Chapter 17
Capital Budgeting Analysis
© 2000 John Wiley & Sons, Inc.
Chapter Outcomes



Explain how the capital budgeting
process should be related to a firm’s
mission and strategies.
Identify and describe the five steps in
the capital budgeting process.
Identify and describe the methods or
techniques used to make proper
capital budgeting decisions.
2
Chapter Outcomes, continued



Explain how relevant cash flows are
determined for capital budgeting
decision purposes.
Describe the importance of
determining the correct base case
from which to estimate project
cash flows.
Discuss how a project’s risk can be
incorporated into capital budgeting
analysis.
3
Capital Budgeting Projects

Seek investment opportunities to
enhance a firm’s competitive
advantage and increase shareholder
wealth
– Typically long-term projects
– Should be evaluated by time value of
money techniques
– Large investment

Mutually exclusive versus
independent
4
Capital Budgeting Process





Identification
Development
Selection
Implementation
Follow-up
5
Data Needs

Economic and Political Data

Financial Data

Non-Financial Data
6
Capital Budgeting Techniques

Net Present Value

NPV = Present value of all cash flows
minus cost of project
7
Cash Flow Data
YEAR
1
2
3
4
5
PROJECT A
5,800
5,800
5,800
5,800
5,800
PROJECT B
4,000
4,000
8,000
10,000
10,000
8
NPV of Project A
YR
0
1
2
3
4
5
CASH
10%
PRESENT
FLOW x PVIF = VALUE
–$20,000
1.000
–$20,000
5,800
5,800
5,800
5,800
5,800
0.909
0.826
0.751
0.683
0.621
5,272
4,791
4,356
3,961
3,602
9
NPV of Project B
CASH
10%
YR FLOW x PVIF
=
VALUE
0
-$25,000
1.000
$25,000
1
4,000 0.909
2
4,000 0.826
3
8,000 0.751
6,008
4
10,000 0.683
PRESENT
3,636
3,304
6,830
10
What Does the NPV Represent?



NPV represents the dollar gain in
shareholder wealth from undertaking
the project
If NPV > 0, do the project as
shareholder wealth rises
If NPV <0, do not undertake; it
reduces shareholder wealth
11
Internal Rate of Return
It is the discount rate that causes NPV
to equal zero
N
NPV =
 [CFt / (1 + IRR)t ] – Inv = 0
t= 1
12
Solution Methods


Compute the IRR by:
– Trial and error
– Financial calculator
– Spreadsheet software
Accept the project if IRR > minimum
required return on the project
13
What Does the IRR Measure?
IRR measures the return earned
on funds that remain internally
invested in the project
14
Profitability Ratio (Benefit/Cost
Ratio)




Profitability Index = Present value of
cash flows/initial cost
Accept project if PI > 1.0
Reject project if PI < 1.0
Interpretation: Measures the present
value of dollars received per dollar
invested in the project
15
Relationships



NPV, IRR, PI will always agree on the
Accept/Reject decision
If one indicates we should accept the
project, they will all indicate “accept”
NPV > 0
IRR>minimum required return 
PI > 1
16
Reject Decision, too


If one indicates we should reject the
project, they will all indicate “reject”
NPV < 0
IRR < minimum required return 
PI < 1
17
A popular, but flawed, measure...


Payback period = number of years
until the cash flows from a project
equal the project’s cost
Accept project is payback period is
less than a maximum desired time
period
18
Payback’s Drawbacks



Ignores time value of money
Any relationship between the
payback, the decision rule, and
shareholder wealth maximization is
purely coincidental!
It ignores the cash flows beyond the
payback period
19
Estimating Project Cash Flows
Important:
 Stand-alone principle
 Incremental after-tax cash flows
from the base case
 Cannibalization or enhancement
effects
 Opportunity costs

20
Ignore….

Sunk costs

Financing costs
21
Up-front or “time zero”
investment
Investment =
cost + transportation, delivery, and
installation charges
22
Cash-Based Income Statement
Cash revenues
$12,000
Cash operating expenses
–5,600
Cash earnings before depreciation
6,400
Depreciation
–4,000
Cash earnings before taxes
2,400
Income taxes (25%)
–600
Cash earnings after taxes $ 1,800
23
Periodic after-tax cash flows
Cash revenues - cash expenses - tax
= $12,000 - 5,600 - 600 = $5,800
 Cash earnings after tax+Depreciation
= $1,800 + 4,000 = $5,800
 (Cash revenues-cash expenses) (1-T)
+ T (Depreciation expense)
= ($12,000-5,600)(1-.25) + (.25)($4,000)
= $5,800

24
Risk-related Considerations

Expected return/risk tradeoff

Higher (lower) than average risk
projects should have a higher (lower)
than average discount rate
25
Cost of Capital


Required return on average risk
project = firm’s cost of capital, or
cost of financing
For average risk projects, use this
number as the discount rate (NPV, PI)
or the minimum required rate of
return (IRR)
26
Risk-adjusted Discount Rate
Adjust the project’s discount rate up or
down from the firm’s cost of capital
for projects of above-average or
below-average risk
27
An Example
Below-average risk:
Discount rate = cost of capital –2%
Average risk:
Discount rate = cost of capital
Above-average risk:
Discount rate = cost of capital + 2%
High risk:
Discount rate = cost of capital + 5%
28
Learning Extension 17A: Strategic Analysis
and Cash Flow Estimation
Strategic analysis, marketing analysis,
and financial analysis should agree
on the accept/reject decision of a
project
29
Common Problem Areas



Determining the correct base case
Overvaluing a strategy
Define project boundaries at the
corporate level
30
Depreciation and Project Cash
Flows


Straight-line depreciation
MACRS--accelerated depreciation
31
Depreciation Classes
3-year class Designated tools and
equipment used in
research
5-year class
Cars, trucks, and some
office equipment such
as computers and
7-year class
copiers
10-year classOther office equipment
and industrial
27.5-year
machinery
class
Other long-lived
32
31.5-year
equipment
Some MACRS Percentages
Asset class
Year
3-year
5-year
7-year
1
33.33%
20.00%
14.29%
2
44.45
32.00
24.49
3
14.82
19.20
17.49
4
7.40
11.52
12.49
5
11.52
8.93
6
5.76
8.93
7
8.93
8
4.45
33
An example
For an asset in the three-year class
that originally cost $50,000, the first
year’s depreciation is $50,000 x
0.3333 = $16,665; the second year’s
depreciation is $50,000 x 0.4445 =
$22,225; for the third year,
depreciation will be $50,000 x 0.1482
= $7,410; the final year’s depreciation
expense will be $50,000 x 0.0740 =
$3,700.
34