1. The Capital Budgeting Decision
Chapter 12
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 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

3. 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

4. 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

5. Capital Budgeting Procedures

6. 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

7. 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

8. Methods of Ranking Investment Proposals
Three methods used:
Payback method
Internal rate of return
Net present value

9. 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

10. 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

11. 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%

12. Internal Rate of Return - Uneven Cash-Flows
Cash Inflows (of $10,000 investment)
Year Investment A Investment B
1……………… $5, $1,500
2……………… , ,000
3……………… , ,500
4……………… ,000
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

13. 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

14. 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 %
1…….$5,000 X = $4,545
2…….$5,000 X = 4,130
3…….$2,000 X = 1,502
$10,177
At 10%, the present value of the inflows exceeds $10,000 – we therefore use a higher discount rate
Year %
1…….$5,000 X = $4,464
2…….$5,000 X = 3,986
3…….$2,000 X = 1,424
$9,874
At 12%, the present value of the inflows is less than $10,000 – thus the discount rate is too high

15. 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…… 10% 10%
- 12% ,000……(cost)
$ $
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%) = % IRR
In Investment B the same process will yield an answer of percent.

16. 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 years Quicker payback: “A”
Internal
Rate of
Return……… % % Higher yield: ”B”

17. 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

18. Net Present Value (cont’d)
$10,000 Investment, 10% Discount Rate
Year Investment A Year Investment B
1……… $5,000 X = $4, ………. $1,500 X = $1,364
2……… $5,000 X = 4, ………. $2,000 X = 1,652
3……… $2,000 X = 1, ………. $2,500 X = 1,878
$10, ………. $5,000 X = 3,415
5………. $5,000 X = 3,105
$11,414
Present value of inflows…..$10, Present value of inflows…..$11,414
Present value of outflows , Present value of outflows ,000
Net present value………… $ Net present value…………...$1,414

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

20. 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

21. 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

22. 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

23. The Reinvestment Assumption – IRR and NPV

24. 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 :

25. 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 = (Appendix B)
FV $15,610

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. Categories for Depreciation Write-Off

33. Depreciation Percentages (Expressed in Decimals)
Table 12–9

34. Depreciation Schedule
Table 12–10

35. 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

36. Actual Investment Decision – Example (cont’d)

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

38. 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

39. 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

40. Book Value of Old Asset and Net Cost of New Asset

41. Incremental Depreciation Benefits
Cash flow analysis on the basis of:
Incremental gain in depreciation
Related tax shield benefits
Cost savings
Table 12–15

42. Cost Savings Benefits
Table 12–16

43. Present Value of the Total Incremental Benefits

44. 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