Chapter 24
Capital Budgeting and
Investment Analysis
Capital Budgeting & Investment Decisions
• These are decisions about when and how much
to spend on capital assets
• Capital budgeting is the process of making such
decisions
 Identify alternatives
 Evaluate and rank choices
 Make the decision
Measures Used in Capital Budgeting
• Net cash inflows include the increases in cash
receipts less the cash payments made on a
project.
 Can be a series of equal or unequal amounts.
• Cost savings are measured as the reduction of
costs under each alternative.
Other Considerations
• Income taxes will affect cash flows and must be
considered.
 Depreciation expense does reduce income and
income taxes, but it does not decrease cash flows.
• Sale of the old assets will provide additional cash
receipts up front.
• Sale of the new assets at the end of their useful
life is an additional cash flow at the end of the
project life.
Payback Period
• Payback is a measure of how long it will take to
recover the initial investment.
• When you have equal cash flows
 Payback = (Initial cost)/(annual net cash inflow)
• If Payback <= useful life of project, then accept
Cash Payback Method
Assumptions:
Investment cost
$200,000
Expected useful life
8 years
Expected annual net
cash Cash
flows (equal)
$40,000
Total Investment
Payback =
Annual Net
Period
Cash Inflows
What is the cash payback period?
Cash Payback Method
Assumptions:
Investment cost
$200,000
Expected useful life
8 years
Expected annual net
cash Cash
flows (equal)
$40,000
Total Investment
Payback =
Annual Net
Period
Cash Inflows
Cash
Payback
Period
=
$200,000
$40,000
= 5 years
Payback with unequal cash flows
• When cash flows are not the same every year,
you cannot apply the previous formula.
• Rather you must determine at what point the
cumulative cash flows become positive. Where
Cumulative CF =
 (initial investment) + CF(yr1) + CF(yr2) + …
Cash Payback Method
Assumptions:
Net Cash
Cumulative
Flow
Net Cash Flow
Year 1 $ 60,000
$ 60,000
Year 2
80,000
140,000
Year 3
105,000
245,000
Year 4
155,000
400,000
Year 5
100,000
500,000
Year 6
90,000
590,000
If the proposed investment is $400,000,
what is the payback period?
Cash Payback Method
Assumptions:
Net Cash
Cumulative
Flow
Net Cash Flow
Year 1 $ 60,000
Year 2
80,000
Year 3
105,000
Year 4
155,000
Year 5
100,000
Year 6
90,000
$ 60,000
140,000
245,000
400,000
500,000
590,000
If the proposed investment is $450,000,
what is the payback period?
Using Payback Period
• Payback is the easiest of the methods to use and it gives
us a quick idea of whether or not to consider the
investment option further.
• Weaknesses:
 It does not consider the timing of the cash flows (relative
amounts over the years)
 It ignores any cash flows received after the point where cash
is fully recovered.
Accounting Rate of Return
• ARR is another method of evaluating
alternatives. It is easy to determine, but it also
ignores the time value of money.
• ARR = (average annual net income)/(avg. investment
cost), where
• Average investment cost =
 (Initial cost + residual value)/2
• If ARR > cost of capital, then accept
Average Rate of Return Method
Assumptions:
Machine cost
$500,000
Expected useful life
4 years
Residual value
none
Expected total income
$200,000
Estimated Average
Average Rate
Annual Income
=
of Return
Average Investment
Average Rate of Return Method
Assumptions:
Machine cost
$500,000
Expected useful life
4 years
Residual value
none
Expected total income
$200,000
Estimated Average
Average Rate
Annual Income
=
of Return
Average Investment
Average Rate
$200,000 / 4 yrs.
=
= 20%
of Return
($500,000 + $0) / 2
Time Value of Money
• Money received today has greater value than
money to be received in the future because of
the effects of compound interest.
 PV(lump sum) = Future value*PV factor
 PV(annuity) = payment*PVA factor
 Where the PV factors are a function of the interest
rate and the time
 An annuity is a series of equal payments.
Net Present Value Method
• This method of evaluating capital projects
involves the
 Calculation of present values of all net cash inflows
less the
 Cost of the initial investment.
• If NPV >= 0, then the project is acceptable.
• This method is the best in evaluating
alternatives.
Net Present Value Method
Present
Present
Annual Net Value of $1
Value of
Year
Cash Flows
Factor
Cash Flows
1
$
4,100
0.8929 $
3,661
2
4,100
0.7972
3,269
3
4,100
0.7118
2,918
4
4,100
0.6355
2,606
5
4,100
0.5674
2,326
6
4,100
0.5066
2,077
7
4,100
0.4523
1,854
8
4,100
0.4039
1,656
Total
$
32,800
$
20,367
Amount to be invested
(16,000)
Net present value of investment
$
4,367
Exh.
24-7
Net Present Value Method
Present value factors
Present
for 12 percent
Annual Net Value of $1
Year
Cash Flows
Factor
1
$
4,100
0.8929
2
4,100
0.7972
3
4,100
0.7118
4
4,100
0.6355
5
4,100
0.5674
6
4,100
0.5066
7
4,100
0.4523
8
4,100
0.4039
Total
$
32,800
Amount to be invested
Net present value of investment
Present
Value of
Cash Flows
$
3,661
3,269
2,918
2,606
2,326
2,077
1,854
1,656
$
20,367
(16,000)
$
4,367
Exh.
24-7
Net Present Value Method
Exh.
24-7
Present
Present
Annual Net Value of $1
Value of
Year
Cash Flows
Factor
Cash Flows
1
$
4,100
0.8929 $
3,661
2
4,100
0.7972
3,269
3
4,100
0.7118
2,918
4
4,100
0.6355
2,606
5
4,100
0.5674
2,326
6
4,100
0.5066
2,077
A positive
net present
indicates that
this
7
4,100 value
0.4523
1,854
project earns
more than
8
4,100 12 percent
0.4039on the investment.
1,656
Total
$
32,800
$
20,367
Amount to be invested
(16,000)
Net present value of investment
$
4,367
Net Present Value Method
PV of an
Present
Annual Net
Annuity
Value of
Year Cash Flows
Factor
Cash Flows
1
$
4,100
4.9676 $
20,367
Amount to be invested
(16,000)
Net present value of investment
$
4,367
Assumptions: 8 years, 12% Interest Rate
Exh.
24-7
Internal Rate of Return (IRR)
The interest rate that makes . . .
 Present
value of
cash inflows
=
Present
value of
cash outflows
 The net present value equal zero.
Internal Rate of Return (IRR) Method
Exh.
24-9
Projects with even annual cash flows
Project life = 3 years
Initial cost = $12,000
Annual net cash inflows = $5,000
Determine the IRR for this project.
1.
Compute present value factor.
2. Using present value of annuity table . . .
Internal Rate of Return (IRR) Method
Exh.
24-9
Projects with even annual cash flows
Project life = 3 years
Initial cost = $12,000
Annual net cash inflows = $5,000
Determine the IRR for this project.
1.
Compute present value factor.
$12,000 ÷ $5,000 per year = 2.4
2. Using present value of annuity table ...
Internal Rate of Return (IRR) Method
Exh.
26-9
1. Determine the present value factor.
$12,000 ÷ $5,000 per year = 2.4000
2. Using present value of annuity table . . .
Locate the row
whose number
equals the
periods in the
project’s life.
Periods
1
2
3
4
5
10%
0.90909
1.73554
2.48685
3.16987
3.79079
12%
0.89286
1.69005
2.40183
3.03735
3.60478
14%
0.87719
1.64666
2.32163
2.91371
3.43308
Internal Rate of Return (IRR) Method
Exh.
26-9
1. Determine the present value factor.
$12,000 ÷ $5,000 per year = 2.4000
2. Using present value of annuity table . . .
In that row,
locate the
interest factor
closest in
amount to the
present value
factor.
Periods
1
2
3
4
5
10%
0.90909
1.73554
2.48685
3.16987
3.79079
12%
0.89286
1.69005
2.40183
3.03735
3.60478
14%
0.87719
1.64666
2.32163
2.91371
3.43308
4
Internal Rate of Return (IRR) Method
Exh.
26-9
1. Determine the present value factor.
$12,000 ÷ $5,000 per year = 2.4000
2. Using present value of annuity
IRR is the
interest rate
of the column
in which the
present value
factor is found.
Periods
1
2
3
4
5
10%
0.90909
1.73554
2.48685
3.16987
3.79079
IRR is
tableapproximately
. . .12%.
12%
0.89286
1.69005
2.40183
3.03735
3.60478
14%
0.87719
1.64666
2.32163
2.91371
3.43308
Payback
period
Cash
flow s
Number
of years
Easy to
Understand
Accounting
rate of return
Accrual
income
Percent
Net present
Internal rate
value
of return
Cash flow s
Cash flow s
Profitability
Profitability
Dollar
Percent
Amount
Considers time Considers time
value of money value of money
Comparing Methods
Basis of
measurement
Measure
expressed as
Strengths
Limitations
Easy to
Understand
Allow s
Allow s
Accommodates
Allow s
comparison
comparison
different risk
comparisons
across projects across projects
levels over
of dissimilar
a project's life
projects
Doesn't
Doesn't
Difficult to
Doesn't reflect
consider time consider time
compare
varying risk
value of money value of money
dissimilar
levels over the
projects
project's life
Doesn't
consider cash
flow s after
payback period
Doesn't give
annual rates
over the life
of a project
Hang in there!
Only
One
More
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