The Capital Budgeting

Decision

Chapter 12
 Chapter 12 - Outline

 What is capital budgeting ?

 3 methods of Evaluating Investment
Proposals
 Accept / Reject Decision
 Capital Rationing
 Net Present Value Profile
 Determining Whether to Purchase a
Machine.
 What is Capital Budgeting?
Capital Budgeting:
- Represents a long-term investment
decision
- Involves the planning of expenditures
for a project with a life of many years
- Usually requires a large initial cash
outflow with the expectation of future
cash inflows
- Uses the present value analysis
- Emphasizes cash flows rather than
 3 Methods of Evaluation

 There are 3 widely used methods of

evaluating investment proposals:
- Payback Method (PB)
- Internal Rate of Return (IRR)
- Net Present Value (NPV)
 Payback Method
Payback Method (PB):
- Computes the amount f time required to
recoup the initial investment
- A cutoff period is established
Advantages:
- Ease to use
- Emphasizes liquidity
Disadvantages:
- Ignores inflows after the cutoff period and
fails to consider the time value of money
- Is inferior to the other 2 methods
 Internal Rate of Return

Internal Rate of Return (IRR):

- Represents a yield (or rate of return)
on an investment.
- Requires calculating the interest rate
that equates the cash outflows (cost)
with the cash inflows.
- Is the interest rate where cash
outflows equals the cash inflows (or
NPV = 0)
 Net Present Value

Net Present Value (NPV):

- The present value of the cash inflows
minus the present value of the cash
outflows
- The cash inflows are discounted back
over the life of the investment
- The basic discount rate is usually the
firm’s cost of capital (WACC)
 Accept / Reject Decision
Payback Method:
- If PB period < cutoff period, accept the
project. (Vice versa)

Internal Rate of Return:

- If IRR > WACC, accept the project (Vice
versa)

Net Present Value:

- If NPV > 0, accept the project (Vice versa)
 How to Calculate the Cash flow?

Earning before depreciation and

taxes (Cash inflow)
$20,000
-Depreciation (non cash expense) (5000)
Earning Before taxes 15,000
- Taxes 40% (cash outflows) (6000)
Earning after taxes (NI) 9000
+ Depreciation 5000
Cash flow 14000
 Investment Alternatives

Cash inflows (of $10,000

Year investment)
Investment A Investment B
1 $5,000 $1,500
2 5,000 2,000
3 2,000 2,500
4 5,000
5 5,000
 Capital Budgeting Results

Project Project Selection

A B (Decision)
Paybac 3.8 Quicker payback:
2 years
k years investment A
Higher yield:
IRR 11.17% 14.33% Investment B
Higher NPV:
NPV $177 $1,414 Investment B
 Capital Rationing

 A limit or constraint on the amount of

funds that can be invested.

 The Firm must rank investments

based on their NPVs

 Those with positive NPVs are

accepted until all funds are
exhausted (used)
 Capital Rationing: example
Total Total
Projec Investme
amount of Investme NPV
t nt
capital nt
$2,000,0 $400,00
available is A
00 0
$5,000,000 2,000,00
B 380,000
0
Capital
1,000,00 5,000,00
rationing C 150,000
0 0
solution
1,000,00
D 100,000
0
6,800,00
Best solution E 800,000 40,000
0
F 800,000 (30,000)
 Net Present Value Profile

Net Present Value Profile:

 A graph of the NPV of a project at 3

different discount rates:

- A zero discount rate
- The normal discount rate (cost of
capital)
- The IRR for the investment
 It is a tool that allows us to visualize

whether or not an investment should

 Net Present Value Profile:
graph
NPV

$1500
Crossover point
$950

IRRB
Discount
IRRA % rate
Project B
Crossover rate

Project A
 Determining Whether to
Purchase a Machine
To Make the actual investment
decision, we need the following:
- Calculate a depreciation schedule
using the appropriate MACRS class
- Figure earnings and cash flow
- Discount the cash flows back to the
present to determine whether the
machine should be purchased (only
if NPV > 0)
 Buying a machine:
depreciation schedule
(1) (2) (3) (4)
Percentage
Depreciatio Annual
Year depreciatio
n base deprecation
n
1 $ 50,000 0.2 $10,000
2 50,000 0.32 16,000
3 50,000 0.192 9,600
4 50,000 0.115 5,750
5 50,000 0.115 5,750
6 50,000 0.058 2,900
Total depreciation 1 50,000
Cash flows related to the purchase
of the Machine
Year Year Year Year
Year 1 Year 2
3 4 5 6
EBDT 18,500 18,500 18,500 12,000 12,000 12,000
-Dep
(10,000 (16,000
(9,600) (5,750) (5,750) (2,900)
) )
EBT 8,500 2,500 8,900 6,250 6,250 9,100
- Tax
(2,975) (875) (3,115) (2,188) (2,188) (3,185)
(35%)
NI 5,525 1,625 5,785 4,062 4,062 5,915

+ Dep 10,000 16,000 9,600 5,750 5,750 2,900

CF 15,525 17,625 15,385 9,812 9,812 8,815

Net present Value analysis
Cash P.V. Factor Present
Year
inflows (at 10%) Value
1 15,525 0.909 14,112
2 17,625 0.826 14,558
3 15,385 0.751 11,554
4 9,812 0.683 6,702
5 9,812 0.621 6,093
6 8,815 0.564 4,972
P.V of cash inflows 57,991
P.V of cash outflows (50,000)
Net present value 7,991
End of
chapter