Chapter 15
Capital Budgeting
Typical Capital Budgeting
Decisions
Capital budgeting tends to fall into two broad
categories . . .
Screening decisions. Does a proposed project
meet some present standard of acceptance?
Preference decisions. Selecting from among
several competing courses of action.
Capital Budgeting Methods
We will consider four Capital Budgeting
methods :
1. Net Present Value Method
2. Internal Rate of Return Method
3. Cash Payback Method
4. Average Rate of Return Method
The Mathematics of Interest
A dollar received
today is worth more
than a dollar received
a year from now
because you can put
it in the bank today
and have more than a
dollar a year from
now.
The Mathematics of Interest – An
Example
Assume a bank pays 10% interest on a
$100 deposit made today. How much
will the $100 be worth in one year?
Fn = P(1 +
n
r)
Computation of Present Value
An investment can be viewed in two
ways—its future value or its present
value.
Present
Value
Future
Value
Let’s look at a situation where the
future value is known and the present
value is the unknown.
Present Value – An Example
If a bond will pay $100 in two years, what
is the present value of the $100 if an
investor can earn a return of 12% on
investments?
Fn
P=
(1 + r)n
Present Value of a Series of Cash
Flows
An investment that involves a series
of identical cash flows at the end
of each year is called an annuity.
$100
$100
1
$100
2
$100
3
$100
4
$100
5
6
Present Value Problems
1. What is the present value of $1,000,000 to be
received 10 years from now, with interest
compounded at 15% annually?
2. What is the present value of an annuity of
$10,000 for 5 years at 12%?
3. How much cash would you need to invest in a
money market account today in order to have
$8,000 at the end of four years? Assume interest
rates are 6%.
Present Value Problems
4. How much cash would you need to invest in a
money market account today in order to be able to
withdraw $8,000 per year at the end of each of the
next four years? Assume interest rates are 6%.
5. Assume you won the grand prize in a sweepstakes.
Would it be better to take your prize in $100,000
payments each year over the next ten years or
$600,000 now? Interest rates are 10%.
Investment Analysis
Project A
Cost
Expected Life
Expected Residual Value
$560,000 $900,000
4 Years
4 Years
$0
$0
Project A
Expected returns
Year 1
Year 2
Year 3
Year 4
Acct.
Income
$
Project B
Project B
Net Cash
Flow
10,000 $
50,000
80,000
84,000
150,000
190,000
220,000
224,000
Acct.
Income
$
Net Cash
Flow
100,000 $
100,000
100,000
100,000
325,000
325,000
325,000
325,000
The Net Present Value Method
To determine net present value we . . .
Determine the net initial investment in the
project
Calculate the sum of the present values of the
future cash flows
Subtract the amount of the initial investment
from the sum of the present value of the future
cash flows to obtain the net present value of the
project
Let’s calculate the NPV for Projects A and B
The Net Present Value Method
If the Net Present
ruleProject
. . . is . . .
Value is . . . General decision
Then the
Acceptable, since it promises a
Positive . . .
return greater than the required
rate of return.
Zero . . .
Acceptable, since it promises a
return equal to the required rate
of return.
Negative . . .
Not acceptable, since it promises
a return less than the required
rate of return.
Net Present Value Method
The net present value of one project cannot
be directly compared to the net present
value of another project unless the
investments are equal.
Ranking Capital Investment Opportunities
Using NPV
Present Value Index =
Sum of PV of cash inflows
Initial Investment
Project A =
$547,028
= 0.977
$560,000
Project B =
$927,875
= 1.031
$900,000
Project B yields a higher return than Project A.
Internal Rate of Return Method
• The internal rate of return is the true rate of
return (yield) promised by an investment project
over its useful life. It is computed by finding the
discount rate that will cause the net present
value of a project to be zero.
• It works well if a project’s cash flows are
identical every year. If the annual cash flows are
not identical, a trial and error process must be
used to find the internal rate of return.
• Let’s calculate the IRR for Projects A and B
Internal Rate of Return Method
General decision rule . . .
If the Internal Rate of Return is . . .
Then the Project is . . .
Equal to or greater than the minimum
required rate of return . . .
Acceptable.
Less than the minimum required rate
of return . . .
Rejected.
When using the internal rate of return,
the cost of capital acts as a hurdle rate
that a project must clear for acceptance.
Internal Rate of Return Method
• Decker Company can purchase a new
machine at a cost of $72,100 that will
save $20,000 per year in cash operating
costs.
• The machine has a 7-year life.
• What is the Internal Rate of Return?
Internal Rate of Return Method
When using the internal rate of return
method to rank competing investment
projects, the preference rule is:
The higher the internal
rate of return, the
more desirable the
project.
The Payback Method
The payback period is the length of time
(in years) that it takes for a project to
recover its initial cost out of the cash
receipts that it generates.
Let’s calculate the payback period for
Projects A and B
The Payback Method – Another Example
• Myers Company wants to install an espresso bar in place of several coffee
vending machines in one of its stores. The company estimates that incremental
annual revenues and expenses associated with the espresso bar would be:
Sales
$100,000
Less variable expenses
30,000
Contribution margin
70,000
Less fixed expenses:
Insurance
$ 9,000
Salaries
26,000
Depreciation
15,000
50,000
Net operating income
$ 20,000
• Equipment for the espresso bar would cost $150,000 and have a 10-year life.
The old vending machines would be thrown away since they have no salvage
value. The company requires a payback of 5 years or less on all investments.
Let’s calculate the Payback Period
Average Rate of Return Method
• Does not focus on cash flows -- rather it
focuses on accounting net operating
income.
• The following formula is used to calculate
the simple rate of return:
Average rate
Estimated average annual income
=
of return
Average investment
• Let’s calculate the Average Rate of Return
for Projects A and B.
The Average Rate of Return Method – Another Example
• Myers Company wants to install an espresso bar in place of several coffee
vending machines in one of its stores. The company estimates that incremental
annual revenues and expenses associated with the espresso bar would be:
Sales
$100,000
Less variable expenses
30,000
Contribution margin
70,000
Less fixed expenses:
Insurance
$ 9,000
Salaries
26,000
Depreciation
15,000
50,000
Net operating income
$ 20,000
• Equipment for the espresso bar would cost $150,000 and have a 10-year life.
The old vending machines would be thrown away since they have no salvage
value. The company requires an average rate of return of 25% or more on all
investments.
Let’s calculate the Average Rate of Return