Chapter 8
Capital Asset Selection and
Capital Budgeting
Learning
Objectives
1. How do managers choose which capital projects to fund?
2. Why do most capital budgeting methods rely on analysis
of cash flows?
3. What are the differences among payback period, the net
present value method, profitability index, and internal
rate of return?
C8
Continuing . . . Learning
Objectives
4. How do the underlying assumptions and limitations of
each capital project evaluation method affect its use?
5. How do taxes and depreciation methods affect cash
flows?
C8
Continuing . . . Learning Objectives
6. Why are quality management, training, and research
and development controlled largely by capital budget
analyses?
7. Why do managers occasionally need to quantify
qualitative information in making capital budgeting
decisions?
C8
Continuing . . . Learning
Objectives
8. Why are environmental issues becoming an
increasingly important influence on the capital
budget?
9. How and why should management conduct a
post-investment audit of a capital project?
C8
Continuing . . . Learning
Objectives
10. What calculations are necessary to control
for the time value of money? (Appendix 1)
11. How is the accounting rate of return for a
project determined? (Appendix 2)
C8
Capital Assets
Lease
Nuclear Power Plant
Copy
Machine
Capital Budgeting Is
Capital budgeting is the process of
evaluating long-range
investment proposals for the
purpose of allocating limited
resources effectively and
efficiently.
Capital Budgeting Questions
• Is the activity worth the investment?
• Which assets can be used for the activity?
• Of the suitable assets, which are the best
investments?
– Screening decision
– Preference decision
• Which of the best investments should the
company choose?
– Mutually exclusive projects
– Independent projects
– Mutually inclusive projects
Cash Flows
• Cash receipts and disbursements that arise from the
purchase, operation, and disposition of capital assets
• Cash receipts
– Project revenues that have been earned and collected
– Savings generated by reduced project operating costs
– Inflows from asset’s sale and release of working capital at end of
asset’s useful life
• Cash disbursements
– Expenditures to acquire asset
– Additional working capital investments
– Amounts paid for related operating costs
Interest
Interest is a cash flow created by the method
of financing a project.
It should not be considered in project evaluation.
Return of Capital
vs. Return on Capital
Return of Capital
Recovery of
original investment
Return on Capital
Income
for each investment period
= Interest included
in receipt or payment
Use a Timeline
to Determine Cash Flows
Time Point
t0
t1
t2
t3
t4
$500
$500
$500
$500
Cash In
Cash Out
Net Cash Flow
Payback Period
A measure of the time it will take a project’s
cash inflows to equal the original investment
• The longer it takes to recover the initial investment,
the greater is the project’s risk
• Management sets a maximum acceptable payback
period
• Often used as a screening technique
Assumptions of Payback Period
• Speed of investment recovery is the key
consideration
• Timing and size of cash flows are
accurately predicted
• Risk (uncertainty) is lower for a shorter
payback project
Purchase of Machine Example
• Machine costs $60,000
• Will be used to produce and sell 3,000 units per
year at $14 for the next 5 years
• Variable costs are $5 per unit
• Annual fixed costs are $5,000
• Cutoff rate of 12 percent
• All revenues and costs are in cash amounts
Annual Incremental Cash Inflows
Annual
Cash Flows
Revenues ($14 x 3,000)
$
15,000
Variable costs ($5 x 3,000)
Contribution margin ($9 x 3,000)
$
27,000
5,000
Fixed costs
Expected increase in net cash inflows
42,000
$
22,000
Payback Period
Payback
Period = Investment required  Annual cash returns
= $60,000 $22,000 = 2.7 years
Limitations of Payback Period
• Ignores cash flows after payback
• Basic method treats cash flows and
project life deterministically without
explicit consideration of probabilities
• Ignores time value of money
• Cash flow pattern preferences are not
explicitly recognized
Discounted Cash Flow Methods
• Net present value (NPV)
• Profitability index (PI)
• Internal rate of return (IRR)
Net Present Value Method
Determines whether the rate of return (ROR) on a
project is equal to, higher than, or lower than
the desired ROR
• Accept if:
– If NPV = 0, actual ROR = desired ROR
– If NPV > 0, actual ROR > desired ROR
• Reject if:
– If NPV < 0, actual ROR < desired ROR
• Does not determine expected ROR
Remember!
• Changing discount rate affects NPV
• Changing timing and size of cash flows affects NPV
• NPV can be used to select the best project when
choosing among investments that can perform the
same task or achieve the same objective
• NPV should not be used to compare independent
investment projects that do not have approximately
the same original asset cost or asset life
Net Present Value Example
Expected increase in net cash inflows $ 22,000
Present value factor
Present value of future cash flows
Investment required
Net present value
3.605
$ 79,310
60,000
$ 19,310
Assumptions of Net Present Value
• Discount rate used is valid
• Timing and size of cash flows are accurately
predicted
• Life of project is accurately predicted
• If the shorter-lived of two projects is selected,
the proceeds of that project will continue to
earn the discount rate of return through the
theoretical completion of the longer-lived
project
Limitations of Net Present Value
• Basic method treats cash flows and project life
deterministically without explicit consideration
of probabilities
• NPV does not measure expected rates of return
on projects being compared
• Cash flow pattern preferences are not explicitly
recognized
• IRR of project is not reflected
Profitability Index
Ratio that compares present value of net cash
inflows with present value of net investment
•
•
•
•
Compares projects with different costs
PI should be at least equal to 1.0
Gauges the firm’s efficiency at using its capital
Does not indicate expected ROR
Continuing . . . Profitability Index
Profitability Index (PI) =
=
PV of Cash Flows
-------------------------Investment required
$79,310
---------$60,000
=
1.3
Assumptions of Profitability Index
• Same as NPV
• Size of PV of net inflows relative to size of PV of
investment measures efficient use of capital
Limitations of Profitability Index
• Same as NPV
• Gives a relative answer but does not reflect
dollars of NPV
Internal Rate of Return
• Is the project’s expected rate of return
• The discount rate where PV of net cash
flows = cost of project
– Discount rate where NPV = 0
• IRR compared with hurdle rate(which is the
lowest acceptable return on investment)
• Acceptable if IRR > hurdle rate
Internal Rate of Return
Discount factor = PV of future flows/Annual cash flows
Discount factor = $60,000/$22,000 = 2.7
The factor of 2.7 corresponds to an interest rate between
24 and 25 percent when the number of periods is five.
The IRR is between 24 and 25 percent.
Assumptions of IRR
• Hurdle rate is valid
• Timing and size of cash flows are accurately
predicted
• Life of project is accurately predicted
• If the shorter-lived of two projects is selected,
the proceeds of that project will continue to
earn the IRR through the theoretical
completion of the longer-lived project
Limitations of IRR
• Projects are ranked for funding based on IRR rather
than dollar size
• Does not reflect dollars of NPV
• Basic method treats cash flows and project life
deterministically without explicit consideration of
probabilities
• Cash flow pattern preferences are not explicitly
recognized
• It is possible to calculate multiple rates of return on the
same project
The Effect of Taxation
On Cash Flows
• Managers should use after-tax cash flows to determine
project’s acceptability
• Depreciation expense is a tax shield for revenues
– Tax benefit equal to depreciation amount multiplied by tax rate
• Type of depreciation method affects amount of annual
taxable income
• Tax laws can change every year; use most current
regulations
• Tax rates and tax related asset lives may also change;
use most current information
Annual Incremental After-Tax
Cash Inflows
Revenues
Cash expenses (variable and fixed)
Cash inflow before taxes
Depreciation
Increase in taxable income
Income taxes (40 percent)
Net increase in annual cash inflow
Tax
Annual
Computation Cash Flows
$
42,000 $
42,000
20,000
20,000
$
22,000 $
22,000
12,000
$
10,000
4,000
4,000
$
18,000
Payback Period
Payback
Period = Investment required  Annual cash returns
= $60,000  $18,000 = 3.3 years
Net Present Value of
After-Tax Example
Expected increase in net cash inflows
Present value factor
Present value of future cash flows
Investment required
Net present value
$ 18,000
3.605
$ 64,890
60,000
$ 4,890
Profitability Index
Profitability Index (PI) =
=
PV of Cash Flows
-------------------------Investment required
$64,890
---------$60,000
=
1.1
Internal Rate of Return
Discount
factor = PV of future flows/Annual cash flows
Discount factor = $60,000/$18,000 = 3.333
The factor of 3.333 corresponds to an interest rate
between 14 and 16 percent when the number of
periods is five.
The IRR is between 14 and 16 percent.
Uneven Cash Flows
Now, assume
that the salvage
value in the
example is
$5,000 at the end
of the fifth year.
Summary of Present Value
of Investment
PV of future cash flows
$ 64,890
Salvage value:
Total salvage value
Tax on salvage value
$
5,000
2,000
After-tax cash inflow on salvage value
$ 3,000
PV factor
Present value of salvage value
Total present value
0.567
1,701
$ 66,591
Net Present Value of
Salvage Value Example
Present value of future cash flows
Investment required
Net present value
$ 66,591
60,000
$ 6,591
High-Tech Investments
The decision is more a question of
“how much” and “when”
than “whether”
Generally requires
massive monetary
investment
Possible Reasons for Not Investing
– Worker displacement
– Morale problems
– Implementation problems
– Computers not considered competitive
assets
– Difficult to justify investment using
traditional analyses
Considerations in High-Tech
Investment Analysis
• Discount or hurdle rate may need to be set
lower
• Both quantitative and qualitative benefits need
to be considered
– Quality improvements
– Shortened delivery time
– Improved competitive position
• High-tech investments are not “free-standing”
• Opportunity cost of not acquiring automated
equipment is often critical
Post-Investment Audit
Compare actual project results with expected results
• Complete after project has stabilized
• Use same analysis techniques as
used for original decision to accept
project
• Used to pinpoint areas of operation
not in line with expectations
• Helps evaluate accuracy of original
cost/benefit predictions
Accounting Rate of Return (ARR)
Measures the expected rate of earnings obtained on the
average capital investment over a project’s life
• Not based on cash flows
• Compared with hurdle rate which may be higher than
the discount rate
• Compared with ARR of other projects
Continuing . . . Accounting Rate
of Return (ARR)
ARR =
Average Annual Income from Project
-----------------------------------------------Average Investment in Project
Before Taxes
After Taxes
=
$22,000 - ($60,000/5)
-----------------------($60,000 - $0)/2
=
33.3%
=
$18,000 - ($60,000/5)
-----------------------($60,000 - $0)/2
=
20.0%
Assumptions of ARR
• Effect on company accounting earnings relative
to average investment in a project is a key
consideration
• Size and timing of investment cost, project life,
salvage value, and increases in earnings can be
accurately predicted
Limitations of ARR
• Ignores cash flows
• Ignores time value of money
• Treats earnings, investment, and project life
deterministically without explicit consideration
of probabilities