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CHAPTER 24
CAPITAL BUDGETING AND INVESTMENT ANALYSIS
Related Assignment Materials
Student Learning Objectives
Questions
Quick
Studies*
Exercises*
Problems*
Beyond the
Numbers
Analytical objectives:
A1. Analyze a capital investment
project using break-even time.
24
24-15
24-16
24-5, 24-6
Procedural 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.
24, 11, 24-12,
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.
24-7, 24-8,
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.
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
Chapter Outline
Capital Budgeting
I. Capital budgeting is a process of analyzing alternative long-term
investments and deciding which assets to acquired or sell
A. An objective of capital budgeting decisions is to earn a satisfactory
rate of return.
B. Such decisions require careful analysis because they are difficult
and risky.
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
decision may be difficult or impossible to reverse.
II. Methods Not Using Time Value of MoneyInvestments are
expected to produce net cash outflows; Net Cash flows equal cash
inflows minus cash outflows. Simple analysis methods do not consider
the time value of money.
A. Payback Period
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
investment over the long run.
b. Company’s risk due to potentially inaccurate long-term
predictions of future cash flows is reduced.
3. To compute payback period, exclude all non-cash revenue and
expenses from computation.
a. When annual cash flows are even in amount:
Payback Period = Cost of Investment
Annual net cash flows
b. When annual cash flows are unequal, payback period is
computed using the cumulative total of net cash flows
(starting with the negative cash flow resulting from the
initial investment); when cumulative net cash flow
changes from positive to negative, the investment is fully
recovered. (see Exhibit 24.3)
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
payback period are not reflected. Investments that provide
cash more quickly are more desirable.
b. All cash flows after the point where its costs are fully
recovered are ignored.
Notes
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:
after tax net income
average annual investment
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)
Investment 2
where ending book value = salvage value if there is one
b. If the depreciation method is other than straight line
method then the general formula is:
Annual = sum of individual year’s average book value
Ave. Invest number of years of the planned investment
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
similar lives and risk.
b. 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.
8. Accounting rate of return method is readily computed, often
used in evaluating investment opportunities, yet usefulness is
often limited. Should never be the only consideration in
evaluating investments. Limitations:
a. Net Incomes may vary from year to year.
b. Ignores the time value of money.
Notes
Chapter Outline
III. Methods Using Time Value of MoneyNet present value and
internal rate of return methods consider time value of money.
A. Net Present Value (see also Appendix B near end of textbook)
1. Net Present Value (NPV) analysis applies the time value of
money to cash inflows and cash outflows so management can
evaluate a project’s benefits and cost at one point in time.
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
the cost of capital that the company must pay to its long-
term creditors and shareholders.
b. 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.
c. Initial amount invested includes all costs incurred to get
asset in proper location and ready to use.
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
summed, and the total multiplied by annual net cash flow
to get total present value of net cash flows.
b. To simplify the computation, the present value of an
annuity of $1 table may be used
c. Calculator with compound interest function or a
spreadsheet program can also be used.
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
additional net cash flow received at end the of asset’s life.
Notes
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
asset’s cash flows
a. 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
years and smaller ones in later years.
b. Early cash flows are more valuable than later ones; as
such, being able to use accelerated depreciation for tax
reporting makes investment more desirable.
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.
i. A present value of an annuity table (see Appendix B)
can be used to determine the discount rate that relates
to this present value factor given the life of the
project.
ii. If the present value factor in the table does not exactly
equal the one computed, the procedure set forth on
page 1086 in the text.
Notes
Chapter Outline
4. When cash flows are unequal, trial and error must be used;
select any reasonable discount rate and compute the NPV.
a. If amount is positive, recompute NPV using higher
discount rate; if amount is negative, recompute NPV using
lower discount rate.
b. Continue steps until two consecutive computations result
in NPVs that have different signs (positive and negative);
IRR lies between these two discount rates; value can be
estimated.
c. Spreadsheet software and calculators can also be used to
compute the IRR. (See Appendix 24A)
5. Compare IRR with hurdle rate (or minimum acceptable rate of
return); if IRR exceeds hurdle rate, invest.
6. If evaluating multiple projects, rank by extent to which IRR
exceeds hurdle rate.
7. 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.
C. Comparison of Capital Budgeting Methods (see Exhibit 24.10)
1. Payback period and accounting rate of return do not consider
time value of money; NPV and IRR do.
2. Payback period method is simple; sometimes used when
limited cash to invest and a number of projects to choose
from. Gives manager an estimate of how soon the initial
investment can be recovered.
3. 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.
4. Net Present Value (NPV):
a. Considers all estimated cash flows of project; can be
applied to equal and unequal cash flows.
b. Can reflect changes in level of risk over life of project.
c. Comparisons of projects of unequal sizes is more difficult
5. Internal Rate of Return (IRR):
a. Considers all estimated cash flows of project.
b. Readily computed when cash flows are equal, but requires
trial and error estimation when cash flows are unequal.
c. Allows comparisons of projects with different investment
amounts.
d. Does not reflect changes in risk over life of project.
Notes
Chapter Outline
IV. Decision AnalysisBreak-Even Time (BET) A variation of the
payback period method – overcomes the limitation of not using the
time value of money
A. The future cash flows are restated in terms of their present values;
B. The payback period is computed using these present values
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 than estimated life of investment, positive net
present value can be expected from investment.
To compare and rank alternative investment projects, choose
the project with the lowest break-even time.
V. Using Excel to Compute Net Present Value and Internal Rate of
Return (Appendix A)
A. These calculations can be performed simply and accurately by
using functions built into Excel.
B. Excel has a function called NPV to compute the net present value.
C. Excel has a function called IRR to compute the internal rate of
return.
Notes
Chapter 24 Alternate Demonstration Problem
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 and profitability index:
(a) Ignoring income taxes, using a discount rate of 10%.
(b) Including the effect of taxes, using a 10% discount rate.
Solution: Chapter 24 Alternate Demonstration Problem
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
Profitability Index
=
Net Present Value
=
$ 162,531
=
.813
Cost of Investment
$ 200,000
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
Profitability Index
=
Net Present Value
=
$ 66,676
=
.333
Cost of Investment
$ 200,000
