Capital Budgeting : The process of evaluating and
selecting long-term investments that are consistent
with the firm’s goal of maximizing owners’ wealth.
Capital expenditure: An outlay of funds by the firm
that is expected to produce benefits over a period of
time greater than 1 year.
Operating expenditure: An outlay of funds by the firm
resulting in benefits received within 1 year.
Companies make capital expenditures for many
reasons. The basic motives for capital expenditures are
to expand operations, to replace or renew fixed assets,
or to obtain some other, less tangible benefit over a
long period.
The capital budgeting process consists of five distinct but interrelated
steps:
1.
2.
3.
4.
5.
Proposal generation. Proposals for new investment projects are made at all
levels within a business organization and are reviewed by finance personnel.
Proposals that require large outlays are more carefully scrutinized than less
costly ones.
Review and analysis. Financial managers perform formal review and analysis
to assess the merits of investment proposals.
Decision making. Firms typically delegate capital expenditure decision
making on the basis of dollar limits. Generally, the board of directors must
authorize expenditures beyond a certain amount. Often plant managers are
given authority to make decisions necessary to keep the production line
moving.
Implementation. Following approval, expenditures are made and projects
implemented. Expenditures for a large project often occur in phases.
Follow-up. Results are monitored, and actual costs and benefits are
compared with those that were expected. Action may be required if actual
outcomes differ from projected ones.
The payback period is the amount of time required for the firm to
recover its initial investment in a project, as calculated from cash inflows.
A. Annuity cash flows
B. mixed stream of cash inflows
The payback period can be found the yearly cash inflows must be
by dividing the initial investment accumulated until the initial
by the annual cash inflow.
investment is recovered.
Although popular, the payback period is generally viewed as an
unsophisticated capital budgeting technique, because it does not
explicitly consider the time value of money.
DECISION CRITERIA
When the payback period is used to make accept–reject decisions, the
following decision criteria apply:
 If the payback period is less than the maximum acceptable payback
period, accept the project.
 If the payback period is greater than the maximum acceptable payback
period, reject the project.
Bennett Company, a medium-sized metal fabricator that is currently
contemplating two projects: Project A requires an initial investment of
$42,000; project B requires an initial investment of $45,000. The projected
relevant cash flows for the two projects are presented in Table 10.1
Calculate the payback period for Bennett Company’s projects A and
B using the data in Table 10.1.
For project A, Annuities
The payback period = $42,000 initial investment / $14,000 annual
cash inflow = 3.0 years
For project B, Mixed streams
Year
0
1
2
3
4
5
cash flows
0
$ 28,000.00
$ 12,000.00
$ 10,000.00
$ 10,000.00
$ 10,000.00
End balance of intial Investment
$
45,000.00
$
17,000.00
$
5,000.00
$
(5,000.00)
$
(15,000.00)
$
(25,000.00)
The payback period = 2 years + (5,000/10,000) = 2.5 years
use web site :project A, Annuities
use web site :project B, Mixed
Example (10-2)
Seema Mehdi is considering investing $20,000 to obtain a
5% interest in a rental property. Her good friend and real
estate agent, Akbar Ahmed, put the deal together and he
conservatively estimates that Seema should receive
between $4,000 and $6,000 per year in cash from her 5%
interest in the property. The deal is structured in a way
that forces all investors to maintain their investment in
the property for at least 10 years. Seema expects to
remain in the 25% income-tax bracket for quite a while.
To be acceptable, Seema requires the investment to pay
itself back in terms of after-tax cash flows in less than 7
years.
Example (10-3)
DeYarman Enterprises, a small medical appliance manufacturer, is
considering two mutually exclusive projects named Gold and Silver.
The firm uses only the payback period to choose projects. The cash
flows and payback period for each project are given in Table 10.2.
Year
0
1
2
3
4
5
cash flows
0
$ 5,000.00
$ 5,000.00
$40,000.00
$10,000.00
$10,000.00
Project gold
End balance of intial Investment
$
50,000.00
$
45,000.00
$
40,000.00
$
$
(10,000.00)
$
(20,000.00)
cash flows
0
$40,000.00
$ 2,000.00
$ 8,000.00
$10,000.00
$10,000.00
Project silver
End balance of intial Investment
$
50,000.00
$
10,000.00
$
8,000.00
$
$
(10,000.00)
$
(20,000.00)
Both projects have 3-year payback periods, which would suggest that they are
equally desirable. But comparison of the pattern of cash inflows over the first 3
years shows that more of the $50,000 initial investment in project Silver is
recovered sooner than is recovered for project Gold. For example, in year 1,
$40,000 of the $50,000 invested in project Silver is recovered, whereas only
$5,000 of the $50,000 investment in project Gold is recovered. Given the time
value of money, project Silver would clearly be preferred project Gold, in spite of
the fact that both have identical 3-year payback periods.
The payback approach does not fully account for the time value of money, which,
if recognized, would cause project Silver to be preferred over project Gold.
The net present value (NPV) is found by subtracting a project’s initial investment
(CF0) from the present value of its cash inflows (CFt) discounted at a rate equal to
the firm’s cost of capital (r).
When NPV is used, both inflows and outflows are measured in terms of present
dollars. For a project that has cash outflows beyond the initial investment, the
net present value of a project would be found by subtracting the present value of
outflows from the present value of inflows.
DECISION CRITERIA
When NPV is used to make accept–reject decisions, the decision criteria are as
follows:
 If the NPV is greater than $0, accept the project.
 If the NPV is less than $0, reject the project.
If the NPV is greater than $0, the firm will earn a return greater than its cost of
capital. Such action should increase the market value of the firm, and therefore
the wealth of its owners by an amount equal to the NPV.
Example (10-4)
Bennett Company, a medium-sized metal fabricator that is currently
contemplating two projects: Project A requires an initial investment of
$42,000; project B requires an initial investment of $45,000. The projected
relevant cash flows for the two projects are presented in Table 10.1
If the firm has a 10% cost of capital, compute the net present
values for projects A (an annuity) and B (a mixed stream)
Both projects are acceptable, because the net present value of each is greater than $0.
If the projects were being ranked, however, project A would be considered superior to
B, because it has a higher net present value than that of B ($11,071 versus $10,924).
Spreadsheet Use The NPVs can be calculated as shown on the
following Excel spreadsheet.
Example (10-5)
Bennett Company, a medium-sized metal fabricator that is currently
contemplating two projects: Project A requires an initial investment of
$42,000; project B requires an initial investment of $45,000. The projected
relevant cash flows for the two projects are presented in Table 10.1
If the firm has a 10% cost of capital, compute the IRR for projects A
(an annuity) and B (a mixed stream)