Chapter

14
Capital Budgeting
Decisions
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LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Evaluate the acceptability of an investment
project using the net present value method.
2. Evaluate the acceptability of an investment
project using the internal rate of return method.
3. Determine the payback period for an
investment.
4. Compute the simple rate of return for an
investment.

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 14-3

Capital Budgeting

Describes how managers plan significant

outlays on projects that have long-term
implications such as the purchase of new
equipment and introduction of new products.

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 14-4

Typical Capital Budgeting Decisions

Plant expansion

Equipment selection Equipment replacement

Lease or buy Cost reduction

Cost reduction Lease or buy

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 14-5

Time Value of Money

 The idea that money
available at the present time
is worth more than the same
amount in the future due to
its potential earning
capacity. This core principle
of finance holds that,
provided money can earn
interest, any amount of
money is worth more the
sooner it is received.
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 14-6

Time Value of Money

A bond will pay $100 in two years. What is

the present value of the $100 if an investor
can earn a return of 12% on the
investment?

We can determine the present value

factor using the formula or using
present value tables.

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 14-7

Time Value of Money

Excerpt from Present Value of $1 Table in

Appendix C of Chapter 14
Rate
Periods 10% 12% 14%
1 0.909 0.893 0.877
2 0.826 0.797 0.769
3 0.751 0.712 0.675
4 0.683 0.636 0.592
5 0.621 0.567 0.519

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 14-8

Time Value of Money

$100 × 0.797 = $79.70 present value

Rate
Periods 10% 12% 14%
1 0.909 0.893 0.877
2 0.826 0.797 0.769
3 0.751 0.712 0.675
4 0.683 0.636 0.592
5 0.621 0.567 0.519

Present value factor of $1 for 2 periods at 12%.

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 14-9

Time Value of Money

An investment that involves a series of

identical cash flows at the end of each year
is called an annuity.

$100 $100 $100 $100 $100 $100

1 2 3 4 5 6

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 14-10

Time Value of Money

Lacey Company purchased a tract of land

on which a $60,000 payment will be due
each year for the next five years. What is
the present value of this stream of cash
payments when the discount rate is 12%?

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 14-11

Time Value of Money

We could solve the problem like this . . .

Look in Appendix C of this Chapter for the
Present Value of an Annuity of $1 Table

Periods 10% 12% 14%

1 0.909 0.893 0.877
2 1.736 1.690 1.647
3 2.487 2.402 2.322
4 3.170 3.037 2.914
5 3.791 3.605 3.433

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 14-12

Time Value of Money

We could solve the problem like this . . .

$60,000 × 3.605 = $216,300

Periods 10% 12% 14%

1 0.909 0.893 0.877
2 1.736 1.690 1.647
3 2.487 2.402 2.322
4 3.170 3.037 2.914
5 3.791 3.605 3.433

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 14-13

Recovery of the Original Investment

St. Joseph Hospital is considering the purchase of an

attachment for its X-ray machine.

Cost $3,170
Life 4 years
Salvage value zero
Increase in annual cash flows 1,000

No investments are to be made unless they have

an annual return of at least 10%.

Should the hospital invest in the attachment?

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 14-14

Recovery of the Original Investment

Present
Value of
Amount of 10% Cash
Item Year(s) Cash Flow Factor Flows
Annual cash inflows 1-4 $ 1,000 3.170 $ 3,170
Initial investment(outflow) Now (3,170) 1.000 (3,170)
Net present value $ -0-

Periods 10% 12% 14%

1 0.909 0.893 0.877 Present value
2 1.736 1.690 1.647
3 2.487 2.402 2.322
of an annuity
4 3.170 3.037 2.914 of $1 table
5 3.791 3.605 3.433

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 14-15

Recovery of the Original Investment

Present
Value of
Amount of 10% Cash
Item Year(s) Cash Flow Factor Flows
Annual cash inflows 1-4 $ 1,000 3.170 $ 3,170
Initial investment(outflow) Now (3,170) 1.000 (3,170)
Net present value $ -0-

Because the net present value is equal to zero,

the attachment investment provides exactly
a 10% return.

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 14-16

Choosing a Discount Rate

 The firm’s cost of capital is

usually regarded as the most
appropriate choice for the
discount rate.
 The cost of capital is the
average rate of return the
company must pay to its long-
term creditors and
shareholders for the use of
their funds.

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 14-17

The Net Present Value Method

To determine net present value we . . .

Calculate the present value of cash inflows,
Calculate the present value of cash
outflows,
Subtract the present value of the outflows
from the present value of the inflows.

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 14-18

The Net Present Value Method

General decision rule . . .
If the Net Present
Value is . . . Then the Project is . . .
Acceptable, since it promises a
Positive . . . return greater than the required
rate of return.

Acceptable, since it promises a

Zero . . . return equal to the required rate
of return.

Not acceptable, since it promises

Negative . . . a return less than the required
rate of return.
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 14-19

The Net Present Value Method

Let’s look at
how we use
present value to
make business
decisions.

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 14-20

The Net Present Value Method

Lester Company has been offered a five-year contract
to provide component parts for a large
manufacturer.

Cost and revenue information

Cost of special equipment $160,000
Working capital required 100,000
Relining equipment in 3 years 30,000
Salvage value of equipment in 5 years 5,000
Annual cash revenue and costs:
Sales revenue from parts 750,000
Cost of parts sold 400,000
Salaries, shipping, etc. 270,000
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 14-21

The Net Present Value Method

 At the end of five years the working capital

will be released and may be used
elsewhere by Lester.
 Lester Company uses a discount rate of
10%.

Should the contract be accepted?

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 14-22

The Net Present Value Method

Annual net cash inflows from operations

Sales revenue $ 750,000

Cost of parts sold (400,000)
Salaries, shipping, etc. (270,000)
Annual net cash inflows $ 80,000

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 14-23

The Net Present Value Method

Cash 10% Present
Years Flows Factor Value
Investment in equipment Now $ (160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)

Net present value

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 14-24

The Net Present Value Method

Cash 10% Present
Years Flows Factor Value
Investment in equipment Now $ (160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1-5 80,000 3.791 303,280

Net present value

Present value of an annuity of $1

factor for 5 years at 10%.

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 14-25

The Net Present Value Method

Cash 10% Present
Years Flows Factor Value
Investment in equipment Now $ (160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1-5 80,000 3.791 303,280
Relining of equipment 3 (30,000) 0.751 (22,530)

Net present value

Present value of $1
factor for 3 years at 10%.

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 14-26

The Net Present Value Method

Cash 10% Present
Years Flows Factor Value
Investment in equipment Now $ (160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1-5 80,000 3.791 303,280
Relining of equipment 3 (30,000) 0.751 (22,530)
Salvage value of equip. 5 5,000 0.621 3,105

Net present value

Present value of $1
factor for 5 years at 10%.

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 14-27

The Net Present Value Method

Cash 10% Present
Years Flows Factor Value
Investment in equipment Now $ (160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1-5 80,000 3.791 303,280
Relining of equipment 3 (30,000) 0.751 (22,530)
Salvage value of equip. 5 5,000 0.621 3,105
Working capital released 5 100,000 0.621 62,100
Net present value $ 85,955

Accept the contract because the project

has a positive net present value.

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 14-28

The Internal Rate of Return Method

 The internal rate of return is the interest

yield promised by an investment project
over its useful life.
 The internal rate of return is computed by
finding the discount rate that will cause
the net present value of a project to be
zero.

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 14-29

The Internal Rate of Return Method

 Decker Company can purchase a new

machine at a cost of $104,320 that will save
$20,000 per year in cash operating costs.
 The machine has a 10-year life.

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 14-30

The Internal Rate of Return Method

Future cash flows are the same every year in

this example, so we can calculate the
internal rate of return as follows:

PV factor for the Investment required

=
internal rate of return Net annual cash flows

$104, 320
=
$20,000

= 5.216

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 14-31

The Internal Rate of Return Method

Using the present value of an annuity of $1 table . . .
Find the 10-period row, move
across until you find the factor
5.216. Look at the top of the column
and you find a rate of 14%.

Periods 10% 12% 14%

1 0.909 0.893 0.877
2 1.736 1.690 1.647
. . . . . . . . . . . .
9 5.759 5.328 4.946
10 6.145 5.650 5.216

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The Internal Rate of Return Method

 Decker Company can purchase a new

machine at a cost of $104,320 that will save
$20,000 per year in cash operating costs.
 The machine has a 10-year life.

The internal rate of return on

this project is 14%.

If the internal rate of return is equal to or

greater than the company’s required rate of
return, the project is acceptable.
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 14-33

Least Cost Decisions

In decisions where revenues are not

directly involved, managers should
choose the alternative that has the least
total cost from a present value
perspective.

Let’s look at the Home Furniture Company.

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 14-34

Least Cost Decisions

 Home Furniture Company is trying to decide

whether to overhaul an old delivery truck
now or purchase a new one.
 The company uses a discount rate of 10%.

Home
Furniture

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 14-35

Least Cost Decisions

Here is information about the trucks . . .
Old Truck
Overhaul cost now $ 4,500
Annual operating costs 10,000
Salvage value in 5 years 250
Salvage value now 9,000

New Truck
Purchase price $ 21,000
Annual operating costs 6,000
Salvage value in 5 years 3,000
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 14-36

Least Cost Decisions

Buy the New Truck
Cash 10% Present
Year Flows Factor Value
Purchase price Now $(21,000) 1.000 $ (21,000)
Annual operating costs 1-5 (6,000) 3.791 (22,746)
Salvage value of old truck Now 9,000 1.000 9,000
Salvage value of new truck 5 3,000 0.621 1,863
Net present value (32,883)

Keep the Old Truck

Cash 10% Present
Year Flows Factor Value
Overhaul cost Now $ (4,500) 1.000 $ (4,500)
Annual operating costs 1-5 (10,000) 3.791 (37,910)
Salvage value of old truck 5 250 0.621 155
Net present value (42,255)

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Least Cost Decisions

Home Furniture should purchase the

new truck.
Net present value of costs
associated with purchase
of new truck $(32,883)
Net present value of costs
associated with remodeling
existing truck (42,255)
Net present value in favour of
purchasing the new truck $ 9,372

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 14-38

Other Approaches to
Capital Budgeting Decisions
Other methods of making capital budgeting
decisions include . . .
The Payback Method.
Simple Rate of Return.

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 14-39

The Payback Method

The payback period is the length of time

that it takes for a project to recover its
initial cost out of the cash receipts
that it generates.
 When the net annual cash inflow is the same
each year, this formula can be used to
compute the payback period:
Investment required
Payback period =
Net annual cash inflow

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 14-40

The Payback Method

 Management at The Daily Grind wants to
install an espresso bar in its restaurant.
 The espresso bar:
Costs $140,000 and has a 10-year life.
Will generate net annual cash inflows of
$35,000.
 Management requires a payback period of 5
years or less on all investments.
What is the payback period for the
espresso bar?
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 14-41

The Payback Method

Investment required
Payback period =
Net annual cash inflow

$140,000
Payback period = $ 35,000

Payback period = 4.0 years

According to the company’s criterion,

management would invest in the
espresso bar because its payback
period is less than 5 years.
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 14-42

Evaluation of the Payback Method

Ignores the
time value
of money.

Short-comings
of the Payback
Period. Ignores cash
flows after
the payback
period.

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 14-43

The Simple Rate of Return Method

 Does not focus on cash flows -- rather it

focuses on accounting income.
 The following formula is used to calculate
the simple rate of return:
Incremental Incremental expenses,
-
Simple rate revenues including amortization
of return =
Initial investment

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 14-44

The Simple Rate of Return Method

 Management of The Daily Grind wants to install
an espresso bar in its restaurant.
 The espresso bar:
 Cost $140,000 and has a 10-year life.
 Will generate incremental revenues of $100,000
and incremental expenses of $65,000 including
amortization.
What is the simple rate of return on the
investment project?

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 14-45

The Simple Rate of Return Method

Simple rate $100,000 - $65,000

= = 25%
of return $140,000

The simple rate of return method

is not recommended for a variety
of reasons, the most important
one being that it ignores the time
value of money.

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