Chapter 12 – Strategy and the Analysis of Capital Investments
Effects of cash flows include direct and indirect (tax) effects. Direct effects include cash receipts, cash
payments, or cash commitments. Indirect or tax effects are changes in income-tax payments precipitated
by the investment decision. The sum of direct and indirect effects is net effect of a given item.
As noted in Exhibit 12.2, cash flows for investment projects occur at three stages: project initiation,
project operation, and project disposal (i.e., final disinvestment). Direct effects of cash outflows at initial
acquisition include cash disbursements for the purchase, installation, and testing of equipment and
facilities, commitment of net working capital needed for the proposed project, cash expenditures to hire
and train personnel, and cash disbursements for disposing of the replaced assets and/or facilities. Tax (i.e.,
indirect) effects of cash flows at time of project initiation relate primarily to recognized gain or loss (if
any) on the disposal of an existing asset.
Cash flows during operations are increases in cash revenues or decreases in cash expenses during the
operation of the investment. Cash flows during project operation typically have both direct and indirect
effects. Items that have cash flow effects during the operating phase of an investment include cash
receipts, cash expenditures, and depreciation deductions on the investment asset.
Cash inflows at the final disinvestment stage include net-of-tax cash proceeds from the sale (disposal)
of the investment and from the release of previously committed net working capital. Cash outflows can
also include expenditures related to the restoration of facilities and the relocation and/or retraining of
company personnel. With the exception of released net working capital, all other items are likely to have
both direct and tax effects.
DCF Capital Budgeting Decision Models
The discounted cash flow (DCF) methods evaluate a capital investment by considering the discounted
present value of after-tax cash inflows and after-tax cash outflows. DCF methods include: net present
value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), discounted payback
period, and present value index (PI) method (discussed in the Appendix).
The NPV method uses the investor’s WACC (discount rate) to bring all subsequent net cash inflows to
their present values and computes the difference between the sum of these present values and the total
initial investment. A desirable investment has a positive difference. That is, under the NPV model we
would accept a proposed investment if its NPV > 0.
The IRR of a project is an estimate of the “real” or “economic” rate of return on a proposed investment.
The IRR of a project is determined as the interest rate that results in a zero NPV for a proposed
investment. A desirable project is one whose IRR > hurdle rate (e.g., WACC).
The two DCF usually yield similar results in evaluating capital investments. However, the result may
differ in evaluating projects that have substantial differences in 1) amounts of initial investments, 2) cash
inflow patterns, or 3) length of useful life. Between the two DCF methods, the NPV method is easier to
use in evaluating projects with fluctuating cost of capital over projects’ lives or in selecting multiple
investment projects.
Some individuals feel that the conventional IRR calculation has an inherent assumption (regarding rates of
return on interim period after-tax cash inflows) and that the use of the unadjusted IRR calculation can
result in suboptimal capital budgeting decisions. These individuals feel that more conservative
representation of project returns is obtained when the interim cash inflows are assumed to be reinvested at
the company’s weighted-average cost of capital (WACC). This is precisely what the so-called modified
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Chapter 12 – Strategy and the Analysis of Capital Investments
internal rate of return (MIRR) does. The underlying mathematics of the MIRR are complicated. Thus, the
text provides the Excel financial function for MIRR.
The present value payback period for a project is defined as the length of time needed for discounted
future net cash flows to equal the original investment outlay of a project. One unique characteristic is that
if the discounted payback period is less than the life of the project (in years), then it must be true that the
project has a positive NPV.
As explained in Appendix B to this chapter, there are situations where the organization is working under a
capital constraint, that is, a situation where capital is “rationed.” In this situation, we employ a logic for
capital budgeting purposes similar to the logic used in Chapter 11 when we explored the short-term
product-mix problem: allocate available funds on the basis of profitability (e.g., NPV) per dollar of
invested capital. This relative measure of profitability is referred to as the present value index (PI). Note,
however, that this decision model is recommended for use only in the situation where the company faces
capital rationing.
Dealing with Uncertainty: Sensitivity Analysis and the Use of Real Options
New to this edition is an expanded discussion of sensitivity analysis. Students should understand that the
capital budgeting decision models used in practice all require as inputs forecasted data. Because of the
inherent nature of capital investment projects, these data can stretch many years in the future. As well,
companies must estimate the discount rate (WACC for use in DCF decision models. In short, the inputs to
the decision models used in capital budgeting are subject to uncertainty.
Thus, a legitimate question is the sensitivity of a capital investment decision with respect to the values of
the input factors in the decision model (WACC, duration, etc.). This issue is addressed analytically through
a general procedure sensitivity analysis.
In this chapter, we discuss the following four methods of conducting a sensitivity analysis within the
context of capital budgeting decisions:
what-if analysis (which focuses on the effect of an independent change in a single variable
at a time)
scenario analysis (which focuses on the joint effect of changes in multiple variables, each
change of which is referred to as a “scenario”)
Monte Carlo simulation (which requires sampling, with replacement, from among
distributions of each input factor in the model; each independent draw produces an
indicated value, such as NPV; after many such draws, a distribution of outcomes is
generated and can be used to inform the capital budgeting decision)
As a complement to the discussion of sensitivity analysis, we include in Chapter 12 an extensive
discussion of the topic of “real options” as an alternative way to address uncertainty in the capital
budgeting process. Real options are of two general types: growth and/or flexibility options (to expand,
contract, etc.) an original investment project. The argument goes that failure to incorporate real options
into a conventional capital investment analysis may grossly understate the value of an investment project.
One important interpretation of real options is that they allow decision-makers to capitalize on (i.e., act on)
new information as new information is revealed over time. This new information reduces uncertainty
regarding cash flows associated with a long-term investment project. As such, we include the topic of real
options as part of the discussion of dealing with uncertainty in the capital budgeting process.
Other Capital Investment Evaluation Techniques
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As indicated in the chapter, the use of DCF models can be justified by sound financial theory. However, as
indicated by survey evidence reported in the chapter, DCF models are not generally used by small
business. Thus, students should be exposed to non-DCF capital budgeting decision models, as follows:
The payback period of an investment is the length of time required for its cumulative after–tax cash
inflows to equal its initial cash outlay. When future cash inflows are expected to be equal, the following
formula is used to calculate the payback period of a proposed investment:
The payback period method is easy to compute and to comprehend. The payback period can also serve as
a rough measurement of the investment’s risk and an indication of the liquidity of the proposed
investment. For projects that require quick payoffs, the payback period method often is the technique used
in evaluating capital investments.
Among the limitations of the payback period method are its failure to consider an investment’s total
profitability and its failure to explicitly incorporate the time value of money into the analysis.
Because of the latter limitation, some companies use what is called the present value payback period,
which is defined as the number of years required for discounted future cash flows to equal the initial
investment outlay. One interesting point to make to students about this method is that if the discounted
payback period is less than the life of the project, then necessarily the project will have a positive NPV.
The accounting (book) rate of return (ARR) is equal to the ratio of some measure of accounting profit to
some measure of invested capital. (This definition is intentionally general to reinforce the point to students
that in practice the ARR is defined in various ways. That is, there is no universally accepted way to
measure ARR.) One option is to define the numerator of the ratio as the average net income from an
investment as a percentage of its book value,
Note that the denominator of the calculation can be defined either as the initial book value or as the
average book value of the proposed investment.
Data for computing the book rate of return (ARR) of an investment can come from the data generated for
financial reports. Another advantage of the book rate of return method is the consistency in the method
used in capital investment decisions and the technique that a firm is likely used in performance evaluations
after the investment becoming operational. In addition, unlike the payback period method, this method
considers the total profitability of an investment.
Similar to the payback period method, the book rate of return method in its assessments of capital
investments ignores time value of money. Uses of accounting data as the input data add another limitation
to the book rate of return method because of the arbitrariness in selecting accounting methods for the
amounts to be reported in accounting reports.
Behavioral Issues in Capital Budgeting
Firms or organizations need to recognize several common behavioral issues associated with the capital
budgeting process in practice: cost escalation, incrementalism, and uncertainty avoidance. As such, care
must be taken to not allow aggressive managers to overestimate revenues or underestimate expenses in
attempts to earn approval of capital investment for their units. Further, research has found that sunk costs
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can play an important role influencing the framing of decisions, such as those related to capital
investments. A rational decision maker should ignore sunk costs. Intolerance of uncertainty often leads
managers to require short payback periods for capital investment. Many critically important capital
investments, however, require a lengthy time to install, test, adjust, train personnel, and gain market
acceptance.
Chapter 12 includes an expanded discussion of the goal-congruency issues associated with the capital
budgeting process. These issues result from using one model for decision making (e.g., DCF) and another
model for financial performance evaluation (e.g., accounting ROI). This issue is one of the most critical
issues related to the design of comprehensive management accounting and control systems, and is
addressed at greater length in Chapter 19 of the text. However, in this chapter we offer at least three
possible ways to deal with the aforementioned goal-congruency problem:
the use of Economic Value Added (EVA®) for performance-evaluation purposes
separating incentive compensation from budgeted performance
conducting post-audits of capital budgeting decisions
Appendix A: Spreadsheet Templates for Conducting a DCF Analysis of an Asset-Replacement
Decision
Appendix A includes a set of templates that provide alternative approaches to structuring a DCF analysis
of an asset-replacement decision—a decision that, we find, is difficult for many students to structure
properly. Panels A and B of Appendix A present two alternative approaches for implementing what can be
called the “differential approach,” while Panel C contains an approach that explicitly recognizes
opportunity costs in the analysis of an asset-replacement decision, an approach that parallels the decision-
analysis approach presented in Chapter 11—Relevant Cost Analysis.
File copy of Chapter 12, Appendix A is embedded below—double-click on the icon to access the file.
Appendix B: DCF Models–Some Advanced Considerations
For instructors who have the time and interest, we present in the Appendix to the chapter a discussion of
three issues related to the use of DCF models in practice:
the issue of multiple IRRs
the issue of mutually exclusive projects (an extreme case of project dependence)
the issue of capital rationing (capital constraint)
In general, the conclusion (from the theory of modern finance) is that in dealing with the first two issues,
managers should be guided by the use of the NPV decision model. In terms of the third problem, capital
rationing, the preferred approach is to use a relative measure of DCF profitability, such as the profitability
index (PI). One version of this model is the ratio of NPV of a project to the initial investment outlay
associated with the project. If the instructor has already covered Chapter 11 (Decision Making) in the text,
then the point can be made that this rule is consistent with the approach taken in the short-term product-
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Appendix.xlsx
Chapter 12 – Strategy and the Analysis of Capital Investments
mix problem. There, we generated contribution margins per unit of the scarce (limiting) resource and then
used these measures of relative profitability to solve for the optimum product mix. The same logic is used
in the capital budgeting process when the organization operates under a capital constraint: allocate
available capital to projects based on the relative profitability of the projects per dollar of invested capital.
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