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Chapter 11
Capital
Budgeting
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Chapter 11 Learning Objectives
1. Describe capital-budgeting decisions and use the netpresent-value (NPV) method to make such decisions.
2. Use sensitivity analysis to evaluate the effect of changes
in predictions on investment decisions.
3. Calculate the NPV difference between two projects using
both the total project and differential approaches.
4. Identify relevant cash flows for NPV analyses.
5. Compute the after-tax net present values of projects.
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Chapter 11 Learning Objectives
6. Explain the after-tax effect on cash received from the
disposal of assets.
7. Use the payback model and the accounting rate-of-return
model and compare them with the NPV model.
8. Reconcile the conflict between using an NPV model for
making decisions and using accounting income for
evaluating the related performance.
9. Compute the impact of inflation on a capital-budgeting
project (Appendix 11).
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Learning
Objective 1
Capital Budgeting
Capital budgeting describes the
long-term planning for making and
financing major long-term projects.
1. Identify potential investments.
2. Choose an investment.
3. Follow-up or “post audit.”
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Discounted-Cash-Flow Models
(DCF)
These models focus on a project’s cash
inflows and outflows while taking into
account the time value of money.
DCF models compare the value
of today’s cash outflows with the
value of the future cash inflows.
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Net Present Value Model
The net-present-value (NPV) method computes
the present value of all expected future cash
flows using a minimum desired rate of return.
The minimum desired rate of return depends on
the risk-the higher the risk, the higher the rate.
The required rate of return (also called hurdle
rate or discount rate) is the minimum desired
rate of return based on the firm’s cost of capital.
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Applying the NPV Method
Identify the amount and timing
of relevant expected cash
inflows and outflows.
Find the present value of each
expected cash inflow or outflow.
Sum the individual present values.
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NPV Example
Original investment (cash outflow): $5,827
Useful life: four years
Annual income generated from
investment (cash inflow): $2,000
Minimum desired rate of return: 10%
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NPV Example
Present
Value
of $1
Total
Sketch of Cash
Discounted Present
Flows at End of Year
At 10%
Value
0
1
2
3
4
Approach 1:
Discounting Cash Flows
Cash flows
Annual savings .9091 $1,818
2,000
.8264
1,653
2,000
.7513
1,503
2,000
.6830
1,366
2,000
Present value of
Future inflows
$6,340
Initial Outlay 1.0000 (5,827) $(5,827)
Net present value
$ 513
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NPV Example
Because the four annual cash flows in the
example are all equal, this table can be used to
make one PV computation instead of four
individual computations.
Approach 2: Using an Annuity Table
Sketch of Cash Flows at End of Year
0
1
2
3
4
Annual Savings 3.1699 $6,340
$2,000 $2,000 $2,000 $2,000
Initial Outlay
1.0000 (5,827) $(5,827)
Net present value
$ 513
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Assumptions of the NPV Model
Two Major Assumptions
World of certainty.
Predicted cash flows
occur at times specified.
There are perfect
capital markets.
Money can be borrowed
or loaned at the same
interest rate.
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Decision Rules
Managers determine the sum of
the present values of all expected
cash flows from the project.
If the sum of the present values is
positive, the project is desirable.
If the sum of the present values is
negative, the project is unattractive.
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Internal Rate of Return Model
The IRR determines the interest rate
at which the NPV equals zero.
If IRR > minimum desired rate of return,
then NPV > 0 and accept the project.
If IRR < minimum desired rate of return,
then NPV < 0 and reject the project.
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Real Option Model
This model recognizes the value
of contingent investments.
Contingent investments are
investments that a company
can adjust as it learns more
about their potential for success.
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Learning
Objective 2
Sensitivity Analysis
Sensitivity analysis shows the financial
consequences that would occur if
actual cash inflows and outflows
differ from those expected.
Managers often use sensitivity
analysis to deal with uncertainty, to
answer the what-if questions.
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Sensitivity Analysis Example
Suppose that a manager knows that the
actual cash inflows in the previous example
could fall below the predicted level of $2,000.
How far below $2,000 must the annual cash
inflow drop before the NPV becomes negative?
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Sensitivity Analysis Example
(3.1699 × Cash flow) – $5,827 = 0
Cash flow = $5,827 ÷ 3.1699 = $1,838
If the annual cash flow is less than $1,838, the NPV
is negative, and the project should be rejected.
Annual cash inflows can drop only
$2,000 – $1,838 = $162 or 8.1%
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Learning
Objective 3
Comparison of Two Projects
Two common methods for
comparing alternatives are:
Total project
approach
Differential
approach
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Total Project Approach
The total project approach computes the
total impact on cash flows for each
alternative and then converts these
total cash flows to their present values.
The alternative with the largest
NPV of total cash flows is best.
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Differential Approach
The differential approach computes
the differences in cash flows between
alternatives and then converts these
differences to their present values.
This method cannot be used to
compare more than two alternatives.
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Learning
Objective 4
Relevant Cash Flows for NPV
Three types of inflows and outflows
should be considered when the
relevant cash flows are arrayed:
1) Initial cash inflows and outflows at time zero
2) Future disposal values
3) Operating cash flows
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Operating Cash Flows
The only relevant cash flows are those
that will differ among alternatives.
Fixed overhead can be ignored.
A reduction in cash outflow is
treated the same as a cash inflow.
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Cash Flows for Investments in Technology
Decision:
Invest in a highly automated production
system to replace a traditional system.
Cash flows predicted for the automated system
should be compared to cash flows predicted
for continuation of present system.
A changing competitive environment can
cause failure to invest in an automated system
which causes a decline in sales and an
uncompetitive cost structure.
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Learning
Objective 5
Income Taxes and Capital Budgeting
Another type of cash flow
that must be considered when
making capital-budgeting decisions is
after-tax cash flows.
In capital budgeting,
the relevant tax
rate is the marginal
income tax rate.
This is the tax rate paid
on incremental
taxable income.
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Effects of Depreciation Deductions
Depreciation expense is a noncash expense and
is ignored for capital budgeting, except that
it is an expense for tax purposes and will
provide a cash inflow from income tax savings.
Organizations that pay income taxes usually
keep two sets of books one set that follows the
rules for financial reporting and one that
follows the tax rules, a practice that is not
illegal or immoral – it is necessary.
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Effects of Depreciation Deductions
U.S. tax authorities allow
accelerated depreciation.
The focus is on the tax reporting rules,
not those for public financial reporting.
The recovery period is the number
of years over which an asset is
depreciated for tax purposes.
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Effects of Depreciation Deductions
Assume the following:
Cash inflow from operations: $60,000
Tax rate: 40%
What is the after-tax inflow from operations?
$60,000 × (1 – tax rate)
= $60,000 × .6 = $36,000
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Effects of Depreciation Deductions
What is the after-tax effect
of $25,000 depreciation?
$25,000 × 40% = $10,000 tax savings
The depreciation deduction reduces
taxes, and thereby increases cash
flows, by $10,000 annually.
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Modified Accelerated Cost Recovery System
Under U.S. income tax laws, companies
depreciate most assets using the Modified
Accelerated Cost Recovery System (MACRS).
MACRS specifies a recovery period and
an accelerated depreciation schedule
for all types of assets in eight classes.
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Present Value of MACRS
Depreciation Tax Deduction
Depreciation Tax Shield is the tax savings
due to depreciation deductions, generally the
present value of the product of the tax rate
and the depreciation deduction. The value of
a depreciation deduction depends on timing.
MACRS specifies the timing of deductions for
each recovery period. The present value of the
depreciation tax shield for any recovery period
can be easily computed.
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Learning
Objective 6
Gains or Losses on Disposal
The disposal of equipment for cash
can also affect income taxes.
Suppose a 5-year piece of equipment purchased
for $125,000 is sold at the end of year 3 after
taking three years of straight-line depreciation.
What is the book value?
$125,000 – (3 × $25,000) = $50,000
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Gains or Losses on Disposal
If the equipment is sold for $50,000
(book value), there is no gain or loss
and there is no tax effect.
If it is sold for more than $50,000, there
is a gain and an additional tax payment.
If it is sold for less than $50,000,
there is a loss and a tax savings.
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Gains or Losses on Disposal
Assume that the equipment is sold for
$70,000 and the tax rate is 40%.
What is the tax savings on the sale?
($70,000 – $50,000) = 20,000 × 40% = $8,000
What is the net cash inflow from the sale?
$70,000 – $8,000 = $62,000
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Cash Flow Effects of
Disposal of Equipment
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Learning
Objective 7
Other Models for Analyzing
Long-Range Decisions
Payback time, or payback period, is the
time it will take to recoup, in the form
of cash inflows from operations, the
initial dollars invested in a project.
P=I÷O
Assume that $12,000 is spent for a commercial
stove with an estimated useful life of 4 years.
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Payback Model Example
Annual savings of $4,000 in cash outflows
are expected from operations.
What is the payback period?
P = $12,000 ÷ $4,000 = 3 years
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Accounting Rate-of-Return Model
The accounting rate-of-return (ARR) model
expresses a project’s return as the increase
in expected average annual operating income
divided by the required initial investment.
Increase in expected
Initial
average annual
ARR =
÷ required
operating income*
investment
*Average annual incremental cash inflow from operations
minus incremental average annual depreciation.
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Accounting Rate-of-Return Example
Assume the following:
Investment is $5,827.
Useful life is four years.
Estimated disposal value is zero.
Expected annual cash inflow
from operations is $2,000.
Annual depreciation = (cost – disposal value)/useful life
Annual depreciation = ($5,827 – 0)/4 = $1,456.75
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Accounting Rate-of-Return Example
ARR =
Average annual incremental
cash inflow –
Incremental annual depreciation
÷
Initial
required
investment
ARR = ($2,000 – $1457) ÷ $5,827 = 9.3%
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Accounting Rate-of-Return Example
Some companies use the “average” investment
(often assumed to be the average book value
over the useful life) instead of original
investment in the denominator
Average annual incremental
cash inflow –
Incremental annual depreciation
÷
Average
investment
ARR = ($2,000 – $1457) ÷ $2,913.50 = 18.6%
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Learning
Objective 8
Performance Evaluation
Many managers are reluctant to accept
DFC models as the best way to make
capital-budgeting decisions.
Their superiors evaluate them
using a non-DCF model.
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Reconciliation of Conflict
Use DCF for both capital-budgeting
decisions and performance evaluation.
Use Economic Value Added (EVA)
Follow-up evaluation
of capital decisions
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Post Audit
Most large companies conduct a
follow-up evaluation of selected
capital-budgeting decisions.
One follow-up evaluation of
capital-budgeting decisions often
used is a post-audit.
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Post Audit
Investment expenditures are
on time and within budget.
Comparing actual versus predicted cash flows.
Improving future predictions of cash flows.
Evaluating the continuation of the project.
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Learning
Objective 9
Capital Budgeting and Inflation
What is inflation?
It is the decline in general purchasing
power of the monetary unit.
The key in capital budgeting is consistent
treatment of the minimum desired rate
of return and the predicted cash
inflows and outflows.
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Watch for Consistency
Consistency can be achieved by
including an element for inflation in
both the minimum desired rate of
return and in the cash-flow predictions.
Many firms base their minimum desired rate
of return on market interest rates (nominal
rates) that include an inflation element.
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