978-1259277160 Chapter 12 Lecture Note

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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

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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.

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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.

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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.

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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

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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

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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

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$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)

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