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CAPITAL
BUDGETING
Chapter
26
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Capital budgeting:
Analyzing alternative long-
term investments and deciding
which assets to acquire or sell.
Outcome
is uncertain.
Large amounts of
money are usually
involved.
Investment involves a
long-term commitment.
Decision may be
difficult or impossible
to reverse.
Capital Investment Decisions
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?
?
?
Plant
Expansion
New
Equipment
Office
Renovation
I will choose the
project with the most
profitable return on
available funds.
Capital Investment Decisions
Limited
Investment
Funds
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Incremental
operating
costs
Initial
investment
Repairs and
maintenance
Capital Investment Decisions:
Typical Cash Outflows
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Cost
savings
Salvage
value
Incremental
revenues
Capital Investment Decisions:
Typical Cash Inflows
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Employee morale
Environmental concerns Corporate image
Employee working conditions
Product quality
Capital Investment Decisions:
Nonfinancial Considerations
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Lets look at
methods used
to make capital
investment
decisions.
Evaluating Capital Investment
Proposals: An Illustration
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Stars Stadium is considering purchasing
vending machines with a 5-year life.
Cost and revenue information
Cost of vending machines $ 75,000
Revenue 84,375 $
Cost of goods sold 50,625
Gross profit 33,750 $
Cash operating costs 3,350 $
Depreciation 14,000 17,350
Pretax income 16,400 $
Income tax 6,400
After-tax income 10,000 $
($75,000 - $5,000) 5 years
Evaluating Capital Investment
Proposals: An Illustration
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Most capital budgeting techniques use
annual net cash flow.

Depreciation is not a cash outflow.
Annual net income 10,000 $
Add annual depreciation 14,000
Annual net cash flow 24,000 $
Evaluating Capital Investment
Proposals: An Illustration
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The payback period of an investment
is the time expected to recover
the initial investment amount.
Payback
period
=
Cost of Investment
Annual Net Cash Flow
Managers prefer investing in projects
with shorter payback periods.
Payback Period
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The payback period of an investment
is the time expected to recover
the initial investment amount.
Payback
period
=
Cost of Investment
Annual Net Cash Flow
Payback
period
=
$75,000
$24,000
= 3.125 years
Payback Period
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Ignores the
time value
of money.
Ignores cash
flows after
the payback
period.
Payback Period
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Consider two projects, each with a
five-year life and each costing $6,000.
Project One Project Two
Net Cash Net Cash
Year Inflows Inflows
1 2,000 $ 1,000 $
2 2,000 1,000
3 2,000 1,000
4 2,000 1,000
5 2,000 1,000,000
Would you invest in Project One just because
it has a shorter payback period?
Payback Period
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ROI =
Average estimated net income
Average investment
Original cost + Salvage value
2
Return on Average Investment (ROI)
ROI focuses on annual income
instead of cash flows.
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ROI = = 25%
$10,000
$40,000
ROI focuses on annual income
instead of cash flows.
$75,000 + $5,000
2
Return on Average Investment (ROI)
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Income may vary
from year to year.
Time value of
money is ignored.
So why
would I ever
want to use
this method
anyway?
Return on Average Investment (ROI)
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Now lets look at a capital budgeting model
that considers the time value of cash flows.
Discounting Future Cash Flows
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A comparison of the present value of cash
inflows with the present value of cash
outflows
Net Present Value (NPV)
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Chose a discount rate the
minimum required rate of return.
Calculate the present
value of cash inflows.
Calculate the present
value of cash outflows.
NPV =
Net Present Value (NPV)
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General decision rule . . .
If the Net Present
Value is . . . Then the Project is . . .
Positive . . .
Acceptable, since it promises a
return greater than the required
rate of return.
Zero . . .
Acceptable, since it promises a
return equal to the required rate
of return.
Negative . . .
Not acceptable, since it
promises a return less than the
required rate of return.
Net Present Value (NPV)
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Savak Company can buy a new machine for
$96,000 that will save $20,000 cash per year in
operating costs. If the machine has a useful life of
10 years and Savaks required return is 12 percent,
what is the NPV? Ignore taxes.

a. $ 4,300
b. $12,700
c. $11,000
d. $17,000
Net Present Value (NPV)
Question
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Savak Company can buy a new machine for
$96,000 that will save $20,000 cash per year in
operating costs. If the machine has a useful life of
10 years and Savaks required return is 12 percent,
what is the NPV? Ignore taxes.

a. $ 4,300
b. $12,700
c. $11,000
d. $17,000
Using the present value of an annuity (table 2)
PV of inflows = $20,000 5.650 = $113,000
NPV = $113,000 - $96,000 = $17,000
Net Present Value (NPV)
Question
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Calculate the NPV if Savak Companys required
return is 15 percent instead of 12 percent.


Note that the NPV is smaller
using the larger interest rate.
Using the present value of an annuity (table 2)
PV of inflows = $20,000 5.019 = $100,380
NPV = $100,380 - $96,000 = $4,380
Net Present Value (NPV)
Question
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Now that you have mastered the basic
concept of net present value, its time
for a more sophisticated checkup!
Lets return to Stars Stadium.
Net Present Value (NPV)
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Stars Stadium is considering purchasing
vending machines with a 5-year life.
Cost and revenue information
Cost of vending machines $ 75,000
Revenue 84,375 $
Cost of goods sold 50,625
Gross profit 33,750 $
Cash operating costs 3,350 $
Depreciation 14,000 17,350
Pretax income 16,400 $
Income tax 6,400
After-tax income 10,000 $
($75,000 - $5,000) 5 years
Evaluating Capital Investment
Proposals: An Illustration
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Most capital budgeting techniques use
annual net cash flow.

Depreciation is not a cash outflow.
Annual net income 10,000 $
Add annual depreciation 14,000
Annual net cash flow 24,000 $
Evaluating Capital Investment
Proposals: An Illustration
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Stars Stadium Net Present Value Analysis

Year(s) Cash Flow PV factor PV
Vending mach. Now (75,000) $ 1.000 (75,000) $
Stars uses a 15% discount rate.
Net Present Value (NPV)
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Year(s) Cash Flow PV factor PV
Vending mach. Now (75,000) $ 1.000 (75,000) $
Annual inflow 1 - 5 24,000 3.352 80,448
Present value of an annuity of $1
factor for 5 years at 15%.
Stars Stadium Net Present Value Analysis
$24,000 3.352 = $80,448
Net Present Value (NPV)
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Year(s) Cash Flow PV factor PV
Vending mach. Now (75,000) $ 1.000 (75,000) $
Annual inflow 1 - 5 24,000 3.352 80,448
Salvage 5 5,000 0.497 2,485
Present value of $1
factor for 5 years at 15%.
Stars Stadium Net Present Value Analysis
Net Present Value (NPV)
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Since the NPV is positive, we know the rate of return is
greater than the 15 percent discount rate.

Year(s) Cash Flow PV factor PV
Vending mach. Now (75,000) $ 1.000 (75,000) $
Annual inflow 1 - 5 24,000 3.352 80,448
Salvage 5 5,000 0.497 2,485
NPV Now 7,933
Stars Stadium Net Present Value Analysis
Net Present Value (NPV)
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Lets use NPV
concepts with
an asset
replacement
decision.
Net Present Value (NPV)
Replacing Assets
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The Maine LobStars are considering replacing an old bus
with a new bus, each with a 5-year life and zero salvage.
Cost and savings information
Cost of new bus $ 65,000
Book value of old bus $ 25,000
Current value of old bus 10,000
Loss if old bus sold $ 15,000
Annual savings of new bus 12,000 $
Depreciation - new bus 13,000 $
old bus 5,000 8,000
Increase in taxable income 4,000 $
Tax @ 40% 1,600
After-tax income 2,400 $
Evaluating Capital Investment
Proposals: An Illustration
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Depreciation is not a cash outflow.
Annual net income 2,400 $
Add increased depreciation 8,000
Annual net cash flow 10,400 $
Tax savings from loss on
disposal of old bus:

$15,000 40% = $6,000
Evaluating Capital Investment
Proposals: An Illustration
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Year(s) Cash Flow PV factor PV
New bus Now (65,000) $ 1.000 (65,000) $
LobStars Bus Net Present Value Analysis,
using a 15 percent discount rate.
Net Present Value (NPV)
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Year(s) Cash Flow PV factor PV
New bus Now (65,000) $ 1.000 (65,000) $
Annual inflow 1 - 5 10,400 3.352 34,861
LobStars Bus Net Present Value Analysis,
using a 15 percent discount rate.
Net Present Value (NPV)
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Year(s) Cash Flow PV factor PV
New bus Now (65,000) $ 1.000 (65,000) $
Annual inflow 1 - 5 10,400 3.352 34,861
Old bus sale Now 10,000 1.000 10,000
LobStars Bus Net Present Value Analysis,
using a 15 percent discount rate.
Net Present Value (NPV)
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Since the NPV is negative, we know the rate of return
is less than the 15 percent discount rate.

Year(s) Cash Flow PV factor PV
New bus Now (65,000) $ 1.000 (65,000) $
Annual inflow 1 - 5 10,400 3.352 34,861
Old bus sale Now 10,000 1.000 10,000
Tax savings 1 6,000 0.870 5,220
NPV Now (14,919) $
LobStars Bus Net Present Value Analysis,
using a 15 percent discount rate.
Net Present Value (NPV)
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Capital budgeting involves many estimates.
Estimates may be pessimistic or optimistic.
Uncertainty about the future may impact
estimates.
Behavioral Issues
in Capital Budgeting
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Conflicts may exist between short-run
performance measures and long-run capital
budgeting criteria.
Behavioral Issues
in Capital Budgeting
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A follow-up after the project has been
approved to see whether or not expected
results are actually realized.
Capital Budget Audit
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End of Chapter 26