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CHAPTER EIGHT
Long-Term (Capital Investment) Decisions
This chapter examines long-term (capital investment) decisions. In
particular, it examines different methods (NPV, IRR, PI and payback
Key Concepts
• If the present value of cash inflows is greater than or equal to the
present value of cash outflows (the NPV is greater than or equal to
zero), then the investment provides a return at least equal to the
• The profitability index is a useful tool for making preference decisions
because it can be used to compare projects that require investment of
different amounts.
• Taxes are a major source of cash outflows for many companies and
patterns.
Learning Objectives
LO1— Use the NPV method to evaluate capital investment decisions.
LO2— Use the IRR method to evaluate capital investment decisions.
LO3— Distinguish between screening and preference decisions and use the
profitability index to evaluate preference decisions.
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Lecture Outline
A. Introduction
1. Capital investment decisions are long-term decisions involving the
purchase (or lease) of new machinery and equipment and the
acquisition or expansion of facilities used in a business.
B. Net Present Value (LO1)
Net present value is a technique for considering the time value of money
whereby the present value of all cash inflows associated with a project is
compared with the present value of all cash outflows.
1. NPV uses discount rate for its analysis. Many companies choose to
use the cost of capital (what a firm would have to pay to borrow or
2. Computing net present value requires comparing the present value
of all cash inflows associated with a project with the present value
of all cash outflows.
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3. If the present value of the inflows is greater than or equal to the
present value of the outflows (the NPV is greater than or equal to
4. If the present value of the outflows is greater than the present value
5. A positive NPV of a project indicates that the project’s rate of return
is higher than the discount rate. However, it does not tell us exactly
what the return is. The actual return of a project can be found out
Key Formula
Key Formula
PVA = R (DFAn,r)
where R is the annual cash inflow, DFA is the discount factor for an ordinary
annuity, and n is the number of periods.
Key Concept
If the present value of cash inflows is greater than or equal to the present value
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C. Internal Rate of Return (LO2)
The internal rate of return (IRR) is the actual yield, or return, earned by an
investment. IRR is the discount rate that equates the present value of all
cash inflows to the present value of all cash outflows or makes NPV = 0.
1. The Problem of Uneven Cash Flows
2. Key Assumptions of Discounted Cash Flow Analysis
o The first assumption is that all cash flows occur at the end
of each period. Although most cost reductions and cash
is used.
a. Under the NPV method, cash inflows are assumed to
be reinvested at the discount rate.
3. The Importance of Qualitative Factors
It may be difficult to evaluate some investment decisions purely
Key Concept
The internal rate of return (IRR) is the actual yield, or return, earned by an
investment.
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D. Screening Decisions and Preference Decisions (LO3)
1. Capital investment decisions typically fall into one of two
categories: screening decisions or preference decisions.
2. Both NPV and IRR can be used as a screening tool. They
accomplish the same objectives but are used in different ways.
o Under NPV, any project that has a positive net present
3. NPV (without adjustment) cannot be used to compare investments
(make preference decisions) unless the competing investments are
4. Profitability Index
Profitability Index is calculated by dividing the present value of the
cash inflows by the initial investment.
Key Formula
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o A profitability index greater than 1.0 suggests that the NPV
is positive. Thus, if the profitability index of a project is
more than 1, the project can be accepted.
o In comparing the PI of competing projects, the project with
o When the investment lives of competing projects are equal
and their cash flows follow similar patterns, the preference
decision as per profitability index method can be confirmed
by using IRR method.
o When asset lives are unequal and cash flows follow
E. The Impact of Taxes on Capital Investment Decisions (LO4)
1. Profit-making companies must pay income taxes on any taxable
Key Concept
The profitability index is a useful tool for making preference decisions because
it can be used to compare projects that require investment of different amounts.
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2. When an asset is sold or disposed of, the gain or loss is calculated
on the difference between the sales price and the book value.
3. Not all tax-deductible expenses involve cash outflows. However,
they may result in indirect cash inflows in the form of tax savings
such as depreciation tax shield.
4. The Depreciation Tax Shield
o Depreciation expense reduces a company’s taxable
income and thus its income tax, resulting in an increase in
cash flow.
F. The Payback Method (LO5)
1. The payback period is the length of time needed to pay back the
Key Concept
Taxes are a major source of cash outflows for many companies and must
be taken into consideration in calculations of the time value of money.
Key Formula
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2. When the net annual cash inflows are the same over the life of a
3. Payback period ignores the time value of money and any cash flow
received after the initial investment is paid for.
4. The payback method can be useful as a quick approximation of the
End-of-Chapter Material
Brief exercises, exercises, problems, and cases based on different learning
objectives have been provided at the end of the chapter. These-end-of chapter
Making It Real:
Capital Investment Decisions in the University
Key Formula
Key Concept
The payback method can be useful as a quick approximation of the