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B. Internal rate of return method
i. When using the internal rate of return method
to rank competing investment projects, the
preference rule is: the higher the internal
rate of return, the more desirable the
project.
C. Net present value method
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1. The project profitability indexes for
investments A and B are 0.01 and 0.20,
respectively.
2. The higher the project profitability index,
the more desirable the project. Therefore,
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available for investment, the project
profitability index is similar to the
contribution margin per unit of the
constrained resource discussed in an earlier
chapter.
VII. Other approaches to capital budgeting decisions
B. The payback method
Learning Objective 5: Determine the payback period
for an investment.
i. Key concepts
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ii. The Daily Grind – an example
1. Assume the management of the Daily Grind
wants to install an espresso bar in its
restaurant.
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espresso bar?
2. The payback period is 4.0 years. Therefore,
management would choose to invest in the
bar.
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.
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Helpful Hint: Ask students to choose between two
options that each require an initial investment of
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2. Strengths
a. It can serve as a screening tool to help
identify which investment proposals
are in the “ballpark.”
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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
cannot be used. Instead, the un-recovered
investment must be tracked year by year.
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C. The simple rate of return method
Learning Objective 6: 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
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.
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iii. Criticism 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
VIII. 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.
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IX. Appendix 13A: the concept of present value (Slide #84 is
the title slide for this appendix)
A. The mathematics of interest
i. A dollar received today is worth more than a
dollar received a year from now because you
can put it in the bank today and have more
than a dollar a year from now.
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2. How much will the $100 be worth in one
year?
3. The equation needed to answer this question
is as shown, where:
a. F = the ending balance.
b. P = the amount invested now.
c. r = the rate of interest per period.
d. n = the number of periods.
iii. Compound interest – the example
continued
1. What if the $108 was left in the bank for a
second year? How much would the original
$100 be worth at the end of the second year?
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3. Solving this equation, the answer is $116.64.
a. The interest that is paid in the second
year on the interest earned in the first
year is known as compound interest.
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B. Computation of present value
ii. Present value – an example
1. Assume a bond will pay $100 in two years.
If an investor can earn 12% on their
investments, what is the present value of
the bond?
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3. Solving this equation, P = $79.72.
a. This process is called discounting. We
have discounted the $100 to its present
value of $79.72. The interest rate used
to find the present value is called the
discount rate.
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5. We can also use the present value of $1
table from Appendix 13B-1 to verify the
accuracy of the $79.72 figure.
Quick Check – present value calculations
C. Present value of a series of cash flows
i. Although some investments involve a single
sum to be received (or paid) at a single point
ii. Lacey Inc. – an example
1. Assume Lacey Inc. purchased a tract of land
on which a $60,000 payment will be due
each of the next five years.
Quick Check – present value of an annuity calculations
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X. Appendix 13C: income taxes in capital budgeting
decisions (Slide #103 is a title slide for this appendix)
Learning Objective 8: Include income taxes in a capital
budgeting analysis.
A. Simplifying assumptions
B. The concept of after-tax cost
i. An expenditure net of its tax effect is known
as after-tax cost.
ii. After tax-cost – an example
1. Assume a company with a 30% tax rate is
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3. The answer can also be determined by
calculating the taxable income and income
tax for two alternatives – without the
training program and with the training
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1. The equation for determining the after-tax
benefit of any taxable cash receipt is as
shown.
Helpful Hint: Ask students to think of examples of
C. Depreciation tax shield
i. While depreciation is not a cash flow, it does
affect the taxes that must be paid and
therefore has an indirect effect on a
company’s cash flows.
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Helpful Hint: Remind students that when an asset is
purchased, a cash outflow occurs. Depreciation is just
the allocation of that purchase price over some
estimated life.
ii. Depreciation tax shield – an example
1. Assume that a company has:
a. Annual cash sales and cash operating
expenses of $500,000 and $310,000,
2. The aforementioned equation can be used to
calculate the depreciation tax shield of
$27,000.
3. The answer can also be determined by
calculating the taxable income and income
tax for two alternatives – without the
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D. Example of income taxes and capital budgeting
i. Holland Company owns the mineral rights to
land that has a deposit of ore. The company is
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1. Pertinent financial information is as shown.
ii. The first step is to compute the net annual
cash receipts ($80,000) from operating the
mine.
iii. The second step is to identify all relevant
cash flows as shown. Notice:
iv. The third step is to translate the relevant cash
flows to after-tax cash flows as shown.
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