CAPITAL INVESTMENT

Capital Investment (Capital Budgeting) involves the allocation of large amounts of

resources in long-term investments.
Examples:
=>
Replacement of Equipment
=>
Expansion of Existing Product Lines
=>
Development of New Product Lines
=>
Intangibles:
=>
Research & Development
=>
Patents
=>
Advertising campaigns
Success:
Texas Instruments - semiconductor in 1950s and 1960s; microchip in 1970s
Microsoft - Bought Quick and Dirty Operating System for $50,000
Failure:
Ford Edsel (Loss of $250 million in 1957-59, or approximately $2 billion today)
Once the Investment is made, it is almost impossible to back out. Unlike a surplus of
inventory which can be quickly corrected, an unutilized refinery just sits vacant.
The firm's existence is a series of capital investment decisions that are necessary for the
company to grow, remain competitive, etc.
Basic Concept: Accept all projects that yield a return that exceeds the cost of financing the
project. Thus, if we are maximizing stockholder wealth, we would accept Projects A D and

%
A
B
C

Cost of
Capital
D
E
F

reject the remainder:

Numerous investment alternatives exist. We need a means of ranking the projects from
best to worst in order to select those that are most valuable to the firm; i.e., a means of
evaluating and ranking proposals.
The primary concern in the investment decision regards cash flows:
=>
=>
=>
=>
=>
=>

Incremental Revenues
Incremental Costs
Taxes
Depreciation considerations
Investment in Working Capital
Cost Savings

Any cash inflow or outflow.

EVALUATION TECHNIQUES
A)

Payback Period
Year 0
Year 1
Year 2
Year 3

Proj. A
--------(3,000)
1,000
2,000
3,000

Payback = 2 years

Proj. B
--------(3,000)
2,000
1,000
4,000
Payback = 2 years

Both projects have a payback of two years, so the payback method indicates that the two
projects are equally desirable.
Problems:
1)

Ignores the Time Value of Money

2)

Ignores cash flows beyond the payback period

Project B returns $1,000 a year earlier than Project A and also returns an additional $1,000 in the
last year.
Present Value (or Discounted) Payback, which utilizes the present value of each year's cash
flow, overcomes the first problem, but not the second.

B)

Present Value (Discounted) Payback

Year 0
Year 1
Year 2
Year 3

Proj. A
--------Cash Flow PV of CF
(3,000)
(3,000)
1,100
1,000
2,420
2,000
3,000
2,254

Proj. B
--------Cash Flow
(3,000)
2,200
1,210
4,000

PV Payback = 2 years

C)

PV of CF
(3,000)
2,000
1,000
3,005

PV Payback = 2 years

Net Present Value (NPV)

We need a methodology that takes into account all of the cash flows as well as the time
value of money. Net Present Value is one such technique:
NPV = PV of Cash Inflows - PV of Cash Outflows
Required Rate of Return = 10%
0
(4,000)

1,000

2,000

3,000

PV at 10% for 1 year

909
PV at 10% for 2 years
1,653
PV at 10% for 3 years
2,254
NPV @ 10% =

816

To calculate the NPV on an HP 10B financial calculator,

Clear All
Enter 4000 and change the sign (+/-) and press CFj
Enter 1000 and press CFj again
Enter 2000 and press CFj
Enter 3000 and press CFj
Enter 10 and press I/YR
Press the shift key and press NPV
NPV represents the increase in the value of the firm that occurs by accepting the project. In
other words, it represents the amount by which the value of the project exceeds its cost.
Proof:
Year 0 Investment

4,000

Cash Flow - Year 1

1,000

Return of Investment

(600)
-------3,400
(1,660)
-------1,740
(2,826)
-------(1,086)
0.7513
--------816

Year 1 Investment
Return of Investment
Year 2 Investment
Return of Investment
Surplus Return
PVIF10%,3
Present Value

Less: Interest

(400) (10%*$4,000)
-------Return of Investment
600
Cash Flow - Year 2
Less: Interest
Return of Investment
Cash Flow - Year 3
Less: Interest
Return of Investment

2,000
(340) (10%*$3,400)
-------1,660
3,000
(174) (10%*$1,740)
-------2,826

The problem with NPV is that there is no consideration of cost, or what is referred to as size
disparity.
Proj. A
Proj. B
-------------Present Value of Inflows
1,050
125
Cost
(1,000)
(100)
-------------Net Present Value
50
25
If these are mutually exclusive projects (i.e., choose one or the other, but not both), the NPV
criterion says to choose Project A. While Project A increases the value of the firm by twice the
amount of Project B, it costs ten times as much. The NPV does not indicate how efficiently
money has been invested.
Capital Rationing - the allocation of a scarce resource, in this case money.
D)

Profitability Index (PI) (or Benefit-Cost Ratio) - a measure of efficiency of investment

Profitability Index

PV of Inflows
PV of Outflows

PIA = 1.05

PIB = 1.25

The interpretation of PI is that of the amount of money in today's dollar terms that you get per
dollar of investment. This indicates how efficiently you have invested money.

E)

Internal Rate of Return (IRR)

Another measure of the efficiency of investment is the Internal Rate of Return. When
someone asks what rate of return an investment is earning, they mean the Internal Rate of

Return. The IRR can be defined as

PV of Inflows @ IRR = PV of Outflows @ IRR
or
NPV @ IRR = 0
This is the actual rate of interest that is being earned on the investment. While the present
value and annuity tables can be used in certain cases, the more general situation of uneven
cash flows requires that the IRR be found by trial and error.
From the previous example, it is clear that more than 10% is being earned, since the NPV is
$816.
Calculating the IRR on the HP 10B is almost identical to calculating the NPV:
Clear All
Enter 4000 and change the sign (+/-) and press CFj
Enter 1000 and press CFj again
Enter 2000 and press CFj
Enter 3000 and press CFj
Press the shift key and press IRR/YR
The Internal Rate of Return is 19.44%
Year 0 Investment
Return of Investment

4,000
(222)

Year 1 Investment
Return of Investment

3,778
(1,266)

Return of Investment

Year 2 Investment
Return of Investment

2,512
2,512

Cash Flow -- Year 2

Less: Interest

Surplus Return

Cash Flow -- Year 1

Less: Interest

1,000
(778) (19.44% * $4,000)
222
2,000
(734) (19.44% * $3,778)

Return of Investment

1,266

Cash Flow -- Year 3

Less: Interest

3,000
(488) (19.44% * $2,512)

Return of Investment

2,512

Hence, it is the rate of interest earned on the funds that remain invested within the project. This
is the economic interpretation of the mathematical solution.

Project A
Project B

Year 0

Year 1

Year 2

(15,000)
(48,000)

10,000
30,000

10,000
30,000

Year 3
0
0

NPV @ 10%

PI @ 10%

IRR

2,355
4,066

1.16
1.08

21.5%
16.3%

PI @ 10%

IRR

Which project is better? The major difference is the costs of the projects.
Year 0
Project C

(10,000)

Year 1

Year 2

8,000

5,600

Year 3
0

NPV @ 10%
1,901

1.19

24.9%

Project D

(10,000)

17,000

2,772

1.28

19.3%

Which project is better? The major difference is the timing of the cash flows.
Note that all three measures agree as to whether a project is acceptable or not. The
conflict is in the ranking of the investment proposals.
Note also that the Profitability Index, a measure of efficiency of investment, does not
always agree with IRR in terms of which is the most efficient use of funds.

THE REINVESTMENT ASSUMPTION

Consider the following two projects, their NPVs, PIs, and IRRs.
Project X
Year 0

Year 1

Year 2

Year 3

(886)

100

100

1,100

Year 0

Year 1

Year 2

Year 3

(886)

900

150

55

Cash Flows
NPV @ 10% = 114
PI @ 10% =
1.13
IRR =
15.0%
Project Y
Cash Flows
NPV @ 10% = 97
PI @ 10% = 1.11
IRR =
20.0%

Most academicians claim that the conflict is a consequence of the reinvestment

assumption. Net Present Value and Profitability Index assume reinvestment at the discount rate.
Internal Rate of Return can be thought of as a special case of NPV (when it equals zero).
Hence, it assumes reinvestment at the IRR.
Realistically, investments are made to maximize future wealth. Present value (discounted
cash flow techniques) are used since we know the value of a dollar today. The reinvestment
assumption is invoked in order to make the future value (terminal value) rankings consistent with
the present value rankings. To see this, let's reinvest the cash flows of Projects X and Y at the
discount rate of 10%.
Project X
Cash Flows

Year 0

Year 1

Year 2

Year 3

(886)

100

100

1,100

1.21
121

1.10
110
Terminal Value =

1,331

Project Y
Cash Flows

Year 0

Year 1

(886)

900

Year 2

Year 3

150

55

1.21
1,089
1.10
165
Terminal Value =

1,309

Since the costs are the same, the terminal values are both relative to the same size of
investment. The $1,331 terminal value of Project X represents a 14.53% rate of return on an
investment of $886 over three years while the $1,309 terminal value of Project Y is a 13.89%
return on the initial investment. The difference in the terminal values of $22 has a present value
of $17 which is the same as the difference in NPVs of the two projects (114 - 97 = 17). Thus, the
terminal value rankings are consistent with the NPV and PI rankings that indicate Project X is
superior to Project Y. Similarly, if the cash flows of each project are reinvested at their respective
IRRs, the following is obtained:
Project X
Cash Flows

Year 0

Year 1

Year 2

(886)

100

Year 3

100

1,100

1.3223
132
1.15
115
Terminal Value =

1,347

Project Y
Cash Flows

Year 0

Year 1

(886)

900

Year 2

Year 3

150

55

1.4400
1,296
1.2000
180
Terminal Value =

1,531

Since the costs are identical, it is clear that Project Y is better since it maximizes future
wealth, and agrees with the rankings of the IRRs. Moreover, the terminal value of $1,347 of
Project X represents a 15% return on the cost of the project, while the $1,531 terminal value of
Project Y is a 20% return on the investment in Project Y.
NON-NORMAL (NON-CONVENTIONAL) PROJECTS
Multiple Internal Rates of Return
Another criticism of the IRR method is that non-normal (or non-conventional) projects
can have multiple IRRs. Consider the following project:

Cash Flows

Year 0

Year 1

Year 2

Year 3

Year 4

(3,000)

2,000

4,500

3,500

(7,200)

Two IRRs exist: IRR1 = 3.2% and IRR2 = 47.16%. Which one is correct? Technically, both of
them provide a solution to the discount rate that yields a Net Present Value = 0. The text
refers to the question of "A borrowing rate or an investment rate?" in explaining why both are
correct. Let's look at the 3.2% solution:
0

(3,000)

2,000

4,500

3,500

(7,200)

(3,000) * (1.032) =

(3,096)
+ 2,000
(1,096) * (1.032) =

(1,131)
+ 4,500
3,369 * (1.032) =

3,477
+ 3,500
6,977 * (1.032) =
Terminal Value =

7,200
+( 7,200)
-0-

In this case, if you only require a 3.2% rate of return, your 3.2% rate of return and your
principal are returned early in Year 2, and you only need to earn a return of 3.2% on the
investment of surplus funds in order to have enough to payoff the cost of $7,200 at the end of
the 4th year. The same is true with the IRR of 47.16%:
0

(3,000)

2,000

4,500

3,500

(7,200)

(3,000) * (1.4716) = (4,415)

+ 2,000
(2,415) * (1.4716) = (3,554)
+ 4,500
946 * (1.4716) =

1,393
+ 3,500
4,893 * (1.4716) =
Terminal Value =

7,200
+( 7,200)
-0-

Because of the higher rate of return (47.16%), it takes longer to receive your rate of return and
principal back (not until almost the end of the 2nd year since more of the cash flow is rate of
return rather than return of principal) and you must now earn a 47.16% rate of return on the
surplus funds to cover the cost of $7,200 at the end of the project life. (Check out the NPV of
this project at 3.2% and 47.16% to verify that you'll get an NPV of zero.)
In short, the economic interpretation (that it is the return on invested funds) is lost
because it also requires that the surplus funds earn the same rate of interest in order to cover
the cash outflow in the last year. In fact, there is an IRR for each time that the cash flows
change sign (in this case only two).
Many believe this is the primary reason to prefer NPV over IRR as an evaluation tool.
Unfortunately, the concept of a rate of return (such as IRR) is preferred by almost all
practitioners, particularly since it can be compared to the cost of funds or other investment
opportunities.
Another shortfall to NPV is if the risk of the project (or future cash outflow) is higher than
the risk of the average investment for the company. Consider the above example where the
outflow is associated with a great deal of uncertainty about the cost (such as decommissioning a
nuclear power plant). The greater uncertainty implies a higher discount rate be used in
calculating the present value. Yet a higher discount rate makes the present value of the cost
lower, and hence the project more attractive rather than less. One solution to this is to discount
future cash outflows at a separate discount rate from the cash inflows. In fact, the more risky the
future cash outflow, the lower the discount rate that should be employed. This has its own
problems: as shown previously, if NPV assumes cash flows are reinvested at the discount rate,
then an above-average risk project assumes that the (positive) cash flows will continue to be
reinvested in above-average risk projects (i.e., earn a high rate of return) while the aboveaverage risk costs (being discounted at a lower discount rate as mentioned) have a belowaverage cost of capital. Confusing, isn't it?
RELEVANT CASH FLOWS
Incremental Cash Flows
The relevant cash flows for investment analysis is the change in the cash flows that
would occur by accepting a proposal, or what is referred to by the term incremental cash flows.
An opportunity cost is a cash flow given up as a consequence of a decision, and is
generally defined as the next-best-alternative. Since an opportunity cost is a change in cash
flow, it is relevant to the investment decision.

A sunk cost refers to past expenditures. Sunk costs are not relevant since they occurred
in the past and the decision of whether or not to undertake a project does not change the past.
A general (simplified) format for analyzing a capital expenditure that considers all
incremental cash flows is on the following page. Note that the relevant cash flows include those
found on the income statement as well as those that are not on the income statement (such as
working capital). Also, some cash flows are only reflected on the income statement in part (such
as the gain or loss on the sale of an asset).

CASH FLOW ANALYSIS

PURCHASE/REPLACEMENT DECISION
Today
A. <Cash outlay for new asset>
B. Cash proceeds from sale
of old asset
C. Tax effect of gain or loss
on disposal of old asset1
D. <Additional working capital
needed to support new asset>

Intervening Years
E. Incremental Revenues
from new asset
F. Less: Incremental Costs
from new asset
G. Less: Incremental Depreciation
------------------------------------------Change in Taxable Income
Less: Taxes on Tax. Inc. (t)
------------------------------------------Change in Net Income
Plus: Incremental Depreciation
------------------------------------------Incremental Operating Cash Flow

Last Year
I. Salvage of new asset
J. Tax effect of gain or
loss on disposal of
new asset1
K. <Salvage value lost
on old asset>
L. Tax effect of gain or
loss on disposal of
old asset1
M. Recovery of working
capital

H. <Additional working capital>

In a Purchase Decision, the relevant occurrences are A, D, E, F, H, I, J, and M
In a Replacement Decision, the relevant occurrences are A through M
1
If the asset is sold for less than the book value, the company incurs a loss which is tax-deductible. This loss reduces taxable income
and thereby creates a tax savings equal to the difference between the market value of the asset and its book value multiplied by the
tax rate: Loss * t
If the asset is sold for more than the book value, the company must report the difference as a profit to be taxed as ordinary income to
the extent that the profit is less than the accumulated depreciation for the asset: Gain * t
In the event that the asset is sold for
more than the original purchase price, the gain above the original purchase price is subject to the capital gains tax rate while the
accumulated depreciation is taxed as ordinary income.
< > indicates that the cash flow is an outflow.

t = applicable tax rate

The Replacement Decision

The classic capital investment decision is that of whether or not to replace a large piece
of equipment.
Example
Kinky's Copying Service is considering expanding operations to include new holographic
color copying services. The new service is expected to result in additional sales of $600,000 in
the first year, increasing by 12% per year as word of the color copies spreads. Labor and
material costs are predicted to rise by $480,000 in the first year, increasing at a 6% annual rate
due primarily to inflation. To accommodate the service, a new color copier will have to be
purchased at a cost of $280,000. The new machine will be depreciated using the MACRS rates
for 5-year assets (20%, 32%, 19.2%, 11.52%, 11.52%, 5.76%), even though you expect that
after three years of 24-hour per day operation, it will have a resale value of only $50,000 and will
have to be replaced. Since the holographic color copier can also make regular color copies, one
of the small existing color copy machines can be sold to a local university for $45,000 rather than
keeping it for the remaining three years of its useful life and scrapping it for $8,000. The existing
color copy machine was purchased for $90,000 two years ago and is also being depreciated
using the same MACRS rates for 5-year assets. The expanded service would use existing floor
space in an adjacent room which would result in an allocation of depreciation totaling $5,000 per
year. Also, $6,000 in administrative expenses would be allocated to the project each year;
however, only $2,000 of the amount represents an actual increase in expenses not otherwise
incurred by the firm (also increasing by 6% per year). The existing floor space of the adjacent
room could be leased annually for $4,500 on a fixed three-year lease if the project is not
accepted. An investment in working capital of $85,000 will initially be required, with additional
increments of 8% per year due to both inflation and increasing sales, all of which will be
recovered in the third year. Kinky's is in the 40% tax bracket. Calculate the net cash flows for
each year of the project's life.
Solution
Year 1

Year 2

Year 3

Incremental Revenues
Increased sales
Lost lease payments

600,000 x 1.12 = 672,000 x 1.12 = 752,640

(4,500)
(4,500)
(4,500)

Total Incremental Revenues

595,500

667,500

748,140

Incremental Costs
Labor & materials
Administrative expense

480,000 x 1.06 = 508,800 x 1.06 = 539,328

2,000 x 1.06 =
2,120 x 1.06 =
2,247

Total Incremental Costs

482,000

510,920

541,575

Year 1
Incremental Depreciation
New Machine
MACRS rate

Year 2

Year 3

280,000
20.00%

280,000
32.00%

280,000
19.20%

New Depreciation

56,000

89,600

53,760

Old Machine
MACRS rate

90,000
19.20%

90,000
11.52%

90,000
11.52%

Old Depreciation

17,280

10,368

10,368

Incremental Depreciation

38,720

79,232

43,392

Sale of Equipment
Old machine - Yr. 0
Market Value
Book Value
Gain (loss)
Tax rate

45,000
43,200
1,800
40%

Tax due (refund)

720

Old machine - Yr. 3

Market Value
Book Value

8,000
5,184

Gain (loss)
Tax rate

2,816
40%

Tax due (refund)

1,126

New machine - Yr. 3

Market Value
Book Value

50,000
80,640

Gain (loss)
Tax rate

(30,640)
40%

Tax due (refund)

(12,256)

Working Capital

(90,000*48%)

(90,000*5.76%)

(280,000*28.8%)

Year

Required

Change

0
1
2
3

85,000
91,800
99,144
107,076

85,000
6,800
7,344
7,932

Putting it all together

Year 0

Year 1

Year 2

Year 3

595,500
(482,000)
(38,720)

667,500
(510,920)
(79,232)

748,140
(541,575)
(43,392)

Change in Taxable Income

Less: Taxes (40%)

74,780
(29,912)

77,348
(30,939)

163,173
(65,269)

Change in Net Income

Add-back depreciation

44,868
38,720

46,409
79,232

97,904
43,392

Change in Operating Cash Flow

83,588

125,641

141,296

( 6,800)

( 7,344)

( 7,932)

Operating Cash Flows

Revenues
Less: Costs
Less: Depreciation

Working Capital Requirements

Additional Working Capital
Working Capital Recovery
107,076
New Machine
Purchase
Sale - Yr. 3
Tax Savings on Sale
Old Machine
Sale - Yr. 0
Tax on Sale

( 85,000)

(280,000)
50,000
12,256
45,000
( 720)

Lost Sale - Yr. 3

Taxes Saved on Lost Sale
Total Incremental Cash Flows

(8,000)
1,126
(320,720)

76,788

118,297

295,822