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Capital Budgeting
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Capital Budgeting:
How managers plan
significant outlays on projects
that have long-term implications
(such as the purchase of new
equipment or introduction of new
products).
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Methods for
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Capital Budgeting Decisions

Methods which do not consider the time value
of money:
* Payback Method
* Simple Rate of Return
Method that does consider the time value of money:
* Net Present Value (NPV) Method covered here
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Time Value of Money

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 Business investments extend

over long periods of time.
 Investments that promise
returns earlier in time are
preferable to those that
promise returns later in time.
 As such, the time value of
money must be considered.
A dollar today is worth more than
a dollar a year from now
since a dollar received today can be invested -
yielding more than a dollar a year from now.
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Typical Cash Outflows

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Repairs and
maintenance

Working Initial
capital investment

Incremental
operating
costs
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Typical Cash Inflows

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Salvage
value

Release of
Reduction
working
of costs
capital

Incremental
revenues
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The Net Present Value Method

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To determine net present value:

* Calculate the present value of cash inflows,
* Calculate the present value of cash outflows,
* Subtract the present value of the outflows
from the present value of the inflows.
* Apply the general decision rule.
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The Net Present Value Method

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General decision rule . . .

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Choosing a Discount Page

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(or Hurdle)Rate
 The firm’s cost of capital is
usually regarded as the most
appropriate choice for the
discount (or hurdle) rate.
 The cost of capital is the
average rate of return the
company must pay to its
long-term creditors and
stockholders for the use
of their funds.
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Simple Illustration
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of the NPV Method

Carver Hospital is considering the purchase of an

attachment for its X-ray machine.
No investments are made unless they have an annual
return of at least 10%.
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Present Value of Initial Investment Here

Start with the present value of the initial investment(s):

Since the initial investment takes place immediately,

the present value of the initial investment equals the outflow.
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Present Value of Cash Inflows Here

Calculate the present value(s) of the other cash flows:

An annuity

x =

Discount (or Hurdle)

Rate

Periods 10% 12% 14%

Present
Present value
value 1 0.909 0.893 0.877
2 1.736 1.690 1.647
of
of an
an annuity
annuity 3 2.487 2.402 2.322
of
of $1
$1 table
table 4 3.170 3.037 2.914
5 3.791 3.605 3.433
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Illustration of the NPV Method Here

Determine the NPV of the cash flows (subtract the present value(s)
of the cash outflow(s) from the present value(s) of the cash inflow(s)):

Apply general decision rule:

Because
Becausethethenet
netpresent
presentvalue
valueis
isequal
equalto
tozero,
zero,
the
theinvestment
investmentprovides
providesexactly
exactlyaa10%
10%return.
return.
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Another Illustration
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Lester Company has been offered a five year contract to provide

component parts for a large manufacturer:

At the end of year 5, the working capital will be released for use
elsewhere. Lester Company uses a discount (or hurdle) rate of 10%.
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Present Value of Page

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Initial Investments
Start with the present value of the initial investment(s):

Since the initial investments

(the investment in the equipment and the working capital needed)
take place immediately,
the present values equal those outflows.
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Present Values Page

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of Other Cash Flows

Calculate the present value of the other cash flows:
Annual net cash inflows from operations:

An annuity

x =

Present value of an annuity of $1 factor for 5 years at 10%.

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Present Value Page

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of Other Cash Flows

Calculate the present value of the other cash flows, continued:

Cash outflow to reline equipment at end of year 3

A single payment

x =

Present value of $1 factor for 3 years at 10%.

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Present Value Page

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of Other Cash Flows

Calculate the present value of the other cash flows, continued:

Cash inflows from sale of equipment and release of

working capital at end of year 5
Single payments

x =
x =

Present value of $1 factor for 5 years at 10%.

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Apply General Decision Rule

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Determine the NPV of the cash flows (subtract the present value(s)
of the cash outflow(s) from the present value(s) of the cash inflows)):

Apply general decision rule:

The project has a positive net present value
(that is, its return is greater than 10%); accept the project.