Chapter 13 – Lecture Notes
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Chapter 13
Lecture Notes
Chapter theme: The term capital budgeting is used to
describe how managers plan significant cash outlays on
projects that have long-term implications such as the
purchase of new equipment and the introduction of new
products. This chapter describes four methods for making
these types of investment decisions—the payback
method, the net present value method, the internal rate
of return method, and the simple rate of return method.
I. Capital budgeting – an overview
A. Typical capital budgeting decisions
i. Capital budgeting analysis can be used for
any decision that involves an outlay now in
order to obtain some future return. Typical
capital budgeting decisions include:
1. Cost reduction decisions. Should new
equipment be purchased to reduce costs?
2. Expansion decisions. Should a new plant or
warehouse be purchased to increase capacity
and sales?
3. Equipment selection decisions. Which of
several available machines should be
purchased?
4. Lease or buy decisions. Should new
equipment be leased or purchased?
5. Equipment replacement decisions. Should
old equipment be replaced now or later?
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B. Types of capital budgeting decisions
i. There are two main types of capital
budgeting decisions:
1. Screening decisions relate to whether a
proposed project passes a preset hurdle.
a. For example, a company may have a
policy of accepting projects only if
they promise a return of 20% on the
investment.
2. Preference decisions relate to selecting
among several competing courses of action.
a. For example, a company may be
considering several different machines
to replace an existing machine on the
assembly line.
C. Cash flows versus net operating income
i. The payback method, the net present value
method and the internal rate of return method
all focus on analyzing the cash flows
associated with capital investment projects,
whereas the simple rate of return method
focuses on incremental net operating
income.
ii. Examples of cash outflows and cash inflows
that accompany capital investment projects
are as follows:
1. Cash outflows include those shown on this
slide. Notice the term working capital,
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which is defined as current assets less
current liabilities.
2. Cash inflows include those shown on this
slide.
Helpful Hint: The role of working capital in capital
budgeting often confuses students. Emphasize that the
initial investment in working capital at the beginning of
the project for items, such as inventories, is recaptured
at the end of the project when working capital is no
longer required. Thus, working capital is recognized as
a cash outflow at the beginning of the project and a
cash inflow at the end of the project.
D. The time value of money
i. The time value of money concept recognizes
that a dollar today is worth more than a
dollar a year from now. Therefore, projects
that promise earlier returns are preferable to
those that promise later returns.
ii. The capital budgeting techniques that best
recognize the time value of money are those
that involve discounted cash flows (the
concepts of discounting cash flows and using
present value tables are explained in greater
detail in Appendix 13A).
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II. The payback method
Learning Objective 1: Determine the payback period
for an investment.
A. The payback method focuses on the payback period,
which is the length of time that it takes for a project to
recoup its initial cost out of the cash receipts that it
generates.
i. Key concepts
1. The payback method analyzes cash flows;
however, it does not consider the time value
of money.
2. When the annual net cash inflow is the
same every year, the formula for computing
the payback period is as shown.
ii. The Daily Grind – an example
1. Assume the management of the Daily Grind
wants to install an espresso bar in its
restaurant.
a. The cost of the espresso bar is
$140,000 and it has a 10-year life.
b. The bar will generate annual net cash
inflows of $35,000.
c. Management requires a payback
period of five years or less.
d. What is the payback period on the
espresso bar?
2. The payback period is 4.0 years. Therefore,
management would choose to invest in the
bar.
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Quick Check – the payback method
iii. Evaluation of the payback method
1. Criticisms
a. A shorter payback period does not
always mean that one investment is
more desirable than another.
b. The payback method ignores cash
flows after the payback period, thus
it has no inherent mechanism for
highlighting differences in useful life
between investments.
c. As previously mentioned, the payback
method does not consider the time
value of money.
Helpful Hint: Ask students to choose between two
options that each require an initial investment of
$4,000. Option A returns $1,000 at the end of each four
years; option B returns $4,000 at the end of the fourth
year. Under the payback method, options A and B are
equally preferable. Note, however, that option A is
better, since the cash flows come earlier. Now add that
in year 5, option A will produce an additional cash
inflow of $5,000 but that option B will never generate
another dollar after the fourth year. Repeat the
question of preference of option A or B using only the
payback method. The payback method ignores the time
value of money and does not measure profitability; it
just measures the time required to recapture the
original investment.
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2. Strengths
a. It can serve as a screening tool to help
identify which investment proposals
are in the “ballpark.”
b. It can aid companies that are “cash
poor” in identifying investments that
will recoup cash investments quickly.
c. It can help companies that compete in
industries where products become
obsolete rapidly to identify products
that will recoup their initial investment
quickly.
iv. Payback and uneven cash flows
1. 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.
2. 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.
III. The net present value method
Learning Objective 2: Evaluate the acceptability of an
investment project using the net present value method.
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A. Key concepts/assumptions
i. The net present value method compares the
present value of a project’s cash inflows with
the present value of its cash outflows. The
difference between these two streams of cash
flows is called the net present value.
ii. Two simplifying assumptions are usually
made in net present value analysis:
1. The first assumption is that all cash flows
other than the initial investment occur at the
end of periods.
2. The second assumption is that all cash flows
generated by an investment project are
immediately reinvested at a rate of return
equal to the discount rate.
B. The net present value method: an example using
discount factors from Exhibits 13B-1 and 13B-2
i. Assume the information as shown with
respect to Lester Company.
1. Also assume that at the end of five years the
working capital will be released and may
be used elsewhere.
2. Lester Company’s discount rate is 11%.
3. Should the contract be accepted?
ii. As a starting point, Lester’s annual net cash
inflow from operations of $80,000 is
computed as shown.
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iii. Since the investments in equipment
($160,000) and working capital ($100,000)
occur immediately, the discounting factor
used is 1.000.
iv. The present value factor for an annuity of $1
for five years at 11% is 3.696. Therefore, the
present value of the annual net cash inflows is
$295,680.
v. The present value factor of $1 for three years
at 11% is 0.731. Therefore, the present value
of the cost of relining the equipment in three
years is $21,930.
vi. The present value factor of $1 for five years
at 11% is 0.593. Therefore, the present value
of the release of working capital and the
salvage value of the equipment is $62,265.
vii. The net present value of the investment
opportunity is $76,015.
Quick Check – net present value calculations
C. The net present value method: an example using
discount factors from Exhibits 13B-1
i. For this next example, we’ll use the same
information from Lester Company.
1. Also assume that at the end of five years the
working capital will be released and may
be used elsewhere.
2. Lester Company’s discount rate is 11%.
3. Should the contract be accepted?
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ii. Since the investments in equipment
($160,000) and working capital ($100,000)
occur immediately, the discounting factor
used is 1.000.
iii. The total cash flows for years 1-5 are
discounted to their present values using the
discount factors from Exhibit 13B-1.
iv. For example, the total cash flows in year 1 of
$80,000 are multiplied by the discount factor
of 0.901 to derive this future cash flow’s
present value of $72,080.
v. As another example, the total cash flows in
year 3 of $50,000 are multiplied by the
discount factor of 0.731 to derive this future
cash flow’s present value of $36,550.
vi. The net present value of the investment
opportunity is $76,015. Notice this amount
equals the net present value from the earlier
approach.
D. The net present value method: interpreting the
results
i. Once you have computed a net present value,
you should interpret the results as follows:
1. A positive net present value indicates that
the project’s return exceeds the discount
rate.
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2. A negative net present value indicates that
the project’s return is less than the discount
rate.
3. If the company’s minimum required rate of
return is used as the discount rate:
a. A project with a positive net present
value has a return that exceeds the
minimum required rate of return and is
therefore acceptable.
b. A project with a negative net present
value has a return that is less than the
minimum required rate of return and is
therefore unacceptable.
4. A company’s cost of capital is usually
regarded as its minimum required rate of
return. The cost of capital is the average
return that the company must pay to its
long-term creditors and its shareholders.
When the cost of capital is used as the
discount rate, it serves as a screening device
in net present value analysis.
E. Recovery of the original investment
i. The net present value method automatically
provides for return of the original
investment.
ii. To illustrate this fact, assume the facts as
shown with respect to Carver Hospital.
1. Notice that the net present value of the
investment is zero.
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