Learning Objectives
1. Why do most capital budgeting methods focus on cash flows?
2. How is payback period computed, and what does it measure?
measure?
4. How is the internal rate of return on a project computed, and what does that rate measure?
5. How do taxation and depreciation affect cash flows?
method?
7. How do managers rank investment projects?
8. How is risk considered in capital budgeting analyses?
CAPITAL BUDGETING
CHAPTER
15
Chapter 15: Capital Budgeting IM 2
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Terminology
Accounting rate of return (ARR): the rate of earnings obtained on the average capital investment over a
project’s life; computed as average annual profits divided by average investment; not based on cash flow
Annuity: a series of equal cash flows (either positive or negative) over time
Annuity due: a series of equal cash flows received or paid at the beginning of a period
Compound interest: a method of determining interest in which interest that was earned in prior periods
is added to the original investment so that, in each successive period, interest is earned on both principal
and interest
compose a firm’s financial structure
Discount rate: the rate of return used to discount future cash flows to their present value amounts; it
net present value amounts
Independent projects: investment projects that have no specific bearing on one another
Internal rate of return (IRR): the discount rate that causes the present value of the net cash inflows to
equal the present value of the net cash outflows
Investment decision: a judgment about which assets to acquire to accomplish an entity’s mission
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Mutually exclusive projects: projects that fulfill the same function; one project will be chosen from such
a group, excluding all others from further consideration because they would provide unneeded or
redundant capability
an investment project
Net present value method: a process that uses the discounted cash flows of a project to determine
whether the rate of return on that project is equal to, higher than, or lower than the desired rate of return
comparing them to the expected results
Preference decision: a decision where projects are ranked according to their impact on the achievement
of company objectives
Present value (PV): the amount that one or more future cash flows is worth currently, given a specified
rate of interest
to the net investment
Reinvestment assumption: an assumption made about the rates of return that will be earned by
Return of capital: the recovery of a project’s original investment (or principal)
from an investment
Risk-adjusted discount rate method: a formal method of adjusting for risk in which the decision maker
increases the rate used for discounting the future cash inflows and decreases the rate used for
discounting future cash outflows to compensate for increased risk
Screening decision: determines whether a capital project is desirable based on some previously
established minimum criterion or criteria
Tax benefit (of depreciation): the amount of depreciation deductible for tax purposes multiplied by the
tax rate; the reduction in taxes caused by the deductibility of depreciation
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Tax shield (of depreciation): the amount of depreciation deductible for tax purposes; the amount of
revenue shielded from taxes because of the depreciation deduction
Time line: a representation of the amounts and timing of all cash inflows and outflows used in analyzing
a capital investment proposal
Time value of money: a term used to describe the fact that a dollar received today has more value than
Chapter 15: Capital Budgeting IM 5
Lecture Outline
LO.1: Why do most capital budgeting methods focus on cash flows?
A. Introduction
decisions for managers.
provide distribution, service, or production capacity.
3. This chapter discusses techniques used to evaluate the potential financial costs and benefits of
capital projects.
B. Capital Asset Acquisition
1. Capital budgeting involves evaluating and ranking alternative future investments to allocate
limited resources effectively and efficiently.
summary information for the long term (6 to 10 years) are shown in the capital budget, which
2. Capital budgeting involves comparing and evaluating alternative projects.
projects.
b. Although financial criteria are used to assess virtually all projects, firms now also use
monetarily.
3. Text Exhibit 15.1 (p. 601) provides quantitative and qualitative criteria used by the forest
products industry to evaluate capital projects.
C. Use of Cash Flows in Capital Budgeting
1. Any investment made by an organization is expected to earn some type of return in the form of
interest, cash dividends, or operating income.
equivalent basis.
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3. Cash flows are the receipts or disbursements of cash; when related to capital budgeting, cash
flows arise from the purchase, operation, and disposition of a capital asset.
4. In evaluating capital projects, a distinction is made between operating cash flows and financing
cash flows.
selection process.
b. Project funding is a financing, not an investment decision.
i. A financing decision is a judgment regarding the method of raising capital to fund an
investment.
entity’s mission.
iii. Management must justify an asset’s acquisition and use prior to justifying the method of
financing that asset.
5. Cash flows from a capital project are received and paid at different times during a project’s life.
a. Some cash flows occur at the beginning of a period, other cash flows occur during the period,
and still others occur at the end.
b. Analysts assume that cash flows always occur at either the beginning or the end of the time
period during which they actually occur in order to simplify capital budgeting analysis.
D. Cash Flows Illustrated
1. Text Exhibit 15.2 (p. 603) presents the expected costs and cost savings of a proposed capital
project for the company discussed in the chapter.
2. Time lines
a. A time line is a device that visually illustrates the points in time when cash flows are
b. Cash inflows are shown as positive amounts on a time line, cash outflows are shown as
negative amounts, and today equals t = 0.
LO.2: How is payback period computed, and what does it measure?
3. Payback period
a. The payback period is the time required for a project’s cash inflows to equal the original
investment.
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b. The longer it takes to recover the initial investment, the greater is the project’s risk because
cash flows in the more distant future are more uncertain than relatively current cash flows.
c. The faster capital is returned from an investment, the more rapidly it can be invested in other
projects.
f. Company management typically sets a maximum acceptable payback period as one of the
evaluation techniques for capital projects.
g. The payback period method ignores three important things: inflows that occur after the
E. Discounting Future Cash Flows
1. General
money.
ii. Discounting is the process of reducing future cash flows to their present value amounts
by removing the portion of the future values representing interest.
b. The “imputed” interest amount is based on two considerations: the length of time until the
cash flow is received or paid and the rate of interest assumed.
associated with a project are discounted.
d. Capital project evaluations require estimates of the amounts and timing of future cash inflows
and outflows.
e. Managers must estimate the rate of return on capital investments required by the company;
this rate is called the discount rate.
weighted average cost of capital.
ii. The cost of capital (COC) is the weighted average cost of the various sources of funds
(debt and stock) that comprise a firm’s financial structure.
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f. Managers must distinguish between cash flows that represent a return of capital and those
representing a return on capital.
i. A return of capital is the recovery of the original investment or the return of principal.
ii. A return on capital represents income and equals the discount rate multiplied by the
investment amount.
g. To determine whether a project meets a company’s desired rate of return, one of several
LO.3: How are the net present value and profitability index of a project computed, and what do
they measure?
2. Net present value method
the desired rate of return.
b. A project’s net present value (NPV) is the difference between the total present value of all
cash outflows and the total present value of all cash outflows for an investment project.
c. Net present value data and calculations are provided in text Exhibit 15.3 (p. 605).
d. The net present value represents the net cash benefit (or, if negative, the net cash cost) of
acquiring and using the proposed asset.
affects the NPV. Increasing the discount rate causes NPV to decrease; decreasing the
discount rate causes NPV to increase.
ii. Changes in estimated amounts and/or timing of cash inflows and outflows affect a
project’s net present value.
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i. This method can also be used to select the best project when choosing among
investments that can perform the same task or achieve the same objective.
invested in the project.
3. Profitability Index
a. The profitability index (PI) is a ratio that compares the present value of net cash flows to the
project’s net investment and is calculated as:
PI = Total Present Value of Net Cash Flows ÷ Net Investment
PV of future cash outflows.
c. The PV of net cash inflows represents an output measure of the project’s worth, whereas the
net investment represents an input measure of the project’s cost.
i. By relating these two measures, the profitability index gauges the efficiency of the firm’s
use of capital.
LO.4: How is the internal rate of return on a project computed, and what does that rate measure?
4. The internal rate of return
a. The internal rate of return (IRR) is the discount rate that causes the present value of the net
cash inflows to equal the present value of the net cash outflows and is the project’s expected
NPV = –Net investment + PV of annuity amount
NPV = –Net investment + (Cash flow annuity amount × PV factor)
Chapter 15: Capital Budgeting IM 10
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c. The investment and annual cash flow amounts are known from the expected data and NPV is
known to be zero at the IRR; the IRR and its PV factor are unknown. To determine the IRR,
substitute known amounts into the formula, rearrange terms, and solve for the unknown PV
factor:
NPV = –Net investment + (Annuity × PV factor)
g. Manually finding the IRR of a project that has unequal annual cash flows is more complex
and requires an iterative trial-and-error process whereby different discount rates are tried until
NPV = 0.
h. A company’s hurdle rate is the rate of return specified as the lowest acceptable rate on an
return on $5!
j. Using the IRR method has three drawbacks:
i. When uneven cash flows exist, the iterative process is inconvenient and time consuming;
ii. Unless PV tables that provide factors for fractional interest rates are available, finding the
precise IRR on a project is difficult; and
time 0).
k. In performing discounted cash flow analyses, accrual–based accounting information must be
converted to cash flow data.
i. One accrual that deserves special attention is depreciation.