Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
The Capital Budgeting Decision
Author's Overview
While early comments on administrative procedures and accounting considerations are helpful,
the major thrust of Chapter 12 is on the various methods for ranking investment proposals. The
basic selection methods are established, mutually exclusive versus non-mutually exclusive
events are compared, and the reinvestment assumption, capital rationing and the net present
value profile are presented.
The chapter continues with a comprehensive discussion of procedures for depreciation write-off
and integrates the resultant cash flow determination with the capital budgeting decision. There
is also a presentation of a replacement decision that examines the process of selling an old piece
of equipment and replacing it with a new version. The tax consequences of replacement are
carefully examined and included in the example presented.
Chapter Concepts
LO1. A capital budgeting decision represents a long-term investment decision.
LO2. Cash flow rather than earnings is used in the capital budgeting decision.
LO3. The payback method considers the importance of liquidity, but fails to consider the time
value of money.
LO4. The net present value and the internal rate of return are generally the preferred methods
of capital budgeting analysis.
LO5. The discount or cut-off rate is normally the cost of capital.
Annotated Outline and Strategy
I. Introduction
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale
or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a
website, in whole or part.
12-1
12
A. Capital expenditures are outlays for projects with lives extending beyond one
year and perhaps for as many as 25 years for utilities and oil and gas companies.
B. Intensive planning is required.
C. Capital expenditures usually require initial cash flows, often large, with the
expectation of future cash inflows. The differing time periods of inflows and
outflows require present-value analysis.
D. The longer the time horizon associated with a capital expenditure, the greater the
uncertainty. Areas of uncertainty are:
1. Annual costs and inflows.
2. Product life.
3. Interest rates.
4. Economic conditions.
5. Technological change.
II. Administrative Considerations
PPT Capital Budgeting Procedures (Figure 12-1)
A. Search and discovery of investment opportunities
B. Collection of data
C. Evaluation and decision making
D. Reevaluation and adjustment
III. Accounting Flows versus Cash Flows
A. The capital budgeting process focuses on cash flows rather than income. Income
figures do not reflect the cash available to a firm due to the deduction of noncash
expenditures such as depreciation.
PPT Cash Flow for Alston Corporation (Table 12-1) and
PPT Revised Cash Flow for Alston Corporation (Table 12-2)
B. Accounting flows are not totally disregarded in the capital budgeting process.
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale
or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a
website, in whole or part.
12-2
1. Investors' emphasis on earnings per share may, under certain conditions,
require use of income rather than cash as the decision criterion.
2. Top management may elect to glean the short-term personal benefits of
an income effect rather than the long-run cash-flow effects which are
more beneficial, from the owner's viewpoint.
IV. Methods for Ranking Investment Proposals
A. Payback Method
1. The payback period is the length of time necessary for the sum of the
expected annual cash inflows to equal the cash investment. A cutoff
period is established for comparison. Capital proposals with a payback
in excess of the cutoff are rejected.
2. Deficiencies of the method
a. Inflows after the payback period are ignored.
b. The pattern of cash flows is ignored, therefore, time value of
money is not considered.
3. Though not conceptually sound, the payback method is frequently used.
a. Easy to use
b. Emphasizes liquidity
c. Quick return is important to firms in industries characterized by rapid
technological development.
PPT Investment Alternatives (Table 12-3)
Perspective 12-1: During periods of high inflation, a quick payback on a project indicates a
rapid return of funds for reinvestment at perhaps even higher inflated returns that some
companies prefer over the superior IRR and NPV methods.
B. Net Present Value (NPV)
1. In this method, the cash inflows are discounted at the firm's cost of
capital or some variation of that measure.
2. If the present value of the cash inflows equals or exceeds the present
value of the cash investment, the capital proposal is acceptable.
3. We use the NPV function of Excel to demonstrate the difference in net
present value between Investments A and B. The use of Excel provides
the opportunity to use sensitivity testing with various discount rates to
demonstrate the change in NPV.
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale
or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a
website, in whole or part.
12-3
Finance in Action: Capital Budgeting Practices Utilized by Smaller, Privately Held
Businesses
This article discusses why small privately owned businesses use the payback method rather
than discounted cash flow techniques. Most small business owners are not as sophisticated
financially as Fortune 500 companies and they don’t really have to be. Their projects are small
and often have short lives. Additionally they don’t have stockholders to hold them accountable
for their rate of return decisions only bankers who want to know how they will repay the loan.
C. Internal Rate of Return (IRR)
1. The IRR method requires calculation of the rate that equates the cash
investment with the cash inflows.
2. The calculation procedure is the same as the yield to maturity
computation presented in Chapter 9.
3. An investment option where the IRR exceeds the minimum return on
investment (usually the firm's cost of capital or some variation of that
measure) is a candidate for approval.
4. To fully comprehend the meaning of the internal rate of return, the
student needs to understand how IRR relates to NPV, and so it is
important to show that the IRR is the discount rate (interest rate) that
makes NPV = 0.
5. We use the IRR function of Excel to demonstrate the difference between
the rates of return for Investments A and B.
6. You can show that the “Goal Seek” function in Excel that was used in
Chapter 10 to calculate the yield to maturity can also be used to calculate
an IRR since the yield to maturity on a bond is nothing more than the
bond’s internal rate of return.
7. A financial calculator can also be used to determine the IRR for both
annuities and uneven cash flows. We demonstrate the keystrokes needed
to solve for IRR with uneven cash flows
Perspective 12-2: Please see the excel examples for NPV and IRR calculations in
Tables 12-4 and 12-5 as well as the calculator keystrokes in the margins on pages 387
and 388. These excel skills should be well learned by Chapter 12.
V. Selection Strategy
A. All non-mutually exclusive projects having an NPV >= 0 (which also means IRR
>= cost of capital) should be accepted under normal conditions. If the NPV = 0,
it means that the company will earn its cost of capital on the project.
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale
or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a
website, in whole or part.
12-4
B. The NPV method and the IRR method always agree on the “accept” or “reject”
decision on non-mutually exclusive projects.
C. A disagreement may arise between the NPV and IRR methods when a choice
must be made between mutually exclusive proposals or when all acceptable
proposals cannot be taken due to capital rationing.
1. The primary cause of disagreement is the differing reinvestment
assumptions. The NPV method inherently assumes reinvestment of cash
inflows at the cost of capital. The IRR method assumes reinvestment of
cash inflows at the internal rate of return.
2. The more conservative net present value technique is usually the
recommended approach when a conflict in ranking arises.
PPT The Reinvestment Assumption—Net Present Value ($10,000
Investment) (Table 12-7)
D. Modified internal rate of return is an alternative calculation to the IRR and NPV
methods.
1. All cash outflows are discounted to the present at the firm’s cost of capital.
2. All cash inflows are converted to a terminal value by compounding them
at the firm’s cost of capital out to the end of the project.
3. The discount rate that equates the future value of the inflows growing at
the cost of capital with the amount invested is the MIRR.
4. Table 12-9 demonstrates the method for calculating MIRR using the
RATE function on Excel.
Perspective 12-3: This can be exemplified by the reinvestment of funds from certificates of
deposit as they come due.
VI. Capital Rationing
A. Management may implement capital rationing by artificially constraining the
amount of investment expenditures.
PPT Capital Rationing
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale
or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a
website, in whole or part.
12-5
B. Under capital rationing, some acceptable projects may be declined due to
management's fear of growth or hesitancy to use external financing.
C. Under capital rationing, projects are ranked by NPV and accepted until the
rationed amount of capital is exhausted.
VII. Net Present Value Profile
A. The characteristics of an investment may be summarized by the use of the net
present value profile.
Perspective 12-3: The net present value profile can be used to reinforce the inverse nature of
required rates of return and present value interest factors and the resultant impact on discounted
cash flow streams.
B. The NPV profile provides a graphical representation of an investment at various
discount rates.
C. Three characteristics of an investment are needed to apply the net present value
profile:
1. The net present value at a zero discount rate.
2. The net present value of the project at the normal discount rate (cost of
capital).
3. The internal rate of return for the investment.
PPT Net Present Value Profile (Figure 12-2)
D. The NPV profile is particularly useful in comparing projects when they are
mutually exclusive or under conditions of capital rationing.
E. The NPV profile demonstrates that the IRR method is not an acceptable decision
criterion when the WACC lies to the left of the cross-over point of two mutually
exclusive investment proposals.
PPT Net Present Value Profile with Crossover (Figure 12-3)
VIII. Combining Cash Flow Analysis and Selection Strategy
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale
or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a
website, in whole or part.
12-6
A. The Rules for Depreciation: The Tax Reform Act of 1986 created classified
eight different categories that determine the allowable rate of depreciation. Each
class is referred to as an "MACRS category" or Modified Accelerated Cost
Recovery Range.
PPT Categories for Depreciation Write Off (Table 12-11)
PPT Depreciation Percentages (Table 12-12)
PPT Depreciation schedule (Table 12-13)
IX. Actual Investment Decision: This section includes an example of calculating the NPV
of an investment proposal that includes the use of MACRS depreciation that results in
an uneven cash flow stream and the calculation of the after-tax cash flow.
PPT Cash Flow Related to the Purchase of Machinery (Table 12-14)
PPT Net Present Value Analysis (Table 12-15)
X. The Replacement Decision
A. Sale of Old Asset
B. Incremental Depreciation
C. Cost Savings
PPT Analysis of Incremental Depreciation Benefits (Table 12-18)
PPT Analysis of Incremental Cost Savings Benefits (Table 12-19)
PPT Present Value of the Total Incremental Benefits (Table 12-20)
XI. Elective Expensing: Under the 2008 Economic Stimulus Act, firms have the option to
write off the purchase of equipment, furniture, tools, and computers for up to $250,000 in the
year they are purchased. This provides a cash flow advantage by deferring taxes to future
periods. The allowance is phased out dollar for dollar when total property purchases exceed
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale
or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a
website, in whole or part.
12-7
$800,000 in a year.
Other Chapter Supplements
Cases for Use with Foundations of Financial Management
Case 18, Aerocomp, Inc. (Methods of Investment Evaluation)
Case 19, Phelps Toy Company (Capital Budgeting and Cash Flow)
© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale
or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a
website, in whole or part.
12-8
