Chapter The Capital

Budgeting Decision
12
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline
• The Capital budgeting decision
• Cash flows in Capital budgeting
• Payback method
• Net Present Value and Internal rate of
Return
• Discount or cutoff rate as Cost of Capital

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 Capital Budgeting Decision –
Administrative Considerations
• Involves planning of expenditures for a project with
a minimum period of a year or longer
• Capital expenditure decision requires:
– Extensive planning
– Coordination of different departments
• These decisions would be affected because of
uncertainties involved in:
– Annual costs and inflows
– Product life
– Interest rates
– Economic conditions
– Technological changes
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 Capital Budgeting Decision –
Administrative Considerations (cont’d)
• Steps in the decision-making process:
– Search for and discovery of investment
opportunities
– Collection of data
– Evaluation and decision making
– Reevaluation and adjustment

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Capital Budgeting Procedures

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 Accounting Flows versus
Cash Flows
• In capital budgeting decisions, emphasis is
on cash flows rather than earnings
– Depreciation (noncash expenditure) is added
back to profit to determine the amount of cash
flow generated
• Example provided in the following slide
• Emphasis is on use of proper evaluation
techniques to make best economic choices
and assure long term wealth maximization
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Cash Flow and Revised Cash Flow
for Alston Corporation

Net earnings before and after taxes are zero, but the company has $20,000
cash in the bank
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 Methods of Ranking
Investment Proposals
• Three methods used:
– Payback method
– Internal rate of return
– Net present value

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 Payback Method
• Time required to recoup initial investment from
Table 12-3:
– Investment A is better
– Investment A recoups $10,000 Initial Investment at the
end of the second year, while Investment B takes longer

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 Payback Method (cont’d)
• Advantages:
– Easy to understand
– Emphasizes liquidity
– Useful in industries characterized by dynamic
technological developments
• Shortcomings:
– Does not consider Time Value of Money
– Ignores cash-flows after the cutoff period
• Fails to discern optimum or most economic solution to
capital budgeting problem

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 Internal Rate of Return (Even Cash-
Flows)
• Requires the determination of the yield on an
investment that equates the cash outflows (cost) of
an investment with subsequent cash inflows
– Assuming that a $1,000 investment returns an annuity of
$244 per annum for five years
– Provides an internal rate of return of 7% as indicated:

(Investment) = $1,000 = 4.1 (PVIFA)

(Annuity) $244

• The present value of an annuity (given in Appendix D) shows

that the factor of 4.1 for five years indicates a yield of 7%
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 Internal Rate of Return - Uneven
Cash-Flows
Cash Inflows (of $10,000 investment)
Year Investment A Investment B
1……………… $5,000 $1,500
2……………… 5,000 2,000
3……………… 2,000 2,500
4……………… 5,000
5……………… 5,000

• To find a beginning value to start the first trial, the inflows are averaged
out as though annuity was really being received
$5,000
5,000
2,000
$12,000 ÷ 3 = $4,000
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 Internal Rate of Return - Uneven
Cash-Flows (cont’d)
• Dividing the investment by the ‘assumed’ annuity value in the previous
step, we have:
(Investment) = $10,000 = 2.5 (PVIFA)
(Annuity) $4,000
• The first approximation (derived from Appendix D) of the internal rate of
return using:
PVIFA factor = 2.5
n (period) = 3

• The factor falls between 9 and 10 percent

• Averaging would either understate or overstate the IRR by moving the

cash-flows either to the end or beginning of the project

• Cash flows in early years are worth more and increase the return

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 Internal Rate of Return - Uneven
Cash-Flows (cont’d)
• Using the trial and error approach, we use both 10% and 12% to arrive at the
answer:
Year 10%
1…….$5,000 X 0.909 = $4,545
2…….$5,000 X 0.826 = 4,130
3…….$2,000 X 0.751 = 1,502
$10,177
• At 10%, the present value of the inflows exceeds $10,000 – we therefore use a
higher discount rate

Year 12%
1…….$5,000 X 0.893 = $4,464
2…….$5,000 X 0.797 = 3,986
3…….$2,000 X 0.712 = 1,424
$9,874
• At 12%, the present value of the inflows is less than $10,000 – thus the discount
rate is too high

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 Interpolation of the Results
• The internal rate of return is determined when the present value of the
inflows (PVI) equals the present value of the outflows (PVO)
• The total difference in present values between 10% and 12% is $303

$10,177…… PVI @ 10% $10,177…….PVI @ 10%

- 9,874…....PVI @ 12% - 10,000……(cost)
$ 303 $ 177

• The solution is ($177/$303) percent of the way between 10 and 12

percent. Due to a 2% difference, the fraction is multiplied by 2% and the
answer is added to 10% for the final answer of:

10% + ($177/$303) (2%) = 11.17% IRR

• In Investment B the same process will yield an answer of 14.33

percent.
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 Interpolation of the Results (cont’d)
• Use of internal rate of return requires calculated selection of Investment
B in preference to Investment A, the conclusion being exactly the
opposite under the payback method
• The final selection of any project will also depend on yield exceeding
some minimum cost standard, such as cost of capital to the firm

Investment A Investment B Selection

Payback
method……. 2 years 3.8 years Quicker payback: “A”
Internal
Rate of
Return……… 11.17% 14.33% Higher yield: ”B”

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 Net Present Value
• Discounting back the inflows over the life of
the investment to determine whether they
equal or exceed the required investment
– Basic discount rate is usually the cost of the
capital to the firm
– Inflows must provide a return that at least equals
the cost of financing those returns

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 Net Present Value (cont’d)
$10,000 Investment, 10% Discount Rate
Year Investment A Year Investment B
1……… $5,000 X 0.909 = $4,545 1………. $1,500 X 0.909 = $1,364
2……… $5,000 X 0.826 = 4,130 2………. $2,000 X 0.826 = 1,652
3……… $2,000 X 0.751 = 1,502 3………. $2,500 X 0.751 = 1,878
$10,177 4………. $5,000 X 0.683 = 3,415
5………. $5,000 X 0.621 = 3,105
$11,414

Present value of inflows…..$10,177 Present value of inflows…..$11,414

Present value of outflows - 10,000 Present value of outflows - 10,000
Net present value………… $ 177 Net present value…………...$1,414

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 Comparison of Capital Budgeting
Results
A summary of the various conclusions reached under the
three methods is presented in the following table:

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 Selection Strategy
• For a project to be potentially accepted:
– Profitability must equal or exceed cost of capital
– Projects that are mutually exclusive:
• Selection of one alternative will preclude selection of
any other alternative
– Projects that are not mutually exclusive:
• Alternatives that provide a return in excess of cost of
capital will be selected

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 Selection Strategy (cont’d)
• In the case of prior Investment A and B, assuming a capital of 10%,
Investment B would be accepted if the alternatives were mutually
exclusive, while both would clearly qualify if they were not so, as
depicted below:

• The IRR and NPV methods will call for the same decision with some
exceptions
• Two rules:
– If an investment has a positive NPV, its IRR will be in excess of the
cost of capital
– In certain limited cases, however, the two methods may give
different answers in selecting the best investment
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 Reinvestment Assumption
• IRR
– All inflows from a given investment can be reinvested at
the Internal Rate of Return (IRR)
– May be unrealistic to assume that reinvestment can
occur at a equally high rate
• NPV
– Makes the more conservative assumption that each
inflow can be reinvested at the cost of capital or discount
rate
– Allows for certain consistency as inflows from each
project are assumed to have the same investment
opportunity

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The Reinvestment Assumption –
IRR and NPV

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 Modified Internal Rate of Return
(MIRR)
• Combines reinvestment assumption of the
NPV method with the IRR method
• MIRR is the discount rate that equates the
terminal (final) value of the inflows with the
investment
• In terms of a formula :

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 Modified Internal Rate of Return
(cont’d)
• Assuming $10,000 produces the following inflows for the next three years:

• The cost of capital is 10%

• Determining the terminal value of the inflows at a growth rate equal to the
cost of capital:

• To determine the MIRR:

PVIF = PV = $10,000 = .641 (Appendix B)
FV $15,610

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 Modified Internal Rate of Return
(cont’d)
• Appendix B shows:
– For a tabular value of .641, the Yield or MIRR is
16 percent
– The conventional IRR computed would have
been 21 percent
• MIRR uses a more realistic assumption of
re-investment at the cost of capital

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 Capital Rationing
• Artificial constraint set on the usage of funds that
can be invested in a given period by Management
• Only those projects with the highest positive NPV
are accepted.
• Reasons for capital rationing:
– Fear of too much growth
– Hesitation to use external sources of financing
• Capital rationing can hinder a firm from achieving
maximum profitability

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 Net Present Value Profile
• A graphical representation of net present
value of a project at different discount rates
• To apply the NPV profile, the following
aspects need to be considered:
– NPV at a zero discount rate
– NPV as determined by a normal discount rate
(such as cost of capital)
– IRR for the project

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 Net Present Value Profile –
Graphic Representation

• Investment B is preferred as both NPV and IRR are higher

in case of Investment B as compared to Investment A
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 Net Present Value Profile
with Crossover

• Below the crossover point of 8.7% Investment B is preferred

• Above the crossover point of 8.7% Investment C is preferred
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 The Rules of Depreciation
• Assets are classified into nine categories to
determine allowable depreciation
– Each class is referred to as Modified
Accelerated Cost Recovery System (MACRS)
category
• Some references are also made to Asset
Depreciation Range (ADR), or the expected
physical life of the asset or class of assets

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 Categories for
Depreciation Write-Off

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 Depreciation Percentages
(Expressed in Decimals)
Table 12–9

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 Depreciation Schedule
Table 12–10

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 Actual Investment Decision -
Example
• Assumption:
– $50,000 depreciation (Table 12–10) of machinery with a six-year
productive life
– Produces an income of $18,500 for first three years before
deductions for depreciation and taxes
– In the last three years, income before depreciation and taxes will be
$12,000
– Corporate tax rate taken at 35% and cost of capital 10%
– For each year:
• The depreciation is subtracted from “Earnings before
depreciation and taxes” to arrive at Earnings before Taxes
• Taxes then subtracted to determine Earnings after Taxes
• Depreciation is added to earnings to arrive at Cash Flows
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Actual Investment Decision –
Example (cont’d)

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 Actual Investment Decision –
Example (cont’d)
Net present value analysis

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 The Replacement Decision
• Investment decision for new technology
• Includes several additions to the basic
investment situation
– The sale of the old machine
– Tax consequences
• Decision can be analyzed by:
– Total analysis of both old and new machines
– An incremental analysis of changes in cash-
flows between old and new machines
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 Sale of Old Asset
• The cash inflow from the sale of an old
asset is based on the sales price as well as
the related tax factors
– To determine these tax factors, the book value
of the old asset is compared with the sales
price to determine if there is a taxable gain or
loss
• If there is a loss, it can be written off against other
income for the corporation
• If there is a gain, it would be taxed at the
corporation’s normal tax rate
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Book Value of Old Asset and Net
Cost of New Asset

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 Incremental Depreciation Benefits
•Cash flow analysis on the basis of:
– Incremental gain in depreciation
– Related tax shield benefits
– Cost savings

Table 12–15

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 Cost Savings Benefits
Table 12–16

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 Present Value of the
Total Incremental Benefits

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 Elective Expensing
• Businesses can write-off certain tangible
properties in the purchased year for up to
$250,000 under the 2008 Economic
Stimulus Act
• Beneficial to small businesses:
– Allowance is phased out dollar for dollar when
total property purchases exceed $800,000 in a
year

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