Chapter 20
Describe the importance of capital investments
and the capital budgeting process


Making capital investment decisions
Examples include:
◦
◦
◦
◦


Purchasing new equipment
Building new facilities
Automating production
Developing Web sites
Affects operations for many years
Requires large sums of money
Copyright (c) 2009 Prentice Hall. All rights reserved.
3
Accounting
Payback
Quick and easy; work well for
rate
investments with a shorter
life spanof
period
return
Use the time value of money; work
well for investments with a longer
life span
Net present
value
Internal rate
of return
Copyright (c) 2009 Prentice Hall. All rights reserved.
4

Operating income differs from cash flows
◦ Cash flows do not include noncash expenses

Cash inflows
◦ Future cash revenue generated
◦ Future savings in ongoing cash operating costs
◦ Future residual value

Cash outflows
◦ Initial investment
◦ Operating costs, maintenance, repairs
Copyright (c) 2009 Prentice Hall. All rights reserved.
5
Identify
potential
investments
Project net
cash inflows
Analyze using
one or more of
the methods
Post-audits
Capital
rationing
Copyright (c) 2009 Prentice Hall. All rights reserved.
6
Use the payback and accounting rate of return
methods to make capital investment decisions



Length of time it takes to recover the cost of the
capital outlay
Measures how quickly the amount invested will be
recovered
The shorter the payback period, the more
attractive the asset
Copyright (c) 2009 Prentice Hall. All rights reserved.
8
Equal annual net cash inflows
Payback
period
Amount invested
Expected annual net cash inflow
Unequal annual net cash inflows
Total net cash inflows until
amount equals investment
Copyright (c) 2009 Prentice Hall. All rights reserved.
9


Focuses only on time, not profitability
Ignores cash flows after the payback period
Copyright (c) 2009 Prentice Hall. All rights reserved.
10
DECISION RULE:
Payback Period
Investments with shorter
payback periods are
more desirable, all else
being equal.
Amount invested
Payback
period
Expected annual net cash inflow
$1,300,000
4.1 years
$314,000
Copyright (c) 2009 Prentice Hall. All rights reserved.
12
Average annual operating income from asset
Average amount invested in asset
Original investment + Residual value
2
Copyright (c) 2009 Prentice Hall. All rights reserved.
13
DECISION RULE: Invest in capital assets?
If expected accounting rate
of return exceeds the
required
rate of return?
If expected accounting rate
of return is less than required
rate of return?
Invest
Do not invest

Questions?
Copyright (c) 2009 Prentice Hall. All rights reserved.
15
1.
Which of the following decisions would
NOT fall under capital budgeting?
A.
B.
C.
D.
Purchasing new equipment
Building a new facility
Buying a short-term investment
Automating production
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
16
1.
Which of the following decisions would
NOT fall under capital budgeting?
A.
B.
C.
D.
Purchasing new equipment
Building a new facility
Buying a short-term investment
Automating production
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
17
2.
When estimating future cash inflows
from a capital investment, which of the
following are included?
A.
B.
C.
D.
Future cash revenue generated
Future savings in operating costs
Future residual value
All of the above
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
18
2.
When estimating future cash inflows
from a capital investment, which of the
following are included?
A.
B.
C.
D.
Future cash revenue generated
Future savings in operating costs
Future residual value
All of the above
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
19
3.
The decision rule regarding the payback
period states that the:
A.
shorter the payback period, the more
attractive the investment.
B. longer the payback period, the more
attractive the investment.
C. payback period should exceed the
asset’s life.
D. payback period should be compared to
the internal rate of return.
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
20
3.
The decision rule regarding the payback
period states that this:
A.
shorter the payback period, the more
attractive the investment.
B. longer the payback period, the more
attractive the investment.
C. payback period should exceed the
asset’s life.
D. payback period should be compared to
the internal rate of return.
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
21
4.
A criticism of the payback period is that it:
A.
uses operating income instead of cash
flows.
focuses only on the time value of money.
de-emphasizes risk of assets with longer
lives.
ignores cash flows after the payback
period.
B.
C.
D.
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
22
4.
A criticism of the payback period is that it:
A.
uses operating income instead of cash
flows.
focuses only on the time value of money.
de-emphasizes risk of assets with longer
lives.
ignores cash flows after the payback
period.
B.
C.
D.
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
23
5.
The unique element of the accounting rate
of return method is:
A.
its focus on operating income instead of
cash flows.
its use of time value of money.
that it ignores cash flows later in the
asset’s life.
that it generates a unique rate of return.
B.
C.
D.
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
24
5.
The unique element of the accounting rate
of return method is:
A.
its focus of operating income instead of
cash flows.
its use of time value of money.
that it ignores cash flows later in the
asset’s life.
that it generates a unique rate of return.
B.
C.
D.
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
25
Use the time value of money to compute the present
and future values of single lump sums and annuities

Invested money earns income over time
Copyright (c) 2009 Prentice Hall. All rights reserved.
27

Principal (p) – amount of the investment
◦ Lump sum
◦ Annuity
 Stream of equal installments at regular time periods

Number of periods (n)
◦ From the beginning of the investment until termination

Interest rate (i) – annual percentage
◦ Simple interest
 Calculated only on principal
◦ Compound interest
 Interest earned is added to principal
Copyright (c) 2009 Prentice Hall. All rights reserved.
28
Time
Present value
Future value
Present value
Future value
Present value
Interest
earned
Future value
Interest
earned
Copyright (c) 2009 Prentice Hall. All rights reserved.
29



Mathematical formulas developed to compute
present and future values
These factors are programmed into business
calculators and spreadsheet programs
See Appendix B for present and future factor
tables:
◦ Present Value of $1 & Future Value of $1 – for lump sum
amounts (one-time investments)
◦ Present Value of Annuity & Future Value of Annuity – for
a series of equal installments
Copyright (c) 2009 Prentice Hall. All rights reserved.
30

Lump sum
◦ Multiply amount by factor found in table
 Table based on interest rate and number of periods

Annuity
◦ Multiply one period’s installment by the factor found in the
table
Copyright (c) 2009 Prentice Hall. All rights reserved.
31
Use discounted cash flow models to make capital
investment decisions


Recognize time value of money
Two methods:
◦ Net present value (NPV)
◦ Internal rate of return (IRR)

Compare amount of investment with its expected net
cash inflows
◦ Cash outflow for investment usually occurs now
◦ Cash inflows usually occur in the future

Companies use present value to make the
comparison
Copyright (c) 2009 Prentice Hall. All rights reserved.
33
Present value of net cash inflows
Less: Investment cost
Equals: Net present value
Interest rate used is
desired rate of return
The higher the risk,
the higher the rate
Also called
“discount rate”
Copyright (c) 2009 Prentice Hall. All rights reserved.
34
DECISION RULE: Invest in capital assets?
If NPV is positive
If NPV is negative
Invest
Do not invest

If investment is expected to bring in even cash
flows:
◦ Use Present Value of Annuity (PVA) table

If amounts are unequal:
◦ Present value of each individual cash flow is computed
◦ Use Present Value of $1 (PV) table
Copyright (c) 2009 Prentice Hall. All rights reserved.
36
Project A
Present value of net cash inflows
57,000 x 4.639 (PVA 14%, 8 periods)
$ 264,423
Investment cost
Net present value
(290,000)
($25,557)
Copyright (c) 2009 Prentice Hall. All rights reserved.
37
Project B
Present value of net cash inflows
77,000 x 5.328 (PVA 12%, 9 periods)
$410,256
Investment cost
Net present value
(380,000)
$30,256
Copyright (c) 2009 Prentice Hall. All rights reserved.
38

Number of dollars returned for every dollar
invested
Present value of net cash inflows
Investment
Copyright (c) 2009 Prentice Hall. All rights reserved.
39


Rate of return a company can expect to earn by
investing in the project
The interest rate that will cause the present value
to equal zero
Investment’s cost
Present value of net cash flows
Copyright (c) 2009 Prentice Hall. All rights reserved.
40
Investment’s cost
PVA
Factor
Annual net cash inflow
Locate PVA factor in table using the
project’s life as the number of periods
Copyright (c) 2009 Prentice Hall. All rights reserved.
41
DECISION RULE: Invest in capital assets?
If the IRR exceeds the
required rate of return?
If the IRR is less than
required rate of return?
Invest
Do not invest
Methods that Ignore the Time Value of Money
Payback Period
Accounting rate of return
Simple to compute
Uses accrual accounting
Focuses on time it takes to
recover cost of asset
Shows how investment will impact
operating income, which is
important to investors
Ignores cash flows after the
payback period
Highlights risks of assets with
longer cash recovery periods
Measures the profitability over the
asset’s life
Ignores time value of money
Ignores time value of money
43
Methods that Incorporate the Time Value of Money
Net present value
Uses time value of money and
asset’s cash flows over its entire
life
Indicates whether the asset will
earn the minimum required rate of
return
Shows excess or deficiency of
asset’s present value of net cash
flows over its initial cost
Internal rate of return
Uses time value of money and
asset’s cash flows over its entire
life
Computes the project’s unique
rate of return
Profitability index should be
computed when assets have
differing investment amounts
No additional steps needed for
capital rationing decisions
44

Question?
Copyright (c) 2009 Prentice Hall. All rights reserved.
45
6.
You want to invest in an account today that
earns 10% interest, so that you can have a
$10,000 down payment on a home in five
years. The formula used to compute the
amount to invest is:
A. PV factor (i = 10%, n = 5) x $10,000.
B. Annuity PV factor (i = 10%, n = 5) x $10,000.
C. FV factor (i = 10%, n = 5) x $10,000.
D. Annuity FV factor (i = 10%, n = 5) x $10,000.
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
46
6.
You want to invest in an account today that
earns 10% interest, so that you can have a
$10,000 down payment on a home in five
years. The formula used to compute the
amount to invest is:
A. PV factor (i = 10%, n = 5) x $10,000.
B. Annuity PV factor (i = 10%, n = 5) x $10,000.
C. FV factor (i = 10%, n = 5) x $10,000.
D. Annuity FV factor (i = 10%, n = 5) x $10,000.
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
47
7.
What factor affects the time value of
money?
A.
B.
C.
D.
Principal – the amount of the invested
Interest rate
Time amount is invested
All of the above
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
48
7.
What factor affects the time value of
money?
A.
B.
C.
D.
Principal – the amount of the invested
Interest rate
Time amount is invested
All of the above
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
49
8.
Which of the following capital budgeting
methods uses the time value of money?
A.
B.
C.
D.
Payback period
Accounting rate of return
Internal rate of return
All of the above
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
50
8.
Which of the following capital budgeting
methods uses the time value of money?
A.
B.
C.
D.
Payback period
Accounting rate of return
Internal rate of return
All of the above
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
51
9.
The profitability index would most likely be
used with which of the following capital
budgeting methods?
A.
B.
C.
D.
Payback period
Accounting rate of return
Internal rate of return
Net present value method
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
52
9.
The profitability index would most likely be
used with which of the following capital
budgeting methods?
A.
B.
C.
D.
Payback period
Accounting rate of return
Internal rate of return
Net present value method
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
53
10. Which of the following capital budgeting
methods sets the cost of the investment
to equal the present value of its expected
cash inflows?
A.
B.
C.
D.
Payback period
Accounting rate of return
Internal rate of return
Net present value
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
54
10. Which of the following capital budgeting
methods sets the cost of the investment
to equal the present value of its expected
cash inflows?
A.
B.
C.
D.
Payback period
Accounting rate of return
Internal rate of return
Net present value
Co
pyr
igh
t
(c)
20
09
Pr
ent
ice
Ha
ll.
All
rig
hts
res
erv
ed.
55