Professional Documents
Culture Documents
Prepared by
Karleen Nordquist..
The College of St. Benedict...
and St. John’s University....
Capital Budgeting
Chapter 10
Capital Budgeting
Additional Considerations
• Intangible Benefits
• Mutually Exclusive Projects
• Risk Analysis
• Post-audit of Projects
CAPITAL
Other Capital Budgeting
BUDGETING
Techniques
• Internal Rate of Return
• Comparing Discounted Cash
Flow Methods
• Annual Rate of Return
Capital Budgeting
The process of making capital expenditure
decisions is known as capital budgeting.
Capital budgeting involves choosing among
various capital projects to find one(s) that
will maximize a company’s return on its
financial investment.
Study Objective 1
Cost of Capital
Investment Net Annual
Cash Inflow =
Cash Payback
Period
Illustration 10-4
Less
Capital Investment
Equals
If zero or positive: If negative:
Net Present Value
Accept Reject
Proposal Proposal
Illustration 10-5
Equal Annual Cash Flows
Example
Stewart’s annual cash inflows are $24,000. If we assume this
amount is uniform over the asset’s useful life, the present value
of its annual cash flows can be computed as shown:
PV at 12%
Discount factor for annuity of $1
for 10 periods 5.65022
negative NPV.
Simplifying Assumptions
In the examples of the NPV method, a number of
simplifying assumptions have been made:
All cash flows come 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.
Because these assumptions are rarely all true in the
“real world,” NPV provides estimated analysis.
Some of these assumptions are relaxed in more
advanced capital budgeting techniques.
Comprehensive Example
Best Taste Foods is considering investing in new
equipment to produce fat-free snack foods. The following
information was determined in consultation with various
company departments:
Initial investment $1,000,000
Cost of equipment overhaul in 5 years $ 200,000
Salvage value of equipment in 10 years $ 20,000
Cost of capital 15%
Estimated annual cash flows:
Cash inflows received from sales $500,000
Cash outflows for cost of goods sold $200,000
Maintenance costs $ 30,000
Other direct operating costs $ 40,000 Illustration 10-11
Comprehensive Example
The computation of the net annual cash inflows for the
project is shown below:
Cash inflows received from sales $500,000 Illustration 10-12
Cash outflows for cost of goods sold (200,000)
Maintenance costs (30,000)
Other direct operating costs (40,000)
Net annual cash inflow $230,000
Present Value
of Cash Flows Initial
Investment =
Profitability
Index
Illustration 10-17
Profitability Index Example
A company must choose between two mutually exclusive
projects. Each project has a 10-year life and a 12%
discount rate can be assumed. Data related to the two
projects is as shown: Project A Project B
Initial investment $40,000 $90,000
Net annual cash inflows 10,000 19,000
Salvage value 5,000 10,000
Illustration 10-16 Net present value 18,112 20,574
With the data in this form, profitability indexes for the two
projects can be computed. Profitability Index = Present Value of Cash Flows
Initial Investment
Project A Project B
Capital Net Annual Internal Rate of
Investment Cash Inflow = Return Factor
Illustration 10-20
Using the Tampa Company data, the internal rate
of return factor is computed as follows:
$249,000 $45,000 = 5.5333
Internal Rate of Return
Step 2: Use the factor and the present value of an
annuity of 1 table to find the internal rate of return.
For Tampa, the net annual cash inflow is expected to
continue for 8 years. Thus, it is necessary to read across
the period-8 row in the present value of an annuity table
to find the discount factor that is closest to the internal
rate of return factor.
Periods 5% 6% 8% 9% 10% 11% 12% 15%
8 6.46321 6.20979 5.74664 5.53482 5.33493 5.14612 4.96764 4.8732
Compared to:
If equal to or
greater than: If less than:
Minimum
Rate of Return
Accept Reject
Proposal Proposal
Illustration 10-21
Comparing Discounted
Cash Flow Methods
A comparison of the two discounted cash flow methods (net
present value and internal rate of return) is presented
below.
When used properly, either method will provide management
with relevant quantitative data for making capital budget
decisions.
Net Present Value Internal Rate of Return
1. Objective Compute net present Compute internal rate of
value (a dollar amount). return (a percentage).
2. Decision rule If net present value is If internal rate of return is equal
zero or positive, accept to or greater than the
the proposal; if net minimum required rate of
present value is return, accept the proposal;
negative, reject the if internal rate of return is
proposal. less than the minimum rate,
Illustration 10-22 reject the proposal.
Study Objective 8
Expected
Average Annual Rate of
Annual Net
Income
Investment = Return