12-1
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.
LO5. The discount or cutoff rate is normally the cost of capital.
12
12-2
Annotated Outline and Strategy
I. Introduction
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. Extensive planning is required.
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
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
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)
PPT Revised Cash Flow for Alston Corporation (Table 12-2)
B. Accounting flows are not totally disregarded in the capital budgeting process.
2. Top management may elect to glean the short-term personal benefits of an
income effect rather than the long-run cash-flow effects that are more
beneficial from the owner’s viewpoint.
IV. Methods of Ranking Investment Proposals
A. Payback Method
1. The payback period is the length of time necessary for the sum of the
2. Deficiencies of the method
3. Though not conceptually sound, the payback method is frequently used.
a. Easy to understand
b. Emphasizes liquidity
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, which 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.
12-4
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
PPT Calculating Net Present Value for Investments A and B (Table 12-4)
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
C. Internal Rate of Return (IRR)
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
4. To fully comprehend the meaning of the internal rate of return, the student
6. You can show that the “Goal Seek” function in Excel that was used in
7. A financial calculator can also be used to determine the IRR for both
PPT Calculating IRR for Investments A and B (Table 12-5)
12-5
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.
2. The more conservative net present value technique is usually the
recommended approach when a conflict in ranking arises.
PPT The Reinvestment Assumption—IRR and NPV ($10,000 Investment)
(Tables 12-7 and 12-8)
D. Modified internal rate of return is an alternative calculation to the IRR and NPV
methods.
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.
4. Table 12-9 demonstrates the method for calculating MIRR using the RATE
12-6
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 MIRR for Investment B (Table 12-9)
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
VII. Net Present Value Profile
A. The characteristics of an investment may be summarized by the use of the net present
value profile.
Perspective 12-4: 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.
3. The internal rate of return for the investments.
12-7
E. The NPV profile demonstrates that the IRR method is not an acceptable decision
criterion when the WACC lies to the left of the crossover 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
A. Tax law changes in 2017 have changed how depreciation is calculated for tax
purposes. Companies can temporarily take 100 percent bonus depreciation in the first
PPT Categories for Depreciation Write-Off (Table 12–11)
PPT Depreciation Percentages (Expressed in Decimals) (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, which includes the use of MACRS depreciation that results in an
uneven cash flow stream and the calculation of the aftertax cash flow.
PPT Cash Flow Related to the Purchase of Machinery (Table 12-14)
PPT Net Present Value (Table 12-15)
X. The Replacement Decision
A. Sale of Old Asset
PPT Book Value of Old Computer and Net Cost of New Computer (Tables
12-16 and 12-17)
12-8
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: Businesses can write off tangible property such as equipment,
furniture, tools, and computers in the year they are purchased for up to $1 million. This tax
deduction is superior to the previous depreciating asset when the write-off takes place over a
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)