Introduction to Capital budgeting for accounting and finance managers

1. 2-1
Chapter 4
Capital Budgeting

2. 2-2
After studying Chapter 4,
you should be able to:
 Define “capital budgeting” and identify the steps involved in the
capital budgeting process.
 Justify why cash, not income, flows are the most relevant to
capital budgeting decisions.
 Summarize in a “checklist” the major concerns to keep in mind
as one prepares to determine relevant capital budgeting cash
flows.
 Define the terms “sunk cost” and “opportunity cost” and explain
why sunk costs must be ignored, while opportunity costs must
be included, in capital budgeting analysis.
 Explain how tax considerations, as well as depreciation for tax
purposes, affects capital budgeting cash flows.
 Determine initial, operating, and terminal period “after-tax,
incremental, cash flows” associated with a capital investment
project.
 Apply the various techniques of evaluating projects

3. 2-3
What is
Capital Budgeting?
The process of identifying,
analyzing, and selecting
investment projects whose
returns (cash flows) are
expected to extend beyond
one year.

4. 2-4
The Capital Budgeting Process
 Generate investment proposals
consistent with the firm’s strategic
objectives.
 Estimate after-tax incremental cash
flows for the investment projects.
 Estimate the cost of capital relevant for
the project
 Evaluate project incremental cash flows.

5. 2-5
Classification of Investment
Project Proposals
1. New products or expansion of
existing products
2. Replacement of existing equipment or
buildings
3. Research and development
4. Exploration
5. Other (e.g., safety or pollution related)

6. 2-6
Estimating After-Tax
Incremental Cash Flows
 Cash (not accounting income) flows
 Operating (not financing) flows
 After-tax flows
 Incremental flows
Basic characteristics of
relevant project flows

7. 2-7
Estimating After-Tax
Incremental Cash Flows
 Ignore sunk costs
 Include opportunity costs
 Include changes in net working
capital
 Include externalities
 Ignore financing costs
Principles that must be adhered
to in the estimation

8. 2-8
Sunk Costs
 Sunk Costs—A cost that has
already been incurred and cannot
be recovered irrespective of the
decision to accept or reject the
project.
 R&D, Market Research,
Consultant’s Fees
 It is irrelevant

9. 2-9
Opportunity Costs
 Opportunity Costs--The cash flow foregone by
using your resources in a particular way.
 Resources have multiple uses
 You can use them in one way to the exclusion
of other uses and this gives rise to opportunity
costs
 By using your own building for your business,
you forego the rent that you could have earned
by renting it to some one else.
 It is relevant to decision making.

10. 2-10
Project Externalities
 Project Externalities--the effect of a
new project (positive or negative) on
an existing project or division of a
firm.
 For instance, introduction of a new
model of a car on other existing
models produced by the same firm.
 Positive externality is revenue of the
project and negative externality is
cost

11. 2-11
Net Working Capital
 Change in Net Working Capital--Net
working capital is defined as current
assets minus current liabilities.
 Investment in working capital is a
cash outflow during the year in
which investment takes place
 Any investment in working capital is
a cash inflow during the last year of
the project and must be treated
accordingly

12. 2-12
Financing costs
 Financing costs are considered in
the discounting rate (the cost of
capital).
 They are not considered in
determining the cash flows of the
project. Otherwise it would be
double counting.

13. 2-13
Types of cash flows
 Initial cash outflow (initial investment) –
is cash flow to make the project ready
for operation.
 Operating Cash flows -- those net cash
flows from operating the project.
 Terminal cash flows -- the final period’s
net cash flow occurring as a result of
terminating and liquidating the project.

14. 2-14
Initial Investment
a) Gross investment (price +
installation + shipment)
b) + (-) Increased (decreased) NWC
c) - Net proceeds from sale of
“old” asset(s)
d) + (-) Taxes (savings) due to the
sale of “old” asset(s)

15. 2-15
Operating Cash Flows
(CFAT)
a) Cash Revenue – Cash Expenses
b) - Depreciation
c) = Net income before taxes
d) - Taxes
e) = Net income after taxes
f) + Depreciation
g) = Operating cash flow for period

16. 2-16
Or , the operating
cashflow…
 Another way to find the annual
operating cash flow is:
 CFAT= CFBT(1-T) +Deprn (T)
 CFBT = Cash rev – Cash Exp
 T = the tax rate

17. 2-17
Terminal Cash Flows
a) Salvage value (disposal/reclamation
costs) of any sold or disposed
assets
b) - (+) Taxes (tax savings) due to asset sale
or disposal of “new” assets
c) + Net working capital recovered
d) = Terminal year incremental net cash
flow

18. 2-18
Example:Expansion Project
Basket Wonders (BW) is considering the
purchase of a new basket weaving machine. The
machine will cost $50,000 plus $20,000 for
shipping and installation. Depreciation is 40%,
30%, 20% and 10% of the gross investment in
years 1, 2, 3, and 4, respectively. NWC will rise
by $5,000. Lisa Miller forecasts that revenues will
increase by $110,000 for each of the next 4 years
and will then be sold (scrapped) for $10,000 at the
end of the fourth year, when the project ends.
Operating costs will rise by $70,000 for each of
the next four years. BW is in the 40% tax bracket.

19. 2-19
Initial investment
a) $50,000
b) + 20,000
c) + 5,000
d) - 0 (not a replacement)
e) + (-) 0 (not a replacement)
f) = $75,000*
* Note that we have calculated this value as a
“positive” because it is a cash OUTFLOW (negative).

20. 2-20
Operating Cash Flows
Year 1 Year 2 Year 3 Year 4
a) $40,000 $40,000 $40,000
$40,000
b) - 28,000 21,000 14,000
7,000
c) = $12,000 $19,000 $26,000
$33,000
d) - 4,800 7,600 10,400
13,200
e) = $7,200 $ 11,400 $15,600

21. 2-21
Terminal cash flow
a) 10,000 Salvage Value.
b) - 4,000 .40*($10,000 - 0) Note, the
asset is fully
depreciated at the end of Year
4.
c) + 5,000 NWC - Project ends.
d) = $11,000 Terminal-cash flow.

22. 2-22
Summary of Project
Net Cash Flows
Asset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
-$75,000* $35,200 $32,400 $29,600
$37,800
* Notice again that this value is a negative
cash flow as we calculated it as the initial
cash OUTFLOW in slide 12-18.

23. 2-23
Example of an Asset
Replacement Project
Let us assume that previous asset expansion
project is actually an asset replacement project.
The original cost of the old machine was $30,000
and depreciated using straight-line over five years
($6,000 per year). The old machine has served for
three years and has two years of useful life remain-
ing. BW can sell the current machine for $6,000.
The new machine will not increase revenues
(remain at $110,000) but it decreases operating
expenses by $10,000 per year (old = $80,000). NWC
will rise to $10,000 from $5,000 (old).

24. 2-24
Initial Cash Outflow
a) $50,000
b) + 20,000
c) + 5,000
d) - 6,000 (sale of “old” asset)
e) - 2,400 <----
f) = $66,600
(tax savings from
loss on sale of
“old” asset)

25. 2-25
Calculation of the
Change in Depreciation
Year 1 Year 2 Year 3 Year 4
a) $28,000 $21,000 $14,000 $
7,000
b) - 6,000 6,000 0
0
c) = $22,000 $15,000 $14,000 $
7,000
a) Represent the depreciation on the “new”
project.
b) Represent the remaining depreciation on

26. 2-26
Incremental Cash Flows
Year 1 Year 2 Year 3 Year 4
a) $10,000 $10,000 $10,000
$10,000
b) - 22,000 15,000 14,000
7,000
c) = $ -12,000 -$5,000 $ -4,000 $
3,000
d) - -4,800 -2,000 -1,600
1,200
e) = $ -7,200 $ -3,000 $ -2,400 $

27. 2-27
Terminal Cash Flows
a) + 10,000 Salvage Value.
b) - 4,000 (.40)*($10,000 - 0). Note,
the asset is fully depreciated
at the end of Year 4.
c) + 5,000 Return of “added” NWC.
d) = $11,000 Terminal cash flow.

28. 2-28
Summary of Project
Net Cash Flows
Asset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
-$75,000 $35,200 $32,400 $29,600
$37,800
Asset Replacement
Year 0 Year 1 Year 2 Year 3 Year 4
-$66,600 $14,800 $12,000 $10,600
$20,000

29. 2-29
Capital Budgeting
Techniques
1. Non-Discounted methods: do
not consider time value of
money.
2. Discounted Methods: Consider
time value of money

30. 2-30
1. Non discounted
Methods
a) Payback Period (PBP)
b) The accounting rate of return

31. 2-31
Proposed Project Data
Julie Miller is evaluating a new project
for her firm, Basket Wonders (BW).
She has determined that the after-tax
cash flows for the project will be
$10,000; $12,000; $15,000; $10,000;
and $7,000, respectively, for each of
the Years 1 through 5. The initial
cash outlay will be $40,000.

32. 2-32
Independent Project
 Independent -- A project whose
acceptance (or rejection) does not
prevent the acceptance of other
projects under consideration.
 For this project, assume that it is
independent of any other potential
projects that Basket Wonders may
undertake.

33. 2-33
a) Payback Period (PBP)
PBP is the period of time
required for the cumulative
expected cash flows from an
investment project to equal
the initial cash outflow.
0 1 2 3 4 5
-40 K 10 K 12 K 15 K 10 K 7 K

34. 2-34
(c)
10 K 22 K 37 K 47 K 54 K
Payback Solution (#1)
PBP = a + ( b - c ) / d
= 3 + (40 - 37) / 10
= 3 + (3) / 10
= 3.3 Years
0 1 2 3 4 5
-40 K 10 K 12 K 15 K 10 K 7 K
Cumulative
Inflows
(a)
(-b) (d)

35. 2-35
Payback Solution (#2)
PBP = 3 + ( 3K ) / 10K
= 3.3 Years
Note: Take absolute value of last
negative cumulative cash flow
value.
Cumulative
Cash Flows
-40 K 10 K 12 K 15 K 10 K 7 K
0 1 2 3 4 5
-40 K -30 K -18 K -3 K 7 K 14 K

36. 2-36
PBP Acceptance Criterion
Yes! The firm will receive back the
initial cash outlay in less than 3.5
years. [3.3 Years < 3.5 Year Max.]
The management of Basket Wonders
has set a maximum PBP of 3.5
years for projects of this type.
Should this project be accepted?

37. 2-37
PBP Strengths
and Weaknesses
Strengths:
 Easy to use and
understand
 Can be used as a
measure of
liquidity & risk
Weaknesses:
 Does not account
for TVM
 Does not consider
cash flows
beyond the PBP
 Cutoff period is

38. 2-38
b) Accounting Rate of Return
ARR = Average NIAT / Average Investment
Eg. A project earns net incomes of Br 10,000, Br
15,000, Br 20,000 and Br 15,000 in years 1, 2, 3, &
4, respectively. The initial investment in the
project is Br 90,000 and it is expected to have a
salvage value of Br 10,000. What is the ARR of the
project?
Average NIAT = 60,000/4 = 15,000
Average Investment = (90000 + 10,000)/2 = 50,000
ARR = 15,000/50,000 = 30%

39. 2-39
2. Discounted Methods
 A) Net Present Value
 B) Internal Rate of Return
 C) Profitability Index

40. 2-40
a) Net Present Value
(NPV)
NPV is the present value of an
investment project’s net cash
flows minus the project’s initial
investment. The discount rate is
the opportunity cost of capital
CF1 CF2 CFn
(1+k)1
(1+k)2
(1+k)n
+ . . . +
+ - IInvt
NPV =

41. 2-41
Basket Wonders has determined that the
opportunity cost of capital appropriate
(Kr) for this project is 13%.
$10,000 $7,000
NPV Solution
$10,000 $12,000 $15,000
(1.13)1
(1.13)2
(1.13)3
+ +
+ - $40,000
(1.13)4
(1.13)5
NPV = +

42. 2-42
NPV Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2)
+ $15,000(PVIF13%,3) + $10,000(PVIF13%,4) +
$ 7,000(PVIF13%,5) - $40,000
NPV = $10,000(.885) + $12,000(.783) +
$15,000(.693) + $10,000(.613) + $
7,000(.543) - $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 - $40,000
= - $1,428

43. 2-43
NPV Acceptance Criterion
No! The NPV is negative. This means
that the project is reducing shareholder
wealth. [Reject as NPV < 0 ]
The management of Basket Wonders
has determined that the required
rate is 13% for projects of this type.
Should this project be accepted?

44. 2-44
NPV Strengths
and Weaknesses
Strengths:
 Cash flows
assumed to be
reinvested at
the hurdle rate.
 Accounts for TVM.
 Considers all
cash flows.
Weaknesses:
 May not include
managerial
options
embedded in the
project.

45. 2-45
b) Internal Rate of Return
(IRR)
IRR is the discount rate that equates the
present value of the future net cash
flows from an investment project with
the project’s initial investment. I.e. NPV
at IRR = 0
CF1 CF2 CFn
(1+IRR)1
(1+IRR)2
(1+IRR)n
+ . . . +
+
IINVt =

46. 2-46
$15,000 $10,000 $7,000
IRR Solution
$10,000 $12,000
(1+IRR)1
(1+IRR)2
Find the interest rate (IRR) that causes the
discounted cash flows to equal $40,000.
+ +
+
+
$40,000 =
(1+IRR)3
(1+IRR)4
(1+IRR)5

47. 2-47
IRR Solution (Try 10%)
$40,000 = $10,000(PVIF10%,1) +
$12,000(PVIF10%,2) +
$15,000(PVIF10%,3) + $10,000(PVIF10%,4)
+ $ 7,000(PVIF10%,5)
$40,000 = $10,000(.909) +
$12,000(.826) +
$15,000(.751) + $10,000(.683) +
$ 7,000(.621)

48. 2-48
IRR Solution (Try 15%)
$40,000 = $10,000(PVIF15%,1) +
$12,000(PVIF15%,2) +
$15,000(PVIF15%,3) + $10,000(PVIF15%,4)
+ $ 7,000(PVIF15%,5)
$40,000 = $10,000(.870) +
$12,000(.756) +
$15,000(.658) + $10,000(.572) +
$ 7,000(.497)

49. 2-49
.10 $1,444
.05 IRR $0.00
$4,603
.15 $3,159
X $1,444
.05 $4,603
IRR Solution (Interpolate)
X
=

50. 2-50
.10 $1,444
.05 IRR $0.00
$4,603
.15 -$3,159
($1,444)(0.05)
$4,603
IRR Solution (Interpolate)
$1,444
X
X = X = .0157
IRR = .10 + .0157 = .1157 or 11.57%

51. 2-51
IRR Strengths
and Weaknesses
Strengths:
 Accounts for
TVM
 Considers all
cash
flows
 Less
subjectivity
Weaknesses:
 Assumes all cash
flows
reinvested at the IRR
 Difficulties with
project rankings
and Multiple IRRs

52. 2-52
Profitability Index (PI)
PI is the ratio of the present value of
a project’s future net cash flows to
the project’s initial investment.
CF1 CF2 CFn
(1+k)1
(1+k)2
(1+k)n
+ . . . +
+ IInVT
PI =
PI = 1 + [ NPV / IINVT ]
<< OR >>
Method #2:
Method #1:

53. 2-53
PI Strengths
and Weaknesses
Strengths:
 Same as NPV
 Allows
comparison of
different scale
projects
Weaknesses:
 Same as NPV
 Provides only
relative
profitability
 Potential Ranking
Problems

54. 2-54
Evaluation Summary
Method Project Comparison Decision
PBP 3.3 3.5 Accept
IRR 11.47% 13% Reject
NPV -$1,424 $0 Reject
PI .96 1.00 Reject
Basket Wonders Independent Project

55. 2-55
Project Relationships
Mutually Exclusive -- A project whose
acceptance precludes the acceptance
of one or more alternative projects.
Independent -- A project whose acceptance
(or rejection) does not prevent the
acceptance of other projects under
consideration.

56. 2-56
Potential Problems
Under Mutual Exclusivity
A. Scale of Investment
B. Cash-flow Pattern
C. Project Life
Ranking of project proposals may
create contradictory results for
NPV and IRR.

57. 2-57
A. Scale Differences
NET CASH FLOWS
Project S Project L
END OF YEAR
0 -$100 -$100,000
1 0 0
2 $400 $156,250
IRR 100% 25%
NPV(10%) $231 $29,132

58. 2-58
B. Difference in Cash Flow
Pattern
NET CASH FLOWS
Project D Project I
END OF YEAR
0 -$1,200 -$1,200
1 1,000 100
2 500 600
3 100 1,080
IRR 23% 17%
NPV (10%) $198 $198

59. 2-59
C. Project Life Differences
NET CASH FLOWS
Project X Project Y
END OF YEAR
0 -$1,000 -$1,000
1 0 2,000
2 0 0
3 3,375 0
IRR 50% 100%
NPV (10%) $1536 $818

60. 2-60
Regular Vs Non regular CF
 Regular
Yr CF
0 -160
1 1,000
2 1,000
Non regular
Yr CF
0 -160
1 1,000
2 -1,000
For non-normal cash flows there may be
multiple IRRs, i.e. there may be at least two
rates that make the NPV = 0. i.e. 25% and
400%

61. 2-61
Reinvestment rate
assumption
Is the rate at which cash flows of a project are
assumed to reinvested.
IRR assumes that the reinvestment rate is the IRR
of the project.
NPV method assumes that the reinvestment rate
is the cost of capital.
Thus NPV method is superior to the IRR method.

62. 2-62
Capital Rationing
Capital Rationing occurs when a constraint (or
budget ceiling) is placed on the total size of capital
expenditures during a particular period. Under this
condition the projects that provide the largest sum
of NPV should be taken.
Example: Julie Miller must
determine what investment
opportunities to undertake for
Basket Wonders (BW). She is

63. 2-63
Available Projects for BW
Project ICO IRR NPV
A $ 500 18% $ 50
B 5,000 25 6,500
C 5,000 37 5,500
D 7,500 20 5,000
E 12,500 26 500
F 15,000 28 21,000
G 17,500 19 7,500