Chapter What you Really Need to Know

10 A. The term capital budgeting is used to describe planning major outlays on projects that commit
the company for some time into the future such as purchasing new equipment, building a new
facility, or introducing a new product.
1. Capital budgeting involves investment, committing funds now to obtain a return in the
future.
2. Capital budgeting decisions fall into two broad categories:
a. Screening decisions: Potential projects are categorized as acceptable or
unacceptable based on some pre-set standard.
b. Preference decisions: Projects must be ranked because funds are insufficient to
support all of the acceptable projects. These decisions are made subsequent to
the screening decision and are more difficult to make.
3. The time value of money should be considered. A dollar today does not have the same
value or worth in the future.
a. Discounted cash flow methods give full recognition to the time value of
money.
b. Two methods involve discounting cash flows—the net present value method
and the internal rate of return method.
B. The difference between the present value of a project’s cash inflows and its cash outflows is
referred to as net present value (NPV). The NPV method is illustrated in Example A and in
Example B and includes the following basic steps:
1. Determine the required investment.
2. Determine the future cash inflows and outflows that result from the investment.
3. Use the present value tables to find the appropriate present value factors.
a. The values (or factors) in the present value tables depend on the discount rate
and the number of periods (usually years).
b. The discount rate is the company's required rate of return, which is often the
company's cost of capital. The cost of capital is the average rate of return the
company must pay its long-term creditors and shareholders for the use of their
funds. The details of the cost of capital are covered in finance courses.
4. Multiply each cash flow by the appropriate present value factor and then sum the
results. The end result (which is net of the initial investment) is called the net present
value of the project.
5. In a screening decision, if the net present value is zero (return = required rate of return)
or positive (return > required rate of return), the investment is acceptable. If the net
present value is negative (return < required rate of return), the investment should be
rejected.
C. Discounted cash flow analysis is based entirely on cash flows—not on accounting net income.
Accounting net income is based on accrual concepts which ignore the timing of cash flows.
1. Typical cash flows associated with an investment are:
a. Outflows: initial investment (including installation costs); increased working
capital needs; repairs and maintenance; and incremental operating costs.
b. Inflows: incremental revenues; reductions in costs; salvage value; and release
of working capital at the end of the project.
2. Depreciation is not a cash flow and therefore is not part of the analysis. (However,
depreciation can affect taxes, which is a cash flow. This aspect of depreciation is
covered in more advanced texts.)
3. Quite often, a project requires an infusion of cash (i.e., working capital) to finance
inventories, receivables, and other working capital items. Typically, at the end of the
project these working capital items can be liquidated (i.e., the inventory can be sold)
and the cash that had been invested in these items can be recovered. Thus, working
capital is counted as a cash outflow at the beginning of a project and as a cash inflow at
the end of the project.
4. We usually assume that all cash flows, other than the initial investment, occur at the end
of a period.
5. Under NPV, cash flows are only considered on an after-tax basis which means using an
 after-tax discount rate.
6. All financing related cash flows are ignored as the impact on the project of the
financing decision made to fund the project is captured in the cost of capital or discount
rate.
D. The NPV method can be used to compare competing projects using the total-cost approach or
the incremental-cost approach:
1. The total-cost approach is the most flexible method. Example C and Exhibit 10-5 shows
this approach. Note in Exhibit 10-5 that all cash inflows and all cash outflows are
included in the solution under each alternative rather than only focusing on relevant
cash flows.
2. The incremental-cost approach is a simpler and more direct route to a decision since it
ignores all cash flows that are the same under both alternatives as these are irrelevant.
Exhibit 10-6 shows this approach.
3. The total-cost and incremental-cost approaches lead to the same decision.
E. Sometimes no revenue or cash inflow is directly involved in a decision. In this situation, the
alternative with the least cost should be selected. The least cost alternative can be determined
using either the total-cost approach or the incremental approach. Exhibits 10-7 and 10-8 illustrate
least-cost decisions.
F. Preference decisions involve ranking investment projects which is necessary whenever funds
available for investment are limited.
1. Preference decisions are sometimes called ranking decisions or rationing decisions
because they ration limited investment funds among competing investment
opportunities.
2. The net present value of one project should not be compared directly to the net present
value of another project, unless the investments in the projects are equal.
a. To make a valid comparison between projects that require different
investments, a project profitability index is computed. The formula for the
index is:

This is basically an application of the idea related to the utilization of a scarce

resource. In this case, the scarce resource is the investment funds. The project
profitability index is similar to the contribution margin per unit of the scarce
resource.
b. The preference rule when using the project profitability index is: The higher
the project profitability index, the more desirable the project.
G. The internal rate of return method is another discounted cash flow method used in capital
budgeting decisions.
1. The internal rate of return is the rate of return promised by an investment project over
its useful life; it is the discount rate that results in a net present value of zero for the
project.
2. When the cash flows are the same every year, the following formula can be used to find
the internal rate of return:

3. For example, assume an investment of $6,710 is made in a project that will last ten
years and has no salvage value. Also assume that the annual cash inflow from the
project will be $1,000.

Since this is a project with a ten-year life, use the 10-year row in Exhibit 10-2 which
provides the present value factors for an annuity. (This is an annuity since the same
cash inflow is received at the end of every year beginning with the first year). Scanning
along the 10-year row, it can be seen that this factor represents an 8% rate of return.
You can verify that this calculation is correct by computing the net present value of the
 investment:
($1,000 x 6.710) -$6,710 = 0
4. If the cash inflows are not the same every year, the IRR is found using trial and error or
using a computer program or spreadsheet such as Microsoft Excel. The internal rate of
return is whatever discount rate that makes the net present value of the project equal
zero.
5. In a screening decision, the IRR is compared to the required rate of return. If the IRR is
less that the required rate of return, the project is rejected. If it is greater than or equal to
the required rate of return, the project is accepted.
H. Two other approaches to capital budgeting, which do not involve discounting cash flows, are the
payback method and the simple rate of return method.
1. The payback method focuses on how long it takes for a project to recover its initial cost
out of the cash receipts it generates. The payback period is expressed in years.
a. When the cash inflows from the project are the same every year, the following
formula can be used to compute the payback period:

b. If new equipment is replacing old equipment, the "investment required" should

be reduced by any salvage value obtained from the disposal of old equipment.
And in this case, when computing the "net annual cash inflows," only the
incremental cash inflow provided by the new equipment over the old
equipment should be used.
2. The payback period is not a measure of profitability, but a measure of how long it takes
for a project to recover its investment cost.
3. The payback method ignores the time value of money and ignores all cash flows that
occur once the initial cost has been recovered. Therefore, this method is very crude and
should be used only with a great deal of caution. Nevertheless, the payback method can
be useful in industries where project lives are very short and uncertain.
I. The simple rate of return (SRR) method is another capital budgeting method that does not
involve discounted cash flows.
1. The simple rate of return method focuses on accounting net operating income, rather
than on cash flows. The formula for its computation is:

If new equipment is replacing old equipment, then the "initial investment" in the new
equipment is the cost of the new equipment reduced by any salvage value obtained from
the old equipment. The incremental net operating income is equal to the incremental
revenues less the incremental expenses (including depreciation).
2. If a cost reduction project is involved then the formula used would be:
Simple rate = Cost savings – Depreciation on new equipment
of return Initial Investment
3. Like the payback method, the simple rate of return method does not consider the time
value of money. Therefore, the rate of return computed by this method will not be an
accurate guide to the return on an investment project.