Capital Budgeting

CAPITAL BUDGETING
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CAPITAL BUDGETING
LONG-RANGE PLANNING

Capital Budgeting
• It is the process of considering alternative capital
projects and selecting those alternatives that
provide the most profitable return on available
funds.
• Examples of capital projects include land,
buildings, equipment and other major fixed asset
items.

I will choose the
project with the most
profitable return on
available funds.
?
?
?
Limited
Investment
Funds
Plant
Expansion
New
Equipment
Office
Renovation
Alternatives:
Capital Budgeting

Capital Budgeting
Implementation of a capital project involves . . .
• a large commitment of money in
the decision period.
• a large increase in fixed costs
for a number of years.
• potential returns in future years.
• an opportunity cost because of
the rejection of other projects.

Project Selection:
A General View
• Analysis of cash inflows and cash outflows
• Net cash inflow is the net cash benefit expected from a
capital project in a period.
• Time value of money
• Cash received today is
worth more than the
same amount received
in the future.
.

Capital Budgeting
Cash Flow Analysis
Initial
Investment
Increased
Working Capital
Repairs
and
Maintenance
Incremental
Operating
Costs
Typical
Cash Outflows

Capital Budgeting
Cash Flow Analysis
Typical
Cash Inflows
Reduced
Operating
Costs
Released
Working
Capital
Incremental
Revenues
Salvage
Value .

Capital BudgetingTerminology
Interest rate
indicating the
cost of debt
and equity
investment
funds
Cost of
capital
Out-of-pocket
costs
Avoided by
not selecting
a project
Future cash
outflows
Sunk
costs
Not avoided
by current
decision
Past cash
outflows

Depreciation and Taxes
Depreciation itself is not a cash flow.
However, depreciation results in a reduction of cash
outflows by reducing federal income taxes.

Example
Apex Company is considering the purchase of
new equipment. Given the following information,
and a tax rate of 40 percent, compute the:
 Tax savings due to depreciation.
 After-tax net cash inflow.
Asset cost 72,000$
Asset life 10 years
Asset salvage value 12,000$
Straight-line depreciation 6,000
Annual cash inflows 90,000
Annual cash outflows 70,000

With Without
Depreciation Depreciation
Net cash inflow from project 20,000$ 20,000$
Depreciation 6,000 -
Amount subject to tax 14,000$ 20,000$
Tax at 40% 5,600$ 8,000$
Tax savings
Tax savings = $2,400
(.40 × $6,000 depreciation = $2,400)
Example

.
Income Cash Flow
Net cash inflow from project 20,000$ 20,000$
Depreciation 6,000 -
Income subject to tax 14,000$ 20,000$
Tax at 40% 5,600 5,600
After-tax amount 8,400$ 14,400$
After-tax net cash inflow
After-tax net Before-tax net Tax Depreciation Tax
cash inflow cash inflow rate expense rate+1 -= [ ]][ ×( ) ×
[$20,000 (1 - .4)] + [$6,000 .4] = $14,400× ×
Alternatively, reducing this analysis to a formula yields:
Example

Project Selection Methods
Payback Period
Unadjusted Rate of Return
Net Present Value (NPV)
Profitability Index
Time Adjusted Rate of Return
i.e., Internal Rate of Return (IRR)

Project Selection Method 1:
Payback Period
Time required for the sum
of the annual net cash
inflows to equal the
initial cash outlay.

Payback Period
When the annual net cash inflows are
equal, use the following formula:
Initial cash outlay
Annual net cash inflow
Payback period =

Payback Period
Example
 Gators wants to install a separate seafood
bar in its pub.
 The seafood bar will . . .
 cost $150,000 and has a 10-year life with zero
salvage value.
 generate net annual cash inflows of $30,000.
 Gators requires a payback period of 6 years
or less on all investments.
Should Gators invest in the seafood bar?

Initial cash outlay
Payback period =
Payback period =
$150,000
$30,000 per year
= 5.0 years
Gators should invest in the seafood bar
because the payback period is less than 6 years.
Payback Period
Example

Payback Period Limitations
Ignores the
time value
of money.
Ignores cash
flows after
the payback
period.

Example
Consider two projects, each with a five-year life and
each costing $6,000.
Project One Project Two
Net Cash Net Cash
Year Inflows Inflows
1 2,000$ 1,000$
2 2,000 1,000
3 2,000 1,000
4 2,000 1,000
5 2,000 1,000,000
Which project has the better payback period?

• Project one returns the $6,000 investment
faster -- shorter payback period of three years
($6,000 ÷ $2,000 per year = 3 years).
• Project two is clearly superior because of the
large cash inflow in the last year.
• Can you see the limitations of the payback
period?
Example

Unadjusted Rate of Return
The unadjusted rate of return focuses on annual
income instead of cash flows.
Unadjusted Average annual income
rate of return Average amount of investment
=
Beginning balance + Ending balance
2

Example
What is the the unadjusted
rate of return on the seafood bar?
 The seafood bar will . . .
 cost $150,000 and has a 10-year life with zero salvage
value.
 generate net annual cash inflows of $30,000.
 Gators requires a payback period of 6 years or
less on all investments and pays tax at 40%.
Reconsider the Gators example:

.
Unadjusted (30,000 - 15,000) x (1 - .40)
rate of return (150,000 + 0) ÷ 2
= = 12.0%
Example
Annual net cash inflows 30,000$
Depreciation ($150,000 ÷ 10 years) 15,000
Annual income before tax 15,000$
Unadjusted Average annual income after tax
rate of return Average amount of investment
=
Unadjusted Average annual before- Average annual Tax
Rate of tax net cash inflow depreciation rate
return Average amount of investment
=
( - )× (1 - )

• Depreciation may be
calculated several ways
thereby giving different
results.
• Time value of
money is ignored.
Limitations

Net Present Value (NPV) Method
A comparison of the present value of cash inflows
with the present value of cash outflows

Chose a minimum rate of return
(cost of capital).
Calculate the present value of cash inflows.
Calculate the present value of cash outflows.
NPV = –
Net Present Value
Procedure

• If NPV is positive, the investment yields a higher
return than the cost of capital.
• Decision rule: Invest if NPV is positive.
Net Present Value
Interpretation

Net Present Value
Question
Savak Company can buy a new machine for $96,000
which will save $20,000 cash per year in operating costs.
If the machine has a useful life of 10 years and Savak’s
required return is 12 percent, what is the NPV
(rounded)?
a. $ 4,306
b. $12,721
c. $11,553
d. $17,004

Savak Company can buy a new machine for
$96,000 which will save $20,000 cash per year
in operating costs. If the machine has a useful
life of 10 years and Savak’s required return is
12 percent, what is the NPV (rounded)?
a. $ 4,306
b. $12,721
c. $11,553
d. $17,004
Use present value of annuity table
(A.4)
PV of inflows = $20,000 × 5.65022 =
$113,004
NPV = $113,004 - $96,000 = $17,004
Net Present Value
Question

Calculate the NPV if Savak Company’s required
return is 14 percent instead of 12 percent.
Net Present Value
Question

Calculate the NPV if Savak Company’s required
return is 14 percent instead of 12 percent.
Use present value of annuity table (A.4)
PV of inflows = $20,000 × 5.21612 = $104,322
NPV = $104,322 - $96,000 = $8,322
Net Present Value
Question
Note that the NPV is smaller
using the larger interest rate.

Net Present Value
Now that you have mastered the basic
concept of net present value, it’s time
for a more sophisticated checkup!

Net Present Value
Example
Harper Co. has been offered a five-year contract to provide
parts for a large manufacturer, requiring an investment in
new equipment.
• The new equipment will . . .
• cost $160,000, have a five-year useful life, and
a $5,000 salvage value.
• need an overhaul at the end of three years costing $30,000.
• Initial working capital requirement is $100,000.

The contract is expected to produce the following
annual cash flows:
Revenues 750,000$
Less: Cost of goods sold 400,000
Gross margin 350,000$
Less: Other cash expenses 270,000
Annual net cash inflow 80,000$
Harper uses a 10 percent discount rate.
Ignoring income taxes, compute the net
present value of the contract.
Net Present Value
Example

Harper Company Net Present Value Analysis
Net Present Value
Example
Year(s) Cash Flow PV factor PV(rounded)
Equipment Now (160,000)$ 1.00000 (160,000)$

Net Present Value
Example
Equipment Now (160,000)$ 1.00000 (160,000)$
Working capital Now (100,000) 1.00000 (100,000)

Equipment Now (160,000)$ 1.00000 (160,000)$
Annual inflow 1-5 80,000 3.79079 303,263
Net Present Value
Example
Present value of an annuity of $1
factor for 5 years at 10%.

Equipment Now (160,000)$ 1.00000 (160,000)$
Annual inflow 1-5 80,000 3.79079 303,263
Net Present Value
Example
$80,000 × 3.79079 = $303,263

Equipment Now (160,000)$ 1.00000 (160,000)$
Annual inflow 1-5 80,000 3.79079 303,263
Overhaul 3 (30,000) 0.75131 (22,539)
Net Present Value
Example
Present value of $1

Equipment Now (160,000)$ 1.00000 (160,000)$
Annual inflow 1-5 80,000 3.79079 303,263
Overhaul 3 (30,000) 0.75131 (22,539)
Working capital 5 100,000 0.62092 62,092
Salvage value 5 5,000 0.62092 3,105
NPV 85,921$
Net Present Value
Example
Present value of $1

Since the contract has positive NPV, we know the rate
of return is greater than the 10 percent discount rate.
Net Present Value
Example
Equipment Now (160,000)$ 1.00000 (160,000)$
Annual inflow 1-5 80,000 3.79079 303,263
Overhaul 3 (30,000) 0.75131 (22,539)
Working capital 5 100,000 0.62092 62,092
Salvage value 5 5,000 0.62092 3,105
NPV 85,921$

Profitability Index
• Provides a means of ranking projects that have
different initial investments.
• Decision rule: consider only those projects with a
profitability index of 1.00 or more.
Present value of net cash inflows
Present value of cash outflows
Profitability index =
.

The interest rate that makes . . .

Time Adjusted Rate of Return
Present
value of
cash inflows
Present
value of
cash outflows
=
Also known as the internal rate of return.
 The net present value equal zero.

For projects with equal annual cash flows (i.e.,
annuities)
Determine the payback period.
Use the present value of annuity table to determine
the IRR.
Internal Rate of Return (IRR)
Procedure

Procedure
Project life = 4 years
Initial cost = $42,523
Annual net cash inflows = $14,000
Determine the IRR for this project.
1. Determine the payback period.
($42,523 ÷ $14,000 per year = 3.03736 years)

Periods 10% 12% 14%
1 0.90909 0.89286 0.87719
2 1.73554 1.69005 1.64666
3 2.48685 2.40183 2.32163
4 3.16987 3.03735 2.91371
5 3.79079 3.60478 3.43308
Locate the row
whose number
equals the life
of the project.
Procedure
($42,523 ÷ $14,000 per year = 3.03736 years)
2. Using present value of annuity table . . .

Periods 10% 12% 14%
1 0.90909 0.89286 0.87719
2 1.73554 1.69005 1.64666
3 2.48685 2.40183 2.32163
4 3.16987 3.03735 2.91371
5 3.79079 3.60478 3.43308
Procedure
($42,523 ÷ $14,000 per year = 3.03736 years)
In that row,
locate the
interest factor
closest in
amount to the
payback period.

Periods 10% 12% 14%
1 0.90909 0.89286 0.87719
2 1.73554 1.69005 1.64666
3 2.48685 2.40183 2.32163
4 3.16987 3.03735 2.91371
5 3.79079 3.60478 3.43308
Procedure
($42,523 ÷ $14,000 per year = 3.03736 years)
IRR is the
interest rate
of the column
in which the
interest factor
is found.

Internal Rate of Return
Example
Decker Company can purchase a new machine at
a cost of $104,322 that will save $20,000 per year
in cash operating costs. The machine will have a
10-year life.
What is the internal rate of return on this
investment project?

In Table A-4 in the appendix of your textbook, look across
the 10-period row until you find an interest factor of
5.21610 in the 14 percent column. The internal rate of
return is 14 percent.
If 14 percent is greater than Decker’s required rate of
return, Decker should purchase the new machine.
Example
$104,322
$20,000 per year
Payback period = = 5.21610
Initial cash outlay
Payback period =

Here’s the proof . . .
Year Amount
14%
Factor
Present
Value
Investment required Now (104,322)$ 1.00000 (104,322)
Annual cost savings 1-10 20,000 5.21610 104,322
Net present value $ 0
Example

Complication #1
If the exact interest rate is not found in the present
value table, an estimate of the interest rate is
required.
Periods 10% 11% 12%
1 0.90909 0.90090 0.89286
2 1.73554 1.71252 1.69005
3 2.48685 2.44371 2.40183
4 3.16987 3.10245 3.03735
5 3.79079 3.69590 3.60478
For a project with a five-year life and a payback period
of 3.65000, the IRR would be approximately 11.5 percent.

Complication #2
If cash inflows involve both annuities and one-time
amounts, a trial and error solution will result if
present value tables are used.
Sophisticated business calculators and electronic
spreadsheets can be used to easily solve these
problems.

Compare the cost of
capital to the internal rate
of return on a project.
To be acceptable, a
project’s rate of return
cannot be less than the
cost of capital.
Net Present Value
The cost of capital is used
as the actual discount rate.
Any project with a negative
net present value is
rejected.
Net Present Value vs.

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Copyright, 2016 by “The Apprentiice” . This presentation, including the information contained herein
and any associated commentary, ("Materials") is provided as a service of The Apprentiice.
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such, these Materials should not be solely relied upon without, or used as a substitute for, future
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Capital Budgeting

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