Capital Budgeting: LongTerm Assets
Chapter 11
Capital Assets
• Chapters 3 and 4 discussed the cost of capacity
resources that organizations purchase and use
for years to make goods and provide services
• Capital assets create these capacity-related
costs
• Cost commitments associated with long-term
assets create risk for an organization:
Need to Control Capital Assets

Long-term commitment creates the potential
for
• Excess capacity that creates excess costs
• Scarce capacity that creates lost opportunities

Large amount of money committed to the
acquisition of capital assets
 Long-term nature of capital assets creates
technological risk
• Capital budgeting is a systematic approach to
evaluating an investment in a capital asset
Investment and Return
• Cost-benefit analysis
• Investment is the monetary value of the assets
the organization gives up to acquire a long-term
asset
• Return is the increased future cash inflows
attributable to the long-term asset
 capital budgeting focuses on whether the
expected increased cash flows (return) will
justify the investment in the long-term asset
Time Value of Money
• Time value of money (TVM) is a central concept
in capital budgeting
• Because money can earn a return:

Its value depends on when it is received
 Using money has a cost
• In making investment decisions, the problem is
that investment cash is paid out now, but the
cash return is received in the future
Time Value of Money (2 of 2)
• Because money has a time-dated
value, the critical idea underlying
capital budgeting is:
Amounts of money spent or received
at different periods of time must be
converted into their value on a
common date in order to be compared
Some Standard Notation
Abbr.
n
FV
PV
a
r
Meaning
Number of periods considered in the investment analysis;
common period lengths are a month, a quarter, or a year
Future value, or ending value, of the investment n periods
from now
Present value, or the value at the current moment in time, of
an amount to be received n periods from now
Annuity, or equal amount, received or paid at the end of each
period for n periods
Rate of return required, or expected, from an investment
opportunity; the rate of interest earned on an investment
Future Value
• Because money has time value, it is better to
have money now than in the future
• The future value (FV) is the amount that today’s
investment will be after earning a stated periodic
rate of return for a stated number of periods
• For one period: FV=PV x (1+r)
FV with Multiple Periods
• An initial amount of $1.00 accumulates to $1.2763
over five years if the annual rate of return is 5%:
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
$1.0000 $1.0500 $1.1025 $1.1576 $1.2155 $1.2763
• This calculation assumes the following:
 Interest earned stays invested until the end of
year
 Compound effect of interest
Computing Future Values For
Multiple Periods (1 of 2)
• The formula for a future value is FV=PV x (1+r)n
• Calculator methods (using 5 years at 5%)



Multiply $1.00 by 1.05 five times
If your calculator computes exponents directly, you
may compute $1.00x(1.05)5
Financial calculators have TVM functions that allow
you to compute FV
Computing Future Values For
Multiple Periods (2 of 2)
• Table Method


Tables that provide the factors needed to compute a
future value for different numbers of periods and rates
of return are available
Find where the column (r) intersects with the row (n).
Multiply this factor by the amount of the initial
investment to find the future value
• Spreadsheet Method

Every computer spreadsheet program can compute
future values and all other financial calculations
described in this chapter
Choosing a Common Date
• An investment’s cash flows must be converted to
their equivalent value at some common date in
order to make meaningful comparisons between
the project’s cash inflows and outflows
• The conventional choice is the point when the
investment is undertaken

Analysts call this time zero, or period zero
• Capital budgeting analysis converts all future
cash flows to their equivalent value at time zero
Present Value
• Analysts call a future cash flow’s value at time
zero its present value
• The process of computing present value is called
discounting
• The FV formula can be rearranged to compute
the present value:
FV = PV x (1 + r)n
PV = FV/(1 + r)n or PV = FV x (1 + r)-n
Decay of a Present Value
• Invested amounts grow at a compound rate over
time
• A fixed amount of cash to be received at some
future time becomes less valuable as:


Interest rates increase
The time period before receipt of the cash increases
• Arbitrarily high interest rates will result in projects
(especially long-term ones) being inappropriately
turned down
Annuities
• Not all investments have cash outlays at time zero
and provide a single benefit at some future point
• Most investments provide a series, or stream, of
benefits over a specified future period
• An investment that promises a constant amount
each period over n periods is called an n-period
annuity
PV of an Annuity
• Suppose you have won a $20 million lottery prize
that pays $1 million a year for 20 years


You are interested in selling this annuity to raise cash to
purchase a business
What is the value of this annuity today, if the current rate
of interest is 7%?
• Using a table we can compute the present value of
the lottery annuity as follows:
PV = a x annuity present value factor7%, 20 periods
= $1,000,000 x 10.594
= $10,594,000
Computing the Required Annuity
• Computing the annuity value that a current
investment will generate

For example, if you agreed to repay a loan with equal
periodic payments, then you are selling the lender an
annuity in exchange for the face value of the loan
• The factor required to compute the amount of the
annuity to repay a present value is simply the
inverse of the present value factor for an annuity:
Annuity factor = 1 / PV factor
Cost of Capital
• The cost of capital is the interest rate used for
discounting future cash flows

Also known as the risk-adjusted discount rate
• The cost of capital is the return the organization
must earn on its investment to meet its investors’
return requirements
• The organization’s cost of capital reflects:


The amount and cost of debt and equity in its financial
structure
The financial market’s perception of the financial risk of
the organization’s activities
Capital Budgeting
• Capital budgeting is the collection of tools that
planners use to evaluate the desirability of
acquiring long-term assets
• Six approaches are discussed here:
Payback
Accounting rate of return
Net present value
 Internal rate of return
 Profitability index
 EVA criterion
Shirley’s Doughnut Hole
• To show how each of these methods works and
alternative perspectives, we apply each to Shirley’s
Doughnut Hole as it considers the purchase of a
new automatic doughnut cooker:

Cost: $70,000
 Life: five years
 Benefit: expanded capacity and reduced operating costs
would increase Shirley’s profits by $20,000 per year with
a cost of capital is 10%
 The new cooker would be sold for $10,000 at the end of
five years
Payback Criterion
• The payback period is the number of periods
needed to recover a project’s initial investment

Shirley’s initial investment of $70,000 is recovered
midway between years 3 and 4 (3.5 years)
• Many people consider the payback period to be a
measure of the project’s risk

The organization has unrecovered investment during
the payback period
 The longer the payback period, the higher the risk
 Compare a project’s payback period with a target that
reflects the organization’s acceptable level of risk
Problems with Payback
• The payback criterion has two problems:
 Ignores the time value of money
 Ignores the cash outflows that occur after the
initial investment and the cash inflows that
occur after the payback period so focus is on
short-run performance instead of overall
profitability
• Despite these limitations, some surveys show
that the payback calculation is the most used
approach by organizations for capital budgeting
Accounting Rate of Return
• Accounting rate of return - average accounting
income divided by the average level of
investment

Used to approximate the return on investment
• The increased annual income that Shirley’s will
report related to the new cooker will be $8000


$20,000 - $12,000 of depreciation
The average income will equal the annual income
since the annual income is equal each year
• The average investment is $40,000
= [($70,000 + 10,000) / 2]
Accounting Rate of Return (2 of 2)
• The accounting rate of return for the cooker
investment is computed as:
$8,000 / $40,000 = 20%
• If the accounting rate of return exceeds the target
rate of return, then the project is acceptable
• Drawback: does not consider the timing of cash
flows
• An improvement over the payback method in that
it considers cash flows in all periods
Net Present Value
• The net present value (NPV) is the sum of the
present values of a project’s cash flows
• The steps used to compute an investment’s net
present value are as follows:

Step 1: Choose the appropriate period length to
evaluate the investment proposal
• The period length depends on the periodicity of the
investment’s cash flows
• The most common period used in practice is one year
» Analysts also use quarterly and semiannual periods
Net Present Value





Step 2: Identify the organization’s cost of capital, and
convert it to an appropriate rate of return for the period
length chosen in step 1
Step 3: Identify the incremental cash flow in each period
of the project’s life
Step 4: Compute the present value of each period’s cash
flow using the organization’s cost of capital for the
discount rate
Step 5: Sum the present values of all the periodic cash
inflows and outflows to determine the investment
project’s net present value
Step 6: If the project’s net present value is positive, the
project is acceptable from an economic perspective
Net Present Value
•
•
•
•
To determine the NPV of Shirley’s investment:
Step 1: The period length is one year
Step 2: Shirley’s cost of capital is 10% per year
Step 3: The incremental cash flows are:

$70,000 outflow immediately
 $20,000 inflow at the end of each year for five years
 $10,000 inflow from salvage at the end of five years
• It is useful to organize the cash flows associated with
a project on a time line to help identify and consider
all the project’s cash flows systematically
Net Present Value
• Step 4: The present value of the cash flows when
the organization’s cost of capital is 10% are:


For a five-year annuity of $20,000, PV = $75,816
For the $10,000 salvage in five years, PV = $6,209
• Step 5: To sum the present values of all the
periodic cash flows and determine NPV



The PV of the cash inflows is $82,025
Because the investment of $70,000 takes place at time
zero, the PV of the total outflows is $(70,000)
The NPV of this investment project is $12,025
• Step 6: Because the NPV is positive, Shirley’s
should purchase the cooker

It is economically desirable
Internal Rate of Return
• The internal rate of return (IRR) is the actual rate
of return expected from an investment
• The IRR is the discount rate that makes the
investment’s net present value equal to zero
If an investment’s NPV is positive, then its IRR exceeds
its cost of capital
 If an investment’s NPV is negative, then it’s IRR is less
than its cost of capital

• By trial and error, or the use of a financial
calculator or spreadsheet software, we find that
the IRR in Shirley’s is 16.14%

Because a 16.14% IRR > 10% cost of capital, the
project is desirable
Internal Rate of Return
• IRR has some disadvantages:
It assumes that a project’s intermediate cash flows can
be reinvested at the project’s IRR
 It can create ambiguous results, particularly:
• When evaluating competing projects in situations
where capital shortages prevent the organization
from investing in all positive NPV projects
• When projects require significant outflows at
different times during their lives
• Because a project’s NPV summarizes all its financial
elements, using the IRR criterion is unnecessary when
preparing capital budget

Survey Results: % Rating the Capital
Budgeting Tool as Extremely Important
NPV
27%
Accounting
Rate of
Return
13%
Payback
32%
IRR
28%
Profitability Index
• The profitability index is a variation of the net
present value method
• It is used to make comparisons of mutually
exclusive projects with different sizes and is
computed by dividing the present value of the
cash inflows by the present value of the cash
outflows
• A profitability index of 1 or greater is required for
the project to be acceptable
Profitability Index
• Shirley’s Doughnut Hole example: the present
value of the cash inflows was $82,025 and the
present value of the cash outflows was $70,000
• The profitability index for that project is 1.17
=
$82,025/$70,000
• It is possible for project A to have a higher
profitability index while project B has a higher
NPV
Economic Value Added
• Economic value added (EVA) criterion - new way
to evaluate organization performance
EVA = adjusted accounting income – (cost of
capital * investment level)
• Accounting income is adjusted for what the EVA
proponents consider to be GAAP’s conservative
bias

Common adjustments: capitalizing and amortizing
research and development and significant product
launch costs, adjusting for the LIFO effect on inventory
valuation, and eliminating the effect of deferred income
taxes
Economic Value Added
• The formula for economic value added is directly
related to the net present value criterion


The major difference between the two is that EVA
begins with accounting income, which includes various
accruals and allocations rather than net cash flow as
does NPV
This is why EVA is more suited to evaluating an ongoing
investment than a new investment opportunity
Effect of Taxes
• In practice, capital budgeting must consider the
tax effects of potential investments
• In general, the effect of taxes is twofold:
 Organizations must pay taxes on any net
benefits provided by an investment
 Organizations can use the depreciation
associated with a capital investment to reduce
income and offset some of their taxes
Effect of Taxes
• Assume Shirley’s income taxed rate is 40%
• Assume that the relevant tax law requires
Shirley’s to claim straight-line depreciation as a
tax-deductible expense

(Historical cost less salvage value) / useful life
• Convert all pretax cash flows to after-tax cash
flows:
Using straight-line depreciation, Shirley’s Doughnut
Hole will claim $12,000 depreciation each year
 Taxable income of $8,000 will result in Shirley’s paying
$3,200 in income taxes each year
 The annual after-tax cash flow will be $16,800

Effect of Taxes
• The investment provides two after-tax benefits:
 Five-year annuity of $16,800
 Lump-sum payment of $10,000 at the end of five years
• Because book value after five years is $10,000,
there is no gain in selling it for $10,000 and,
therefore, no tax
• The present value of the five-year annuity of $16,800
discounted at 10% is $63,685
• The present value of the lump-sum payment of $10,000 is
$6,209
• The net present value of this investment project is $(106)
= ($63,685 + 6,209 - 70,000)
• Because the project’s net present value is
negative, it is not economically desirable
Effect of Inflation
• Inflation is a general increase in the price level
• Adjust future cash flow to compare dollars of
similar purchasing power

Discount future cash flows to the present using an
appropriate discount rate to account for the time value
of money
 Discount each cash flow by the appropriate discount
rate and the expected inflation rate
• If Shirley’s expected inflation of 2.5%, the
combined discount rate would be 1.1275%
= 1.10 x 1.025
Uncertainty in Cash Flows
• Capital budgeting analysis relies on estimates of
future cash flows
• Estimating future cash flows is an important and
difficult task


Important because many decisions will be affected by
those estimates
Difficult because these estimates will reflect
circumstances that the organization may not have
previously experienced
Uncertainty in Cash Flows
• Most cash flow estimation is incremental
• Many organizations assume that learning will
systematically reduce the costs of a new system
or process
• Cash flows related to sales of a new product are
often estimated based on past experiences with
similar products
• The forecast usually starts with previous
experience and makes adjustments
High Low Method
• Estimate the most likely effect of a decision, such as a cost
decrease or a revenue increase, and then estimate the
highest and lowest possible values
• Constructs a normal distribution with a mean equal to the
most likely value estimated and a standard deviation
calculated by subtracting the mean from the highest
estimated value and dividing the difference by 3
• Only the mean or expected value of the estimate is needed
for the net present value model, but by developing a
distribution of expected outcomes, the probabilistic
statements about the results can be developed
Expected Value Method
• Identify 4-5 possible outcomes and assign each a
probability of occurring, such that the total
probabilities assigned equals one
• Compute the expected value of the estimate by
weighting each estimate by its probability
• This estimate is used in the capital budgeting
model to project the revenue and cost effects of
the investment project
Wait and See
• In some circumstances, an organization may be
able to delay a final decision and undertake a
smaller version of the project to gain more
information
• In real options analysis, the organization
purchases an option that allows the option holder
to purchase an asset at a specified future point in
time at a specified price (a European call option)
• The value of the option is determined by the
volatility of the future value of the asset
What-If & Sensitivity Analysis
• Two other approaches to handling uncertainty are
what-if and sensitivity analysis

In the Shirley’s Doughnut Hole example, Shirley might
ask, “What must the cash flows be to make this project
unattractive?”
• The planner can set up a computer spreadsheet
to make changes to the estimates of the
decision’s key parameters
What-If & Sensitivity Analysis
• If the analysis explores the effect of a change in a
parameter on an outcome, we call this
investigation a what-if analysis

For example: “What will my profits be if sales are only
90% of the plan?”
• A planner’s investigation of the effect of a change
in a parameter on a decision, rather than on an
outcome, is called a sensitivity analysis

For example: “How low can sales fall before this
investment becomes unattractive?”
Strategic Considerations
• The common benefits associated with acquiring
long-term assets (e.g., increased profits) ignore
the assets’ strategic benefits, which are of
increasing importance
• Including strategic benefits in a capital budgeting
example is controversial because they can be
difficult to estimate
Strategic Considerations
• Long-term assets usually provide the following
strategic benefits:
 They allow an organization to make goods or
deliver a service that competitors cannot
 They support improving product quality by
reducing the potential to make mistakes
 They help shorten the production cycle time
Strategic Considerations
•
Shirley’s may consider investing in a cooker that
senses when a doughnut is cooked and ejects it
automatically
•
The benefits from the automatic cooker can
include increased sales and lower operating
expenses if the competitors do not have this
cooker
The automatic cooker can prevent an erosion of
sales if Shirley’s competitors also purchase it
•
Post-Implementation Audits
• Revisiting the decision to purchase a long-lived
asset is called a post-implementation audit of
the capital budgeting decision and provides many
valuable insights for decision makers
• When estimates are used to support proposals,
recognizing the behavioral implications that lie
behind them is important
Post-Implementation Audits
• Many organizations fail to compare the estimates
made in the capital budgeting process with the
actual results
• This is a mistake for three reasons:
Post-Implementation Audits
•
•
•
By comparing estimates with results, the
organizations planners can identify where
estimates are wrong and avoid making similar
mistakes in the future
By assessing the skill of planners, organizations
can identify and reward those who are good at
making capital budgeting decisions
By auditing the results of acquiring long-term
assets, companies create an environment in
which planners are less tempted to inflate
estimates of the cash benefits associated with
their projects in order to get them approved
Budgeting Other
Spending Proposals
• Organizations develop spending proposals for
discretionary items other than capital expenditures
• Such items can provide benefits that will be
realized for many periods into the future
• Their magnitude suggests that they should be
evaluated like capital spending projects when
possible
Budgeting Other
Spending Proposals
• The approach to analyzing a discretionary
expenditure is identical to that used to decide
whether to make a capital investment:


Estimate the discounted cash inflows (benefits) and
discounted cash outflows (costs) associated with any
discretionary spending project
Accept the project if the NPV is positive