Basic Capital Budgeting Chapter #11 &

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Capital Budgeting
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Capital Budgeting Defined
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Capital Budgeting is making long-run planning decisions
for investing in projects
Capital Budgeting is a decision-making and control tool
that spans multiple years

Project-by-Project Dimension: one project spans

multiple accounting periods
Period-by-Period Dimension: one period contains
multiple projects
 Six Stages in Capital Budgeting
1. Identification Stage – determine which types of capital investments are
necessary to accomplish organizational objectives and strategies
2. Search Stage – explore alternative capital investments that will
achieve organization objectives
3. Information-Acquisition Stage – consider the expected costs and
benefits of alternative capital investments
4. Selection Stage – choose projects for implementation
5. Financing Stage – obtain project financing
6. Implementation and Control Stage – get projects under way and
monitor their performance

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Project Evaluation Technique-Pay Back Period Method
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Pay Back Period Method
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 Cash Flows Defined
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A. Net Initial Investment: Three D. Terminal Disposal of Investment:
Components:  Two Components:
1. Initial Machine Investment
1. After-tax cash flow from
2. Initial Working Capital Investment
terminal disposal of asset
3. After-tax Cash Flow from Current
(investment)
Disposal of Old Machine
B. Cash Flow from Operations Two 2. After-tax cash flow from
Components: recovery of working capital
4. Inflows (after-tax) from producing (liquidating receivables and
and selling additional goods or inventory once needed to
services, or from savings in support the project)
operating costs. Excludes
depreciation, handled below:
5. Income tax cash savings from
annual depreciation deductions
 Time Value Of Money
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Future Value (FV) The amount to which a
cash flow or series of cash flows will grow
over a given period of time when
compounded at a given interest rate
 Time Value of Money…Contd,
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 Present Value (PV)
 The value today of a future cash flow or series
of Cash Flows
 Opportunity Cost
 The rate of return you could earn on an
alternative investment
 t of similar
Present Value of an Ordinary Annuity
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FV of the funds for at least three reasons:
Opportunity.
Funds you have now could (in principle) be invested now, and
gain return or interest between the present and the future
time. You cannot use now funds that you will not have until a
"future" time. 
Risk. 
Funds you have now are not at risk, but funds arriving in the
future are uncertain. A well-known proverb states this
principle more colorfully: "A bird in the hand is worth two in
the bush."
Inflation.
A sum you have today will very likely buy more than an equal
amount you will not have until years in future. The buying
power of money decreases over time due to inflation

Present Value (PV) The value

today of a future cash flow or
series of cash flows.
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 Income Taxes and Capital Budgeting
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Cash flows from an investment proposal affect the
company’s profit and its income tax liability.

Income = Revenue - Expenses + Gains - Losses

 High Country Department Stores
Income Statement
After-Tax Cash Jun
For the Year Ended
16- Flows
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30, 2007

Revenue $ 1,000,000
Expenses (475,000)
Income before taxes 525,000
Income taxes (210,000)
Net Income 315,000

The
The tax
tax rate
rate is
is 40%,
40%, so
so income
income taxes
taxes are
are
$525,000
$525,000 ×× 40%
40% == $$ 210,000
210,000
Not
Not all
all expenses
expenses require
require cash
cash outflows.
outflows. The
The most
most common
common example
example is
is depreciation.
depreciation.
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Discounted Cash Flows Methods- NPV & IRR
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 C. Ranking Investment
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Projects
We
We can
can invest
invest in
in either
either of
of these
these projects.
projects. Use
Use aa 10%
10%
discount
discount rate
rate to
to determine
determine thethe net
net present
present value
value of
of
the
the cash
cash flows.
flows.
Project A Project B
Immediate cash outlay $ 100,000 $ 100,000
Cash inflows:
Year 1 $ 50,000 $ 30,000
Year 2 40,000 40,000
Year 3 30,000 50,000
Total inflows $ 120,000 $ 120,000

The total cash flows are the same, but the pattern of the flows is
different.
 Ranking Investment
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Projects
Here is the net present value of the cash flows
associated with Project B.

Project B PV Factor PV
Immediate cash outlay $(100,000) 1.000 $(100,000)
Cash inflows:
Year 1 $ 30,000 0.909 27,270
Year 2 40,000 0.826 33,040
Year 3 50,000 0.751 37,550
Net present value $ (2,140)

Project
Project BB has
hasaanegative
negative net
netpresent
present value
value which
whichmeans
means
the
the project’s
project’s return
returnis
is less
less than
than the
the discount
discountrate.
rate.
 Ranking Investment
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Projects
Here is the net present value of the cash flows
associated with Project B.

Project B PV Factor PV
Immediate cash outlay $(100,000) 1.000 $(100,000)
Cash inflows:
Year 1 $ 30,000 0.909 27,270
Year 2 40,000 0.826 33,040
Year 3 50,000 0.751 37,550
Net present value $ (2,140)

Project
Project BB has
hasaanegative
negative net
netpresent
present value
value which
whichmeans
means
the
the project’s
project’s return
returnis
is less
less than
than the
the discount
discountrate.
rate.
 Ranking Investment
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Projects
Let’s calculate the present value of the cash flows
associated with Project A.

Project A PV Factor PV
Immediate cash outlay $(100,000) 1.000 $(100,000)
Cash inflows:
Year 1 $ 50,000 0.909 45,450
Year 2 40,000 0.826 33,040
Year 3 30,000 0.751 22,530
Net present value $ 1,020

This
This project
projecthas
has aapositive
positive net
netpresent
present value
valuewhich
which means
means
the
theproject’s
project’s return
returnis
is greater
greaterthan
thanthe
the discount
discount rate.
rate.
Rationale of DCF Methods
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 Rationale of DCF Methods
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Data: Original Investment $3,791,
Useful Life 5 years; Present Value factor/ DCF
/WAAC 8%
and Annual Cash inflows after taxes $ 1,000 If IRR > WACC then the project is
profitable.
If IRR > k = accept
If IR < k = reject

Multiple IRRs The situation

where a project has two or
more IRRs.
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 Multiple IRRs The situation where a project
has two or more IRRs.
 Choosing the16-
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Hurdle Rate
The discount rate generally is
associated with the company’s
cost of capital.
The cost of capital involves a
blending of the costs of all sources
of investment funds, both debt
and equity.
Comparing the NPV and IRR Methods 16-
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The
The net
net present
present value
value method
method hashas
the
the following
following advantages
advantages over over
the
the internal
internal rate
rate of
of return
return
method
method .. .. ..
 Easier
Easier to
to use.
use.
 Easier
Easier to
to adjust
adjust for
for risk.
risk.
Assumptions Underlying Discounted-Cash-
Flow Analysis
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Assumes a
All cash flows are perfect
treated as though capital
they occur at year end. market.

Cash inflows are

Cash flows are immediately
treated as if reinvested at
they are known the required
with certainty. rate of return.
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Modified IRR Method..Contd.,
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 A graph showing the relationship between a project’s

NPV and the firm’s cost of capital .

 Crossover Rate The cost of capital at which the NPV
profiles of two projects cross and, thus, at which the
projects’ NPVs are equal.
Comparing Two Investment Projects 16-
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To compare competing investment projects we can use
the following net present value approaches:
 Total-Cost Approach.
 Incremental-Cost Approach.
 Total-Cost16-
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Approach
Each system would last five years.
12 percent hurdle rate for the analysis.

MAINFRAME PC _
Salvage value old system $ 25,000 $ 25,000
Cost of new system (400,000) (300,000)
Cost of new software ( 40,000) ( 75,000)
Update new system ( 40,000) ( 60,000)
Salvage value new system 50,000 30,000
================================================
Operating costs over 5-year life:
Personnel (300,000) (220,000)
Maintenance ( 25,000) ( 10,000)
Other costs ( 10,000) ( 5,000)
Datalink services ( 20,000) ( 20,000)
Revenue from time-share 25,000 -
 Total-Cost Approach
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MAINFRAME ($) Today Year 1 Year 2 Year 3 Year 4 Year 5
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Acquisition cost computer (400,000)
Acquisition cost software ( 40,000)
System update ( 40,000)
Salvage value 50,000
Operating costs (335,000) (335,000) (335,000) (335,000) (335,000) (335,000)
Time sharing revenue 20,000 20,000 20,000 20,000 20,000 20,000
Total cash flow 440,000 (315,000) (315,000) (355,000) (315,000) (265,000)
X Discount factor X 1.000 X .893 X .797 X .712 X .636 X .567
Present value (440,000) (281,295) (251,055) (252,760) (200,340) (150,255)
SUM = ($1,575,705)
PERSONAL COMPUTER ($) Today Year 1 Year 2 Year 3 Year 4 Year 5
Acquisition cost computer (300,000)
Acquisition cost software ( 75,000)
System update ( 60,000)
Salvage value 50,000
Operating costs (235,000) (235,000) (235,000) (235,000) (235,000) (235,000)
Time sharing revenue -0- -0- -0- -0- -0- -0- _
Total cash flow 375,000 (235,000) (235,000) (295,000) (235,000) (205,000)
X Discount factor X 1.000 X .893 X .797 X .712 X .636 X .567
Present value (375,000) (209,855) (187,295) (210,040) (149,460) (116,235)
SUM = ($1,247,885)
 Total-Cost16-
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Approach

Net cost of purchasing Mainframe system ($1,575,705)

Net cost of purchasing Personal Computer system ($1,247,885)
Net Present Value of costs ($ 327,820)

Mountainview should purchase the personal

computer system for a cost savings of
$327,820.
 Incremental-Cost Approach
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INCREMENTAL ($)
Today Year 1 Year 2 Year 3 Year 4 Year 5
Acquisition cost computer (100,000)
Acquisition cost software 35,000
System update 20,000
Salvage value 20,000
Operating costs (100,000) (100,000) (100,000) (100,000) (100,000)
Time sharing revenue 20,000 20,000 20,000 20,000 20,000 20,000
Total cash flow ( 65,000) ( 80,000) ( 80,000) ( 80,000) ( 80,000) ( 60,000)
X Discount factor X 1.000 X .893 X .797 X .712 X .636 X .567
Present value ( 65,000) ( 71,440) ( 63,760) ( 42,720) ( 50,880) ( 34,020)
SUM = ($ 327,820)
 Total-Incremental Cost Comparison
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Total Cost:
Net cost of purchasing Mainframe system ($1,575,705)
Net cost of purchasing Personal Computer system ($1,247,885)
Net Present Value of costs ($ 327,820)
Incremental Cost:
Net Present Value of costs ($ 327,820)

Different methods, Same results.

End of Chapter
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