Chapter What you Really Need to Know

10 A. The term capital budgeting is used to describe planning major outlays on

projects that commit the company for some time into the future such as
purchasing new equipment, building a new facility, or introducing a new
product.

1. Capital budgeting involves investment, committing funds now to

obtain a return in the future.

2. Capital budgeting decisions fall into two broad categories:

a. Screening decisions: Potential projects are categorized as

acceptable or unacceptable based on some pre-set
standard.

b. Preference decisions: Projects must be ranked because

funds are insufficient to support all of the acceptable projects.
These decisions are made subsequent to the screening
decision and are more difficult to make.

3. The time value of money should be considered as investments

involve returns overly fairly long periods of time. A dollar today does
not have the same value or worth in the future so capital budgeting
techniques involve discounted cash flow methods which give full
recognition to the time value of money. Several approaches can be
used to evaluate investments using discounted cash flows including
the:

a. net present value method

b. internal rate of return method

B. The difference between the present value of a project’s cash inflows and its
cash outflows is referred to as net present value (NPV). The NPV method
is illustrated in Example A and in Example B and includes the following
basic steps:

1. Determine the required investment.

2. Determine the future cash inflows and outflows that result from the
investment.

3. Use the present value tables to find the appropriate present value
factors.

a. The values (or factors) in the present value tables depend on

the discount rate and the number of periods (usually years).

b. The discount rate is the company's required rate of return,

which is often the company's cost of capital. The cost of
capital is the average rate of return the company must pay its
 long-term creditors and shareholders for the use of their
funds. The details of the cost of capital are covered in
finance courses.

4. Multiply each cash flow by the appropriate present value factor and
then sum the results. The end result (which is net of the initial
investment) is called the net present value of the project.

5. In a screening decision, if the net present value is zero (return =

required rate of return) or positive (return > required rate of return),
the investment is acceptable. If the net present value is negative
(return < required rate of return), the investment should be rejected.

C. Discounted cash flow analysis is based entirely on cash flows—not on

accounting net income. Accounting net income is based on accrual
concepts which ignore the timing of cash flows.

1. Typical cash flows associated with an investment are:

a. Outflows: initial investment (including installation costs);

increased working capital needs; repairs and maintenance;
and incremental operating costs.

b. Inflows: incremental revenues; reductions in costs; salvage

value; and release of working capital at the end of the
project.

2. Depreciation is not a cash flow and therefore is not part of the

analysis. Depreciation for tax purposes, which is called capital cost
allowance, can affect taxes and therefore cash flow. This aspect of
depreciation is briefly discussed in Appendix 10C but more readily
covered in advanced corporate finance texts.)

3. Quite often, a project requires an infusion of cash (i.e., working

capital) to finance inventories, receivables, and other working capital
items. Typically, at the end of the project these working capital items
can be liquidated (i.e., the inventory can be sold) and the cash that
had been invested in these items can be recovered. Thus, working
capital is counted as a cash outflow at the beginning of a project and
as a cash inflow at the end of the project.

4. We usually assume that all cash flows, other than the initial
investment, occur at the end of a period.

5. Under NPV, cash flows are only considered on an after-tax basis

which means using an after-tax discount rate.

6. All financing related cash flows are ignored as the impact on the
project of the financing decision made to fund the project is captured
in the cost of capital or discount rate.
D. The NPV method can be used to compare competing projects using the
total-cost approach or the incremental-cost approach:

1. The total-cost approach is the most flexible method. Example C and

Exhibit 10-5 illustrate this approach. Note in Exhibit 10-5 that all
cash inflows and all cash outflows are included in the solution under
each alternative rather than only focusing on relevant cash flows.

2. The incremental-cost approach is a simpler and more direct route to

a decision since it ignores all cash flows that are the same under
both alternatives as these are irrelevant. Exhibit 10-6 shows this
approach.

3. The total-cost and incremental-cost approaches lead to the same

decision.

E. Sometimes no revenue or cash inflow is directly involved in a decision. In

this situation, the alternative with the least cost should be selected. The
least cost alternative can be determined using either the total-cost approach
or the incremental approach. Exhibits 10-7 and 10-8 illustrate least-cost
decisions.

F. Preference decisions involve ranking investment projects which is

necessary whenever funds available for investment are limited.

1. Preference (rationing or ranking) decisions are sometimes called

ranking decisions or rationing decisions because they ration limited
investment funds among competing investment opportunities.

2. The net present value of one project should not be compared

directly to the net present value of another project, unless the
investments in the projects are equal in size.

a. To make a valid comparison between projects that require

different investments, a project profitability index is
computed. The formula for the index is:

This is basically an application of the idea related to the

utilization of a scarce resource. In this case, the scarce
resource is the investment funds. The project profitability
index is similar to the contribution margin per unit of the
scarce resource.

b. The preference rule when using the project profitability index

is: The higher the project profitability index, the more
desirable the project.
G. The internal rate of return method is another discounted cash flow method
used in capital budgeting decisions.

1. The internal rate of return is the rate of return promised by an

investment project over its useful life; it is the discount rate that
results in a net present value of zero for the project.

2. When the cash flows are the same every year, the following formula
can be used to find the internal rate of return:

3. For example, assume an investment of $6,710 is made in a project

that will last ten years and has no salvage value. Also assume that
the annual cash inflow from the project will be $1,000.

Since this is a project with a ten-year life, use the 10-year row in
Exhibit 10-2 which provides the present value factors for an annuity.
(This is an annuity since the same cash inflow is received at the end
of every year beginning with the first year). Scanning along the 10-
year row, it can be seen that this factor represents an 8% rate of
return. You can verify that this calculation is correct by computing
the net present value of the investment:

($1,000 x 6.710) -$6,710 = 0

4. If the cash inflows are not the same every year, the IRR is found
using trial and error or using a computer program or spreadsheet
such as Microsoft Excel. The internal rate of return is whatever
discount rate that makes the net present value of the project equal
zero.

5. In a screening decision, the IRR is compared to the required rate of

return (cost of capital). If the IRR is less than the required rate of
return, the project is rejected. If it is greater than or equal to the
required rate of return, the project is accepted.

H. Two other approaches to capital budgeting, which do not involve

discounting cash flows, are the payback method and the simple rate of
return method.

1. The payback method focuses on how long it takes for a project to

recover its initial cost out of the cash receipts it generates. The
payback period is expressed in years.
 a. When the cash inflows from the project are the same every
year, the following formula can be used to compute the
payback period:

b. When the cash inflows from the project are not the same
every year, the payback period must be derived by tracking
the unrecovered investment year by year.

c. If new equipment is replacing old equipment, the "investment

required" should be reduced by any salvage value obtained
from the disposal of old equipment. And in this case, when
computing the "net annual cash inflows," only the
incremental cash inflow provided by the new equipment over
the old equipment should be used.

2. The payback period is not a measure of profitability, but a measure

of how long it takes for a project to recover its investment cost.

3. The payback method ignores the time value of money and ignores
all cash flows that occur once the initial cost has been recovered.
Therefore, this method should be used only with a great deal of
caution. Nevertheless, the payback method can be useful in
industries where project lives are very short and uncertain.

I. The simple rate of return (accounting or unadjusted rate of return; also

known as the financial statement method) method is another capital
budgeting method that does not involve discounted cash flows.

1. The simple rate of return method focuses on accounting net

operating income, rather than on cash flows. The formula for its
computation is:

If new equipment is replacing old equipment, then the "initial

investment" in the new equipment is the cost of the new equipment
reduced by any salvage value obtained from the old equipment. The
incremental net operating income is equal to the incremental
revenues less the incremental expenses (including depreciation).

2. If a cost reduction project is involved, then the formula used would

be:

Simple rate = Cost savings – Depreciation on new equipment

of return Initial Investment
 3. Like the payback method, the simple rate of return method does not
consider the time value of money. Therefore, the rate of return
computed by this method may be misleading.

J. A key part of the capital budgeting process is to conduct a postaudit by

following-up to see whether expected results are realized. If a project was
approved on the basis of a net present value analysis, then the same
procedure should be used to perform the postaudit by using actual
observed data rather than estimated data.

Appendix 10A: The Concept of Present Value

A. A dollar received today is more valuable than a dollar received a year from
now for the simple reason that if you have a dollar today, you can put it in
the bank and have more than a dollar a year from now. As such, the theory
of interest provides us with the means to weight cash flows that are
received at different times for comparison purposes. A present outlay is
known as the present value or discounted value of the future.

B. Compound interest refers to interest earned on interest. If you earn $5 on a

$100 deposit and retain that $5 in your account then for the next period you
will not only earn interest again on the $100 but also on the $5 interest you
earned in the earlier period and kept in your account. Interest can be
compounded on a semiannual, quarterly, or even more frequent basis.

C. If we know the value, today, of a sum of money (such as the $100 deposit),
it is a relatively simple task to compute the sum’s future value in n years by
using formula (6). On the other hand, the present value of any sum to be
received in the future can be computed by turning formula (6) around and
solving for P. Fortunately, tables are available in which many of the
calculations have already been done for you. Exhibit 10–1 in the chapter
shows the discounted present value of $1 to be received at various periods
in the future at various interest rates.

D. Although some investments involve a single sum to be received (or paid) at

a single point in the future, other investments involve a series of cash flows.
A series (or stream) of identical cash flows is known as an annuity. Exhibit
10-2 in the chapter provides the present value factors for a series of cash
flows considering the number of periods and the interest rate.

Appendix 10B: Inflation and Capital Budgeting

A. Inflation is the term commonly used to refer to increases in the price level of
an economy as time passes. Capital budgeting analysis should reflect
inflation, if it exists, to enable managers to make appropriate decisions.

B. The current year is referred to as the base year. All the future cash flows
are said to be real cash flows. Real cash flows are cash flows whose
purchasing power is equal to the purchasing power of money in the base
year. The impact of inflation is that it increases the price level in future
years. A price index number tells you how to determine the price level in a
 future year given the base year’s price level and the rate of inflation. A price
index number is calculated using the following formula:

Price index number for year n = (1 + inflation rate)n

C. By multiplying a real cash flow by the corresponding price index number,

the original real cash flow can be expressed in terms of the purchasing
power of money in the year the cash flow is received. Such cash flows are
called nominal cash flows.

D. When the cost of capital also includes an inflation premium, it is called the
nominal rate of return. Nominal rates are also referred to as market-based
returns because the market rates always reflect expected inflation. Refer to
formula (10) in appendix 10B.

Appendix 10C: Income Taxes and Capital Budgeting Decisions

A. Income tax is a cash outflow and we must consider after-tax cash flows
when doing a capital budgeting analysis. After-tax cash flow is calculated
as:

After-tax cash flow = Pre-tax cash flow × (1 − tax rate)

B. The most important noncash tax-deductible expense is depreciation.

However, for income tax purposes, the CRA allows a company to deduct
only CCA. Depreciation calculated by any other method, even if permitted
under generally accepted accounting principles (GAAP), is not allowed as a
deduction. The method of calculating CCA is the declining balance method
where the amount to be depreciated is multiplied by the depreciation rate to
obtain the capital cost allowance. This rate is provided by CRA according to
the class of the asset.

C. The CCA calculated in the first year of asset ownership is based on a

depreciation rate that is 1.5 times the rate applicable to subsequent years.
This is the Accelerated Investment Incentive. The reason for this rule is to
encourage a company to undertake investments in depreciable property by
enabling entities to deduct their investment costs more quickly. This is a
brand new provision introduced in November 2018 by the Canadian federal
government.

D. CCA provides a tax shield. This is the amount by which a company’s tax is
reduced because depreciation is claimed as a deduction from income, even
though it is not a cash expense. The present value of the tax shields for n
periods of ownership must be considered in capital budgeting decisions and
is calculated by using formula (13) in appendix 10C.

Refer to Exhibit 10C-1 for a comprehensive example of income taxes and capital
budgeting.