CHAPTER 9

Capital Budgeting
and
Other Long-Run Decisions

Slide 9-2
 Long
Long Run
Run Decisions
Decisions
ƒ Capital expenditure decisions
- Decisions related to investments in
property, plant and equipment
- Proper analysis requires taking into
account the time value of money
- Capital expenditure decisions affect cash
flows across multiple years

Slide 9-3
 Capital
Capital Budgeting
Budgeting Decisions
Decisions
ƒ Investment decisions are important because
they have a long run impact
ƒ Capital expenditure decisions
- Decisions involving the acquisition of long-
lived assets
ƒ Capital budgeting
- Process of evaluating investment opportunities
- The final list of approved projects is referred to
as the capital budget

Slide 9-4 Learning objective 1: Define capital expenditure

decisions and capital budgets
 Capital
Capital Budgeting
Budgeting Decision
Decision
Examples
Examples

Slide 9-5 Learning objective 1: Define capital expenditure

decisions and capital budgets
The
The Net
Net Present
Present Value
Value Method
Method
Steps in the NPV method
1. Identify the amount and time period
of each cash flow associated with a
potential investment
2. Identify required rate of return and
calculate the present values of the
cash flows
3. Evaluate the net present value

Slide 9-6 Learning objective 2: Evaluate investment opportunities using

the net present value approach
The
The Net
Net Present
Present Value
Value Method
Method
ƒ Amount and time period of each
cash flow
- Cash outflows are negative
- Cash inflows are positive
ƒ Only incremental cash flows are
relevant to the decision
- Cash flows already incurred (sunk
costs) are not relevant

Slide 9-7 Learning objective 2: Evaluate investment opportunities using

the net present value approach
The
The Net
Net Present
Present Value
Value Method
Method
ƒ Required rate of return (i.e. hurdle
rate)
ƒ Evaluate the investment opportunity
- If NPV = 0, the investment earns the
hurdle rate
- If NPV > 0, the investment earns
more than the hurdle rate
- If NPV < 0, the investment earns
less than the hurdle rate

Slide 9-8 Learning objective 2: Evaluate investment opportunities using

the net present value approach
 Net
Net Present
Present Value
Value Approach
Approach

Slide 9-9 Learning objective 2: Evaluate investment opportunities using

the net present value approach
 Net
Net Present
Present Value
Value Example
Example
Since the NPV > 0, the company should buy the equipment.

Slide 9-10 Learning objective 2: Evaluate investment opportunities using

the net present value approach
 Comparing
Comparing Alternatives
Alternatives with
with NPV
NPV

Slide 9-11 Learning objective 2: Evaluate investment opportunities using

the net present value approach
 The
The Internal
Internal Rate
Rate of
of Return
Return
Method
Method

Slide 9-12 Learning objective 3: Evaluate investment opportunities using

the internal rate of return approach
 Internal
Internal Rate
Rate of
of Return
Return Example
Example
ƒ Investment = $100
ƒ Cash flow $60 per year for two years
ƒ PV factor = 100 / 60 = 1.667
ƒ Check PV annuity table, row 2
ƒ Closest factor is in 13% column
Present Value of an Annuity
11% 12% 13% 14%
1 0.9009 0.8929 0.8850 0.8772
2 1.7125 1.6901 1.6681 1.6467

Factor closest to 1.667, IRR approx 13%

Slide 9-13 Learning objective 3: Evaluate investment

opportunities using the internal rate of return approach
 Internal
Internal Rate
Rate of
of Return
Return With
With
Unequal
Unequal Cash
Cash Flows
Flows
ƒ Utilized when annual cash flows are not
equal amounts
- Must estimate IRR
- Use estimated IRR to calculate the NPV of
the project
ƒ If NPV > 0, increase estimated IRR
ƒ If NPV < 0, decrease estimated IRR
- Recalculate until NPV is equal to or close to
zero

Slide 9-14 Learning objective 3: Evaluate investment opportunities using

the internal rate of return approach
 Internal
Internal Rate
Rate of
of Return
Return With
With
Unequal
Unequal Cash
Cash Flows
Flows
The IRR is approximately 16%

Slide 9-15 Learning objective 3: Evaluate investment

opportunities using the internal rate of return approach
 Use
Use of
of NPV
NPV and
and IRR
IRR

Slide 9-16 Learning objective 3: Evaluate investment opportunities using

the internal rate of return approach
 Considering
Considering ““Soft”
Soft” Benefits
Benefits in
in
Investment
Investment Decisions
Decisions

ƒ NPV and IRR allow for a quantitative analysis of

a situation
ƒ “Soft” benefits are difficult to quantify
ƒ “Soft” benefits include a project’s impact on:
- Future sales
- Firm’s reputation
- New production techniques

Slide 9-17 Learning objective 3: Evaluate investment opportunities using

the internal rate of return approach
 ““Soft”
Soft” Benefits

Slide 9-18 Learning objective 3: Evaluate investment opportunities using

the internal rate of return approach
 Calculating
Calculating the
the Value
Value of
of ““Soft”
Soft”
Benefits
Benefits
Example
ƒ A high-tech wheelchair project
-NPV of negative $80,000
-Required rate of return 15%, 10-year life

Slide 9-19 Learning objective 3: Evaluate investment opportunities using

the internal rate of return approach
 Cost
Cost of
of Capital
Capital Examples
Examples

Slide 9-20 Learning objective 3: Evaluate investment opportunities using

the internal rate of return approach
 Example
Example ofof the
the
Depreciation
Depreciation Tax
Tax Shield
Shield

Slide 9-21 Learning objective 4: Calculate the depreciation tax shield, and explain why
depreciation is important in investment analysis only because of income taxes
 Other
Other Long-Run Decisions
Long-Run Decisions
ƒ Evaluation of decision to sponsor a golf
tournament

Slide 9-22 Learning objective 5: Evaluate long-run decisions, other than investment
decisions, using time value of money techniques