Kung Transportation is considering the purchase
of a new junk carrier for HKD8 million. The forecast
revenues are HKD5 million a year and total operating
costs are HKD4 million. A major ret costing HKD2
million will be required after both the fth and tenth
years. After 15 years, the ship is expected to be sold for
scrap at HKD1.5 million.
Required: If the discount rate is 8 percent, what is the
NPV of investing in the new ship?