Capital Budgeting Decisions

PowerPoint Authors:
Jon A. Booker, Ph.D., CPA, CIA
Charles W. Caldwell, D.B.A., CMA
Susan Coomer Galbreath, Ph.D., CPA
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
12-2

Typical Capital Budgeting

Decisions
Plant expansion

Equipment selection

Lease or buy Cost reduction

12-3

Typical Capital Budgeting

Decisions
Capital budgeting tends to fall into two broad
categories . . .
Screening decisions. Does a proposed
project meet some present standard of
acceptance?
Preference decisions. Selecting from
among several competing courses of action.
12-4

Time Value of Money

A dollar today is worth
more than a dollar a
year from now.
Therefore, investments
that promise earlier
returns are preferable to
those that promise later
returns.
12-5

Time Value of Money

The capital budgeting

techniques that best
recognize the time
value of money are
those that involve
discounted cash flows.
flows
12-6

Learning Objective 1

Evaluate the acceptability

of an investment project
using the net present
value method.
12-7

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,
The difference between the two streams of
cash flows is called the net present value.
12-8

The Net Present Value Method

General decision rule . . .
12-9

The Net Present Value Method

Net present value analysis
emphasizes cash flows and not
accounting net income.

The reason is that

accounting net income is
based on accruals that
ignore the timing of cash
flows into and out of an
organization.
12-10

Typical Cash Outflows

Repairs and
maintenance

Working Initial
capital investment

Incremental
operating
costs
12-11

Typical Cash Inflows

Salvage
value

Release of
Reduction
working
of costs
capital

Incremental
revenues
12-12

Two Simplifying Assumptions

Two simplifying assumptions are usually
made in net present value analysis:
All
All cash
cash flows
flows other
other All
All cash
cash flows
flows
than
than the
the initial
initial generated
generated by by an
an
investment
investment occur
occur atat investment
investment project
project
the
the end
end of
of periods.
periods. are
are immediately
immediately
reinvested
reinvested at at aa rate
rate of
of
return
return equal
equal to
to the
the
discount
discount rate.
rate.
12-13

Choosing a Discount Rate

• The company’s cost of
capital is usually
regarded as the minimum
required rate of return.

• The cost of capital is the

average rate of return the
company must pay to its
long-term creditors and
stockholders for the use
of their funds.
12-14

The Net Present Value Method

Let’s look at how

we use the net
present value
method to make
business
decisions.
12-15

The Net Present Value Method

Lester Company has been offered a five year
contract to provide component parts for a large
manufacturer.
12-16

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?

12-17

The Net Present Value Method

Annual net cash inflows from operations
12-18

The Net Present Value Method

12-19

The Net Present Value Method

Present value of an annuity of $1

factor for 5 years at 10%.
12-20

The Net Present Value Method

Present value of $1
factor for 3 years at 10%.
12-21

The Net Present Value Method

Present value of $1
factor for 5 years at 10%.
12-22

The Net Present Value Method

Accept the contract because the project has a

positive net present value.
12-23

Quick Check 
Denny Associates has been offered a four-year contract
to supply the computing requirements for a local bank.

 The working capital is released at the end of the contract.

 Denny Associates requires a 14% return.
12-24

Quick Check 
What is the net present value of the
contract with the local bank?
a. $150,000
b. $ 28,230
c. $ 92,340
d. $132,916
12-25

Quick Check 
What is the net present value of the
contract with the local bank?
a. $150,000
b. $ 28,230
c. $ 92,340
d. $132,916
12-26

Expanding the Net Present Value Method

To compare competing investment
projects, we can use the following net
present value approaches:
▫ Total-cost
▫ Incremental cost
12-27

The Total-Cost Approach

 White Co. has two alternatives:
(1) remodel an old car wash or,
(2) remove it and install a new one.
 The company uses a discount rate of 10%.

New Car Old Car

Wash Wash
Annual revenues $ 90,000 $ 70,000
Annual cash operating costs 30,000 25,000
Net annual cash inflows $ 60,000 $ 45,000
12-28

The Total-Cost Approach

If White installs a new washer . . .

Cost $300,000
Productive life 10 years
Salvage value 7,000
Replace brushes at
the end of 6 years 50,000
Salvage of old equip. 40,000

Let’s look at the net present

value of this alternative.
12-29

The Total-Cost Approach

Install the New Washer
Cash 10% Present
Year Flows Factor Value
Initial investment Now $ (300,000) 1.000 $ (300,000)
Replace brushes 6 (50,000) 0.564 (28,200)
Annual net cash inflows 1-10 60,000 6.145 368,700
Salvage of old equipment Now 40,000 1.000 40,000
Salvage of new equipment 10 7,000 0.386 2,702
Net present value $ 83,202

If we install the new washer, the

investment will yield a positive net
present value of $83,202.
12-30

The Total-Cost Approach

If White remodels the existing washer . . .

Remodel costs $175,000

Replace brushes at
the end of 6 years 80,000

Let’s look at the present value

of this second alternative.
12-31

The Total-Cost Approach

Remodel the Old Washer
Cash 10% Present
Year Flows Factor Value
Initial investment Now $ (175,000) 1.000 $ (175,000)
Replace brushes 6 (80,000) 0.564 (45,120)
Annual net cash inflows 1-10 45,000 6.145 276,525
Net present value $ 56,405

If we remodel the existing washer, we will

produce a positive net present value of
$56,405.
12-32

The Total-Cost Approach

Both projects yield a positive net present value.

However, investing in the new washer will

produce a higher net present value than
remodeling the old washer.
12-33

The Incremental-Cost Approach

Under
Under the
the incremental-cost
incremental-cost approach,
approach,
only
only those
those cash
cash flows
flows that
that differ
differ
between
between thethe two
two alternatives
alternatives are
are
considered.
considered.

Let’s
Let’s look
look at
at an
an analysis
analysis of
of the
the White
White
Co.
Co. decision
decision using
using the
the incremental-
incremental-
cost
cost approach.
approach.
12-34

The Incremental-Cost Approach

Cash 10% Present
Year Flows Factor Value
Incremental investment Now $(125,000) 1.000 $(125,000)
Incremental cost of brushes 6 $ 30,000 0.564 16,920
Increased net cash inflows 1-10 15,000 6.145 92,175
Salvage of old equipment Now 40,000 1.000 40,000
Salvage of new equipment 10 7,000 0.386 2,702
Net present value $ 26,797

We get the same answer using either the

total-cost or incremental-cost approach.
12-35

Quick Check 
Consider the following alternative projects. Each project would last
for five years.
Project A Project B
Initial investment $80,000 $60,000
Annual net cash inflows 20,000 16,000
Salvage value 10,000 8,000
The company uses a discount rate of 14% to evaluate projects.
Which of the following statements is true?
a. NPV of Project A > NPV of Project B by $5,230
b. NPV of Project B > NPV of Project A by $5,230
c. NPV of Project A > NPV of Project B by $2,000
d. NPV of Project B > NPV of Project A by $2,000
12-36

Quick Check 
Consider the following alternative projects. Each project would last
for five years.
Project A Project B
Initial investment $80,000 $60,000
Annual net cash inflows 20,000 16,000
Salvage value 10,000 8,000
The company uses a discount rate of 14% to evaluate projects.
Which of the following statements is true?
a. NPV of Project A > NPV of Project B by $5,230
b. NPV of Project B > NPV of Project A by $5,230
c. NPV of Project A > NPV of Project B by $2,000
d. NPV of Project B > NPV of Project A by $2,000
12-37

Least Cost Decisions

In
In decisions
decisions where
where revenues
revenues are
are not
not
directly
directly involved,
involved, managers
managers should
should
choose
choose thethe alternative
alternative that
that has
has the
the least
least
total
total cost
cost from
from aa present
present value
value
perspective.
perspective.

Let’s
Let’s look
look at
at the
the Home
Home Furniture Company..
Furniture Company
12-38

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%.
12-39

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
12-40

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)
12-41

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 favor of
purchasing the new truck $ 9,372
12-42

Quick Check 
Bay Architects is considering a drafting machine
that would cost $100,000, last four years, and
provide annual cash savings of $10,000 and
considerable intangible benefits each year. How
large (in cash terms) would the intangible
benefits have to be per year to justify investing
in the machine if the discount rate is 14%?
a. $15,000
b. $90,000
c. $24,317
d. $60,000
12-43

Quick Check 
Bay Architects is considering a drafting machine
that would cost $100,000, last four years, and
provide annual cash savings
$70,860/2.914 of $10,000 and
= $24,317
considerable intangible benefits each year. How
large (in cash terms) would the intangible
benefits have to be per year to justify investing
in the machine if the discount rate is 14%?
a. $15,000
b. $90,000
c. $24,317
d. $60,000
12-44

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
12-45

The Payback Method

Management
Management at at The
The Daily
Daily Grind
Grind wants
wants toto install
install an
an
espresso
espresso bar
bar in
in its
its restaurant.
restaurant.
The
The espresso
espresso bar: bar:
1.
1. Costs
Costs $140,000
$140,000 and and has
has aa 10-year
10-year life.
life.
2.
2. Will
Will generate
generate annual
annual net
net cash
cash inflows
inflows ofof $35,000.
$35,000.

Management
Management requires
requires aa payback
payback period
period of
of 55 years
years or
or
less
less on
on all
all investments.
investments.

What
What is
is the
the payback
payback period
period for
for the
the espresso
espresso bar?
bar?
12-46

The Payback Method

Investment required
Payback period =
Net annual cash inflow

$140,000
Payback period = $35,000

Payback period = 4.0 years

The
The payback
payback period
period is
is 4.0
4.0 years.
years.
Therefore,
Therefore, management
management would
would choose
choose
to
to invest
invest in
in the
the bar.
bar.
12-47

Quick Check 
Consider the following two investments:
Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 3-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined
12-48

Quick Check 
Consider the following two investments:
Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 3-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project
•Project X has a Ypayback period of 2 years.
•Project
c. Cannot
Y has a be determined
payback period of slightly more than 2 years.
•Which project do you think is better?
12-49

Evaluation of the Payback Method

Ignores the
time value
of money.

Criticisms
of the payback
period. Ignores cash
flows after
the payback
period.
12-50

Evaluation of the Payback Method

Serves as Identifies
screening investments that
tool. recoup cash
investments
Strengths quickly.
of the
payback If products
method. become obsolete,
It will help focus
on short payback
period projects.
12-51

Payback and Uneven Cash Flows

When the cash flows associated with an
investment project change from year to year,
the payback formula introduced earlier cannot
be used.
Instead, the un-recovered investment must be
tracked year by year.
$1,000 $0 $2,000 $1,000 $500

1 2 3 4 5
12-52

Payback and Uneven Cash Flows

For example, if a project requires an
initial investment of $4,000 and
provides uneven net cash inflows in
years 1-5, as shown, the investment
would be fully recovered in year 4.
$1,000 $0 $2,000 $1,000 $500

1 2 3 4 5
12-53

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