LONG TERM DECISION

MAKING
Capital Budgeting Decisions

Chapter 6

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Capital Budgeting Process

Plant expansion

Equipment selection Equipment replacement

Capital budgeting is a decision-making approach

aimed at helping managers make decisions about
investments in major capital assets, such as new
facilities, equipment, new products, and research and
development projects.

Lease or buy Cost reduction

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Capital Investment Decisions

There are two main types of

capital investment decisions.

Screening Decisions Preference Decisions

Pertain to whether or Attempt to rank

not some proposed acceptable
investment is alternatives from the
acceptable; these most to least
decisions come first. appealing.
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Capital Investment Decisions

Capital budgeting decisions can

be placed into two categories.

Independent Projects Mutually Exclusive

Projects

Projects are unrelated, Investment choices are

so investing in one does
not preclude or
eliminate investing in
the other projects.
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competing alternatives,
so accepting one leads
to rejection of the
others.
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Capital Budgeting Methods

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Capital Budgeting Methods

To illustrate how the five capital budgeting methods work, assume that managers in
Apple’s iPod division are considering producing a special version of the iPod Touch
that would be marketed to children and their parents.The new device, called the
iKids Touch, would be designed to appeal to children, with durable components,
“kid friendly” controls, and bright colors.

The basic question that

managers must answer
is whether this
proposed project is
worth the $1 million
up-front investment.

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Risk and uncertainty and sensitivity
analysis
Risk Analysis in Capital Budgeting:
a) Sensitivity Analysis:
This is also known as a “what if analysis”. Because of the uncertainty of the
future, if an entrepreneur wants to know about the feasibility of a project in
variable quantities, for example investments or sales change from the
anticipated value, sensitivity analysis can be a useful method. This is calculated
in terms of NPV, or net present value.
b) Scenario Analysis:
In the case of scenario analysis, the focus is on the deviation of a number of
interconnected variables. It is different from sensitivity analysis, which usually
concentrates on the change in one particular variable at a specific point of time.
c) Break Even Analysis:
The Break Even Analysis allows a company to determine the minimum
production and sales amounts for a project to avoid losing money. The lowest
possible quantity at which no loss occurs is called the break-even point. The
break-even point can be delineated both in financial or accounting terms.

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Risk Analysis in Capital Budgeting:

d) Simulation Analysis: Simulation analysis is utilized for formulating the

probability analysis for a criterion of merit with the help of random blending of
variable values that carry a relationship with the selected criterion.
e) Decision Tree Analysis: The principal steps of decision tree analysis are the
definition of the decision tree and the assessment of the alternatives.
f) Corporate Risk Analysis: Corporate risk analysis focuses on the analysis of risk
that may influence the project in terms of the entire cash flow of the firm. The
corporate risk of a project refers to its share of the total risk of a company.
g) Risk Management: Risk management focuses on factors such as pricing
strategy, fixed and variable costs, sequential investment, insurance, financial
leverage, long term arrangements, derivatives, strategic alliance and improvement
of information.
h) Selection of project under risk: This involves procedures such as payback
period requirement, risk adjusted discount rate, judgmental evaluation and certainty
equivalent method.
i) Practical Risk Analysis: The techniques involved include the Acceptable Overall
Certainty Index, Margin of Safety in Cost Figures, Conservative Revenue
Estimation, Flexible Investment Yardsticks and Judgment on Three Point Estimates.
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Learning Objective 11-1

Calculate the accounting rate of

return and describe its major
weaknesses.

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Accounting Rate of Return

Annual Accounting
Net
Income
÷ Initial
Investment = Rate of
Return

$108,000 ÷ $1,000,000 = 10.8%

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Accounting Rate of Return

Shortcoming and Criticisms

 The time value of money is ignored.
 The accounting rate of return is based on accounting
net income instead of cash flow.
 Depreciation may be calculated several ways
and, in addition, other accounting method
alternatives may have an impact on reported
net income.

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Net Cash Flow versus Net Income

To convert from net income to net cash flow, we must

add back the depreciation that was deducted in the
computation of net income, as shown below.

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Learning Objective 11-2

Calculate the payback period and

describe its major weaknesses.

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Payback Period

Annual
Initial
Investment ÷ Net Cash = Payback
Period
Flow

Net Income + Depreciation

$1,000,000 ÷ $308,000 = 3.25 years

$108,000 + $200,000
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Payback Period

When annual cash flows are unequal, the payback

period must be computed on a year by year basis by
subtracting the net cash flow from the unpaid
investment balance each year.

Starting Annual Net Unpaid

Year Investment Cash Flow Investment
1 $ 1,000,000 – $ 250,000 = $ 750,000
2 750,000 – 300,000 = $ 450,000
3 450,000 – 340,000 = $ 110,000
4 110,000 – 375,000 = $ (265,000)
5 N/A N/A N/A

The payback period is somewhere

between 3 and 4 years.
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Payback Period

Shortcoming and Criticisms

 The time value of money is ignored.
 The payback period ignores cash flows
after the payback period.

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Time Value of Money

One dollar received today is worth more than one

dollar received a year from now because the dollar
can be invested to earn interest.

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Time Value of Money

Discounting is exactly the opposite of compounding.

Just as interest builds up over time through
compounding, discounting involves backing out the
interest to determine the equivalent value in today’s
present value dollars.

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Time Value of Money

Discounted Cash Flow Methods

Net Present Value
Internal Rate of Return
Profitability Index
Assumptions:
1.All future cash flows happen at the end of the year.
2.Cash inflows are immediately reinvested in another
project.
3.All cash flows can be projected with 100 percent
certainty.
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Learning Objective 11-3

Calculate net present value and

describe why it is superior to the
other capital budgeting techniques.

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Net Present Value (NPV)

The net present value (NPV) method compares

the present value (PV) of a project’s future cash
inflows to the PV of the cash outflows.

The reason is that

accounting net income is
based on accruals that
ignore the timing of cash
flows into and out of an
organization.
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Net Present Value (NPV)

Chose a discount rate – the

minimum required rate of return.

Calculate the present

value of cash inflows.

Calculate the present

value of cash outflows.

NPV = –
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Net Present Value (NPV)

Relationship Between NPV and

the Required Rate of Return
If the Net Present
Value is . . . Then the Project is . . .
Acceptable, since it promises a
Positive . . . return greater than the required
rate of return (discount rate).

Acceptable, since it promises a

Zero . . . return equal to the required rate of
return (discount rate).

Not acceptable, since it promises

Negative . . . a return less than the required rate
of return (discount rate).
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Net Present Value (NPV)

Let’s return to iKids Touch’s proposal. Recall that the up-front

investment is $1,000,000, and the product’s estimated life is 5
years. iKids Touch’s required rate of return is 12%. iKids Touch
estimates the new product will generate $308,000 in cash
flow for each of the next five years.

Since the NPV is positive, we know the rate of return

is greater than the 12 percent discount rate.
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Net Present Value (NPV)

Assume that the expected cash flows for the iKids Touch
project for years 1 to 5 are $250,000, $300,000, $340,000,
$375,000, and $300,000, respectively. The project will still
require an investment of $1,000,000 and the cost of capital
is still 12 percent.

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Computing NPV in Excel

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Relationship Between NPV and
Discount Rates

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14-28

Learning Objective 11-4

Predict the internal rate of return

and describe its relationship to net
present value.

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14-29

Internal Rate of Return (IRR)

The internal rate of return is the interest

rate that makes . . .
 Present Present
value of = value of
cash inflows cash outflows

 The net present value equal zero.

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Computing IRR in Excel

One important note about the IRR function is that you must
include the original cash outflow in the calculation.
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Internal Rate of Return (IRR)

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Profitability Index

The profitability index is the ratio of a project’s benefits

(measured by the present value of the future cash flows)
to its costs (or required investment).

Profitability Index > 1 = Project Acceptable

Profitability Index < 1 = Project Unacceptable

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 Comparing Capital Budgeting Methods
14-33

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Effect of inflation and taxation

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Effect of inflation
Inflation: a general increase in prices and fall in the purchasing
value of money.

-Inflation has ramifications for the realized value of a capital

project.

-When evaluating capital projects, companies can evaluate

capital projects in nominal or real (i.e. inflation adjusted) terms.

-Real cash flows are based on purchasing power at the time

the decision to invest would is made.

-Under a real cash flow approach, the discount rate would

remove the expected inflation rate, as the cash flows will
already reflect the effects of inflation.
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-There are several aspects of inflation that an analyst must consider when evaluating
a capital project:

• Inflation and the Depreciation Tax Shied: if inflation is higher than expected at
the time of the investment decision, then the value of the depreciation tax shield is
lowered and true net present value of the project is lowered.

• Inflation and Debt Payments: the discount rate may be based on a company’s
cost of debt, if debt is used to finance the capital project. When inflation is lower
than expected, this increases the firm’s debt costs and lowers the net present
value of the project.

• Inflation, Revenues, and Expenses: the revenues and expenses associated

with a capital project will not be equally affected by inflation. When a firm is not
able to pass the costs of inflation to product inputs on to customers in the form of
higher prices, the net present value of the project will be lower.

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 Income Taxes in Capital
Budgeting Decisions

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Simplifying Assumptions
Taxable income
equals net
income as
computed for
financial reports.

The tax rate is a

flat percentage of
taxable income.

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Concept of After-tax Cost

An expenditure net of its tax effect is

known as after-tax cost.

Here is the equation for determining the

after-tax cost of any tax-deductible cash
expense:

After-tax cost
= (1-Tax rate) Tax-deductible cash expense
(net cash outflow)

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After-tax Cost – An Example

Assume a company with a 30% tax rate is

contemplating investing in a training program
that will cost $60,000 per year.

We can use this equation to determine that the

after-tax cost of the training program is
$42,000.

After-tax cost
= (1-Tax rate) Tax-deductible cash expense
(net cash outflow)
$42,000 = (1 - .30) $60,000

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After-tax Cost – An Example

The answer can also be determined by

calculating the taxable income and income tax
for two alternatives—without the training
program and with the training program.

The after-tax cost of

the training program is
the same—$42,000.

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After-tax Cost – An Example

The amount of net cash inflow

realized from a taxable cash
receipt after income tax effects
have been considered is known
as the after-tax benefit.

After-tax benefit
= (1-Tax rate) Taxable cash receipt
(net cash inflow)

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Depreciation Tax Shield

While depreciation is not a cash

flow, it does affect the taxes that
must be paid and therefore has
an indirect effect on a
company’s cash flows.

Tax savings from

the depreciation = Tax rate Depreciation deduction
tax shield
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Depreciation Tax Shield – An Example

Assume a company has annual cash sales and

cash operating expenses of $500,000 and
$310,000, respectively; a depreciable asset,
with no salvage value, on which the annual
straight-line depreciation expense is $90,000;
and a 30% tax rate.
Tax savings from
the depreciation = Tax rate Depreciation deduction
tax shield

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Depreciation Tax Shield – An Example

Assume a company has annual cash sales and

cash operating expenses of $500,000 and
$310,000, respectively; a depreciable asset,
with no salvage value, on which the annual
straight-line depreciation expense is $90,000;
and a 30% tax rate.
Tax savings from
the depreciation = Tax rate Depreciation deduction
tax shield
$27,000 = .30 $90,000

The depreciation tax shield is $27,000.

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Depreciation Tax Shield – An Example

The answer can also be determined by

calculating the taxable income and income tax
for two alternatives—without the depreciation
deduction and with the depreciation deduction.

The depreciation tax

shield is the same—
$27,000.

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14-47

Holland Company – An Example

Holland Company owns the mineral

rights to land that has a deposit of ore.
The company is deciding whether to
purchase equipment and open a mine
on the property. The mine would be
depleted and closed in 10 years and
the equipment would be sold for its
salvage value.

More information is provided on the next slide.

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Holland Company – An Example

Cost of equipment $ 300,000

Working capital needed $ 75,000 Should
Estimated annual cash $ 250,000
receipts from ore sales
Holland open
Estimated annual cash a mine on
expenses for mining ore $ 170,000 the property?
Cost of road repairs
needed in 6 years $ 40,000
Salvage value of the
equipment in 10 years $ 100,000
After-tax cost of capital 12%
Tax rate 30%

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Holland Company – An Example

Step One: Compute the net annual cash

receipts from operating the mine.

Cash receipts from ore sales $ 250,000

Less cash expenses for mining ore 170,000
Net cash receipts $ 80,000

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Holland Company – An Example

Step Two: Identify all relevant cash flows

as shown.
Holland Company
(1) (2)

Items and Computations Year Amount

Cost of new equipment Now $ (300,000)
Working capital needed Now $ (75,000)
Net annual cash receipts 1-10 $ 80,000
Road repairs 6 $ (40,000)
Annual depreciation deductions 1-10 $ 30,000
Salvage value of equipment 10 $ 100,000
Release of working capital 10 $ 75,000
Net present value

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Holland Company – An Example

Step Three: Translate the relevant cash

flows to after-tax cash flows as shown.
Holland Company
(1) (2) (3) (4)
Tax
Effect After-Tax
Items and Computations Year Amount (1) (2) Cash Flows
Cost of new equipment Now $ (300,000) 0 $ (300,000)
Working capital needed Now $ (75,000) 0 $ (75,000)
Net annual cash receipts 1-10 $ 80,000 1-.30 $ 56,000
Road repairs 6 $ (40,000) 1-.30 $ (28,000)
Annual depreciation deductions 1-10 $ 30,000 .30 $ 9,000
Salvage value of equipment 10 $ 100,000 1-.30 $ 70,000
Release of working capital 10 $ 75,000 0 $ 75,000
Net present value

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Holland Company – An Example

Step Four: Discount all cash flows to

their present value as shown.
Holland Company
(1) (2) (3) (4) (5) (6)
Tax
Effect After-Tax 12% Present
Items and Computations Year Amount (1) (2) Cash Flows Factor Value
Cost of new equipment Now $ (300,000) 0 $ (300,000) 1.000 $ (300,000)
Working capital needed Now $ (75,000) 0 $ (75,000) 1.000 (75,000)
Net annual cash receipts 1-10 $ 80,000 1-.30 $ 56,000 5.650 316,400
Road repairs 6 $ (40,000) 1-.30 $ (28,000) 0.507 (14,196)
Annual depreciation deductions 1-10 $ 30,000 .30 $ 9,000 5.650 50,850
Salvage value of equipment 10 $ 100,000 1-.30 $ 70,000 0.322 22,540
Release of working capital 10 $ 75,000 0 $ 75,000 0.322 24,150
Net present value $ 24,744

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Challenges and issues in capital
expenditure decision
Capital expenditure decisions represent the most important decision taken by a
company. Their importance from three inter – related reasons.

1.Effects in the long Run: the consequences of capital expenditure decisions extend
into the feature. The scope of current manufacture activities of a company governed
largely by capital expenditures in the past. Likewise, current capital expenditure
decisions provide the frame work for future activities. Capital investment decisions
have an enormous bearing on the basic character of a company.

2.Irreversibility: The market for used capital equipment in general is ill-organized.

Further, for some types of capital equipment, custom-made to meet specific
requirement, the market virtually be non-existent. Once such equipment is acquired,
reversal of decision may mean scrapping the capital equipment. Thus, a wrong capital
investment decision cannot be reversed without incurring a substantial loss.

3.Substantial outlays: Capital expenditures usually involve substantial outlays. An

integrated steel plant, for example, involves an outlay of several thousand millions.
Capital costs tend to increase with advanced technology.

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Difficulties
While capital expenditure decisions are extremely important, they also pose difficulties
which supported from three principal sources:

Measurement problems: Identifying and measuring the costs and benefits of a capital
expenditure proposal tends to be difficult. This is more so when a capital expenditure
has a bearing o some other activities of the company like cutting into sales of some
existing product or has some intangible consequences like improving the morale of
workers.

Uncertainty: A capital expenditure decision involves costs and benefits that extend for
into future. It is impossible to predict exactly what will happen in future. Hence, there is
usually a great deal of uncertainty characterizing the costs and benefits of a capital
expenditure decision.

Temporal Spread: The costs and benefits associated with a capital expenditure decision
are spread out over a long period of time, usually 10-20 years for industrial projects and
20-50 years for infrastructural projects. Such a temporal spread creates some problems
in estimating discount rates and establishing equivalence.

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End of Chapter 6

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