Chapter Nine
Capital Budgeting
1
Capital Budgeting Decisions

require sizable commitments of cash.

are expected to generate returns that will
last more than one year.

involve time value of money.
2
Importance of Capital
Budgeting Decisions
Capital budgeting decisions
commit companies to
courses of action. The
success or failure of a
particular strategy, or even
of the company itself, can
hinge on one or a series of
such decisions.
3
Importance of Capital Budgeting
Decisions (continued)

In addition, capital budgeting decisions
are generally riskier than short-term ones
for the following reasons:
 The
company expects to recoup its
investment over a longer period.
 Reversing
a capital budgeting decision is
much more difficult than reversing a shortterm decision.
4
Types of Capital Budgeting
Decisions

Investments made to further strategic
goals

Investments made to increase capacity or
reduce costs

Investments made for non-financial
reasons

Investments mandated by law or policy
5
Cost of Capital
Cost of capital is the cost, expressed as a
percentage, of obtaining the money needed
to operate the company.
Capital is obtained from two sources, creditors
and owners, corresponding to divisions of
liabilities and owners’ equity on the balance
sheet.
6
Weighted Average Cost of Capital
Average costs of debt and equity
components
 Example - debt with after tax cost of 5% is
40% of capital structure and equity with
after cost of 15% is 60% of capital
structure
 Cost of capital is:

40% * 5% =
60% * 15% =
Total
2%
9%
11%
7
Cutoff Rate
Because of the practical
difficulties of determining
cost of capital, managers
might simply use their
judgment to set a
minimum acceptable rate,
called a cutoff rate, hurdle
rate, or target rate.
8
The Capital Budgeting Decision Models

Discounted Cash Flow (DCF) Techniques:
 Net
present value (NPV)
 Internal

rate of return (IRR)
Nondiscounted Cash Flow Techniques
 Payback
 Book
period
rate of return
9
Net Present Value Method
The net present value method (NPV) uses
the minimum acceptable rate to find the
present value (PV) of the future returns and
compares that value with the cost of the
investment.
10
Internal Rate of Return Method
The internal rate of return
method (IRR) finds the rate
of return associated with
the project and compares
that rate with the minimum
acceptable rate.
NPV = PV of future returns Cost of the investment
11
Decision Rules

Under the NPV method, a project having a
positive NPV should be accepted; others
should be rejected.

Under the IRR method, a project having
an IRR greater than the company’s cost of
capital should be accepted.
12
Purchase of Machine Example

Machine costs $60,000

Sell 3,000 units per year at $14 for the
next 5 years

Variable costs are $5 per unit

Annual cash fixed costs are $5,000

Cutoff rate of 12 percent
13
Annual Incremental Cash
Inflows
Annual
Cash Flows
Revenues ($14 x 3,000)
Variable costs ($5 x 3,000)
Contribution margin ($9 x 3,000)
Cash fixed costs
Expected increase in net cash
$42,000
15,000
$27,000
5,000
$22,000
14
Net Present Value Example
Expected increase in net cash
$22,000
Present value factor (PVA 5 12%) x 3.6048
Present value of future cash flows $79,306
Investment required
Net present value
60,000
$19,306
15
Internal Rate of Return
Factor = PV of future flows/Annual cash
flows
Factor = $60,000/$22,000 = 2.727
The 2.727 corresponds to an interest rate
between 20 and 30 percent when the number of
periods is five.
The IRR is about 25%.
16
Taxes and Depreciation
Additional information:
Tax rate is 40 percent.
Straight-line depreciation is used.
17
Annual After-Tax Cash Inflows
Revenues
Cash expenses
Cash inflow before taxes
Depreciation
Income
Cash Flow
$42,000
$42,000
20,000
20,000
$22,000
$22,000
12,000
Increase in taxable income
$10,000
Income taxes (40 percent)
4,000
Net Income
$6,000
Depreciation
12,000
Net increase in cash inflow
$18,000
4,000
$18,000
18
Net Present Value of After-Tax
Example
Expected increase in net cash inflows
$18,000
Present value factor
x 3.6048
Present value of future cash flows
$64,887
Investment required
60,000
Net present value
$4,887
19
Internal Rate of Return
Factor = PV of future flows/Annual cash
flows
Factor = $60,000/$18,000 = 3.333
The 3.333 corresponds to an interest rate
between 15 and 16 percent when the number of
periods is five.
The IRR is between 15 and 16 percent.
20
Payback Period
Payback
Period = Investment /Annual cash return
= $60,000/$18,000 = 3.333 years
21
Book Rate of Return
Average book
rate of return = Net income/Average book
investment
= $6,000/($60,000/2) = 20 percent
Net income is cash flow less depreciation
Average investment is (investment +residual)/2
This is the only method discussed that does not
use cash flows.
22
Tax Depreciation




For Tax, depreciation is computed using either
the Modified Accelerated Cost Recovery System
(MACRS) or optional straight line.
MACRS gives rapid depreciation according to
tables published by the IRS
Optional straight line uses a shorter life than the
actual life and a half year convention
Tax deprecation will almost always end up with
uneven cash flows.
23
Cash Flow




Problem Information - A company is offered
an 8 year contract that will yield an annual
gross cash flow of $450,000 with cash
expenses of $261,500.
Working capital investment is $90,000, and
machinery costing $700,000 is required.
The equipment is 5 year property for MACRS
depreciation, and has a useful life of 9 years,
but will be sold at the end of year 8 for
$25,000.
The tax rate is 30% and the cost of capital is
14%.
24
Calculating Annual Cash Flow
Year
Equipment Cost
Working Capital
Cash Flow
Cum Cash Flow
0
-700000
-90000
-790000
-790000
25
Calculating Cash Flows
Year
Gross Rev
Cash Expense
Less Depreciation
Plus Salvage
Taxable Income
Tax
Net
DEP
Working Capital
Cash Flow
1
2
3, 4, 5
450000 450000 450000
-261500 -261500 -261500
-140000 -224000 -134400
48500
-14550
33950
140000
-35500
10650
-24850
224000
54100
-16230
37870
134400
173950
199150
172270
26
Final Cash Flows
Gross Rev
Cash Expense
Less Depreciation
Plus Salvage
Taxable Income
Tax
Net
DEP
Working Capital
Cash Flow
6
7
8
450000 450000 450000
-261500 -261500 -261500
-40600
25000
147900 188500 213500
-44370
-56550
-64050
103530 131950 149450
40600
0
0
90000
144130 131950 239450
27
MACRS Example
MACRS Example
Year
0
Equipment
Cost
1
2
3
4
5
6
7
8
450000
-261500
-140000
450000
-261500
-224000
450000
-261500
-134400
450000
-261500
-80500
450000
-261500
-80500
450000
-261500
-40600
450000
-261500
450000
-261500
-700000
Gross Rev
cash expense
Less Depreciation
Plus Salvage
Taxable Income
Tax
Net
DEP
Working
-90000
Capital
Cash Flow
-790000
Cum Cash
-790000
Flow
Net Present Value
Internal rate of ret
48500
-14550
33950
140000
-35500
10650
-24850
224000
54100
-16230
37870
134400
108000
-32400
75600
80500
108000
-32400
75600
80500
147900
-44370
103530
40600
188500
-56550
131950
0
25000
213500
-64050
149450
0
90000
173950
-616050
199150
-416900
172270
-244630
156100
-88530
156100
67570
144130
211700
131950
343650
239450
583100
$7,939 Do this using NPV function
14.30% Do this using IRR function
28
Straight Line Example
Year
Equipment Cost
Gross Rev
Cash Expense
Less Depreciation
Plus Salvage
Taxable Income
Tax
Net
DEP
Working Capital
Cash Flow
Cum Cash Flow
Net Present Value
Internal rate of ret
0
Capital Budgeting Example Using Straight Line
1
2
3
4
5
6
7
8
450000
-261500
-70000
450000
-261500
450000
-261500
-700000
450000
-261500
-70000
118500
-35550
82950
70000
-90000
-790000
-790000
450000
-261500
-140000
48500
-14550
33950
140000
450000
-261500
-140000
48500
-14550
33950
140000
450000
-261500
-140000
450000
-261500
-140000
48500
-14550
33950
140000
48500
-14550
33950
140000
118500
-35550
82950
70000
188500
-56550
131950
0
152950 173950 173950 173950
-637050 -463100 -289150 -115200
($4,881) Do this using NPV function
13.82% Do this using IRR function
173950
58750
152950
211700
131950
343650
25000
213500
-64050
149450
0
90000
239450
583100
29