CAPITAL BUDGETING  Increase revenues/reduce costs

 Selling for salvage value when a

 Capital budgeting – describe how
project ends
managers plan investments in projects
 WC that was tied up in a project
that have long-term implications
can be released for use at the
 Capital budgeting decision – decision
end of the project.
that involves a cash outlay now to
 Time value of money – a dollar
obtain a future earn
today is worth more than a
- Falls into 2 categories:
dollar year from now.
 Screening decisions – relate
- Capital investments that
to whether a proposed
promise earlier cash flows are
project is acceptable
preferable to those that
(whether it passes a preset
promise later cash flows.
hurdle) – required rate of
 Payback method – focuses on the
return is the minimum rate
payback period. Payback period –
of return a project must
length of time it takes for a project to
yield to be acceptable
recover its initial cost from the net cash
 Preference decisions –
inflows it generates. The more quickly
selecting from among
the cost of an investment can be
several acceptable
recovered, the more desirable it is.
alternatives
 When annual net cash inflow is
 The payback, NPV and IRR method
the same every year:
focus on analysing cash flows
Investment required
associated with capital investment Payback period=
Annual net cash inflow
projects. On the other hand, simple rate
 The payback method is not a
of return method focus on incremental
true measure of profitability. It
net operating income.
ignores all cash flows that occur
 Typical cash outflows – 3 most
after the payback period. It
common types of cash outflows:
doesn’t consider the time value
 Initial investment ( SV realized
of money.
from sale of old equipment can
 Can be used as a screening tool
be recognized as a reduction in
to help answer the question,
the initial investment)
“Should I consider this proposal
 Working capital – current assets
further?”
– current liabilities. When a
 Is often important to new
company takes on a new
companies that are “cash poor”
project, current asset accounts
 Is sometimes used in industries
often increase. (Ex. need for
where products become
additional inventory when
obsolete very rapidly
opening a new department)
 Depreciation is added back to
 Periodic outlays for repairs and
net operating income to obtain
maintenance and additional
annual net cash inflow.
operating costs.
Depreciation is not a cash
 Typical cash inflows – 3 most common outlay; thus it must be added
types of cash inflows:
 back to adjust net operating  Internal rate of return method - Internal
income to a cash basis. rate of return is the rate of return of an
 When cash inflows change from investment project over its useful life. It
year to year: is the discount rate that results in a NPV
Payback period= # of years up of zero.
to the year the investment is - The simplest and most direct
paid off + (unrecovered approach when the net cash inflow
investment beg.of the year in is the same every year is to divide
which the investment is paid the investment by the expected
off) / (cash inflow in the period annual net cash inflow. This
in which the investment is paid computation yields a factor from
off) which the IRR can be determined.
 NPV method – compares the PV of cash Investment required
Factor of IRR=
inflows to the PV of its cash outflows Annual net cash inflow
- 2 assumptions: - If IRR ≥ RRR, then the project is
 All cash flows other than acceptable. If IRR ≤ RRR, then the
the initial investment occur project is rejected.
at the end of periods.  Both NPV and IRR methods use the cost
 All cash flows generated by of capital to screen out undesirable
an investment project are investment projects.
immediately reinvested at a  When the IRR method is used, the cost
rate of return equal to the of capital is used as the hurdle rate that
discount rate. If this a project must clear for acceptance.
condition is not met, the  When the NPV method is used, the cost
NPV computations will not of capital is the discount rate is used to
be accurate. compute the NPV of a proposed
- PV 1.00 = PV factor for any cash project.
flow that occurs immediately  The NPV method is often simpler to use
- A positive NPV indicates the than the IRR method particularly when
project’s returns > discount rate. a project doesn’t have identical cash
- A negative NPV indicates the flows every year. If a project has some
project’s returns < discount rate. salvage value at the end of its life in
- If NPV is zero, it is acceptable addition to its annual cash inflows, the
because project’s returns = discount IRR method requires a trial-and-error
rate. process to find the rate of return that
 Cost of capital – minimum will result in a NPV of zero.
required rate of return. It is  Both methods assume that cash flows
the average rate of return generated by a project during its useful
that the company must pay life are immediately reinvested
to its creditors and elsewhere. However, the 2 methods
shareholders for use of make different assumptions concerning
their funds. It serves as a the rate of return that is earned on
screening device. those cash flows.
  The NPV method assumes  Screening decisions which come first
the rate of return is the pertain to whether or not a proposed
discount rate. investment is acceptable.
 The IRR method assumes  Preference decisions - come after and
the rate of return earned attempt to answer the question, “Which
on cash flows is the IRR. one(s) would be best for the company
 It is generally more realistic to accept?”
to assume that cash inflows - Are called rationing/ranking
can be reinvested at a rate decisions
of return equal to the - Either the IRR or NPV can be used.
discount rate. - When using the IRR method, the
 When the NPV and the IRR preference rule is: The higher the
method do not agree, it is IRR, the more desirable the project.
best to go with the NPV - The NPV of one project cannot be
method. directly compared to the NPV of
 Future cash flows are often uncertain or another project unless the initial
difficult to estimate. investments are equal.
 Intangible benefits such as 
greater reliability, speed and NPV of the project
Project profitability index=
higher quality certainly impact Investment required
future cash flows but the cash  The preference rule is: The
flow effects are difficult to higher the project profitability
estimate. index, the more desirable the
 If a discounted cash flow project.
analysis of just the tangible  The investment required refers
costs and benefits shows a to any cash outflows that occur
negative NPV, if the intangible at the beginning of the project,
benefits are large enough they reduced by any salvage value
could turn the negative NPV recovered from the sale of old
into positive. equipment. It also includes any
 The amount of additional cash investment in WC.
flow per year from the  Simple rate of return method – often
intangible benefits that would referred to as the
be needed to make the project accounting/unadjusted rate of return
finally attractive can be Annual incremental net operating income
computed as follows:
¿
Initial investment
NPV ¿ be offset ¿  The AINOI should be reduced by
PVA factor
the depreciation charges that
 This technique can also be used
result from making the
when the SV is difficult to
investment.
estimate.
- Suffers from 2 limitations:
NPV ¿ be offset ¿
PV factor  It focuses on accounting net
operating income rather than
cash flows. Thus if a project
 doesn’t have constant
incremental revenues and
expenses over its useful life, the
SRR will fluctuate from year to
year.
 It doesn’t involve discounting
cash flows.
 After an investment project has been
approved and implemented, a postaudit
should be conducted. A postaudit
involves checking whether or not
expected results are actually realized.
 The data used should be actual
observed data rather than
estimated data.