Chapter 13
Lecture Notes
Chapter theme: The term capital budgeting is used to
describe how managers plan significant cash outlays on
I. Capital budgeting – planning investments
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:
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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
considering several different machines
to replace an existing machine on the
assembly line.
C. 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
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present value tables are explained in greater
detail in Appendix 13A).
II. Discounted cash flows – the net present value method
A. Key concepts/assumptions
i. The net present value method compares the
present value of a project’s cash inflows with
the present value of its cash outflows. The
difference between these two streams of cash
flows is called the net present value.
ii. The net present value is interpreted as
follows:
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iii. Net present value analysis (as well as the
internal rate of return, which will be discussed
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1. Examples of typical cash outflows that are
included in net present value calculations are
as shown. Notice the term working capital
which is defined as current assets less
current liabilities.
2. Examples of typical cash inflows that are
included in net present value calculations are
as shown.
iv. The net present value method excludes
depreciation for two reasons:
1. First, depreciation is not a current cash
outflow.
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c. This implies that the cash inflows are
sufficient to recover the $3,170 initial
investment (therefore depreciation is
unnecessary) and to provide exactly a
10% return on the investment.
v. Two simplifying assumptions are usually
made in net present value analysis:
1. The first assumption is that all cash flows
other than the initial investment occur at the
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vi. A company’s cost of capital, defined as the
average rate of return a company must pay to
its long-term creditors and shareholders for
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B. The net present value method: an example
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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ii. The annual net cash inflow from operations
($80,000) is computed as shown.
iv. The present value factor for an annuity of $1
for five years at 10% is 3.791. Therefore, the
present value of the annual net cash inflows is
$303,280.
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vii. The net present value of the investment
opportunity is $85,955. Since the net present
value is positive, it suggests making the
investment.
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III. Discounted cash flows – the internal rate of return
method
Learning Objective 2: Evaluate the acceptability of an
investment project using the internal rate of return
method.
A. Key concepts
ii. The internal rate of return is the discount rate
that will result in a net present value of zero.
iii. This technique works very well if a project’s
cash flows are identical every year. If the cash
flows are not identical every year a trial-and-
error process can be used to find the internal
rate of return.
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B. Internal rate of return – an example
i. Assume the facts as shown with respect to the
Decker Company.
Quick Check – internal rate of return calculations
C. Comparing the net present value and internal rate
of return methods
i. The net present value method offers two
important advantages over the internal rate
of return method.
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a. If the internal rate of return is high,
this assumption may be unrealistic. It
is more realistic to assume that the
cash flows can be reinvested at the
discount rate, which is the underlying
assumption of the net present value
method.
IV. Expanding the net present value method
B. The total cost approach – an example
i. Assume that White Co. has two
alternatives—remodel an old car wash or
remove the old car wash and replace it with a
new one.
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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. The incremental cost approach – continuing with
the example
i. Under the incremental cost approach, only
those cash flows that differ between the
remodeling and replacing alternatives are
considered.
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Quick Check – total cost and incremental cost
approaches
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D. Least cost decisions
ii. Home Furniture Company – an example
(we will analyze this decision using the total-
cost approach.
1. Assume the following:
2. The information pertaining to the old and
new trucks is as shown.
3. The net present value of buying a new truck
is ($32, 883). The net present value of
overhauling the old truck is ($42,255).
Quick Check – least cost decisions
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V. Uncertain cash flows
Learning Objective 3: Evaluate an investment project
that has uncertain cash flows.
A. Handling the complication of uncertain future cash
flows – an example
1. Using a discount rate of 12%, management
has determined that the net present value of
all the cash flows except the salvage value is
a negative $1.04 million.
ii. The equation shown can be used to determine
that if the salvage value of the supertanker is
at least $10 million, the net present value of
the investment would be positive and
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B. Real options
i. The analysis in this chapter has assumed that
an investment cannot be postponed and that,
once started, nothing can be done to alter the
course of the project.
iii. The value of these options can be quantified
using what is called real options analysis,
which is beyond the scope of the book.
VI. Preference decisions – the ranking of investment
projects
A. Background
i. Recall that when considering investment
opportunities, managers must make two types
of decisions – screening decisions and
preference decisions.