Chapter 14
Capital Budgeting
Decisions
Capital Budgeting
How managers plan significant outlays
on projects that have long-term
implications such as the purchase of
new equipment and introduction of
new products.
Typical Capital Budgeting Decisions
Plant expansion
Equipment selection
Lease or buy
Equipment replacement
Cost reduction
Typical Capital Budgeting Decisions
Capital budgeting tends to fall into two broad
categories . . .
Screening decisions. Does a proposed
project meet some present standard of
acceptance?
Preference decisions. Selecting from among
several competing courses of action.
Time Value of Money
Business investments
extend over long periods
of time, so we must
recognize the time value
of money.
Investments that promise
returns earlier in time are
preferable to those that
promise returns later in
time.
Time Value of Money
A dollar today is worth
more than a dollar a
year from now since a
dollar received today
can be invested,
yielding more than a
dollar a year from now.
Interest and the Time Value of Money
If $100 is invested today at 8% interest,
how much will you have in two years?
At the end of one year:
$100 + 0.08  $100 = (1.08)  $100 = $108
At the end of two years:
(1.08)$108 = $116.64
or
(1.08)2 × $100 = $116.64
Interest and the Time Value of Money
The present value of any sum to be
received in the future can be computed by
turning the interest formula around and
solving for P:
P = Fn
1
(1 + r)n
Interest and the Time Value of Money
A bond will pay $100 in two years. What is
the present value of the $100 if an investor
can earn a return of 12% on investments?
1
P = 100 (1 + .12)2
P = $100 (0.797)
P = $79.70
Interest and the Time Value of Money
A bond will pay $100 in two years. What is
the present value of the $100 if an investor
can earn a return of 12% on investments?
Present Value = $79.70
What does this mean?
If $79.70 is put in the bank today,
it will be worth $100 in two years.
In that sense, $79.70 today is
equivalent to $100 in two years.
Time Value of Money
$100 × 0.797 = $79.70 present value
Periods
1
2
3
4
5
10%
0.909
0.826
0.751
0.683
0.621
Rate
12%
0.893
0.797
0.712
0.636
0.567
14%
0.877
0.769
0.675
0.592
0.519
Present value factor of $1 for 2 periods at 12%.
Quick Check 
How much would you have to put in the bank
today to have $100 at the end of five years if the
interest rate is 10%?
a. $62.10
b. $56.70
c. $90.90
d. $51.90
Quick Check 
How much would you have to put in the bank
today to have $100 at the end of five years if the
interest rate is 10%?
a. $62.10 $100  0.621 = $62.10
b. $56.70
c. $90.90
d. $51.90
Time Value of Money
An investment that involves a series
of identical cash flows at the end of
each year is called an annuity.
$100
$100
1
$100
2
$100
3
$100
4
$100
5
6
Time Value of Money
Lacey Inc. purchased a tract of land on
which a $60,000 payment will be due
each year for the next five years. What is
the present value of this stream of cash
payments when the discount rate is 12%?
Time Value of Money
We could solve the problem like this . . .
Look in Appendix C of this Chapter for the
Present Value of an Annuity of $1 Table
Periods
1
2
3
4
5
10%
0.909
1.736
2.487
3.170
3.791
12%
0.893
1.690
2.402
3.037
3.605
14%
0.877
1.647
2.322
2.914
3.433
Time Value of Money
We could solve the problem like this . . .
Periods
1
2
3
4
5
10%
0.909
1.736
2.487
3.170
3.791
12%
0.893
1.690
2.402
3.037
3.605
14%
0.877
1.647
2.322
2.914
3.433
$60,000 × 3.605 = $216,300
Quick Check 
If the interest rate is 14%, how much would you
have to put in the bank today so as to be able to
withdraw $100 at the end of each of the next
five years?
a. $34.33
b. $500.00
c. $343.30
d. $360.50
Quick Check 
If the interest rate is 14%, how much would you
have to put in the bank today so as to be able to
withdraw $100 at the end of each of the next
five years?
a. $34.33
b. $500.00
c. $343.30 $100  3.433 = $343.30
d. $360.50
Typical Cash Outflows
Repairs and
maintenance
Working
capital
Initial
investment
Incremental
operating
costs
Typical Cash Inflows
Salvage
value
Release of
working
capital
Reduction
of costs
Incremental
revenues
Recovery of the Original Investment
Carver Hospital is considering the purchase of an
attachment for its X-ray machine.
Cost
$3,170
Life
4 years
Salvage value
zero
Increase in annual cash inflows 1,000
No investments are to be made unless they have an
annual return of at least 10%.
Will we be allowed to invest in the attachment?
Recovery of the Original Investment
Year
Cash flow
PV
NPV
Periods
1
2
3
4
5
0
1
2
3
4
0-4
(3170)
1,000
1,000 1,000 1,000
(3170)
909
827
751
683
sum of discounted cash flows =
0
10%
0.909
1.736
2.487
3.170
3.791
12%
0.893
1.690
2.402
3.037
3.605
14%
0.877
1.647
2.322
2.914
3.433
Present value
of an annuity
of $1 table
Quick Check 
Suppose that the investment in the attachment
for the X-ray machine had cost $4,000 and
generated an increase in annual cash inflows of
$1,200. What is the net present value of the
investment?
a. $ 800
b. $ 196
c. $(196)
d. $(800)
Recovery of the Original Investment
Depreciation is not deducted in computing
the present value of a project because . . .
It is not a current cash outflow.
Discounted cash flow methods automatically
provide for return of the original investment.
Choosing a Discount Rate
The firm’s cost of capital is
usually regarded as the most
appropriate choice for the
discount rate.
The cost of capital is the
average rate of return the
company must pay to its longterm creditors and
stockholders for the use of
their funds.
The Net Present Value Method
To determine net present value we . . .
Calculate the present value of cash inflows,
Calculate the present value of cash outflows,
Subtract the present value of the outflows
from the present value of the inflows.
The Net Present Value Method
General decision rule . . .
If the Net Present
Value is . . .
Positive . . .
Then the Project is . . .
Acceptable, since it promises a
return greater than the required
rate of return.
Zero . . .
Acceptable, since it promises a
return equal to the required rate
of return.
Negative . . .
Not acceptable, since it promises
a return less than the required
rate of return.
The Net Present Value Method
Lester Company has been offered a five year
contract to provide component parts for a
large manufacturer.
Cost and revenue information
Cost of special equipment
$160,000
Working capital required
100,000
Relining equipment in 3 years
30,000
Salvage value of equipment in 5 years
5,000
Annual cash revenue and costs:
Sales revenue from parts
750,000
Cost of parts sold
400,000
Salaries, shipping, etc.
270,000
The Net Present Value Method
At the end of five years the working capital
will be released and may be used elsewhere
by Lester.
Lester Company uses a discount rate of 10%.
Should the contract be accepted?
The Net Present Value Method
Annual net cash inflows from operations
Sales revenue
Cost of parts sold
Salaries, shipping, etc.
Annual net cash inflows
$ 750,000
(400,000)
(270,000)
$ 80,000
The Net Present Value Method
Investment in equipment
Working capital needed
Net present value
Years
Now
Now
Cash
Flows
$ (160,000)
(100,000)
10%
Factor
1.000
1.000
Present
Value
$ (160,000)
(100,000)
The Net Present Value Method
Investment in equipment
Working capital needed
Annual net cash inflows
Years
Now
Now
1-5
Cash
Flows
$ (160,000)
(100,000)
80,000
Net present value
Present value of an annuity of $1
factor for 5 years at 10%.
10%
Factor
1.000
1.000
3.791
Present
Value
$ (160,000)
(100,000)
303,280
The Net Present Value Method
Investment in equipment
Working capital needed
Annual net cash inflows
Relining of equipment
Years
Now
Now
1-5
3
Cash
Flows
$ (160,000)
(100,000)
80,000
(30,000)
Net present value
Present value of $1
factor for 3 years at 10%.
10%
Factor
1.000
1.000
3.791
0.751
Present
Value
$ (160,000)
(100,000)
303,280
(22,530)
The Net Present Value Method
Investment in equipment
Working capital needed
Annual net cash inflows
Relining of equipment
Salvage value of equip.
Years
Now
Now
1-5
3
5
Cash
Flows
$ (160,000)
(100,000)
80,000
(30,000)
5,000
10%
Factor
1.000
1.000
3.791
0.751
0.621
Net present value
Present value of $1
factor for 5 years at 10%.
Present
Value
$ (160,000)
(100,000)
303,280
(22,530)
3,105
The Net Present Value Method
Investment in equipment
Working capital needed
Annual net cash inflows
Relining of equipment
Salvage value of equip.
Working capital released
Net present value
Years
Now
Now
1-5
3
5
5
Cash
Flows
$ (160,000)
(100,000)
80,000
(30,000)
5,000
100,000
10%
Factor
1.000
1.000
3.791
0.751
0.621
0.621
Present
Value
$ (160,000)
(100,000)
303,280
(22,530)
3,105
62,100
$ 85,955
Accept the contract because the project has a
positive net present value.
Internal Rate of Return Method
The internal rate of return is the rate of
return promised by an investment project
over its useful life.
The internal rate of return is computed by
finding the discount rate that will cause the
net present value of a project to be zero.
Internal Rate of Return Method
Decker Company can purchase a new
machine at a cost of $104,320 that will save
$20,000 per year in cash operating costs.
The machine has a 10-year life.
Internal Rate of Return Method
Future cash flows are the same every year in
this example, so we can calculate the internal
rate of return as follows:
PV factor for the
=
internal rate of return
$104, 320
$20,000
Investment required
Net annual cash flows
= 5.216
Internal Rate of Return Method
Using the present value of an annuity of $1 table . . .
Find the 10-period row, move
across until you find the factor
5.216. Look at the top of the column
and you find a rate of 14%.
Periods
1
2
. . .
9
10
10%
0.909
1.736
. . .
5.759
6.145
12%
0.893
1.690
. . .
5.328
5.650
14%
0.877
1.647
. . .
4.946
5.216
Internal Rate of Return Method
Decker Company can purchase a new
machine at a cost of $104,320 that will save
$20,000 per year in cash operating costs.
The machine has a 10-year life.
The internal rate of return on
this project is 14%.
If the internal rate of return is equal to or
greater than the company’s required rate of
return, the project is acceptable.
Quick Check 
The expected annual net cash inflow from a
project is $22,000 over the next 5 years. The
required investment now in the project is
$79,310. What is the internal rate of return on
the project?
a. 10%
b. 12%
c. 14%
d. Cannot be determined
Net Present Value vs. Internal Rate of
Return
 NPV is easier to use.
 Assumptions
 NPV assumes cash inflows
will be reinvested at the
discount rate.
 Internal rate of return
method assumes cash
inflows are reinvested at
the internal rate of return.
Ranking Investment Projects
Profitability
=
index
Present value of cash inflows
Investment required
Investment
A
Present value of cash inflows $81,000
Investment required
80,000
Profitability index
1.01
B
$6,000
5,000
1.20
The higher the profitability index, the
more desirable the project.