CHAPTER 24
Planning for Capital Investments
LEARNING OBJECTIVES
1.
DISCUSS CAPITAL BUDGETING EVALUATION, AND EXPLAIN
INPUTS USED IN CAPITAL BUDGETING.
2.
DESCRIBE THE CASH PAYBACK TECHNIQUE.
3.
EXPLAIN THE NET PRESENT VALUE METHOD.
4.
IDENTIFY THE CHALLENGES PRESENTED BY INTANGIBLE
BENEFITS IN CAPITAL BUDGETING.
5.
DESCRIBE THE PROFITABILITY INDEX.
6.
INDICATE THE BENEFITS OF PERFORMING A POST-AUDIT.
7.
EXPLAIN THE INTERNAL RATE OF RETURN METHOD.
8.
DESCRIBE THE ANNUAL RATE OF RETURN METHOD.
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CHAPTER REVIEW
The Capital Budgeting Evaluation Process
1.
(L.O. 1) The capital budgeting evaluation process generally has the following steps:
a. Project proposals are requested from departments, plants, and authorized personnel.
b. Proposals are screened by a capital budget committee.
c. Officers determine which projects are worthy of funding; and
d. Board of directors approves capital budget.
Cash Flow Information
2.
While accrual accounting has advantages over cash accounting in many contexts, for purposes of
capital budgeting, estimated cash inflows and outflows are preferred for inputs into the capital
budgeting decision tools.
3.
Sometimes cash flow information is not available, in which case adjustments can be made to
accrual accounting numbers to estimate cash flows.
4.
The capital budgeting decision, under any technique, depends in part on a variety of considerations:
a. The availability of funds;
b. Relationships among proposed projects;
c. The company’s basic decision-making approach; and
d. The risk associated with a particular project.
Cash Payback
5.
(L.O. 2) The cash payback technique identifies the time period required to recover the cost of
the capital investment from the net annual cash flow produced by the investment. The formula for
computing the cash payback period is:
Cost of Capital Investment ÷ Net Annual Cash Flow = Cash Payback Period
6.
Net annual cash flow can be approximated by adding depreciation expense to net income; it can
also be approximated by “Net cash provided by operating activities” from the statement of cash
flows.
The evaluation of the payback period is often related to the expected useful life of the asset.
a. With this technique, the shorter the payback period, the more attractive the investment.
b. This technique is useful as an initial screening tool.
c. This technique ignores both the expected profitability of the investment and the time value of
money.
Net Present Value Method
7.
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(L.O. 3) Under the net present value (NPV) method, cash flows are discounted to their present
value and then compared with the capital outlay required by the investment. The difference
between these two amounts is the net present value (NPV).
a. The interest rate used in discounting the future net cash flows is the required minimum rate of
return.
b. A proposal is acceptable when NPV is zero or positive.
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c.
The higher the positive NPV, the more attractive the investment.
8.
When there are equal annual cash inflows, the table showing the present value of an annuity of
1 can be used in determining present value. When there are unequal annual cash inflows, the
table showing the present value of a single future amount must be used in determining present
value of each annual cash flow.
9.
The discount rate used by most companies is its cost of capital—that is, the rate that the
company must pay to obtain funds from creditors and stockholders.
10.
The net present value method demonstrated in the text requires the following assumptions:
a. All cash flows come at the end of each year;
b. All cash flows are immediately reinvested in another project that has a similar return; and
c. All cash flows can be predicted with certainty.
Intangible Benefits
11.
(L.O. 4) By ignoring intangible benefits, such as increased quality or improved safety, capital
budgeting techniques might incorrectly eliminate projects that could be financially beneficial to the
company. To avoid rejecting projects that actually should be accepted, two possible approaches
are suggested;
a. Calculate net present value ignoring intangible benefits, and then, if the NPV is negative, ask
whether the intangible benefits are worth at least the amount of the negative NPV.
b. Project rough, conservative estimates of the value of the intangible benefits, and incorporate
these values into the NPV calculation.
Mutually Exclusive Projects
12.
(L.O. 5) In theory, all projects with positive NPVs should be accepted. However, companies rarely
are able to adopt all positive-NPV proposals because (1) the proposals are mutually exclusive (if
the company adopts one proposal, it would be impossible to also adopt the other proposal), and
(2) companies have limited resources.
13.
In choosing between two projects, one method that takes into account both the size of the original
investment and the discounted cash flows is the profitability index. The profitability index
formula is as follows:
Present Value of
Net Cash Flows
÷
Initial
Investment
=
Profitability
Index
The project with the greater profitability index should be the one chosen.
14.
Another consideration made by financial analysts is uncertainty or risk. One approach for
dealing with uncertainty is sensitivity analysis. Sensitivity analysis uses a number of outcome
estimates to get a sense of the variability among potential returns. In general, a higher-risk project
should be evaluated using a higher discount rate.
Post-Audit of Investment Projects
15.
(L.O. 6) A post-audit is a thorough evaluation of how well a project’s actual performance
matches the projections made when the project was proposed. Performing a post-audit is
beneficial for the following reasons:
a. Management will be encouraged to submit reasonable and accurate data when they make
investment proposals;
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b.
16.
A formal mechanism is used for determining whether existing projects should be supported or
terminated;
c. Management improves their estimation techniques by evaluating their past successes and
failures.
A post-audit involves the same evaluation techniques that were used in making the original capital
budgeting decision—for example, use of the net present value method. The difference is that, in
the post-audit, actual figures are inserted where known, and estimation of future amounts is
revised based on new information.
Internal Rate of Return Method
17.
(L.O. 7) The internal rate of return method finds the interest yield of the potential investment.
This is the interest rate that will cause the present value of the proposed capital expenditure to
equal the present value of the expected net annual cash inflows.
Determining the internal rate of return can be done with a financial (business) calculator,
computerized spreadsheet, or by employing a trial-and-error procedure.
18.
The decision rule is: Accept the project when the internal rate of return is equal to or greater than
the required rate of return, and reject the project when the internal rate of return is less than the
required rate.
Annual Rate of Return Method
19.
(L.O. 8) The annual rate of return method is based directly on accrual accounting data
rather than on cash flows. It indicates the profitability of a capital expenditure and its formula is:
Expected Annual Net Income ÷ Average Investment = Annual Rate of Return
Average investment is based on the following:
Original investment + Value at end of useful life
= Average
Investment
2
20.
The annual rate of return is compared with management’s required minimum rate of return for
investments of similar risk. The minimum rate of return (the hurdle rate or cutoff rate) is generally
based on the company’s cost of capital. The decision rule is: A project is acceptable if its rate of
return is greater than management’s minimum rate of return; it is unacceptable when the reverse
is true.
21.
When the rate of return technique is used in deciding among several acceptable projects, the
higher the rate of return for a given risk, the more attractive the investment.
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LECTURE OUTLINE
A.
Capital Budgeting Evaluation Process
1. The process of making capital expenditure decisions in business is
referred to as capital budgeting.
2. Capital budgeting involves choosing among various projects to find the
one(s) that will maximize a company’s return on its financial investment.
3. Top management requests proposals for projects from each department
and a capital budgeting committee screens the proposals and recommends worthy projects to company officers.
4. Company officers decide which projects to fund and submit this list of
projects to the board of directors for approval.
5. For purposes of capital budgeting, estimated cash inflows and outflows
are the preferred inputs.
B.
Cash Payback.
1. The cash payback technique identifies the time period required to
recover the cost of the capital investment from the net annual cash flow
produced by the investment.
2. Net annual cash flow is computed by adding back depreciation expense
to net income. Depreciation expense is added back because it is an
expense that does not require an outflow of cash.
a.
The formula when net annual cash flows are equal is: Cost of
Capital Investment ÷ Net Annual Cash FIow = Cash Payback
Period.
b.
The shorter the payback period, the more attractive the investment.
c.
The cash payback technique recognizes that:
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(1) The earlier the investment is recovered, the sooner the company
can use the cash funds for other purposes.
(2) The risk of loss from obsolescence and changed economic
conditions is less in a shorter payback period.
C.
d.
In the case of uneven net annual cash flows, the company
determines the cash payback period when the cumulative net cash
flows from the investment equal the cost of the investment.
e.
The cash payback technique is relatively easy to compute and
understand.
f.
It should not ordinarily be the only basis for the capital budgeting
decision because it ignores the expected profitability of the project
and the time value of money.
Net Present Value Method.
1. Discounted cash flow techniques are generally recognized as the most
informative and best conceptual approaches to making capital budgeting
decisions.
2. These techniques consider both the time value of money and the
estimated net cash flow from the investment.
3. The primary discounted cash flow technique is the net present value
method.
4. The net present value method involves discounting net cash flows to
their present value and then comparing that present value with the
capital outlay required by the investment. The difference between these
two amounts is referred to as net present value (NPV).
a.
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Company management determines what interest rate to use in
discounting the future net cash flows. This rate is often referred to
as the discount rate or required rate of return.
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b.
A proposal is acceptable when net present value is zero or positive,
because this means the rate of return on the investment equals or
exceeds the required rate of return.
c.
The higher the positive net present value, the more attractive the
investment.
MANAGEMENT INSIGHT
Verizon has spent billions of dollars to upgrade its network from 3G to 4G. But,
there aren’t that many 4G-compatible devices, coverage is spotty, and most
applications don’t really need higher speeds. Verizon is hoping that its
investment in 4G works out.
Based on the potentially slow initial adoption of 4G by customers, how might the
conclusions of a cash payback analysis of Verizon’s 4G investment differ from a
present value analysis?
Answer: If the initial adoption of 4G by customers is slow, then the amount of
cash received in the early years will be low. This would lengthen the
cash payback period, making it unlikely that the investment would get
high marks with this test. However, the long-run potential of 4G is
probably quite high as more people switch to smart phones and
consequently increase their use of services that benefit from a highspeed connection. These later cash flows may well be large enough
that they provide a positive net present value amount.
D.
Intangible Benefits.
1. Intangible benefits, such as increased quality, improved safety, or
enhanced employee loyalty, are difficult to quantify, and thus often are
ignored in capital budgeting decisions.
2. To avoid rejecting projects that should actually be accepted, managers
can either
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a.
Calculate net present value (NPV) ignoring intangible benefits, and
if the resulting NPV is negative, evaluate whether the intangible
benefits are worth at least the amount of the negative NPV.
b.
Incorporate intangible benefits into the NPV calculation by projecting
rough, conservative estimates of their value. If, after using conservative estimates, the net present value is positive, the project should
be accepted.
ETHICS INSIGHT
Most manufacturers say that employee safety matters above everything else, but
“safety doesn’t sell.” Recently a woodworking hobbyist with a Ph.D. in physics
invented a device that automatically stops a power saw if the blade comes in
contact with human flesh. The inventor eventually started his own company to
build the devices and sell then directly to businesses that use power saws since
existing saw manufacturers were unwilling to include the device into their saws.
In addition to the obvious humanitarian benefit of reducing serious injuries, how
else might the manufacturer of this product convince potential customers of its
worth?
Answer: Serious injuries cost employers huge sums, which can sometimes
force small companies out of business. In addition to the obvious
humanitarian benefit, the manufacturer can demonstrate that this
device is a sound financial investment in terms of reduced health-care
and workers’ compensation costs and fewer hours missed due to
injury. Also, as the device gains wider acceptance, employers that do
not have the device may ultimately be found negligent with regard to
worker safety.
E.
Mutually Exclusive Projects.
1. Proposals are often mutually exclusive—if the company adopts one
proposal, it would be impossible to also adopt the other proposal.
2. The profitability index is a method that compares the relative merits of
alternative capital investment projects.
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3. This method takes into account both the size of the original investment
and its discounted cash flows.
4. It is computed by dividing the present value of net cash flows by the
initial investment.
5. The higher the profitability index, the more desirable the project.
MANAGEMENT INSIGHT
Building a new factory to produce 50-inch-plus TV screens can cost billions of
dollars and manufacturers are wondering whether such investments are worth
the gamble. Recently, the supply of big-screen TVs was estimated to exceed
demand by 12%, and this imbalance may rise to 16% in the future. .
What implications does the excess capacity have for the cash payback and net
present value calculations of these investments?
Answer: Because the companies have excess capacity, they are not selling as
many units as expected. Also, to increase sales, they are being forced
to cut selling prices in order to sell units. Therefore, the revenues that
they generate are lower than the amounts that would have been
estimated when the plants were planned and built. This means that
cash payback periods are longer and net present values are lower than
desired levels.
F.
Post-Audit of Investment Projects.
1. A post-audit is a thorough evaluation of how well a project’s actual
performance matches the original projections.
2. Performing a post-audit is important for several reasons.
a.
Since managers know that their results will be evaluated, there is
an incentive for them to make accurate estimates rather than
presenting overly-optimistic estimates in an effort to get projects
approved.
b.
A post-audit provides a formal mechanism for determining whether
existing projects should be continued, expanded, or terminated.
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c.
Post-audits improve future investment proposals because managers
improve their estimation techniques by evaluating past successes
and failures.
3. A post-audit involves the same evaluation techniques used in making
the original capital budgeting decision. In the post-audit, managers use
actual figures where known, and they revise estimates of future amounts
based on new information.
MANAGEMENT INSIGHT
Inaccurate trend forecasting and market positioning are more detrimental to
capital investment decisions than using the wrong discount rate. Companies
often adopt projects or businesses only to discontinue them in response to
market changes. Texas Instruments has dropped out of 12 business lines in
recent years.
How important is the choice of discount rate in making capital budgeting
decisions?
Answer: The point of this discussion is that errors in implementation, as well as
the accuracy of the estimated future benefits and costs as measured
by cash inflows and outflows, are what matters the most when making
capital expenditure decisions. While the choice of discount rates will
result in incremental differences in present value calculations. “missing
the big picture” has the potential to cause much bigger decision
errors. Underestimating potential future cash inflows can result in
missed opportunities. Underestimating future costs can result in failed
investments.
G.
Internal Rate of Return.
1. The internal rate of return method differs from the net present value
method in that it finds the interest yield of the potential investment.
a.
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The internal rate of return is the interest rate that will cause the
present value of the proposed capital expenditure to equal the
present value of the expected net annual cash flows.
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b.
The determination of the internal rate of return involves the use of a
financial calculator or computerized spreadsheet to solve for the
rate (if the cash flows are uneven).
c.
If the net annual cash flows are equal, an easier approach to
solving for the internal rate of return can be used. This approach
involves two steps:
(1) Compute the internal rate of return factor.
(2) Use the factor and the present value of an annuity of 1 table to
find the internal rate of return.
d.
When cash flows are equal, the formula for determining the internal
rate of return factor is: Capital Investment ÷ Net Annual Cash Flows
= Internal Rate of Return Factor.
e.
Once managers know the internal rate, of return, they compare it to
the company’s required rate of return (the discount rate).
f.
The IRR decision rule is: Accept the project when the internal rate
of return is equal to or greater than the required rate of return.
Reject the project when the internal rate of return is less than the
required rate.
2. The two discounted cash flow methods differ as follows:
a.
Objective:
(1) Net present value: compute net present value (a dollar
amount).
(2) Internal rate of return: compute internal rate of return
(a percentage).
b.
Decision rule:
(1) Net present value (NPV): If NPV is zero or positive, accept the
proposal. If NPV is negative, reject the proposal.
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(2) Internal rate of return (IRR): If IRR is equal to or greater than
the required rate of return, accept the proposal. If IRR is less
than the required rate of return, reject the proposal.
H.
Annual Rate of Return Method.
1. The annual rate of return method is based directly on accounting data
rather than on cash flows.
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a.
Annual rate of return is obtained from the following formula:
Expected Annual Net Income ÷ Average Investment.
b.
Management compares the annual rate of return with its required
rate of return for investments of similar risk.
c.
The required rate of return is generally based on the company’s
cost of capital.
d.
The decision rule is: A project is acceptable if its rate of return is
greater than management’s required rate of return. It is unacceptable
when the reverse is true.
e.
The higher the rate of return for a given risk, the more attractive the
investment.
f.
The principal advantages of this method are the simplicity of its
calculation and management’s familiarity with the accounting terms
used in the computation.
g.
A major limitation of this method is that it does not consider the time
value of money.
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20 MINUTE QUIZ
Circle the correct answer.
True/False
1.
For purposes of capital budgeting, estimated cash inflows and outflows are the preferred
inputs.
True
2.
The cash payback technique is relatively easy to compute and considers the expected
profitability of the project.
True
3.
False
The internal rate of return is the interest rate that will cause the present value of the
proposed capital expenditure to equal the present value of the expected net annual cash
flows.
True
10.
False
The internal rate of return method does not recognize the time value of money.
True
9.
False
Performing a post-audit is important because if managers know their estimates will be
compared to actual results they will be more likely to submit reasonable and accurate
data when they make investment proposals.
True
8.
False
The profitability index takes into account both the size of the original investment and the
discounted cash flows.
True
7.
False
Intangible benefits, such as increased quality or improved safety, should be ignored in
capital budgeting decisions.
True
6.
False
A company’s cost of capital is the rate that it must pay to obtain funds from creditors and
stockholders.
True
5.
False
The primary discounted cash flow technique is the net present value method.
True
4.
False
False
The annual rate of return is computed by dividing net annual cash flow by the average
investment.
True
False
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Multiple Choice
1.
All of the capital budgeting methods use cash flow except the
a. cash payback method.
b. annual rate of return method.
c. internal rate of return method.
d. profitability index method.
2.
The cash payback period is computed by dividing the
a. cost of the capital investment by the annual net income.
b. cost of the capital investment by the present value of the cash flows.
c. cost of the capital investment by the net annual cash flow.
d. present value of the cash flows by the cost of the capital investment.
3.
The primary discounted cash flow technique is the
a. Annual rate of return method.
b. Cash payback method.
c. Net present value method.
d. None of the above.
4.
A company is considering investing in a project that costs $780,000 and is expected to
generate net annual cash flows of $315,000 each year for 3 years. The company has a
required rate of return of 9%. The present value of an annuity of 1 for 3 periods at 9% is
2.531. The net present value of this project is
a. $797,265.
b. $465,000.
c. $797,725.
d. $17,265.
5.
If capital investment is $800,000 and equal annual cash inflows are $200,000, the
internal rate of return factor is
a. 25.0.
b. 4.0.
c. 5.0.
d. .25.
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ANSWERS TO QUIZ
True/False
1.
2.
3.
4.
5.
True
False
True
True
False
6.
7.
8.
9.
10.
True
True
False
True
False
Multiple Choice
1.
2.
3.
4.
5.
b.
c.
c.
d.
b.
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