Chapter 21

Capital Budgeting:
Methods of Investment
Analysis

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 Learning Objectives

1. Apply the concept of the time value of money to capital

budgeting decisions
2. Evaluate discounted cash flow (DCF) and non-DCF methods
to calculate rate of return (ROR)
3. Apply the concept of relevance to DCF methods of capital
budgeting
4. Assess the complexities in capital budgeting within an
interdependent set of value-chain business functions
5. Apply the concept of defensive strategic investment to the
capital budgeting process

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 Capital Budgeting

 Long-term planning for making and financing

acquisitions (investments)
 Focuses on projects that can be accounted for using
life cycle costing and that must be evaluated taking
into consideration the time value of money
 A decision process that focuses on a project which
may span multiple years

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 Capital Budgeting
Decision Model
 Identify capital expenditures relevant to achieving
strategic goals
 Establish common assumptions for all potential
capital investments
 Analyze present value of future cash flows and
relevant qualitative factors
 Decide on projects, timing of implementation and
performance criteria
 Obtain financing
 Initiate investment and monitor results
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 Capital Budgeting:
A Decision Process
 Rate of return: ratio of predicted net cost flows
divided by total outflow for an investment
 Two dimensions of cost analysis:
• Project dimension: one project spans multiple
accounting periods
• Time dimension: one period contains multiple projects
which span several years
 Must consider the time value of money: a dollar
received today is worth more than a dollar received
tomorrow
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 The Project and Time
Dimensions of Capital Budgeting

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 Discounted Cash Flow (DCF)
Methods
 Two methods: net present value (NPV) and internal
rate of return (IRR)
 Measure all expected future cash inflows and
outflows of a project as if they occurred at a single
point in time
• Focuses on cash inflows and outflows rather than net
income
 Consider the time value of money

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 Required Rate of Return (RRR)

 The minimum acceptable annual rate of return on an

investment
 The return that an organization could expect to
receive elsewhere for an investment of comparable
risk
 Also called the discount rate, hurdle rate, cost of
capital, or opportunity cost of capital

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 Net Present Value (NPV)
Method
 Calculates the expected net monetary gain or loss
from a project by discounting all expected future
cash inflows and outflows to the present point in
time, using the required rate of return
 Based on financial factors alone, only projects with
a zero or positive NPV are acceptable

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 Three-Step NPV Method

 Sketch the relevant cash inflows and outflows

 Convert the inflows and outflows into present value
figures using tables or a calculator
 Sum the present value figures to determine the NPV
• Positive or zero NPV signals acceptance
• Negative NPV signals rejection

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 Internal Rate of Return (IRR)
Method
 Calculates the discount rate at which the present
value of expected cash inflows from a project equals
the present value of its expected cash outflows
• Rate at which NPV = 0
 A project is accepted only if the IRR equals or
exceeds the RRR

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 IRR Method

 Analysts use a calculator or computer program to

provide the IRR
 Trial and error approach: Use a discount rate and
calculate the project’s NPV. Goal: find the discount
rate for which NPV = 0
• If the calculated NPV is greater than zero, use a higher
discount rate
• If the calculated NPV is less than zero, use a lower
discount rate
• Continue until NPV = 0

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 Sensitivity Analysis

 Useful to compare how the evaluation of the

projects will change if there is a change in:
• Projected cash flows
• Timing of the cash flows
• Required rates of return change

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 Payback Method

 Measures the time it will take to recoup, in the form

of expected future cash flows, the net initial
investment in a project
• Assumes uniform cash flows through the expected life
cycle
 Where organizations choose a project payback
period, the greater the risk, the shorter the payback
period
 Easy to understand
 Ignores the time value of money and cash flows
after payback period
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 Payback Method (continued)

 With uniform cash flows:

Payback
Period = Net Initial Investment
Uniform Increase in Annual Future Cash Flows

 With non-uniform cash flows:

• Construct a table of cumulative cash inflows if the
annual cash flows are non-uniform
• Add cash flows period by period until the initial
investment is recovered
• Count the number of periods included for payback
period
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 Accrual Accounting Rate of
Return (AARR) Method
 An accounting measure of income divided by an accrual
accounting measure of investment
 Also called the accounting rate of return or return on
investment (ROI) model

Increase in Expected Average

Accrual Accounting
Rate of Return = Annual After-Tax Operating Income
Net Initial Investment

 The greater the positive difference between the AARR of a

project and the AARR hurdle rate (discount rate), the more
preferable is the investment

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 AARR Method

 Firms vary in how they calculate AARR

 Easy to understand, and use numbers reported in
financial statements
 Does not track cash flows
 Ignores time value of money

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 Relevant Cash Flows

 DCF methods focus exclusively on differences in

expected future cash flows
 Relevant cash flows are those that differ between
alternatives
 Estimating useful lifetime of an investment is
difficult due to rapid pace of technological change

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 Five Major Categories
of Cash Flows
1. Initial investment – the cash purchase price and any
investment in working capital required as a result
2. Disposal price of old equipment – a cash inflow
3. Recurring operating cash flows that differ between
alternatives
• Amortization is irrelevant because non-cash

4. Proceeds of disposal at end of project

• Including any recovery of working capital

5. Income tax impact on above cash flows

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 Complexities in Capital
Budgeting
 Predicting the full set of benefits and costs is a
challenge and often difficult to quantify
• Benefit of faster response time to market changes
• Benefit of increased worker knowledge of automation
 Difficult to recognize the full time horizon of the
project
• When benefits will occur over a long period of time
• When major benefits occur far in the future
 Use of accounting rate-of-return model may lead
manager to reject profitable projects
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 Post-Investment Audits

 Compares the predictions of investment costs and

outcomes made at the time a project was selected to
the actual results achieved
 Point to areas requiring corrective action
• Underestimation of time to implement a new project
• Underestimation of capital investment requirements
• Overestimation of savings from new investment
 Conduct the post-investment audit after the project
outcomes have stabilized

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 Strategic Considerations in
Capital Budgeting
 A company’s strategy is the source of its strategic
capital budgeting decisions
 Some firms regard R&D projects as important
strategic investments
• Outcomes very uncertain
• Far in the future

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