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Chapter 11

Capital BudgetingACCT 2200

PROFESSOR THOMAS BOURVEAU

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Capital Budgeting Methods

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Predict the internal rate of returnand describe its relationship to net

present value.

Learning Objective 11-4

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Internal Rate of Return (IRR)

Present

value of 

cash inflows

Present

value of 

cash outflows=

The net present value equal zero.

The internal rate of return is the interest

rate that makes . . .

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5

Using the cash flows for the preceding example, we get:

Internal Rate of Return ( IRR)

The internal rate of return is the discount rate which equates the  NPV of a

stream of cash flows to zero.

t 

t 

 IRR

CF 

)1(0

If the  IRR can be determined, then, in general,

choosing IRR > r often leads to the same decision as choosing NPV > 0.

The  IRR criterion is useful for choosing among projects with the same  NPV .

0 =   – 90 +55

+60.50

(1 + IRR)1 (1 + IRR)2

 IRR = 18% > 10% Accept the project

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Computing IRR in Excel

One important note about the IRR function is that you must

include the original cash outflow in the calculation.

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Internal Rate of Return (IRR)

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ApplicationA local company, Lester Inc. has a minimum required rate of return / cost of capital of 8% per year. The company is consideringinvesting in a robotic project that costs HKD68,337 and is expectedto generate cash flows of approximately HKD 27,000 per year for

the next three years. The approximate internal rate of return of this project is:

A. 8%

B. 9%

C. 10%D. Less than the required 8%

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Profitability Index

The profitability index is the ratio of a project’s benefits (measuredby the present value of the future cash flows) to its costs (or

required investment).

Profitability Index > 1 = Project Acceptable

Profitability Index < 1 = Project Unacceptable

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Comparing Capital Budgeting Methods

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Use the net present value method toanalyze mutually exclusive capital

investments.

Learning Objective 11-5

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Case 1: Lease or Buy Equipment

iKids Touch is trying to decide whether to buy a new copier orlease it from a copier company, and has gathered the following

information about the two options:

iKids Touch uses net present value to evaluate

investment options. If the discount rate is 10%,

should the company lease or buy?

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Case 1: Lease or Buy Equipment

Lease option costs $1,419 less.

To analyze this decision, we can use the NPV method to

compare the relevant costs (in present dollar values) of

each option.

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Case 2: Investing in Automation

iKids Touch is thinking of spending $10,000,000 to

automate a production facility. The investment is

expected to have the following effects:

• Automation will increase the capacity of the plant and allow it

to boost production and sales by 20 percent.•The company will be able to reduce packaging labor cost per

unit by 30 percent.

•Factory supervision costs will increase by $500,000 per year.

•The estimated useful life of the equipment is six years, at which

point it will have a residual value of $1,000,000. Straight-line

depreciation of the assets will be $1,500,000 per year[($10,000,000  – 1,000,000) ÷ 6 years = $1,500,000].

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Case 2: Investing in Automation

iKids Touch uses net present value to evaluate

investments. If the discount rate is 12%, should

the company make the $10,000,000 investment?

This table summarizes the effects on net income. The per-unit costs

in the first column are assumed. Note that automation increases net

income by $1,100,000.

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Case 2: Investing in Automation

Remember that the net present value method is based on cash flow

rather than net income. So, we need to add back the depreciation (a

noncash expense) to net income to get net cash flow. We also need

to incorporate the initial investment (at time zero) and the salvage

value of the machinery at the end of six years.

The positive net present value of $1,196,240 means that the

proposed investment in automation will generate a return in excess

of the 12% cost of capital.

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Exercise E11-7 Your friend Harrold is trying to decide whether to buy or lease hisnext vehicle. He has gathered information about each option but isnot sure how to compare the alternatives. Purchasing a new vehicle cost $26,500, and Harrold expects to spend about $500 per

 year in maintenance costs. He would keep the vehicle for five years and estimate the salvage value to be $10,500. Alternatively,he could lease the same vehicle for five years at a cost of $3,480per year, including maintenance. Assume a discount rate of 10percent.

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Use the profitability index toprioritize independent capital

investment projects.

Learning Objective 11-6

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Profitability

Index

Present Value of

Future Cash flowsInitial

Investment÷=

The profitability index is used to prioritize

capital investment projects.

When using the profitability index to prioritize projects,

the preference rule is: the higher the profitability index,

the more desirable the project.

Prioritizing Independent

Projects

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Prioritizing Independent

Projects

iKids Touch is trying to decide how to prioritize their limited

research and development budget. They are

considering these three independent projects.

How should iKids Touch prioritize these three projects?

A, then B, then C

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ApplicationLester Inc. just raised HKD1,000,000 from investors in Hong Kong tofund the creation of a new robot with a cost of capital of 10%. The CEOof the company hesitates between two different mutually exclusiveprojects. Both of them requires an initial cash outflow of HKD1,000,000but have the following cash flow patterns:

Which one should the firm opt for?

Year 1 Year 2 Year 3 Year 4 Year 5 Total

Project A 800,000 600,000 400,000 200,000 100,000 2,100,000

Project B 100,000 200,000 400,000 600,000 800,000 2,100,000

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ApplicationSai Kung Transportation is considering the purchaseof a new junk carrier for HKD8 million. The forecastrevenues are HKD5 million a year and total operatingcosts are HKD4 million. A major refit costing HKD2million will be required after both the   fifth and tenth

 years. After 15 years, the ship is expected to be sold forscrap at HKD1.5 million.

  equired If the discount rate is 8 percent, what is the

NPV of investing in the new ship?