Chapter

25 Capital Budgeting

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 Capital Investment Decisions

Outcome Investment involves a

is uncertain. long-term commitment.

Capital budgeting:
Analyzing alternative long-
term investments and deciding
which assets to acquire or sell.

Decision may be Large amounts of

difficult or impossible money are usually
to reverse. involved.
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 Capital Investment Decisions
I will choose the
project with the most
profitable return on
available funds. Plant
Expansion
?
Limited
New
Investment ? Equipment
Funds
?
Office
Renovation
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 Capital Investment Decisions:
Typical Cash Outflows

Repairs and Initial

maintenance investment

Incremental
operating
costs

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 Capital Investment Decisions:
Typical Cash Inflows

Salvage Cost
value savings

Incremental
revenues

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 Capital Investment Decisions:
Nonfinancial Considerations

Employee working conditions

Environmental concerns Corporate image

Employee morale Product quality

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 Evaluating Capital Investment
Proposals: An Illustration
Let’s look at
methods used
to make capital
investment
decisions.

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 Evaluating Capital Investment
Proposals: An Illustration
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

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($75,000 - $5,000) ÷ 5 years © The McGraw-Hill Companies, Inc., 2002
 Evaluating Capital Investment
Proposals: An Illustration
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

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 Payback Period

The payback period of an investment

is the time expected to recover
the initial investment amount.

Payback Cost of Investment

=
period Annual Net Cash Flow

Managers prefer investing in projects

with shorter payback periods.
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 Payback Period

The payback period of an investment

is the time expected to recover
the initial investment amount.

Payback Cost of Investment

=
period Annual Net Cash Flow
Payback $75,000
= = 3.125 years
period $24,000
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 Payback Period

Ignores the
time value
of money.

Ignores cash
flows after
the payback
period.

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 Payback Period
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?
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 Return on Average Investment
(ROI)
ROI focuses on annual income
instead of cash flows.

Average estimated net income

ROI =
Average investment

Original cost + Salvage value

2

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 Return on Average Investment
(ROI)
ROI focuses on annual income
instead of cash flows.

$10,000
ROI = = 25%
$40,000

$75,000 + $5,000
2

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 Return on Average Investment
(ROI)
So why
 Income may vary would I ever
from year to year. want to use
this method
 Time value of anyway?
money is ignored.

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 Discounting Future Cash Flows
Now let’s look at a capital budgeting
model that considers the time value of
cash flows.

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 Net Present Value (NPV)

A comparison of the present value of cash

inflows with the present value of cash
outflows

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 Net Present Value (NPV)
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 = –
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 Net Present Value (NPV)
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

Negative . . . promises a return less than the
required rate of return.

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 Net Present Value (NPV)
Question
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 Savak’s required return is 12 percent,
what is the NPV? Ignore taxes.

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

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

Note that the NPV is smaller

using the larger interest rate.

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 Net Present Value (NPV)
Now that you have mastered the basic
concept of net present value, it’s time
for a more sophisticated checkup!
Let’s return to Stars’ Stadium.

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 Evaluating Capital Investment
Proposals: An Illustration
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

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($75,000 - $5,000) ÷ 5 years © The McGraw-Hill Companies, Inc., 2002
 Evaluating Capital Investment
Proposals: An Illustration
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

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 Net Present Value (NPV)
Star’s 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.

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 Net Present Value (NPV)
Star’s Stadium Net Present Value Analysis

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%.

$24,000 × 3.352 = $80,448

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 Net Present Value (NPV)
Star’s Stadium Net Present Value Analysis

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%.
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 Net Present Value (NPV)
Star’s Stadium Net Present Value Analysis

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

Since the NPV is positive, we know the rate of return is

greater than the 15 percent discount rate.
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 Net Present Value (NPV)
Replacing Assets

Let’s use NPV

concepts with
an asset
replacement
decision.

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 Evaluating Capital Investment
Proposals: An Illustration
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
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 Evaluating Capital Investment
Proposals: An Illustration
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

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 Net Present Value (NPV)
LobStar’s Bus Net Present Value Analysis,
using a 15 percent discount rate.
Year(s) Cash Flow PV factor PV
New bus Now $ (65,000) 1.000 $ (65,000)

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 Net Present Value (NPV)
LobStar’s Bus Net Present Value Analysis,
using a 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

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 Net Present Value (NPV)
LobStar’s Bus Net Present Value Analysis,
using a 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

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 Net Present Value (NPV)
LobStar’s Bus Net Present Value Analysis,
using a 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)

Since the NPV is negative, we know the rate of return

is less than the 15 percent discount rate.
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 Behavioral Issues
in Capital Budgeting
Capital budgeting involves many estimates.
 Estimates may be pessimistic or optimistic.
 Uncertainty about the future may impact estimates.

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 Behavioral Issues
in Capital Budgeting
Conflicts may exist between short-run
performance measures and long-run capital
budgeting criteria.

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 Capital Budget Audit
A follow-up after the project has been
approved to see whether or not expected
results are actually realized.

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 THE END

I told you that’s the end. You

can’t work any more accounting
problems in my class!

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