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Chapter 12
The Capital Budgeting
Decision
Chapter 12 - Outline
 What is Capital Budgeting?
 3 Methods of Evaluating Investment Proposals
 Payback
 IRR
 NPV
 Accept/Reject Decisions
 Capital Rationing
 Determining Whether to Purchase a Machine
What is Capital Budgeting?
Capital Budgeting:
– represents a long-term investment decision
– involves the planning of expenditures for a project with a life of
many years
– usually requires a large initial cash outflow with the expectation
of future cash inflows
– uses present value analysis
– emphasizes cash flows rather than income
Cash flow for
Alston Corporation
Revised cash flow for
Alston Corporation
Categories for depreciation write-off
Depreciation
percentages
(expressed in
decimals)
Depreciation schedule
Investment alternatives
3 Methods of Evaluating
Investment Proposals
3 widely used methods of evaluating investment proposals:
 Payback Method (PB)
 Internal Rate of Return (IRR)
 Net Present Value (NPV)
Payback Method
Payback Method (PB):
– computes the amount of time required to recoup the initial investment
Advantages:
– easy to use (“quick and dirty” approach)
– emphasizes liquidity
Disadvantages:
– ignores inflows after the cutoff period and fails to consider the time
value of money
– is inferior to the other 2 methods
Internal Rate of Return
Internal Rate of Return (IRR):
– represents a yield on an investment or an interest rate
– requires calculating the interest rate that equates the cash
outflows (cost) with the cash inflows
– is the interest rate where the cash outflows equal the cash
inflows (or NPV = 0)
– reinvestment assumption and magnitude considerations may
make the results misleading
Solving for Rate of Return (r) with
uneven cash flows
0 = C0 + C1
(1 + r)1
+
C2
+ . . .
(1 + r)2
•Spreadsheets (use financial function =IRR)
•Financial calculators (IRR using cash flow register)
•Manual (Trial and error until PV of all cash flows equal
zero)
Net Present Value
Net Present Value (NPV):
– the present value of the cash inflows minus the present value of the cash
outflows
– the cash inflows are discounted back over the life of the investment
Net Present Value in the General
discounted cash flow formula
NPV = C0 +
C1
(1 + r)1
+
C2
(1 + r)2
+ . . .
Accept/Reject Decision
Payback Method (PB):
–if PB period < cutoff period, accept the project
– if PB period > cutoff period, reject the project
Internal Rate of Return (IRR):
– if IRR > cost of capital, accept the project
– if IRR < cost of capital, reject the project
Net Present Value (NPV):
– if NPV > 0, accept the project
– if NPV < 0, reject the project
Capital Rationing
 A limit or constraint on the amount of funds that can be invested
 Can rank investments based on their NPVs. Those with positive NPVs
are accepted until all funds are exhausted.
 Or could base decisions based on most value for the buck.
- Then would rank based on highest Profitability Index:
Profitability Index = PV inflows / PV outflows
Determining Whether to
Purchase a Machine
To make the actual investment decision:
– calculate a depreciation schedule
– figure earnings and cash flow (CF)
– discount the cash flows back to the present to determine whether the
machine should be purchased (only if NPV > 0)
Capital budgeting
results
Another example
Cash flow related to the
purchase of machinery
Assuming cost of capital is 10%