Chapter 12

The Capital Budgeting Decision

Chapter 12 - Outline

 What is Capital Budgeting?

    3 Methods of Evaluating Investment Proposals  Payback  IRR  NPV Accept/Reject Decisions Capital Rationing 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 present value analysis – emphasizes cash flows rather than income

Cash flow for Alston Corporation

Revised cash flow for Alston Corporation

Categories for depreciation write-off

Depreciation percentages (expressed in decimals)

Depreciation schedule

Investment alternatives

3 Methods of Evaluating Investment Proposals

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 of time required to recoup the initial investment Advantages: – easy to use (“quick and dirty” approach) – 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 on an investment or an interest rate – requires calculating the interest rate that equates the cash outflows (cost) with the cash inflows – is the interest rate where the cash outflows equal the cash inflows (or NPV = 0) – reinvestment assumption and magnitude considerations may make the results misleading

Solving for Rate of Return (r) with uneven cash flows

0 = C 0 (1 + r) 1 (1 + r) 2

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Spreadsheets (use financial function =IRR)

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Financial calculators (IRR using cash flow register)

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Manual (Trial and error until PV of all cash flows equal zero)

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

Net Present Value in the General discounted cash flow formula

NPV = C 0 C 1 C 2 + + + . . .

(1 + r) 1 (1 + r) 2

Accept/Reject Decision

Payback Method (PB): –if PB period < cutoff period, accept the project – if PB period > cutoff period, reject the project Internal Rate of Return (IRR): – if IRR > cost of capital, accept the project – if IRR < cost of capital, reject the project Net Present Value (NPV): – if NPV > 0, accept the project – if NPV < 0, reject the project

Capital Rationing

   A limit or constraint on the amount of funds that can be invested Can rank investments based on their NPVs. Those with positive NPVs are accepted until all funds are exhausted.

Or could base decisions based on most value for the buck. Then would rank based on highest Profitability Index: Profitability Index = PV inflows / PV outflows

Determining Whether to Purchase a Machine

To make the actual investment decision: – calculate a depreciation schedule – figure earnings and cash flow (CF) – discount the cash flows back to the present to determine whether the machine should be purchased (only if NPV > 0)

Capital budgeting results

Another example Cash flow related to the purchase of machinery

Assuming cost of capital is 10%