EN.662.611 Chap.11 Capital Budgeting Decisions
Capital Budgeting Decisions
Why capital budgeting exists
Capital budgeting decides which long-lived investments a company should fund, and it matters because capital is limited. Week 11 lists the common kinds of decision: protecting or growing sales, reducing costs, replacing assets, meeting regulatory requirements and choosing between leasing and buying.
Cash flows that count
The analysis uses relevant, incremental cash flows.
Outflows include the capitalized cost of the new asset net of any salvage from selling the old one, investment in working capital, tax impacts and relevant operating costs such as materials, labor and maintenance.
Inflows include sales growth, cost reductions and the tax saved through depreciation, and, at the end of the project, salvage value and the release of working capital.
Evaluate, then rank
The course uses two steps. Evaluation asks whether a project meets expectations, using payback, net present value and internal rate of return.
Payback is the time to recover the investment: investment divided by annual inflow when flows are even, or A plus B over C when they are not. It is crude but easy and speaks to liquidity. Net present value discounts future inflows at the cost of capital, also called the hurdle rate, discount rate or WACC, and a project is accepted when it is zero or more.
The internal rate of return is the discount rate that makes net present value zero, and a project is accepted when it exceeds the required return.
Ranking and the post audit
When accepted projects exceed the budget, the profitability index, the present value of inflows divided by the investment, ranks them by benefit per dollar.
After a project goes live, a post audit checks whether it delivered, holds its owners to their assumptions, discourages inflated proposals and finds the root cause of surprises.
How the techniques compare
The lecture compares the three evaluation methods on four questions. Payback is simple, but it does not measure profitability, ignores the time value of money and ignores cash after the payback date.
Net present value and internal rate of return are harder to compute but answer yes to all three. They differ in the reinvestment rate they imply: net present value assumes cash is reinvested at the discount rate, internal rate of return at the project's own rate.
What this chapter covers
- 01
Types of capital budgeting decision
- 02
Relevant cash outflows and inflows
- 03
Working capital and depreciation tax shields
- 04
Payback period
- 05
Net present value and the cost of capital
- 06
Internal rate of return
- 07
Profitability index and ranking
- 08
The post audit
Worked example · free
Payback and NPV for an even-flow project
- 1Payback: $150,000 divided by $50,000 is 3.0 years.
- 2Present value of savings: $50,000 times 3.0373 is $151,865.
- 1NPV: $151,865 less $150,000 is $1,865, so accept.
Key terms
- Payback Period
- The time a project takes to recover its initial investment from its cash inflows.
- Cost of Capital
- The return a company must pay its creditors and investors, used as the discount rate for projects.
- Internal Rate of Return
- The discount rate at which a project's net present value equals zero.
- Profitability Index
- The present value of a project's cash inflows divided by the investment it requires.
- Post Audit
- A review, a set time after a project goes live, of whether it delivered the results it promised.
- Working Capital Investment
- Cash tied up in inventory and receivables at a project's start and released at its end.
Capital Budgeting Decisions FAQ
Why does payback ignore profitability?
It stops counting once the investment is recovered, so cash after that point never enters the measure, and it treats a dollar in year three as equal to a dollar today. It is a liquidity test, not a profitability test.
Why rank by profitability index rather than by NPV?
When the budget is limited, the scarce resource is capital, so the question is which projects create the most value per dollar spent. A set of smaller projects with high indexes can beat one large project with the biggest NPV.
Is depreciation a cash flow in capital budgeting?
Not in itself, since nothing is paid when it is recorded. But it reduces taxable income, and the tax it saves is a real cash inflow that belongs in every year of the project.
Exam move
Build one project's cash flows year by year, labeling each line relevant or not, then compute payback, NPV and IRR and write a one-line decision. Finish by ranking three projects on a fixed budget with the profitability index.
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