CHAPTER
4
Capital Investment
Decisions
Learning Objective 1
Understand the
importance of capital
budgeting and the
concepts underlying
strategic and capital
investment decisions.
Define Capital Budgeting and Capital
Capital Budgeting
Systematic planning for long-term
investments in operating assets.
Capital
The total amount of money or other
resources owned or used to acquire
future income or benefits.
Capital Investment Decisions
What three aspects of capital investment
decisions are critical to long-run profitability?
 Large capital outlays are required.
 There is a long-term impact on earnings.
 There is a lack of liquidity (they cannot be
readily disposed of).
Capital Budgeting Analysis Requires
What Two Processes?
Screening
Determining
whether a capital
investment meets
a minimum
standard of
financial
acceptability.
Ranking
The ordering of
acceptable investment
alternatives from the
most to least desirable.
What is the Time Value of Money?
- The concept
that a dollar to
be received now
is worth more
than a dollar to
be received far
in the future.
- Interest is the
payment (cost)
for the use of
the money.
Because of the time value of
money, a difference in the
timing of cash flows can
make one investment more
attractive than another.
Example: Discounting
Cash Flows
Project A
$90,910
Discounted at 10%
Discounted value at
beginning of Year 1
Project B
$41,320
45,455
$86,775
$100,000
Year 1
Discounted at 10% per year
Discounted value at
beginning of Year 1
$50,000
$50,000
Year 1
Year 2
What are Cash Outflows?
All investment opportunities have an initial
cost plus other expected outlays or cash
outflows associated with an investment.
Investment
opportunity
Cash
outflows
Example: Cash Outflows
Cash
Outflows
PV PV of Cash
Factor
Outflows
Initial cash outlay. . . . . . . $20,000
1.0000
$20,000
Future cash outlay. . . . . .
0.6302
3,151
Total present value
of cash outflows. . . . . . .
5,000
$23,151
Example: Internal Rate
of Return Method
George’s Power Tools wants to purchase a wood
lathe for $5,000. The machine will save $1,200 a year
for the next 5 years. Determine the internal rate of
return.
Calculate the present value factor by dividing
the investment cost by annual net cash
inflows.
Remember Using applicable present value tables and the
the 3 steps: life of the investment, find the present value
factor closest to the number derived in step 1.
Using interpolation, if necessary, find the exact
internal rate of return represented by the
present value factor in step 1.
Example: Internal Rate
of Return Method
Steps
1: Present value factor =
Investment cost
Annual net cash inflows
= $5,000
$1,200
= 4.1667
Example: Internal Rate
of Return Method
Steps
1: Present value factor
=
4.1667
2: Using the table, we find the yield for the machine is
between 6 and 7 percent.
4%
5%
6%
7%
8%
4
3.6299
3.5460
3.4651
3.3872
3.3121
5
4.4518
4.3295
4.2124
4.1002
3.9927
6
5.2421
5.0757
4.9173
4.7665
4.6229
Steps
Example: Internal Rate
of Return Method
1: Present value factor
2:
5
4.4518
4.3295
=
4.2124
4.1667
4.1002
3.9927
3: Find the exact rate of return.
High factor
True factor
Low factor
Difference
Rate
6%
7%
1%
Present Value
4.2124
4.1667
0.0457
Internal rate =
0.0457
0.06 + 0.01 x
of return
0.1122
Factors
4.2124
4.1002
0.1122
= 0.0641
What are Cash Inflows?
Cash inflows are any current or expected
revenues or savings directly associated with an
investment.
Cash
inflows
Investment
opportunity
Cash
outflows
Example: Cash Inflows
Cash
Inflows
PV PV of Cash
Factor
Inflows
Revenues . . . . . . . . . . . . . . $3,000
7.7160
$23,148
Salvage value . . . . . . . . . . . 5,000
0.3855
1,928
Total present value
of cash inflows. . . . . . . . .
$25,076
Learning Objective 2
Describe and use
two nondiscounted
capital budgeting
techniques: the
payback method and
the unadjusted rate
of return method.
Capital Budgeting Techniques
Non-discounted capital budgeting techniques
do not take into account the time value of
money. What are two common techniques?
 Payback Method
 Unadjusted Rate of
Return Method
Define Payback Method and Provide the
Formula
A capital budgeting technique that determines
the amount of time it takes the net cash inflows
of an investment to repay the investment costs.
Payback period =
Investment cost
Annual net cash inflows
Example: Payback Method
John wants to determine the payback period for
an investment with an initial cost of $2,500. He
estimates the net cash flows from the investment
to be $800 per year. Estimate the payback
period.
Payback period =
Investment cost
Annual net cash inflows
$2,500
=
$800
= 3.1 years
Define Unadjusted Rate of Return and
Provide the Formula
A capital budgeting technique in which management
can quickly estimate a simple rate of return to
evaluate an investment opportunity.
Increase in future average
annual net income
Unadjusted rate of return =
Initial investment cost
Example: Unadjusted Rate of Return
Method
Paul’s new investment is estimated to increase
net income by $25,000 each year. The initial
investment is $150,000. Determine the
unadjusted rate of return.
Increase in future average
annual net income
Unadjusted rate of return =
Initial investment cost
=
$25,000
$150,000
= 16.67%
Learning Objective 3
Describe and use
two discounted
capital budgeting
techniques: the
net present value
method and the
internal rate of
return method.
Define Capital Budgeting Techniques
Discounted capital budgeting techniques take
into account the time value of money by
comparing discounted cash flows. What are
two common techniques?
Net Present Value Method
Internal Rate of Return Method
Selecting a Discount Rate
In order to evaluate investments using discounted
cash flows, a firm must first establish a cost of
capital, or acceptable rate of return.
Define Cost of Capital
The average cost of a firm’s debt
and its equity; equals the rate of
return that a company must earn
in order to satisfy the demands of
its owners and creditors.
What are the Three Steps to Do the Net
Present Value Method?
Using a predetermined interest rate or discount
factor, compute the present values of all
expected cash inflows and outflows of an
investment.
Subtract the total present value of the cash
outflows from the total present value of the
cash inflows. The difference is the investment’s
net present value.
If the net present value of the investment is
positive, or at least zero, the project is
acceptable from a financial standpoint.
What is the Decision Rule for the Net
Present Value Method?
Accept
NPV
$0
If the NPV is zero or greater, the
investment is generating a rate of
return that is equal to or greater
than the required rate of return.
What is the Decision Rule for the Net
Present Value Method?
If the NPV is less than zero, the
investment is generating a rate
of return that is lower than the
required rate of return.
NPV
$0
Reject
Example: Net Present Value
Method
George’s Power Tools wants to purchase a wood lathe for
$5,000. The machine will save $1,200 a year for the next 5
years. The wood lathe can then be sold at the end of 5
years for $1,000. If the required rate of return is 12 percent,
should the company invest in the new equipment?
Cash Flows
Purchase price . . . . . . . .
Cost savings. . . . . . . . . .
Salvage value. . . . . . . . .
Net present value. . . .
PV
Amount
Present
Factor
$(5,000)
1,200
1,000
1.0000
3.6050
0.5674
Value
$(5,000)
4,326
567
$ (107)
What is a Least-Cost Decision?
In cases where investments must be
made, managers should use a leastcost decision.
Least-cost decision:
A decision to undertake the project
with the smallest negative net
present value.
Such a decision satisfies certain
requirements at the lowest
possible cost to the firm.
Define the Internal Rate of Return
Method
The discount rate that yields a net present
value of zero when applied to cash flows of an
investment—both inflows and outflows.
What are the three steps?
1. Calculate the present value factor by dividing the
investment cost by the annual net cash inflows.
2. Using applicable present value tables and the life of the
investment, find the present value factor closest to the
number derived in step 1.
3. Using interpolation, if necessary, find the exact internal
rate of return represented by the present value factor in
step 1.
Internal Rate of Return Method
Internal Rate of Return
 The “true” discount rate that will produce a net
present value of zero when applied to the cash flows
of investment inventory goods held for resale.
What is Interpolation?
 A method of determining the internal rate of return
when the factor for that rate lies between the factors
given in the present value table.
 Its purpose is to determine the “true” rate of interest
indicated by the present value factor.
What is a Hurdle Rate?
The minimum rate of return that an investment
must provide in order to be acceptable.
Hurdle rate:
To determine the value of an
investment, management must
compare the project’s internal rate of
return with the company’s usual
discount or hurdle rate.
What Is the Decision Rule for
Internal Rate of Return Method?
Accept
IRR
Hurdle Rate
Management should undertake
the investment if the IRR is
greater than the hurdle rate, or
required rate of return.
What Is the Decision Rule for
Internal Rate of Return Method?
Management should not accept
the investment if the IRR is
lower than the hurdle rate, or
required rate of return.
IRR
Hurdle Rate
Reject
Learning Objective 4
Understand the
need for
evaluating
qualitative factors
in strategic and
capital
investment
decisions.
$
Qualitative Factors in Decisions



An investment’s effect on the quality of products
and services offered.
An investment’s effect on the time with which
products and services can be produced and
delivered to customers.
Other qualitative factors:
- Consumer safety
- Government regulations
- Pollution control and environmental protection
- Worker safety
- Company image and prestige
- Preferences of owners and management
- Community welfare
Expanded Material
Learning Objective 5
Use sensitivity
analysis to assess
the potential
effects of
uncertainty in
capital budgeting.
?
Define Sensitivity Analysis
Sensitivity Analysis

A method of assessing the
reasonableness of a decision that was
based upon estimates; involves
calculating how far reality can differ from
an estimate without invalidating the
decision.

Used to determine whether the
conclusions still seem reasonable under
modified circumstances.
Example: Sensitivity Analysis
Beatles Inc. wants to purchase a new belt buckle
press for $9,000. The press will save $2,000 a
year for the next 10 years. The press can then
be sold at the end of 10 years for $1,000.
Beatles Inc. has established a rate of 8 percent
as the hurdle rate. Should the company invest
in the new equipment?
PV
Amount
Present
Factor
Purchase price . . . . . . . . .$(9,000)
Cost savings. . . . . . . . . . . 2,000
Salvage value. . . . . . . . . .
1,000
Net present value. . . . .
1.0000
6.1446
0.3855
Cash Flows
Value
$(9,000)
12,289
386
$ 3,675
Example: Sensitivity Analysis
If expected cash flows are uncertain,
what is the minimum cash flow needed
to still meet the required 10 percent
hurdle rate, which has a present value
factor of 6.1146?
Initial cost. . . . . . . . . . . . . . . . . . . . . . . $9,000
Discounted disposal value. . . . . . . . . . 386
Net cost of investment . . . . . . . . . . . $8,614
Present value factor . . . . . . .. . . . . 6.1146
Minimum cash flows needed. . . . . . . $1,409
Example: Sensitivity Analysis
If the expected useful life is
uncertain, how long does the press
need to last in order for the
investment to still be acceptable?
4
5
6
7
10%
3.1669
3.7908
4.3553
4.8684
Present value factor = 4.301
Example: Sensitivity Analysis
According to the present value tables,
the internal rate of return is between 18
and 20 percent.
Internal Rate of Return Method
$8,614
Present value factor =
$2,000
= 4.307
Expanded Material
Learning Objective 6
Explain how to
use capital
budgeting
techniques in
ranking capital
investment
projects.
What Is Capital Rationing?

Allocating limited resources among ranked
acceptable investments.

Enables management to select the most
profitable investments first.

Helps a company use limited resources to the
best advantage by investing only in the
projects that offer the highest return.

Either the internal rate of return method or the
net present value method may be used in
ranking investments.
Example: Capital Rationing
The Ono Company needs to rank the
following investment opportunities. The
company requires a hurdle rate of 16
percent. Use the capital rationing
techniques to determine the appropriate
investments.
Project
A
B
C
D
Expected
Rate of Return
16%
13%
22%
18%
Ranking
Order
Decision
3
—
1
2
Accept
Reject
Accept
Accept
How Do You Rank by Net
Present Value?
Profitability index
In order to rank projects using net present value, a
profitability index must be used to rank different
investments.
Equal to the present value of net cash inflows
divided by the investment cost.
Profitability index = Present value of net cash inflows
Investment cost
Example: Ranking by Net Present Value
The Ono Company has the following two
possible investments. Rank them using a
profitability index.
A
B
Present value of cash inflows. . . . $6,000
Investment cost. . . . . . . . . . . . . . . . 5,000
Net present value . . . . . . . . . . . . . .$1,000
Profitability index. . . . . . . . . . . . .
Rank . . . . . . . . . . . . . . . . . . . . . . . .
$11,000
10,000
$ 1,000
1.20
1.10
1
2
Expanded Material
Learning Objective 7
Explain how
income taxes
affect capital
budgeting
decisions.
Income Tax Considerations
Examples of income tax effects:
 A capital investment may allow a company to
take an expense deduction for the cost of the
asset and expense deductions for repairs and
depreciation.
 The resulting income from operations and any
gain on the eventual sale of an asset are affected
by taxes.
Such tax effects can be so significant that the net
present value of the cash flows changes from
positive to negative, or vice versa.
Income Tax Considerations
 Cash inflows and outflows of capital budgeting
decisions must be converted to after-tax amounts
before the present values are computed.
 They are converted to after-tax amounts by
including such amounts as:
 Expense deduction for the cost of the asset.
 Expense deduction for repairs to the asset.
 Expense deduction for depreciation (MACRS).
 Income from operations.
 Gain on sale of disposal of asset.