CHAPTER 24
CAPITAL BUDGETING AND INVESTMENT ANALYSIS
Related Assignment Materials
Student Learning Objectives Questions
Quick
Studies* Exercises* Problems*
Beyond the
Numbers
Analytical objectives:
P1. Compute the payback period
and describe its use.
24-1, 24-2,
24-3, 24-4,
24-5, 24-6
24-1, 24-4,
24-5, 24-16
24-1, 24-3,
24-4, 24-5,
24-8, 24-16
24-1, 24-2,
24-5, 24-6
24-4, 24-5,
24-6, 24-7
P2. Compute accounting rate of
return and explain its use.
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24-13
24-6, 24-7 24-7, 24-8 24-1, 24-2 24-4, 24-7
P3. Compute net present value and
describe its use.
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24-10, 24-11,
24-12, 24-13
24-2, 24-8,
24-9, 24-10,
24-11, 24-12
24-16
24-2, 24-6,
24-9, 24-10,
24-11, 24-12
24-14
24-1, 24-2,
24-3, 24-4
24-1, 24-2,
24-3, 24-4,
24-5, 24-6,
24-7, 24-8,
24-9
P4. Compute internal rate of return
and explain its use.
24-9, 24-13 24-3, 24-13,
24-14
24-13, 24-14,
24-15
24-1, 24-7,
24-9
* See additional information on next page that pertains to these quick studies, exercises and problems.
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Additional Information on Related Assignment Material
Connect (Available on the instructor’s course-specific website) repeats all numerical Quick Studies, all
Exercises and Problems Set A. Connect provides new numbers each time the Quick Study, Exercise or
Problem is worked. It allows instructors to monitor, promote, and assess student learning. It can be used
in practice, homework, or exam mode.
Synopsis of Chapter Revision
Adafruit Industries—New opener
Revised discussion of accounting rate of return
Revised discussion of net present value
Revised discussion of internal rate of return
Updated graphic showing cost of capital estimates by industry
Revised discussion of profitability index
New exhibit for profitability index
Added 7 Quick Studies and 6 Exercises
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Chapter Outline
Capital Budgeting
1. Difficult because of need to make predictions of events that
will occur well into the future.
2. Risky because: Outcome is uncertain, large amounts of money
are involved, a long-term commitment is required, and the
1. Payback period is the expected amount of time recover the
initial investment amount.
2. Managers prefer investments with shorter payback periods.
a. Shorter payback period reduces risk of an unprofitable
3. To compute payback period, exclude all non-cash revenue and
expenses from computation.
a. When annual cash flows are even in amount:
4. Payback period should not be only consideration in evaluating
investments; two factors are ignored.
a. Differences in the timing of net cash flows within the
Notes
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Chapter Outline
B. Accounting Rate of Return
1. The percentage accounting return on annual average
investment.
2. Called “accounting” return because it is based on net income
instead of on cash flows.
3. Computed as:
4. Accrual basis after-tax net income is used.
5. Compute the average investment:
a. If straight-line deprecation is used then:
Annual average = (Beg. Book Value + End. Book value)
6. Accounting Rate of Return = After-tax net income
Average investment amount
7. Risk of an investment should be considered.
a. Investment’s return is satisfactory or unsatisfactory only
when related to returns from other investments with
8. Accounting rate of return method is readily computed, often
used in evaluating investment opportunities, yet usefulness is
Notes
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Chapter Outline
1. Net Present Value (NPV) analysis applies the time value of
2. NPV is computed by discounting the future net cash flows
from the investment at the required rate of return, and then
subtract the initial amount invested.
a. The required rate of return also called the hurdle rate or
3. Net Present Value Decision Rule
a. Net Present Value = PV of cash flows – Amount Invested
b. If the NPV is greater than or equal to $0, then asset is
expected to recover its cost and provide a return at least as
high as that required; invest.
c. If NPV is negative, Do not invest
4. NPV analysis can be used when comparing several investment
opportunities; if investment opportunities have same cost and
same risk, the one with highest NPV is preferred.
5. When annual net cash flows are equal in amount, NPV
calculation can be simplified.
a. Individual annual present value of $1 factors can be
6. NPV analysis can also be applied when net cash flows are
unequal. (Use procedures and decision-rules above.)
7. If salvage value is expected at end of useful life, treat as an
Notes
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Chapter Outline
8. Accelerated depreciation methods do not change basics of
NPV analysis, but can change results; using accelerated
depreciation for tax reporting affects net present value of
9. NPV is of limited value for comparison purposes if initial
investment differs substantially across projects.
10. When a company can’t fund all positive net present value
projects , they can be compared using the profitability index
a. Profitability Index = Net present value of cash flows
Cost of investment
b. A higher profitability index makes the project more
desirable
11. When the projects being compared have different risks, the
NPVs of individual projects should be computed using
different discount rates; the greater the risk, the higher the
discount rate.
B. Internal Rate of Return
1. IRR is a rate used to evaluate acceptability of an investment; it
equals the rate that yields a NPV of zero for an investment.
2. If the total present value of a project’s net cash flows is
computed using the IRR as the discount rate, and then subtract
the initial investment from this total present value, we get a
zero NPV.
3. Two step process in computing IRR (equal cash flows)
a. Step 1: Compute the present value factor for the project
by dividing the amount invested by net cash flows.
b. Step 2: Find discount rate (IRR) yielding the PV factor.
Notes
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