Class 12

1.Describe capital budgeting inputs.

Cash Flow Information

For purposes of capital budgeting, though, estimated cash inflows and outflows are the preferred
inputs.

Illustrative Data

2.Apply the payback technique.

Cash Payback
The cash payback technique identifies the time period required to recover the cost of the capital
investment from the net annual cash flow produced by the investment.

Net annual cash flow can also be approximated by “Net cash provided by operating
activities” from the statement of cash flows.

It follows that when the payback technique is used to decide among acceptable alternative
projects, the shorter the payback period, the more attractive the investment.

In the case of uneven net annual cash flows, the company determines the cash payback period
when the cumulative net cash flows from the investment equal the cost of the investment.

However, cash payback should not ordinarily be the only basis for the capital budgeting decision
because it ignores the expected profitability of the project.

A further—and major—disadvantage of this technique is that it ignores the time value of money.

3.Use the net present value method.

Capital budgeting techniques that take into account both the time value of money and the
estimated net cash flows from an investment are called discounted cash flow techniques.
The primary discounted cash flow technique is the net present value method. A second method,
discussed later in the chapter, is the internal rate of return.

The net present value (NPV) method involves discounting net cash flows to their present value
and then comparing that present value with the capital outlay required by the investment. The
difference between these two amounts is referred to as net present value (NPV).
This rate, often referred to as the discount rate or required rate of return.

The NPV decision rule is this: A proposal is acceptable when net present value is zero or
positive.

The required rate of return is management’s minimum acceptable rate of return on

investments, sometimes called the discount rate or cost of capital.
When making a selection among acceptable proposals, the higher the positive net present value,
the more attractive the investment

Equal Annual Cash Flows

Table 4

Unequal Annual Cash Flows

When net annual cash flows are unequal, we cannot use annuity tables to calculate their present
value. Instead, we use tables showing the present value of a single future amount for each annual
cash flow.
Table 3

Choosing a Discount Rate

In most instances, a company uses a required rate of return equal to its cost of capital—that is,
the rate that it must pay to obtain funds from creditors and stockholders.

Cost of capital is the rate that management expects to pay on all borrowed and equity
funds. It does not relate to the cost of funding a specific project.

Positive net present values increase the value of the firm.

The higher the risk the higher the return.

The discount rate is often referred to by alternative names, including the required rate of
return, the hurdle rate, and the cutoff rate.

Simplifying Assumptions
-All cash flows occur at the end of each year.
-All cash flows are immediately reinvested in another project that has a similar return.
-All cash flows can be predicted with certainty.

Comprehensive Example

4.Use the internal rate of return method.

The internal rate of return method differs from the net present value method in that it finds the
interest yield of the potential investment. The internal rate of return (IRR) is the interest rate
that causes the present value of the proposed capital expenditure to equal the present value of the
expected net annual cash flows (that is, NPV equal to zero).

The IRR helps a company determine if it should invest in a proposed project.

The IRR decision rule is as follows: Accept the project when the internal rate of return is
equal to or greater than the required rate of return. Reject the project when the internal
rate of return is less than the required rate of return.

Comparing Discounted Cash Flow Methods

5.Use the annual rate of return method.

The final capital budgeting technique we will look at is the annual rate of return method.
It indicates the profitability of a capital expenditure by dividing expected annual net income by
the average investment.
Management then compares the annual rate of return with its required rate of return for
investments of similar risk. The decision rule is A project is acceptable if its rate of return is
greater than management’s required rate of return. It is unacceptable when the reverse is true.
When companies use the rate of return technique in deciding among several acceptable projects,
the higher the rate of return for a given risk, the more attractive the investment.

A capital budgeting decision based on only one technique may be misleading. It is often
wise to analyze an investment from a number of different perspectives.

6.Show how the profitability index method is used for mutually exclusive projects.

However, companies rarely are able to adopt all positive-NPV proposals. First, proposals often
are mutually exclusive.

Even in instances where projects are not mutually exclusive, managers often must choose
between various positive-NPV projects because of limited resources.
One relatively simple method of comparing alternative projects is the profitability index. This
method takes into account both the size of the original investment and the discounted cash flows.

The profitability index helps a company determine which investment proposal to accept.

7.Identify capital budgeting challenges and refinements (e.g., risk analysis).

Intangible Benefits

Intangible benefits might include increased quality, improved safety, or enhanced employee
loyalty. By ignoring intangible benefits, capital budgeting techniques might incorrectly eliminate
projects that could be financially beneficial to the company.

To avoid rejecting projects that actually should be accepted, analysts suggest two possible
approaches:
1. Calculate net present value ignoring intangible benefits. Then, if the NPV is negative, ask
whether the project offers any intangible benefits that are worth at least the amount of the
negative NPV.
2. Project conservative estimates of the value of the intangible benefits, and incorporate
these values into the NPV calculation.
Risk Analysis

A simplifying assumption made by many financial analysts is that projected results are known
with certainty. In reality, projected results are only estimates based upon the forecaster’s belief as
to the most probable outcome. One approach for dealing with such uncertainty is sensitivity
analysis. Sensitivity analysis uses a number of outcomes estimates to get a sense of the
variability among potential returns.

Post-Audit of Investment Projects

Any well-run organization should perform an evaluation, called a post-audit, of its investment
projects after their completion. A post-audit is a thorough evaluation of how well a project’s
actual performance matches the original projections.