Chapter 11 Capital Budgeting Decisions
Chapter 11
Lecture Notes
Chapter theme: The term capital budgeting is used to
describe how managers plan significant cash outlays on
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?
Chapter 11 Capital Budgeting Decisions
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.
2. Preference decisions relate to selecting
among several competing courses of action.
a. For example, a company may be
C. Cash flows versus net operating income
i. The payback method, the net present value
method and the internal rate of return method
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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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
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
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II. The payback method
Learning Objective 11-1: Determine the payback
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;
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.
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.
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
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2. Strengths
a. It can serve as a screening tool to help
identify which investment proposals
are in the “ballpark.”
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
III. The net present value method
Learning Objective 11-2: Evaluate the acceptability of
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A. Key concepts/assumptions
i. The net present value method compares the
ii. Two simplifying assumptions are usually
made in net present value analysis:
1. The first assumption is that all cash flows
B. The net present value method: an example using
discount factors from Exhibits 11B-1 and 11B-2
i. Assume the information as shown with
respect to Lester Company.
1. Also assume that at the end of five years the
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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.
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.
Quick Check – net present value calculations
C. The net present value method: an example using
discount factors from Exhibits 11B-1
i. For this next example, we’ll use the same
information from Lester Company.
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ii. Since the investments in equipment
iii. The total cash flows for years 1-5 are
discounted to their present values using the
discount factors from Exhibit 11B-1.
iv. For example, the total cash flows in year 1 of
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:
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3. If the company’s minimum required rate of
return is used as the discount rate:
a. A project with a positive net present
4. A company’s cost of capital is usually
regarded as its minimum required rate of
return. The cost of capital is the average
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
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2. This implies that the cash inflows are
IV. Expanding the net present value method
A. We will now expand the net present value method to
include two alternatives. We will analyze the
alternatives using the total cost approach.
B. Net present value analysis: an expanded example
i. Assume that White Co. has two
ii. In addition, assume that the information as
shown relates to the installation of a new
washer.
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iv. If White chooses to remodel the existing
washer, the remodeling costs would be
$175,000 and the cost to replace the brushes
at the end of six years would be $80,000.
C. Least cost decisions
i. In decisions where revenues are not directly
involved, managers should choose the
1. Assume the following:
a. Home Furniture Company is trying to
2. The information pertaining to the old and
new trucks is as shown.
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3. The net present value of buying a new truck
is ($32,883). The net present value of
V. Preference decisions – the ranking of investment
projects
Learning Objective 11-3: Rank investment projects in
order of preference.
A. Background
i. Recall that when considering investment
1. Screening decisions, which come first,
pertain to whether or not some proposed
investment is acceptable.
2. Preference decisions, which come after
screening decisions, attempt to rank
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B. Net present value method
i. The net present value of one project cannot
ii. In the case of unequal investments, a project
profitability index can be computed as
shown. Notice:
1. The project profitability indexes for
investments A and B are 0.01 and 0.20,
respectively.
Chapter 11 Capital Budgeting Decisions
VI. The simple rate of return method
Learning Objective 11-4: Compute the simple rate of
return for an investment.
i. Key concepts
1. The simple rate of return method (also
known as the accounting rate of return or
of return 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
iii. Criticisms of the simple rate of return
1. It does not consider the time value of
money.
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2. The simple rate of return fluctuates from
year to year when used to evaluate projects
iv. The behavioral implications of the simple
rate of return
1. When investment center managers are
VII. Postaudit of investment projects
A. A postaudit is a follow-up after the project has been
completed to see whether or not expected results were
actually realized.
i. The data used in a postaudit analysis should