Capital Budgeting

Chapter 26

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All

Capital Investment
Decisions
Outcome Investment involves a
is uncertain. long-term commitment.

Capital budgeting:
Analyzing alternative long-
term investments and deciding
which assets to acquire or sell.

Decision may be Large amounts of

difficult or impossible money are usually
to reverse. involved.
26-2
Capital Investment
Decisions
I will choose the
project with the most
profitable return on
available funds. Plant
Expansion
?
Limited
New
Investment ? Equipment
Funds
?
Office
Renovation
26-3
Capital Investment
Decisions:
Typical Cash Outflows

Repairs and Initial

maintenance investment

Incremental
operating
costs

26-4
Capital Investment
Decisions:
Typical Cash Inflows

Salvage Cost
value savings

Incremental
revenues

26-5
Payback Period
The payback period of an investment
is the time expected to recover
the initial investment amount.

Payback Cost of Investment

=
period Annual Net Cash Flow

Managers prefer investing

in projects with shorter
payback periods.
26-6
Payback Period

Ignores the
time value
of money.

Ignores cash
flows after
the payback
period.

26-7
Return on Average
Investment (ROI)
ROI focuses on annual income
instead of cash flows.

Average estimated net income

ROI =
Average investment

Original cost + Salvage value

2

26-8
Return on Average
Investment (ROI)
Income may vary from
year to year.
So why
Time
value of would I ever
money is ignored. want to use
this method
anyway?

26-9
Discounting Future Cash
Flows
Now let’s look at a capital
budgeting model that considers
the time value of cash flows.

26-10
Net Present Value (NPV)
A comparison of the present value of
cash inflows with the present value of
cash outflows.

26-11
Net Present Value (NPV)
Chose a discount rate – the
minimum required rate of return.

Calculate the present

value of cash inflows.

Calculate the present

value of cash outflows.

NPV = Pvinflows - PVoutflows

26-12
Relationship Between NPV
and
the Required Rate of Return
General decision rule . . .
If the Net Present
Value is . . . Then the Project is . . .
Acceptable, since it promises a
Positive . . . return greater than the required
rate of return (discount rate).

Acceptable, since it promises a

Zero . . . return equal to the required rate of
return (discount rate).

Not acceptable, since it promises

Negative . . . a return less than the required rate
of return (discount rate).

26-13
Behavioral Issues
in Capital Budgeting
Capital
Capital budgeting
budgeting involves
involves many
many
estimates.
estimates.
◦◦ Estimates
Estimates may
may be
be pessimistic
pessimistic or
or optimistic.
optimistic.
◦◦ Uncertainty
Uncertainty about
about the
the future
future may
may impact
impact
estimates.
estimates.

26-14
End of Chapter 26

26-15