CHAPTER 9
Capital Budgeting and
Other Long-Run Decisions
Slide 9-2
Capital Budgeting Decisions
 Companies, like individuals, make
investments in long-lived assets
 Examples include
 Duke Energy invests in 400 roof-top solar
panel installations
 Pfizer invests in a $294 million biotechnology
factory in Ireland
 Nordstrom invests in a new store in New
Jersey
 Starbucks invests in a new product: instant
coffee
Slide 9-3
Capital Budgeting Decisions
 Investment decisions are important because
they have a long run impact on a firm’s
operations
 Decisions involving the acquisition of longlived assets are referred to as capital
expenditure decisions
 They often require that capital (company
funds) be expended to acquire additional
resources
 Also called capital budgeting decisions
Slide 9-4
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Capital Budgeting Decisions
 Most firms carefully analyze the potential
projects in which they may invest
 The process of evaluating the investment
opportunities is referred to as capital
budgeting
 The final list of approved projects is referred
to as the capital budget
Slide 9-5
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Which of the following is not a capital expenditure
decision?
a.
b.
c.
d.
Building a new factory
Purchasing a new piece of equipment
Purchasing inventory
Purchasing another company
Answer: c
Purchasing inventory
Slide 9-6
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
The Time Value of Money
 In evaluating an investment opportunity, a
company must not only know how much but
also when cash is received or paid
 Time value of money recognizes that it is
better to receive a dollar today than in the
future
 This is because a dollar received today can be
invested so that it amounts to more than a
dollar in the future
Slide 9-7
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Evaluating Opportunities: Time Value
of Money Approaches
 Companies invest money today hoping to
receive more money in the future
 By how much must the future cash flows
exceed the cost of the investment?
 Money in the future is not equivalent to money
today
 A company needs to convert future dollars into
their equivalent current , or present value
Slide 9-8
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Basic Time Value of Money
Calculations
Formula to convert future value to present value
𝐅
𝐏=
Where:
Slide 9-9
(𝟏+𝒓)𝒏
P = Present value
F = Future amount
r = Required rate of return
n = Number of years
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Basic Time Value of Money
Calculations - Example
At an interest rate of 10%, how much is $121
received two years from now worth today?
𝑷=
𝑷=
Slide 9-10
$𝟏𝟐𝟏
(𝟏+ .𝟏𝟎)𝟐
$𝟏𝟐𝟏
𝟏.𝟐𝟏
= $𝟏𝟎𝟎
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Present Value Tables
 Managers can use present value tables to
look up present value factors
 Present value factors are simply calculations
𝟏
of
𝒏
(𝟏+𝒓)
 Turn to Table 1 in Appendix B of this chapter
 To find the factor for r = 12% and n = 5
 Go across the top of the table to a discount rate
of 12 percent and down five rows
Slide 9-11
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Using the formula on slide 9-10, what is the
present value of $500 received two years in the
future if you desire a return of 10%?
a.
b.
c.
d.
$413.22
$468.58
$471.60
$480.30
Answer: a
$𝟓𝟎𝟎
$𝟓𝟎𝟎
𝑷=
=
= $𝟒𝟏𝟑. 𝟐𝟐
𝟐
(𝟏+ . 𝟏𝟎)
𝟏. 𝟐𝟏
Slide 9-12
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
The Net Present Value Method
The only relevant cash flows are those that
are incremental


The cash flows that will be incurred if the
project is undertaken
Cash flows that have already been
incurred are sunk


Slide 9-13
They have no bearing on a current
investment decision
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
The Net Present Value Method
Steps in the NPV method
1. Identify the amount and time period of each
cash flow associated with a potential
investment
2. Discount the cash flows to their present
values using a required rate of return
3. Evaluate the net present value, which is the
sum of the present value of all cash inflows
and outflows
Slide 9-14
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
The Net Present Value Method
Evaluate the investment opportunity

If the NPV is zero, the investment earns the
required rate of return


If the NPV is positive



Slide 9-15
The investment should be undertaken
It should also be undertaken because it
earns more than the required rate
Investments that have a negative NPV are
not accepted because they earn less than
the required rate
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Net Present Value Approach
Slide 9-16
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
If the net present value of a project is zero, the
project is earning a return equal to:
a.
b.
c.
d.
Zero
The rate of inflation
The accounting rate of return
The required rate of return
Answer: d
The required rate of return
Slide 9-17
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Net Present Value Example
An auto repair shop is considering the purchase of an
automated paint spraying machine. The machine will
last five years.
Following information is available:






Slide 9-18
Each year $2,000 will be saved on paint
It will reduce labor costs by $20,000 each year
It will require maintenance costs of $1,000 each year
The machine costs $70,000
The expected residual value is $5,000
The required rate of return is 12%
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Net Present Value Example
Since the NPV > 0, the company should buy the equipment
Slide 9-19
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Comparing Alternatives with NPV
 Calculate the NPV of each alternative and
choose the alternative with the highest NPV
 The difference between the NPVs of any two
alternatives is the incremental value of the
highest NPV investment
 Another method to evaluate alternatives is
to compute the present value of their
incremental cash flows
Slide 9-20
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Comparing Alternatives with NPV
Slide 9-21
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
The Internal Rate of Return (IRR)
Method
 The internal rate of return is that rate of return
that equates the present value of the future cash
flows to the investment outlay
 The rate of return that makes the net present
value equal to zero
 If the IRR of a potential investment is equal to or
greater than the required rate of return, the
investment should be undertaken
Slide 9-22
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
The Internal Rate of Return Method
Slide 9-23
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
An investment should be undertaken if:
a. The IRR is equal to or greater than the required
rate of return
b. The IRR is equal to or greater than zero
c. The IRR is greater than the accounting rate of
return
d. The IRR is greater than the present value factor
Answer: a
The IRR is equal to or greater than the required rate of
return
Slide 9-24
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
The Internal Rate of Return with Equal
Cash Flows
 Equal cash flows are called an annuity
 For an annuity,
PV = PV factor x Annuity
 Therefore:
 Use the table to find the closest PV factor
for the same number of years
Slide 9-25
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Internal Rate of Return Example





Investment = $100
Cash flow $60 per year for two years
PV factor = 100 / 60 = 1.667
Check PV annuity table, row 2
Closest factor is in 13% column
Present Value of an Annuity
11%
12%
1
0.9009
0.8929
2
1.7125
1.6901
13%
0.8850
1.6681
14%
0.8772
1.6467
Factor closest to 1.667, IRR approx 13%
Slide 9-26
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.




Investment costs = $79,100
Returns $14,000 a year for 10 years
Required return is 18%
Calculate IRR and evaluate
PV Factor = 79,100 / 14,000 = 5.65
Present Value of an Annuity
11%
12%
9
5.5370
5.3282
10
5.8892
5.6502
13%
5.1317
5.4262
14%
4.9464
5.2161
Factor closest to 5.65, IRR approx 12%
Do not make investment, IRR less than required return
Slide 9-27
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Internal Rate of Return
Slide 9-28
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Internal Rate of Return With Unequal
Cash Flows
 Utilized when annual cash flows are not
equal amounts
 Use trial and error
 Must estimate IRR
 Use estimated IRR to calculate the NPV of the
project
 If NPV > 0, increase estimated IRR
 If NPV < 0, decrease estimated IRR
 Recalculate until NPV is equal to or close to
zero
Slide 9-29
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Internal Rate of Return With Unequal
Cash Flows
The IRR is approximately 16%
Slide 9-30
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Use of NPV and IRR
Slide 9-31
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Considering “Soft” Benefits in
Investment Decisions
 It is important that managers consider “soft”
benefits in addition to a project’s NPV or IRR
 “Soft” benefits are difficult to quantify
 Ignoring soft benefits may lead firms to pass
up investments that are of strategic
importance
 Especially investments in advanced
manufacturing technology
Slide 9-32
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
“Soft” Benefits
Slide 9-33
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Calculating the Value of “Soft” Benefits
 Example
 Dynamic Medical Equipment is considering
production of a high tech wheelchair
 Suppose the finance department fails to
consider that production of the wheelchair will
improve the firm’s reputation as an industry
leader
 The reputation is difficult to quantify
 New construction techniques will be developed
for producing future products
Slide 9-34
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Calculating the Value of “Soft” Benefits
 Suppose the project has a negative NPV of
$80,000
 With a required return of 15%, benefits of
$15,989 per year would make NPV zero
Slide 9-35
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Estimating the Required Rate of Return
 In previous examples the required rate of
return was simply stated
 In practice, management must estimate the
required rate of return
 In some cases, the required rate of return
should equal cost of capital
 The cost of capital is the weighted average of
debt and equity financing used
Slide 9-36
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
The cost of capital is:
a. The cost of debt financing
b. The cost of equity financing
c. The weighted average of the costs of debt and
equity financing
d. The internal rate of return
Answer: c
The weighted average of the costs of debt and equity
financing
Slide 9-37
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Additional Cash Flow Considerations
 Both NPV and IRR consider cash inflows and
outflows, not revenues and expenses
 Only cash inflows and outflows are
discounted back to present value:
 Must consider the timing of collection of
revenues
 Depreciation does not require cash outflow in
the period it is recorded
Slide 9-38
Learning objective 1: Define capital expenditure decisions and capital
budgets and evaluate investment opportunities using the net present
value approach and the internal rate of return approach.
Cash Flows, Taxes, and the
Depreciation Tax Shield
 In the previous examples we ignored the
effect of taxes on cash flow
 Tax considerations play a major role in capital
budgeting
 If a project generates taxable revenue, cash
inflows will be reduced by taxes paid on the
revenue
 If a project generates tax deductible expenses,
cash inflows will be increased by the tax
savings generated
Slide 9-39
Learning objective 2: Calculate the depreciation tax shield and evaluate long-run
decisions, other than investment decisions, using time value of money techniques.
Cash Flows, Taxes, and the
Depreciation Tax Shield
 We stated that depreciation is not relevant in
present value analysis
 Depreciation affects cash flows indirectly
 Depreciation reduces the amount of tax a
company must pay
 The term depreciation tax shield refers to the
tax savings from depreciation
Slide 9-40
Learning objective 2: Calculate the depreciation tax shield and evaluate long-run
decisions, other than investment decisions, using time value of money techniques.
Example of the
Depreciation Tax Shield
Slide 9-41
Learning objective 2: Calculate the depreciation tax shield and evaluate long-run
decisions, other than investment decisions, using time value of money techniques.
Adjusting Cash Flows for Inflation
 It may be important to consider inflation when
estimating the cash flows associated with
investment opportunities
 Inflation can be taken into account by
multiplying the current cash flows by the
expected rate of inflation
Slide 9-42
Learning objective 2: Calculate the depreciation tax shield and evaluate long-run
decisions, other than investment decisions, using time value of money techniques.
Adjusting Cash Flows for Inflation
 If inflation is ignored in net present value
analysis, worthwhile opportunities might be
rejected
 This is because current rates of return for debt
and equity financing already include estimates
of future inflation
 Cash flows will be low
 Required rates of return will be high
Slide 9-43
Learning objective 2: Calculate the depreciation tax shield and evaluate long-run
decisions, other than investment decisions, using time value of money techniques.
Other Long-Run Decisions
 Time value of money techniques are also
applicable to the analysis of other long-run
decisions
 Examples of these decisions include:
 Decision to outsource grounds maintenance
 Decision to drop a product line
 Decision to buy rather than make a
subcomponent of a product
Slide 9-44
Learning objective 2: Calculate the depreciation tax shield and evaluate long-run
decisions, other than investment decisions, using time value of money techniques.
Other Long-Run Decisions
Evaluation of decision to sponsor a golf tournament
Slide 9-45
Learning objective 2: Calculate the depreciation tax shield and evaluate long-run
decisions, other than investment decisions, using time value of money techniques.
Simplified Approaches to Capital
Budgeting
 Many companies continue to use simpler
approaches
 Two of these are
 Payback period method
 Accounting rate of return
 Both methods have significant limitations in
comparison to NPV and IRR
Slide 9-46
Learning objective 3: Use the payback period and the accounting rate of return
methods to evaluate investment opportunities. And explain why managers may
concentrate erroneously on the short-run profitability of investments rather than their net
present values.
Payback Period Method
 The payback period is the length of time it
takes to recover the initial cost of an
investment
 An investment which costs $1,000 and
yields cash flows of $500 per year has a
payback period of 2 years ($1,000 / $500)
 If an investment costs $1,000 and yields
cash flows of $300 per year it has a payback
period of 3 1/3 years
Slide 9-47
Learning objective 3: Use the payback period and the accounting rate of return
methods to evaluate investment opportunities. And explain why managers may
concentrate erroneously on the short-run profitability of investments rather than their net
present values.
Payback Period Method
 One approach is to accept projects that
have a payback period less than some
specified requirement
 This can lead to poor decisions
 The payback method does not take into
account the total cash flows
 It only considers the stream of cash flows up
until the investment is repaid
 It does not consider the time value of money
Slide 9-48
Learning objective 3: Use the payback period and the accounting rate of return
methods to evaluate investment opportunities. And explain why managers may
concentrate erroneously on the short-run profitability of investments rather than their net
present values.
Which of the following methods ignores the time
value of money (present and future values) in its
calculation?
a.
b.
c.
d.
Net present value
Internal rate of return
Payback period
External rate of return
Answer: c
Payback period
Slide 9-49
Learning objective 3: Use the payback period and the accounting rate of return
methods to evaluate investment opportunities. And explain why managers may
concentrate erroneously on the short-run profitability of investments rather than their net
present values.
Accounting Rate of Return (ARR)
 Accounting Rate of Return Formula:
ARR =
Average Net Income
Average Investment
 Average investment is the initial investment
divided by 2
 Like the payback period method, the
accounting rate of return ignores the time
value of money
Slide 9-50
Learning objective 3: Use the payback period and the accounting rate of return
methods to evaluate investment opportunities. And explain why managers may
concentrate erroneously on the short-run profitability of investments rather than their net
present values.
Conflict Between Performance
Evaluation and Capital Budgeting
 Managers may be discouraged from using PV
techniques for evaluating investments
depending on how their performance is
evaluated
 An investment may have high depreciation in
the early years, or revenue may be low
 Managers need to be assured that if they
approve projects with long run positive NPV
their compensation will take the expected
benefits into account
Slide 9-51
Learning objective 3: Use the payback period and the accounting rate of return
methods to evaluate investment opportunities. And explain why managers may
concentrate erroneously on the short-run profitability of investments rather than their net
present values.
Short-Run Accounting Profit
Slide 9-52
Learning objective 3: Use the payback period and the accounting rate of return
methods to evaluate investment opportunities. And explain why managers may
concentrate erroneously on the short-run profitability of investments rather than their net
present values.
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Slide 9-53