1. Chapter 26
CAPITAL BUDGETING
Chapter 26: Capital Budgeting

2. To explain the nature of capital investment decisions.
Learning Objective
To explain the nature of capital investment decisions.
Learning objective number 1 is to explain the nature of capital investment decisions.
LO1

3. Capital Investment Decisions
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 budgeting: Analyzing alternative long- term investments and deciding which assets to acquire or sell.
Capital budgeting is the process of analyzing alternative long-term investments and deciding which assets to acquire or sell. Careful analysis is necessary as future outcomes of today’s investments may by very uncertain The amounts of money involved are usually large and the investment period is typically many years. Capital budgeting decisions often involve plant expansion issues, equipment selection, and equipment replacement.

4. Capital Investment Decisions
I will choose the project with the most profitable return on available funds. ?
Plant Expansion
New Equipment
Office Renovation
Limited Investment Funds
Most companies have limited amounts of capital to invest. Managers must select investment alternatives that promise the greatest returns on limited available capital.

5. Capital Investment Decisions: Typical Cash Outflows
Repairs and
maintenance
Initial
investment
Here are some typical cash outflows associated with a long-term investment.
The initial investment amount includes the purchase cost and all other current expenditures to get an asset ready for its intended use. As we use an asset, we have cash outflows for operating costs such as utilities and supplies. Repairs and maintenance expenditures are necessary to keep the asset in proper working order.
Incremental
operating
costs

6. Capital Investment Decisions: Typical Cash Inflows
Salvage
value
Cost
savings
Just as we have cash outflows from a typical long-term investment, we also have cash inflows.
We might expect to have some incremental revenues from increased business activity, and we might also experience some cost reductions from using the new, possibly more efficient assets. At the end of the investment’s useful life, we may receive salvage value back from scrap or the sale of the asset.
Incremental
revenues

7. To identify nonfinancial factors in capital investment decisions.
Learning Objective
To identify nonfinancial factors in capital investment decisions.
Learning objective number 2 is to identify nonfinancial factors in capital investment decisions.
LO2

8. Capital Investment Decisions: Nonfinancial Considerations
Employee working conditions
Environmental concerns
Corporate image
Employee morale
Product quality
In addition to choosing investment alternatives that provide the greatest financial returns, managers must often consider non-financial factors as they make capital budgeting decisions. When evaluating alternatives where the financial returns are similar, managers may find that non-financial considerations may provide the information necessary to make the best decision.

9. Learning Objective LO3 To evaluate capital investment proposals using:
Payback period
Return on investment
Discounted cash flows
Learning objective number 3 is to evaluate capital investment proposals using:
Payback period
Return on investment
Discounted cash flows
LO3

10. Evaluating Capital Investment Proposals: An Illustration
Stars’ Stadium is considering purchasing vending machines with a 5-year life.
Stars’ Stadium is considering an investment in vending machines that will cost $75,000, and is projected to provide an after-tax annual income of $10,000. The vending machines have a five-year life with a $5,000 salvage value. Using the straight-line depreciation method, we see that depreciation is $14,000 per year.
($75,000 - $5,000) ÷ 5 years

11. Evaluating Capital Investment Proposals: An Illustration
Most capital budgeting techniques use annual net cash flow.
Depreciation is not a cash outflow.
The payback period method and the net present value method use annual cash flow in the capital budgeting analysis. Since depreciation is an expense that does not require a cash outflow, we add it back to net income to get the annual net cash flow from the investment.

12. Managers prefer investing in projects with shorter payback periods.
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
The payback period is the length of time it takes a project to recover its initial cost. When the annual net cash inflows are equal in each year, we can calculate the payback period by dividing the investment required, by the net annual cash inflows. All other things equal, a shorter payback period is better than a longer payback period.
Managers prefer investing in projects with shorter payback periods.

13. Payback Period
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
Part I
Recall that the vending machines cost $75,000, and the annual net cash inflow from the machines is $24,000. Let’s calculate the payback period for the new machine.
Part II
Because the net annual cash inflows are the same each year, we can calculate the payback period easily by dividing the machines’ cost by their annual net cash flows. The payback period is years. The vending machines will return their original cost in annual net cash flows in years, less than their expected five-year useful life.
Management at Stars’ Stadium may have an investment decision rule such as: invest only in projects with a payback period of four years or less. If so, they would invest in the new machines because the payback period is less than four years.
Payback
period =
$75,000
$24,000
= years

14. Payback Period Ignores the time value of money. Ignores cash
flows after
the payback
period.
There are several short-comings of the payback method. First, and foremost, the method ignores the time value of money. Second, it ignores any cash inflows after the payback period. For these reasons we would probably want to use the more sophisticated net present value method on projects requiring a significant commitment of company resources. We will discuss net present value later in the chapter.

15. Payback Period
Consider two projects, each with a five-year life and each costing $6,000.
This example illustrates the shortcomings of the payback method. Calculate the payback period for each investment. Did you find that Project One has the shorter payback period? Would you select Project One or would you select Project Two and patiently wait for the $1,000,000 cash flow?
Would you invest in Project One just because it has a shorter payback period?

16. Return on Average Investment (ROI)
ROI focuses on annual income instead of cash flows.
ROI =
Average estimated net income Average investment
The return on average investment method uses accounting income rather than cash flows. We calculate the return on average investment by dividing annual after-tax net income by the average investment in assets used to generate the annual after-tax net income. The average investment in assets is the sum of the original cost in the first year plus the salvage value in the last year, divided by two.
Original cost + Salvage value 2

17. Return on Average Investment (ROI)
ROI focuses on annual income instead of cash flows.
ROI = = 25%
$10,000 $40,000
Let’s return to the Stars’ Stadium example. The vending machines cost $75,000 and are expected to produce annual after-tax income of $10,000.
Since the original cost for the new machine is $75,000 and the salvage value is $5,000, the average investment is the sum of $75,000 and $5,000 divided by two.
Now we can compute the return on average investment. Dividing annual after-tax net income of $10,000 by the average investment of $40,000 results in a return on average investment of 25 percent.
$75, $5,000 2

18. Return on Average Investment (ROI)
Income may vary from year to year.
Time value of money is ignored.
So why
would I ever want to use this method anyway?
The accounting rate of return has just as many shortcomings as the payback period method. In addition to ignoring the time value of money, the accounting rate of return is affected by the choice of depreciation methods and potential variations in income from year to year.

19. Discounting Future Cash Flows
Now let’s look at a capital budgeting model that considers the time value of cash flows.
Decisions that will impact operations over a long period should recognize the time value of money. Investments that promise early returns are preferable to those that promise later returns because of the time value of money. In other words, a dollar that we receive relatively soon is more valuable than a dollar we are to receive at some distant time. Net present value considers the time value of money. We will use cash flows with the net present value method instead of accounting income.

20. Net Present Value (NPV)
A comparison of the present value of cash inflows with the present value of cash outflows
Net present value is the present value of future cash inflows less the present value of future cash outflows. We find the present value of future cash flows using an interest rate referred to as the required rate of return. The process of computing the present value of future cash flows is call discounting future cash flows.

21. 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 = –
To find the net present value of an investment, we first chose an interest rate, referred to as the required rate of return. It is the minimum acceptable rate of return on investment alternatives. Second, we use the required rate of return to calculate the present value of future cash inflows over the life of the investment. Third, we repeat step two for cash outflows. Net present value is the present value of future cash inflows less the present value of future cash outflows.

22. 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
Here’s the question. The investment has one cash outflow, its initial cost, and it has a series of cash inflows, the $20,000 per year annual savings.

23. 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
Using the present value of an annuity (Exhibit 26-4)
PV of inflows = $20,000 × = $113,000
NPV = $113,000 - $96,000 = $17,000
The $20,000 cost savings is an annuity that occurs each year over the next 10 years. We must compute the present value of the annuity using the present value of an annuity table at 10 years and 12 percent. We find the present value of an annuity interest factor in Exhibit 26-4 of your textbook and multiply it times $20,000 to find the present value of $113,000. The $96,000 initial cost of the new machine is a present value amount. Net present value is the present value of cash inflows, $113,000, less the $96,000 cost of the investment. Since the net present value is positive, we know that the return on the new machine is greater than the required return of 12 percent. We should invest.

24. 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 (Exhibit 26-4)
PV of inflows = $20,000 × = $100,380
NPV = $100,380 - $96,000 = $4,380
Part I
Let’s see what happens to the net present value if the required return is higher than 12 percent. We will repeat the computation using a required return of 15 percent.
Part II
The net present value is again positive, so we know that the return on the new machine is greater than the required return of 15 percent. We should invest.
Note that the net present value of $4,380 is smaller than the net present value when the required return was 12 percent. If we continue to increase the required return, eventually the net present value would be negative, indicating that we should not invest.
Note that the NPV is smaller using the larger interest rate.

25. 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.
Let’s return to the Stars’ Stadium example and use net present value to see if we should invest in the vending machines

26. Evaluating Capital Investment Proposals: An Illustration
Stars’ Stadium is considering purchasing vending machines with a 5-year life.
Here is the original information from Stars’ Stadium that we will use.
Stars’ Stadium is considering an investment in vending machines that will cost $75,000, and is projected to provide an after-tax annual income of $10,000. The vending machines have a five-year life with a $5,000 salvage value. Using the straight-line depreciation method, we see that depreciation is $14,000 per year.
($75,000 - $5,000) ÷ 5 years

27. Evaluating Capital Investment Proposals: An Illustration
Most capital budgeting techniques use annual net cash flow.
Depreciation is not a cash outflow.
The net present value method uses annual cash flow in the capital budgeting analysis. Since depreciation is an expense that does not require a cash outflow, we add it back to net income to get the annual net cash flow from the investment.

28. Net Present Value (NPV)
Stars’ Stadium Net Present Value Analysis
Stars requires all investment proposals to return a minimum of 15 percent. The $75,000 initial cost of the new machine is a present value amount. It occurs now, as indicated in the table on your screen.
Note that we have placed this number in parentheses to indicate that it is a cash outflow.
Stars uses a 15% discount rate.

29. Net Present Value (NPV)
Stars’ Stadium Net Present Value Analysis
The $24,000 annual net cash inflow is an annuity. When we look in the present value of an annuity table at fifteen percent for five years, we find the interest factor is We multiply times $24,000 to get the present value of the annuity which is $80,448.
Present value of an annuity of $1
factor for 5 years at 15%.
$24,000 × = $80,448

30. Net Present Value (NPV)
Stars’ Stadium Net Present Value Analysis
The $5,000 salvage value is a cash inflow that occurs once at the end of 5 years. When we look in the present value of $1 table at 15 percent for 5 years, we find the interest factor is We multiply times $5,000 to get the present value of the salvage which is $2,485.
Present value of $1
factor for 5 years at 15%.

31. Net Present Value (NPV)
Stars’ Stadium Net Present Value Analysis
Last we subtract the $75,000 initial cost from the present value of the two cash inflows to get the net present value of $7,933. Since the net present value is positive, we know that the rate of return on the vending machines is greater than the required return of 15 percent. We should invest.
Since the NPV is positive, we know the rate of return is greater than the 15 percent discount rate.

32. Learning Objective
To discuss the relationship between net present value and an investor’s required rate of return.
Learning objective number 4 is to discuss the relationship between net present value and an investor’s required rate of return.
LO4

33. Relationship Between NPV and the Required Rate of Return
General decision rule . . .
As a general rule, if the net present value is positive or zero, the project is acceptable since the promised return is equal to or greater than the required rate of return. When we have a negative net present value, the project is not acceptable. Let’s look at a question to see if we can compute net present value.

34. Net Present Value (NPV) Replacing Assets
Let’s use NPV concepts with an asset replacement decision.
Now let’s look at an example where we will use net present value to make an asset replacement decision.

35. 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.
The Main LobStars are considering replacing their old team bus with a new bus. The new bus costs $65,000, and it will have zero salvage value at the end of its five-year useful life. Dividing the cost of the new bus less zero salvage value by the five-year useful life results in annual depreciation of $13,000, which is $8,000 higher than the old bus depreciation.
The new bus is projected to provide annual savings before tax and depreciation of $12,000. If the new bus is acquired, the old bus can be sold for $10,000, resulting in a loss of $15,000.
Annual after-tax income is expected to increase by $2,400 over the five-year life of the new bus.
This example contains a lot of financial information. Study the numbers on your screen to make sure you have a firm grasp on this situation before advancing to the net present value analysis.

36. Evaluating Capital Investment Proposals: An Illustration
Depreciation is not a cash outflow.
The net present value method uses annual cash flow in the capital budgeting analysis. Since depreciation is an expense that does not require a cash outflow, we add it back to net income to get the $10,400 annual net cash flow from the investment.
The $15,000 loss on the sale of the old bus is tax deductible. Using a 40 percent tax rate, the loss creates a $6,000 tax savings in the year of sale.
Tax savings from loss on disposal of old bus:
$15,000 × 40% = $6,000

37. Net Present Value (NPV)
LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.
LobStars requires all investment proposals to return a minimum of 15 percent. The $65,000 initial cost of the new bus is a present value amount. It occurs now, as indicated in the table on your screen.
Note that we have placed this number in parentheses to indicate that it is a cash outflow.

38. Net Present Value (NPV)
LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.
The $10,400 annual net cash inflow is an annuity. When we look in the present value of an annuity table at 15 percent for 5 years, we find the interest factor is We multiply times $10,400 to get the present value of the annuity which is $34,861.

39. Net Present Value (NPV)
LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.
The $10,000 received from the sale of the old bus is a present value amount. It occurs now, as indicated in the table on your screen

40. Net Present Value (NPV)
LobStar’s Bus Net Present Value Analysis, using a 15 percent discount rate.
The $6,000 tax savings from the loss on sale of the old bus is a cash inflow that occurs once at the end of the first year when LobStars files a tax return. . When we look in the present value of one dollar table at 15 percent for one year, we find the interest factor is We multiply times $6,000 to get the present value of the tax savings which is $5,220.
Last we subtract the $65,000 cost from the present value of the three cash inflows to get the net present value that is a negative $14,919. Since the net present value is negative, we know that the rate of return on the new bus is less than the required return of 15 percent. We should not invest.
Since the NPV is negative, we know the rate of return is less than the 15 percent discount rate.

41. Learning Objective
To explain the behavioral issues involved in capital budgeting and identify how companies try to control the capital budgeting process.
Learning objective number 5 is to explain the behavioral issues involved in capital budgeting and identify how companies try to control the capital budgeting process.
LO5

42. Behavioral Issues in Capital Budgeting
Capital budgeting involves many estimates.
Estimates may be pessimistic or optimistic.
Uncertainty about the future may impact estimates.
The future is always uncertain and cash flow estimates used in capital budgeting analysis are uncertain. Those who provide the estimates may in some cases be overly optimistic and in other cases be overly pessimistic. If possible, it is helpful to obtain estimates from more than one source. Careful evaluation of cash flow estimates by seasoned and impartial managers is critical factor in the final choices among the investment alternatives.

43. Behavioral Issues in Capital Budgeting
Conflicts may exist between short-run performance measures and long-run capital budgeting criteria.
Capital budgeting involves the commitment of large sums of money for many years into the future. The objective is to enhance the long-run profitability and success of the business. Often, short-run performance measures could be improved with the funds required for the capital investments. Conflicts may occur when capital is limited and choices must be made to fund some alternatives and reject others.

44. Capital Budget Audit
A follow-up after the project has been approved to see whether or not expected results are actually realized.
Anytime we have an investment project that requires a significant commitment of company resources, it is essential to follow-up after the project has been approved and see if expected results are being realized. This task is usually the function of a group charged with post-audit project review.

45. Ethics, Fraud, and Corporate Governance
Public companies whose stock is traded on the New York Stock Exchange or on NASDAQ are required to maintain a code of business conduct and ethics.
Many companies provide training on their codes of conduct and ethics, and require employees to certify in writing on a yearly basis that they are in compliance with the code.
Public companies whose stock is traded on the New York Stock Exchange or on NASDAQ are required to maintain a code of business conduct and ethics.
Many companies provide training on their codes of conduct and ethics, and require employees to certify in writing on a yearly basis that they are in compliance with the code.

46. End of Chapter 26
End of Chapter 26.