CHAPTER 1212

PLANNING FOR
CAPITAL INVESTMENTS

Chapter 12-1
 Study Study Objectives
1. Discuss the capital budgeting evaluation
process, and explain what inputs are used in
capital budgeting.
2. Describe the cash payback technique.
3. Explain the net present value method.
4. Identify the challenges presented by
intangible benefits in capital budgeting.
5. Describe the profitability index.
6. Indicate the benefits of performing a post-
audit.
7. Explain the internal rate of return method.
8. Describe the annual rate of return method.

Chapter 12-2
 Capital Budgeting Evaluation Process

Many companies follow a carefully prescribed

process in capital budgeting. At least once a
year:
1) Proposals for projects are requested from
each department.
2) The proposals are screened by a capital
budgeting committee, which submits its
finding to officers of the company.
3) Officers select projects and submit a list of
projects to the board of directors.

LO 1 Discuss the capital budgeting evaluation

process, and explain what inputs are used
Chapter 12-3 in capital budgeting.
 Capital Budgeting Evaluation Process

The capital budgeting decision depends on a

variety of considerations:
1) The availability of funds.
2) Relationships among proposed
projects.
3) The company’s basic decision-making
approach.
4) The risk associated with a particular
project.

LO 1 Discuss the capital budgeting evaluation

process, and explain what inputs are used
Chapter 12-4 in capital budgeting.
 Cash Payback Formula

•The cash payback technique identifies the time period

required to recover the cost of the capital investment
from the annual cash inflow produced by the
investment.
•The formula for computing the cash payback period
is:

Chapter 12-5 LO 2 Describe the cash payback technique.

 Estimated Annual Net Income from
Capital Expenditure

Assume that Reno Co. is considering an investment of $130,000 in

new equipment. The new equipment is expected to last 5 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
Less: Costs and expenses $132,000
Depreciation expense ($130,000/5) 26,000
Selling and administrative expenses 22,000 180,000
Income before income taxes 20,000
Income tax expense 7,000
Net income $ 13,000

Chapter 12-6 LO 2 Describe the cash payback technique.

 Computation of Annual Cash Inflow

Cash income per year equals net income plus depreciation

expense.

Annual (or net) cash inflow is approximated by taking net income and adding
back depreciation expense. Depreciation expense is added back because
depreciation on the capital expenditure does not involve an annual outflow
of cash.

Net income $13,000

Add: Depreciation expense 26,000
Cash income $39,000
Chapter 12-7 LO 2 Describe the cash payback technique.
 Cash Payback Period

The cash payback period in this example is therefore 3.33

years, computed as follows:

$130,000 ÷ $39,000 = 3.33 years

When the payback technique is used to decide among acceptable

alternative projects, the shorter the payback period, the more
attractive the investment. This is true for two reasons:
1) the earlier the investment is recovered, the sooner the cash
funds can be used for other purposes, and
2) the risk of loss from obsolescence and changed economic
conditions is less in a shorter payback period.

Chapter 12-8 LO 2 Describe the cash payback technique.

 Review Question

A $100,000 investment with a zero scrap value has an 8-year life. Compute
the payback period if straight-line depreciation is used and net income is
determined to be $20,000.

a. 8.00 years.
b. 3.08 years.
c. 5.00 years.
d. 13.33 years.

Chapter 12-9 LO 2 Describe the cash payback technique.

 Review Question

A $100,000 investment with a zero scrap value has an 8-year life. Compute
the payback period if straight-line depreciation is used and net income is
determined to be $20,000.

a. 8.00 years.
b. 3.08 years.
c. 5.00 years.
d. 13.33 years.

Chapter 12-10 LO 2 Describe the cash payback technique.

 Net Present Value Method
S

• The discounted cash flow technique is

generally recognized as the best conceptual
approach to making capital budgeting decisions.
• This technique considers both the estimated
total cash inflows and the time value of money.
• Two methods are used with the
discounted cash flow technique:
1) net present value and
2) internal rate of return

Chapter 12-11 LO 3 Explain the net present value method.

 Net Present Value Method

• Under the net present value method, cash

inflows are discounted to their present value
and then compared with the capital outlay
required by the investment.
• The interest rate used in discounting the
future cash inflows is the required minimum
rate of return.
• A proposal is acceptable when NPV is zero or
positive.
• The higher the positive NPV, the more
attractive the investment.

Chapter 12-12 LO 3 Explain the net present value method.

 Net Present Value Decision Criteria

Chapter 12-13
LO 3 Explain the net present value method.
 Present Value of Annual
Cash Inflows-Equal Annual Cash Flows

Stewart Soup Company’s annual cash inflows are $24,000. If we

assume this amount is 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. The
computations at rates of return of 12% and 15%, respectively are:

Chapter 12-14 LO 3 Explain the net present value method.

 Computation of Net Present Values

The analysis of the proposal by the net

present value method is as follows:

The proposed capital expenditure is acceptable at a required rate of

return of 12% (not 15%) because the net present value is positive.

Chapter 12-15 LO 3 Explain the net present value method.

 Present Value of Annual Cash Inflows-Unequal
Annual Cash Flows
When annual cash inflows are unequal, we cannot use annuity tables to calculate
their present value. Instead tables showing the present value of a single future
amount must be applied to each annual cash inflow.
Assumed Discount Factor Present Value
Annual
Year Cash Inflows 12% 15% 12% 15%
(1) (2) (3) (1) x (2) (1) x (3)
1 $36,000 .89286 .86957 $32,143 $31,305
2 32,000 .79719 .75614 25,510 24,196
3 29,000 .71178 .65752 20,642 19,068
4 27,000 .63552 .57175 17,159 15,437
5 26,000 .56743 .49718 14,753 12,927
6 24,000 .50663 .43233 12,159 10,376
7 23,000 .45235 .37594 10,404 8,647
8 22,000 .40388 .32690 8,885 7,192
9 21,000 .36061 .28426 7,573 5,969
10 20,000 .32197 .24719 6,439 4,944
$260,000 $155,667 $140,061

Chapter 12-16 LO 3 Explain the net present value method.

 Analysis of Proposal Using Net Present
Value Method

Therefore, the analysis of the proposal by

the net present value method is as follows:
12% 15%
Present value of future cash inflows: $155,667 $140,061
Capital investment 130,000 130,000
Positive (negative) net present value $ 25,667 $10,061

In this example, the present values of the cash inflows are

greater than the $130,000 capital investment. Thus, the
project is acceptable at both a 12% and 15% required rate
of return.

Chapter 12-17 LO 3 Explain the net present value method.

Review Question
Compute the net present value of a $260,000 investment with a 10-year life,
annual cash inflows of $50,000 and a discount rate of 12%.

a. $(9,062).
b. $22,511.
c. $9,062.
d. $(22,511).

Chapter 12-18 LO 3 Explain the net present value method.

Review Question
Compute the net present value of a $260,000 investment with a 10-year life,
annual cash inflows of $50,000 and a discount rate of 12%.

a. $(9,062).
b. $22,511.
c. $9,062.
d. $(22,511).

Chapter 12-19 LO 3 Explain the net present value method.

 Additional Considerations

• The previous NPV example relied on

tangible costs and benefits that can be
relatively easily quantified.
• By ignoring intangible benefits, such as
increased quality, improved safety, etc.
capital budgeting techniques might
incorrectly eliminate projects that
could be financially beneficial to the
company.

LO 4 Identify the challenges presented by

Chapter 12-20 intangible benefits in capital budgeting.
 Additional Considerations

To avoid rejecting projects thatactually should be

accepted, two possible approaches are
suggested:

1. Calculate net present value ignoring intangible

benefits. Then, if the NPV is negative, ask
whether the intangible benefits are worth at
least the amount of the negative NPV.

2. Project rough, conservative estimates of the

value of the intangible benefits, and incorporate
these values into the NPV calculation.

LO 4 Identify the challenges presented by

Chapter 12-21 intangible benefits in capital budgeting.
 The Profitability Index

Present Value of Net Cash ÷ Initial Investment = Profitability

Flows Index

Project A Project B
Present Value $58,112 $110,574
of Net Cash
Flows
Initial $40,000 $90,000
Investment
Profitability 1.45 1.23
Index

Chapter 12-22 LO 5 Describe the profitability index.

 Profitability Index

• In the previous slide, the

profitability index of Project A
exceeds that of Project B.
• Thus, Project A is more desirable.
• If the projects are not mutually
exclusive, and if resources are not
limited, then the company should
invest in both projects, since both
have positive NPVs.

Chapter 12-23 LO 5 Describe the profitability index.

 Review Question

Assume Project A has a present value of net cash inflows of $79,600 and an
initial investment of $60,000. Project B has a present value of net cash
inflows of $82,500 and an initial investment of $75,000. Assuming the
projects are mutually exclusive, which project should management select?

a. Project B.
b. Project A or B.
c. Project A.
d. There is not enough data to answer the question.

Chapter 12-24 LO 5 Describe the profitability index.

Review Question

Assume Project A has a present value of net cash inflows of $79,600 and an
initial investment of $60,000. Project B has a present value of net cash
inflows of $82,500 and an initial investment of $75,000. Assuming the
projects are mutually exclusive, which project should management select?

a. Project B.
b. Project A or B.
c. Project A.
d. There is not enough data to answer the question.

Chapter 12-25
LO 5 Describe the profitability index.
 Post-Audit of Investment Projects

Performing a post-audit is important for

a variety of reasons.
1. If managers know that their estimates will be
compared to actual results they will be more likely
to submit reasonable and accurate data when
making investment proposals.
2. A post-audit provides a formal mechanism by
which the company can determine whether
existing projects should be supported or
terminated.
3. Post-audits improve future investment proposals
because by evaluating past successes and failures,
managers improve their estimation techniques.
LO 6 Indicate the benefits of performing
Chapter 12-26 a post-audit.
 Internal Rate of Return Method
Formula for Internal Rate
of Return Factor
• The internal rate of return method finds the interest
yield of the potential investment.
• This is 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.
• Determining the true interest rate involves two steps:
STEP 1.Compute the internal rate of return factor
using this formula:

Chapter 12-27 LO 7 Explain the internal rate of return method.

 Internal Rate of Return Method

The computation for the Stewart Soup Company,

assuming equal annual cash inflows is:

$244,371 ÷ $1000,000 =
2.44371

Chapter 12-28 LO 7 Explain the internal rate of return method.

 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.
• The internal rate of return is found by locating the
discount factor that is closest to the internal rate
of return factor for the time period covered by the
annual cash flows.
• For Stewart Soup, the annual cash flows are
expected to continue for 3 years. In the table
below, the discount factor of 2.44371 represents
an interest rate of 11%.

Chapter 12-29 LO 7 Explain the internal rate of return method.

 Internal Rate of Return Decision Criteria

The decision rule is: Accept the project when the internal rate
of return is equal to or greater than the required rate of return.
Reject the project when the internal rate of return is less than
the required rate.
Chapter 12-30 LO 7 Explain the internal rate of return method.
 Comparison of Discounted Cash Flow Methods

• In practice, the internal rate of return and cash

payback methods are most widely used.
• A comparative summary of the two discounted cash
flow methods-net present value and internal rate of
return- is presented below:
Item Net Present Value Internal Rate of Return
1. Objective Compute net Compute internal rate of
present value. return.
2. Decision rule If net present If internal rate of return
value is zero or is equal to or greater
positive, accept than the minimum
the proposal; if required rate of return,
net present value accept the proposal; if
is negative, reject internal rate of return is
the proposal. less than the minimum
rate, reject the proposal.
Chapter 12-31 LO 7 Explain the internal rate of return method.
Review Question
A $60,000 project has net cash inflows for 10 years of $9,349. Compute the
internal rate of return from this investment.

a. 8%.
b. 10%.
c. 9%.
d. 11%.

Chapter 12-32 LO 7 Explain the internal rate of return method.

Review Question
A $60,000 project has net cash inflows for 10 years of $9,349. Compute the
internal rate of return from this investment.

a. 8%.
b. 10%.
c. 9%.
d. 11%.

Chapter 12-33 LO 7 Explain the internal rate of return method.

 Annual Rate of Return Formula

• The annual rate of return technique is based

on accounting data. It indicates the
profitability of a capital expenditure. The
formula is:

The annual rate of return is compared with its required

minimum rate of return for investments of similar risk.
This minimum return is based on the company’s cost of capital,
which is the rate of return that management expects to pay on
all borrowed and equity funds.

Chapter 12-34 LO 8 Describe the annual rate of return method.

 Formula for Computing
Average Investment

Expected annual net income ($13,000) is obtained from

the projected income statement. Average investment is
derived from the following formula:

For Reno, average investment is $65,000: [($130,000 +

$0)/2]

Chapter 12-35 LO 8 Describe the annual rate of return method.

 Solution to Annual Rate of Return Problem

The expected annual rate of return for Reno Company’s

investment in new equipment is therefore 20%, computed
as follows:

$13,000 ÷ $65,000 =
20%
The decision rule is:
A project is acceptable if its rate of return is greater than management’s
minimum rate of return. It is unacceptable when the reverse is true. When
choosing among several acceptable projects, the higher the rate of return
for a given risk, the more attractive the investment.

Chapter 12-36 LO 8 Describe the annual rate of return method.

Review Question

Bear Company computes an expected annual net income from an

investment of $30,000. The investment has an initial cost of $200,000 and a
terminal value of $20,000. Compute the annual rate of return.

a. 15%.
b. 30%.
c. 25%.
d. 27.3%.

Chapter 12-37 LO 8 Describe the annual rate of return method.

Review Question

Bear Company computes an expected annual net income from an

investment of $30,000. The investment has an initial cost of $200,000 and a
terminal value of $20,000. Compute the annual rate of return.

a. 15%.
b. 30%.
c. 25%.
d. 27.3%.

Chapter 12-38 LO 8 Describe the annual rate of return method.

 All About You: The Risks of Adjustable
Rates

Chapter 12-39
All About You: The Risks of Adjustable
Rates
All About You: The Risks of Adjustable
Rates
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Chapter 12-40