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Chapter 24 Capital Budgeting and Investment Analysis
Chapter 24
Capital Budgeting and Investment Analysis
Related Assignment Materials
Student Learning Objectives
Discussion
Questions
Quick
Studies*
Exercises*
Problems*
Beyond the
Numbers
Conceptual objectives:
C1. Describe the selection of a
hurdle rate for an investment.
1, 2, 3, 9, 10,
11, 12
GD
Analytical objectives:
A1. Analyze a capital investment
project using break-even time.
24-7
24-8
24-5, 24-6
Procedural objectives:
P1. Compute payback period and
describe its use.
4, 5
24-1, 24-2,
24-9
24-1, 24-2,
24-9
24-1, 24-2,
24-5, 24-6
CIP, TIA, ED,
TTN
P2. Compute accounting rate of
return and explain its use.
6, 7
24-4
24-3, 24-4
24-1, 24-2
CIP, ED
P3. Compute net present value and
describe its use.
8
24-3, 24-5,
24-8, 24-9
24-4, 24-5,
24-7, 24-9
24-1, 24-2,
24-3, 24-4
RIA, EC, CIP,
CA, ED, HTR,
TTNJ
P4. Compute internal rate of return
and explain its use.
24-6
24-6
CIP, TIA, CA,
ED
* See additional information on next page that pertains to these quick studies, exercises and problems.
Chapter 24 Capital Budgeting and Investment Analysis
*Assignment materials that can be completed by students using:
Sage 50 and QuickBooks Pro 2013 templates – None.
The Serial Problem for Success Systems continues in this chapter.
Excel template – Problems 24-1A.
** The Serial Problem for Success Systems, which covers numerous learning objectives, can be
most of the chapters. Even if previous segments were not assigned, students can begin the segment
of the serial problem that is included in this chapter. It is most readily solved if students use the
Working Papers that accompany the book.).
Synopsis of Chapter Revision
• Gamer Grub: NEW opener with new entrepreneurial assignment
• Updated graphic on industry cost of capital estimates
• New presentation on payback periods for health care providers
• New discussion on link between CEO compensation and IRR
• Simplified computation of the accounting rate of return
Chapter 24 Capital Budgeting and Investment Analysis
Chapter Outline
I. Introduction to Capital Budgeting--fundamental goal of capital is to
earn a satisfactory rate of return. Such decisions require careful
analysis, and are the most difficult and risky decisions that managers
make because of need to make predictions of events that will occur
well into the future. It is also risky because outcome is uncertain, large
amounts of money are involved, long-term commitment is required,
and decision may be difficult or impossible to reverse. Several
techniques are used to make capital budgeting decisions.
A. Methods Not Using Time Value of Money⎯Investments are
expected to produce cash inflows and cash outflows; net cash flow
equals cash inflows minus cash outflows. Simple analysis methods
do not consider the time value of money.
1. Payback Period--the time period expected to recover the
initial investment amount. That is, the time it will take the
investment to generate enough net cash flow to return (or pay
back) the cash initially invested to buy it. Managers prefer
investments with shorter payback period. Shorter payback
period reduces risk of unprofitable investment over the long
run. Company’s risk due to potentially inaccurate long-term
predictions of future cash flows is reduced.
a. Computing Payback period with Even Cash Flows.
i. When annual cash flows are even in amount, payback
period equals cost of investment divided by annual net
cash flow.
iv. Cash flows exclude all noncash revenues and expenses.
Depreciation is a noncash item.
b. Computing Payback Period with Uneven Cash Flows-
When annual cash flows are unequal, payback period is
Cumulative refers to the addition of each period’s net cash
flows as we progress through time.
Notes
Chapter 24 Capital Budgeting and Investment Analysis
Chapter Outline
Notes
c. Using the Payback Period--should not be only
consideration in evaluating investments; two factors are
ignored.
i. Differences in the timing of net cash flows within the
payback period are not reflected. Investments that
provide cash more quickly are more desirable.
ii. All cash flows after the point where its costs are fully
recovered are ignored.
c. Average investment must be computed.
i. If net cash flows are received evenly, then average
investment for any one year is computed as average of
beginning and ending book values.
ii. Average investment (or average book value for asset’s
entire life) is then computed by taking the average of the
individual yearly averages.
iii. When using straight-line depreciation, average book value
complicated. The book value of the asset is computed for
each year of its life. See Exhibit 24.5 for the general
formula.
v. If investment has salvage value, the average investment is
computed as sum of beginning book value and salvage
value divided by two.
ii. Capital investment with least risk, shortest payback
period, and highest return for the longest time is often
identified as best; analysis can be challenging because
different investments often yield different rankings
depending on measure used.
e. Accounting rate of return method is readily computed, often
Chapter 24 Capital Budgeting and Investment Analysis
Chapter Outline
Notes
i. Amount invested is based on book values for future
periods.
ii. If asset’s yearly net incomes vary, average annual net
incomes must be used; method fails to distinguish between
two investments with same average annual net income
when one investment yields higher amounts in early years
and the other in later years.
B. Methods Using Time Value of Money⎯Net present value and
internal rate of return methods consider time value of money. Surveys
show internal rate of return (IRR) is most popular method, followed
by payback period and net present value (NPV). Few companies use
accounting rate of return (ARR).
1. Net Present Value (see Appendix B near end of textbook)
To compute NPV, discount the future net cash flows from
the investment at the required rate of return, and then
subtract the initial amount invested.
a. Each annual net cash flow is multiplied by the related
present value of 1 factor or discount factor. (Obtain from
Table B.1 in Appendix B.)
i. Discount factors assume that net cash flows are
received at the end of each year.
ii. Rate of return required by the company and number of
years until cash flow is received are used to determine
discount factors.
b. Initial amount invested includes all costs incurred to get
asset in proper location and ready to use.
c. Net Present Value Decision Rule - Sum of present values
If sum of present values of annual net cash flows equals or
exceeds initial investment (that is, if the net present value
of all cash flows is positive), then asset is expected to
recover its cost and provide a return at least as high as that
required; project is accepted.
same cost and same risk, the one with highest positive net
present value is preferred.
Chapter 24 Capital Budgeting and Investment Analysis
Chapter Outline
d. Simplifying Computations - when annual net cash flows
are equal in amount, NPV calculation can be simplified.
Individual annual present value of 1 factors can be
summed, and total multiplied by annual net cash flow to
get total present value of net cash flows.
Calculator with compound interest function or a
spreadsheet program can be used.
e. Uneven Cash Flows - NPV analysis can also be applied
when net cash flows are unequal. (Use procedures and
decision-rules above.)
depreciation for tax reporting affects net present value of
asset’s cash flows.
Accelerated depreciation produces larger depreciation
deductions in early years of asset’s life and smaller ones in
later years; large net cash inflows are produced in early
proceed with a capital investment project, we approve if
NPV is positive but reject if it is negative.
NPV is of limited value for comparison purposes if initial
investment differs substantially across projects.
When considering several projects of similar investment
discount rate.
i. Inflation – large price-level increases should be considered
in NPV analyses. Hurdle rates already include inflation
forecasts. Net cash flows can be adjusted for inflation by
using future value computations.
Notes
Chapter 24 Capital Budgeting and Investment Analysis
Chapter Outline
Notes
b. If the total present value of a project’s net cash flows is
computed using the IRR as the discount rate, it will equal
the initial investment.
c. Computation involves a two-step process:
i. Step One – compute the present value factor for the
investment project. Present value factor = amount
invested / net cash flows.
ii. Step Two – identify the discount rate (IRR) yielding
the present value factor. Search Table B.3 for a present
value factor equal to the present value factor identified
in step one.
iii. When cash flows are equal, the present value factor
equals the amount invested divided by the net cash
flows.
iv. An annuity table (see Appendix B) can be used to
Exhibit 24..9 can be used to estimate the IRR.
d. Uneven Cash Flows - when cash flows are unequal, trial
and error must be used; select any reasonable discount rate
and compute the NPV.
i. If amount is positive, recompute NPV using higher
discount rate; if amount is negative, recompute NPV
iii. Spreadsheet software can also compute the IRR.
e. Use of Internal Rate of Return - compare IRR with a
predetermined hurdle rate which is a minimum
acceptable rate of return; if IRR exceeds hurdle rate,
accept project.
additional profit to reward company for risk.
iii. If project is internally financed, hurdle rate is often
based on actual returns from comparable projects.
Chapter 24 Capital Budgeting and Investment Analysis
Chapter Outline
Notes
iv. If evaluating multiple projects, rank by extent to
which IRR exceeds hurdle rate.
f. IRR is not subject to limitations of NPV when comparing
projects with different amounts invested; IRR is expressed
as percent rather than an absolute dollar value using NPV.
3. Comparison of Capital Budgeting Methods (see Exhibit
24.10)
a. Payback period and accounting rate of return do not
consider time value of money; NPV and IRR do.
b. Payback period method is simple; sometimes used when
there is a limited amount of cash to invest and a number of
projects to choose from.
c. Accounting rate of return is a percent computed using
accrual income instead of cash flows, and is an average
rate for the entire investment period; annual returns are
not reflected.
d. NPV:
i. Considers all estimated cash flows of project; can be
e. IRR:
i. Considers all estimated cash flows of project.
ii. Readily computed when cash flows are equal, but
requires trial and error estimation or use of a computer
when cash flows are unequal.
period method.
A. Start by restating future cash flows in terms of their present
values; must discount the cash flows.
B. Then compute the payback period using the present values of
future cash flows.
C. Break-even time (BET) is useful measure; managers know when
to expect cash flows to yield net positive returns.
D. If BET is less that estimated life of investment, positive net
present value can be expected from investment.
Chapter 24 Capital Budgeting and Investment Analysis
Chapter Outline
Notes
E. To compare and rank alternative investment projects, choose the
project with the lowest break-even time.
III. Using Excel to Compute Net Present Value and Internal Rate of
Return (Appendix 24A)—the calculations for present value and
internal rates of return for projects with uneven cash flows can be
performed simply and accurately by using functions built into Excel.
A. The formulas to compute net present value and the Internal Rate of
Return in Excel are shown in Appendix 24-A.
Chapter 24 Capital Budgeting and Investment Analysis
website, in whole or part. 24-10
Chapter 24: Alternate Demonstration Problem #1
A company is planning to buy a new machine at a cost of $200,000. The
machine is expected to last for 10 years and have no salvage value at the
end of its useful life. Straight-line depreciation will be used. The company
expects to save 10,000 hours of direct labor each year because of the new
machine, as well as $4,000 each year in other operating costs.
Management’s best estimate is that on average the hourly rate for the labor
saved will be $5.50. With the exception of the initial purchase, assume all
cash flows take place at the end of the year, and a tax rate of 40%.
Required:
1. Calculate the payback period on the investment in new machinery.
2. Calculate the rate of return on the average investment.
3. Calculate the net present value of the investment:
(a) Ignoring income taxes, using a discount rate of 10%.
(b) Including the effect of taxes, using a 10% discount rate.
Chapter 24 Capital Budgeting and Investment Analysis
website, in whole or part. 24-11
Solution: Chapter 24 Alternate Demonstration Problem #1
1.
First, calculate annual net cash flow:
Determine increase in after-tax net income:
Labor savings: 10,000 hours @ $5.50 per hour
$55,000
Other operating savings
4,000
Annual cash savings before tax
59,000
Less: annual depreciation expense
20,000
Increase in net income before tax
39,000
Less: Increase in annual income tax @ 40%
15,600
Increase in net income after tax
$23,400
Then, add back depreciation expense (noncash):
Increase in net income after tax
$23,400
Plus annual depreciation expense
20,000
Annual net cash flow
$43,400
Payback period equals cost of new machine divided by annual net cash flow or
$200,000 / $43,400 = 4.6 years.
2.
The rate of return on average investment equals the increase in net income after
tax divided by the amount of the average investment.
The average investment would be $200,000 / 2, or $100,000.
Rate of return on average investment = $23,400 / $100,000 = 23.4%
3(a)
There is a cash savings of $59,000 each year for 10 years if income taxes are
ignored. The present value factor for a 10-year annuity at 10% is 6.1446.
Present value of cash savings ($59,000 x 6.1446)
$362,531
Present value of investment
200,000
Net present value (positive)
$162,531
3(b)
There is a cash savings of only $43,400 each year for 10 years if income taxes are
considered.
Present value of cash savings ($43,400 x 6.1446)
$266,676
Present value of investment
200,000
Net present value (positive)
$ 66,676
