1. Capabilities
1. Discuss the difficulty encountered in finding profitable projects in competitive markets and the importance of the search.
2. Determine whether or not a new project should be accepted or rejected using the payback period, the net present value, the profitability index, and the internal rate of return.
3. Explain how the capital-budgeting decision process changes when a dollar limit is placed on the dollar size of the capital budget.
4. Discuss the problems encountered in project ranking.
5. Explain the importance of ethical considerations in capital-budgeting decisions.
6. Discuss the trends in the use of different capital-budgeting criteria.

2. ●    Finding Profitable Projects
●    Capital-Budgeting Decision Criteria
●    Capital Rationing
●    Problems in Project Ranking—Capital Rationing, Mutually Exclusive Projects, and Problems with the IRR
●    Ethics in Capital Budgeting
A Glance at Actual Capital-Budgeting Practices

3. Objective 1 FINDING PROFITABLE PROJECTS
to evaluate profitable projects or investments in fixed assets, a process referred to as capital budgeting,
Axiom 5: The Curse of Competitive Markets—Why It’s Hard to Find Exceptionally Profitable Projects.

4. The payback period is the number of years needed to recover the initial cash outlay.

5. Objective 2 CAPITAL-BUDGETING DECISION CRITERIA
A B
Initial cash outlay －$10, －$10,000
Annual net cash inflows
Year $ 6, $ 5,000
, ,000 , , ,

6. Net Present Value
The net present value (NPV) of an investment proposal is equal to the present value of its annual net cash flows after taxes less the investment’s initial outlay.

7. NPV =
- IO

8. NPV ACFt = the annual after-tax cash flow in time period t .
k = the appropriate discount rate; that is, the required rate of return or cost of capital
IO = the initial cash outlay
n = the project’s expected life

9. Principal
NPV ≥ 0.0 : accept
NPV ＜ 0.0 : reject

10. NPV Illustration of Investment in New Machinery AFTER-TAX CASH FLOW
Inflow year ,000
,000
,000
,000
,000
Initial outlay －$40,000

11. Calculation for NPV Illustration of Investment in New Machinery
PRESENT VALUE
AFTER-TAX FACTOR AT PRESENT
CASH FLOW PERCENT VALUE
, ,158
, ,256
, ,632
, ,237
Initial outlay －40,000
Inflow year , $13,395
Present value of cash flows $ 47,678
Net present value $ 7,678

12. Profitability Index (Benefit-Cost Ratio)
The profitability index (PI), or benefit-cost ratio, is the ratio of the present value of the future net cash flows to the initial outlay.

13. PI =

14. ACFt = the annual after-tax cash flow in time
ACFt = the annual after-tax cash flow in time period t (this can take on either positive or negative values )
k = the appropriate discount rate; that is, the required rate of return or cost of capital
IO = the initial cash outlay
n = the project’s expected life

15. Principale
PI ≥ 1.0 : accept
PI ＜ 1.0 : reject

16. AFTER-TAX FACTOR AT PRESENT CASH FLOW 10 PERCENT VALUE
PRESENT VALUE
AFTER-TAX FACTOR AT PRESENT
CASH FLOW PERCENT VALUE
Inflow year , ,635
, ,608
, ,510
, ,196
, ,694
, ,024
Initial outlay －$50, －$50,000

17. =

18. Internal Rate of Return
The internal rate of return (IRR) the discount rate that equates the present value of the project’s future net cash flows with the project’s initial cash outlay.

19. IO =

20. IRR
ACFt = the annual after-tax cash flow in time period t (this can take on either positive or negative values )
IO = the initial cash outlay
n = the project’s expected life
IRR = the project’s internal rate of return

21. $45,555 =
$45,555 = ,000

22. $45,555 = $15,000 (PVIFA i , 4yr )
Dividing both sides by $15,000, this becomes
3.037 = PVIFA i, 4yr

23. IRR for Uneven Cash Flows
Present Value
Net Cash Flows Factor at 15 Percent Present Value
Inflow year $1, $ 870
Inflow year , ,512
Inflow year , ,974
Present value of inflows $ 4,356
Initial outlay －$ 3,817
2. TRY i = 20 PERCENT:

25. Present value of inflows $ 3,958 Initial outlay －$ 3,817
Net Cash Flows Factor at 20 Percent Present Value
Inflow year $1, $ 833
Inflow year , ,388
Inflow year , ,737
Present value of inflows $ 3,958
Initial outlay －$ 3,817
3. TRY i = 22 PERCENT:

26. Present value of inflows $ 3,817 Initial outlay －$ 3,817
Net Cash Flows Factor at 22 Percent Present Value
Inflow year $1, $ 820
Inflow year , ,344
Inflow year , ,653
Present value of inflows $ 3,817
Initial outlay －$ 3,817

27. Three IRR Investment A B C Initial outlay －$10,000 －$10,000 －$10,000
Inflow year , ,000
Inflow year , ,000
Inflow year , ,000
Inflow year , , ,000

28. 15% Inflow year 1 $1,000 .870 $ 870 Inflow year 2 3,000 .756 2,268
Present Value
Net Cash Flows Factor at 15 Percent Present Value
Inflow year $1, $ 870
Inflow year , ,268
Inflow year , ,948
Inflow year , ,004
Present value of inflows $11,090
Initial outlay －$ 10,000

29. Net Cash Flows Factor at 19 Percent Present Value
Inflow year $1, $ 840
Inflow year , ,118
Inflow year , ,558
Inflow year , ,493
Present value of inflows $10,009
Initial outlay －$ 10,000

31. Objective 4 1 Size disparity 2 Time disparity 3 Unequal live
PROBLEMS IN PROJECT RANKING-CAPITAL RATIONING, MUTUALLY EXCLUSIVE PROJECTS, AND PROBLEMS WITH THE IRR.
1 Size disparity
2 Time disparity
3 Unequal live

32. Capital-Rationing Example of Five Indivisible Projects
Project Initial Outlay Profitability Index Net Present Value
A $200, $280,000
B , ,000
C , ,000
D , ,000
E , ,000

33. Internal rate of return 88% 11% 99% Net present value 63% 22% 85%
Investment Evaluation A Primary A Secondary Total Using
Methods Used: Method Method This Method
Payback period % % %
Internal rate of return % % %
Net present value % % %
Profitability index % % %

34. Very small Up to $100,000 Plant Small $100,000 to $1 million Division
Project Size and Decision-Making Authority
Project Size Typical Boundaries Primary Decision Site
Very small Up to $100, Plant
Small $100,000 to $1 million Division
Medium $1 million to $10 million Corporate investment committee
Large Over $10 million CEO & board

35. KEY TERMS Benefit-Cost Ratio (see Profitability Index)
Capital Budgeting
Capital Rationing
Equivalent Annual Annuity (EAA)
Internal Rate of Return (IRR)
Mutually Exclusive Projects
Net Present Value (NPV)
Payback period
Profitability Index (PI or Benefit-Cost Ratio)