unsophisticated capital budgeting technique,

CHAPTER 10: Capital Budgeting because it does not explicitly consider the
Techniques time value of money
Capital budgeting If the payback period is less than the
the process of evaluating and selecting long- maximum acceptable payback period, accept
term investments that are consistent with the the project.
firm’s goal of maximizing owners’ wealth If the payback period is greater than the
Fixed assets maximum acceptable payback period, reject
often referred to as earning assets, generally the project.
provide the basis for the firm’s earning power Bail-out period
and value An approach that incorporates the salvage
capital expenditure value in payback computations
an outlay of funds by the firm that is expected Payback reciprocal
to produce benefits over a period of time Measures the rate of recovery of investment
greater than 1 year during the payback period
operating expenditure
an outlay resulting in benefits received within
1 year.
Fixed-asset outlays are capital expenditures, but not
all capital expenditures are classified as fixed assets. Accounting rate of return
Also known as simple rate of return
The capital budgeting process consists of five distinct Measures of project’s profitability from a
but interrelated steps. conventional accounting standpoint by
1. Proposal Generation relating the required investment to the future
2. Review and Analysis annual net income
3. Decision Making
4. Implementation
5. Follow-up

Two Categories of Investment

1. Independent projects are those whose cash
flows are unrelated to (or independent of) one
another; the acceptance of one project does
not eliminate the others from further
consideration. If accounting rate of return is greater than or
2. Mutually exclusive projects are those that equal to rate of return, accept. Otherwise,
have the same function and therefore compete reject.
with one another. The acceptance of one net present value (NPV)
eliminates from further consideration all other A sophisticated capital budgeting technique;
projects that serve a similar function. found by subtracting a project’s initial
unlimited funds investment from the present value of its cash
The financial situation in which a firm is able inflows discounted at a rate equal to the firm’s
to accept all independent projects that provide cost of capital.
an acceptable return. method used by most large companies to
capital rationing evaluate investment projects
The financial situation in which a firm has
only a fixed number of dollars available for
capital expenditures, and numerous projects
compete for these dollars.
accept–reject approach
The evaluation of capital expenditure
proposals to determine whether they meet the
firm’s minimum acceptance criterion.
If the NPV is greater than $0, accept the
ranking approach
project.
The ranking of capital expenditure projects on
If the NPV is less than $0, reject the project
the basis of some predetermined measure,
Profitability index
such as the rate of return.
A variation of the npv rule
payback period
the amount of time required for the firm to
recover its initial investment in a project, as
When the PI is greater than one, that implies
calculated from cash inflows.
that the present value of cash inflows is
 greater than the (absolute value of the) initial It is a method that recognizes the time value
cash outflow, so a profitability index greater of money in a payback context
than one corresponds to a net present value
greater than zero.
Economic Value Added
registered trademark of the consulting firm
Stern Stewart & Co., is another close cousin
of the NPV method
the EVA calculation asks whether a project
generates positive cash flows above and
beyond what investors demand. If so, then the
project is worth undertaking.
The EVA method determines whether a
project earns a pure economic profit. - A
profit above and beyond the normal
competitive rate of return in a line of business.
Major cash flow components
1. Initial investment. Relevant cash outflow at
internal rate of return (IRR) time zero.
one of the most widely used capital budgeting 2. Operating cash inflows. The incremental
techniques after-tax cash inflows resulting from
the discount rate that equates the NPV of an implementation of a project
investment opportunity with $0 3. Terminal cash flow. The after-tax
the rate of return that the firm will earn if it nonoperating cash flow occurring in the final
invests in the project and receives the given year of a project. It is usually attributable to
cash inflows liquidation of the project.
Expansion decisions

If the IRR is greater than the cost of capital,

accept the project.
If the IRR is less than the cost of capital,
reject the project
There is no guarantee that NPV and IRR will rank
projects in the same order. However, both methods
should reach the same conclusion about the
acceptability or non-acceptability of projects.

net present value profile

Graph that depicts a project’s NPVs for
various discount rates.
Useful in evaluating and comparing projects,
especially when conflicting rankings exist
conflicting rankings
Conflicts in the ranking given a project by
NPV and IRR, resulting from differences in
the magnitude and timing of cash flows.
intermediate cash inflows
Cash inflows received prior to the termination
of a project
multiple IRRs
More than one IRR resulting from a capital
budgeting project with a nonconventional cash
flow pattern; the maximum number of IRRs
for a project is equal to the number of sign
changes in its cash flows.
Discounted payback period
A capital budgeting method that determines
the length of time required for an investments
cash flows, discounted at the investments cost
of capital to cover its cost