Capital Budgeting: Long Range Planning

Capital budgeting defined

Capital budgeting is the process of considering alternative capital projects and selecting those alternatives that provide the most profitable return on available funds, within the framework of company goals and objectives. A capital project is any available alternative to purchase, build, lease, or renovate buildings, equipment, or other long-range major items of property. The alternative selected usually involves large sums of money and brings about a large increase in fixed costs for a number of years in the future. Once a company builds a plant or undertakes some other capital expenditure, its future plans are less flexible.

Poor capital-budgeting decisions can be costly because of the large sums of money and relatively long periods involved. If a poor capital budgeting decision is implemented, the company can lose all or part of the funds originally invested in the project and not realize the expected benefits. In addition, other actions taken within the company regarding the project, such as finding suppliers of raw materials, are wasted if the capital-budgeting decision must be revoked. Poor capital-budgeting decisions may also harm the company's competitive position because the company does not have the most efficient productive assets needed to compete in world markets.

Investment of funds in a poor alternative can create other problems as well. Workers hired for the project might be laid off if the project fails, creating morale and unemployment problems. Many of the fixed costs still remain even if a plant is closed or not producing. For instance, advertising efforts would be wasted, and stock prices could be affected by the decline in income.

On the other hand, failure to invest enough funds in a good project also can be costly. Ford's Mustang is an excellent example of this problem. At the time of the original capital-budgeting decision, if Ford had correctly estimated the Mustang's popularity, the company would have expended more funds on the project. Because of an undercommitment of funds, Ford found itself short on production capacity, which caused lost and postponed sales of the automobile.

Finally, the amount of funds available for investment is limited. Thus, once a company makes a capital investment decision, alternative investment opportunities are normally lost. The benefits or returns lost by rejecting the best alternative investment are the opportunity cost of a given project.

For all these reasons, companies must be very careful in their analysis of capital projects. Capital expenditures do not occur as often as ordinary expenditures such as payroll or inventory purchases but involve substantial sums of money that are then committed for a long period. Therefore, the means by which companies evaluate capital expenditure decisions should be much more formal and detailed than would be necessary for ordinary purchase decisions.

Source: Roger H. Hermanson, Georgia State University; James D. Edwards, University of Georgia; and Michael W. Maher, University of California at Davis https://open.umn.edu/opentextbooks/textbooks/accounting-principles-a-business-perspective
This work is licensed under a Creative Commons Attribution-NonCommercial 4.0 License.

Project selection: A general view

Making capital-budgeting decisions involves analyzing cash inflows and outflows. This section shows you how to calculate the benefits and costs used in capital-budgeting decisions. Because money has a time value, these benefits and costs are adjusted for time under the last two methods covered in the chapter.

Money received today is worth more than the same amount of money received at a future date, such as a year from now. This principle is known as the time value of money. Money has time value because of investment opportunities, not because of inflation. For example, USD 100 today is worth more than USD 100 to be received one year from today because the USD 100 received today, once invested, grows to some amount greater than USD 100 in one year. Future value and present value concepts are extremely important in assessing the desirability of long-term investments (capital budgeting). If you need to review these concepts, refer back to the appendix to Chapter 15, which covers these concepts.

The net cash inflow (as used in capital budgeting) is the net cash benefit expected from a project in a period.

The net cash inflow is the difference between the periodic cash inflows and the periodic cash outflows for a proposed project.

Asset acquisition

Assume, for example, that a company is considering the purchase of new equipment for USD 120,000. The equipment is expected (1) to have a useful life of 15 years and no salvage value, and (2) to 979 produce cash inflows (revenue) of USD 75,000 per year and cash outflows (costs) of USD 50,000 per year. Ignoring depreciation and taxes, the annual net cash inflow is computed as follows:

Depreciation and taxes

The computation of the net cash inflow usually includes the effects of depreciation and taxes. Although depreciation does not involve a cash outflow, it is deductible in arriving at federal taxable income. Thus, depreciation reduces the amount of cash outflow for federal income taxes. This reduction is a tax savings made possible by a depreciation tax shield. A tax shield is the total amount by which taxable income is reduced due to the deductibility of an item. For example, if depreciation is USD 8,000, the tax shield is USD 8,000. To simplify the illustration, we assume the use of the straight-line depreciation for tax purposes throughout the chapter. Straight-line depreciation can be elected for tax purposes, even under the new tax law.

The tax shield results in a tax savings. The amount of the tax savings can be found by multiplying the tax rate by the amount of the depreciation tax shield. The formula is:

Tax rate x Depreciation tax shield=Tax savings

Using the data in the previous example and assuming straight-line depreciation of USD 8,000 per year and a 40 percent tax rate, the amount of the tax savings is USD 3,200 (40 percent x USD 8,000 depreciation tax shield). Now, considering taxes and depreciation, we compute the annual net cash inflow from the USD 120,000 of equipment as follows:

If there were no depreciation tax shield, federal income tax expense would have been USD 10,000, or (USD 25,000 x 40 percent), and the net after-tax cash inflow from the investment would have been USD 15,000, found by (USD 25,000 - USD 10,000), or [USD 25,000 x (1 - 40 percent)].

The depreciation tax shield, however, reduces federal income tax expense by USD 3,200, or (USD 8,000 x 40 percent), and increases the investment's after-tax net cash inflow by the same amount. Therefore, the following formula also can be used to determine the after-tax net cash inflow from an investment:

Net cash inflow after taxes = [Net cash inflow before taxes x (1 - Tax rate)] + [Depreciation expense X Tax rate]

                                                              v                                                                                                     v

                    Net cash inflow after taxes (ignoring depreciation)           Tax savings attributable To depreciation tax shield

= (USD25,000x( 1 -.4))+( USD 8,000 X.4 )=USD 18,200

 Asset replacement Sometimes a company must decide whether or not it should replace existing plant assets. Such replacement decisions often occur when faster and more efficient machinery and equipment appear on the market.

The computation of the net cash inflow is more complex for a replacement decision than for an acquisition decision because cash inflows and outflows for two items (the asset being replaced and the new asset) must be considered. To illustrate, assume that a company operates two machines purchased four years ago at a cost of USD 18,000 each. The estimated useful life of each machine is 12 years (with no salvage value). Each machine will produce 40,000 units of product per year. The annual cash operating expenses (labor, repairs, etc.) for the two machines together total USD 14,000. After the old machines have been used for four years, a new machine becomes available. The new machine can be acquired for USD 28,000 and has an estimated useful life of eight years (with no salvage value). The new machine produces 60,000 units annually and entails annual cash operating expenses of USD 10,000. The USD 4,000 reduction in operating expenses (USD 14,000 - USD 10,000) is a USD 4,000 increase in net cash inflow (savings) before taxes.

The firm pays USD 28,000 in the first year to acquire the new machine. In addition to this initial outlay, the annual net cash inflow from replacement is computed as follows:

Net cash inflow after taxes= (Annual net cash inflows(savings) before taxes×(1 – tax rate)) + Additional annual depreciation expense × Tax rate

In formula format, the calculation is:

Net cash inflow after taxes = ( USD 4,000x ( 1 - .4) )+( USD 500 x.4) = USD 2,600

Notice that these figures concentrated only on the differences in costs for each of the two alternatives. Two other items also are relevant to the decision. First, the purchase of the new machine creates a USD 28,000 cash outflow immediately after acquisition. Second, the two old machines can probably be sold, and the selling price or salvage value of the old machines creates a cash inflow in the period of disposal. Also, the previous example used straight-line depreciation. If the modified Accelerated Cost Recovery System (modified ACRS) had been used, the tax shield would have been larger in the early years and smaller in the later years of the asset's life.

Out-of-pocket and sunk costs

A distinction between out-of-pocket costs and sunk costs needs to be made for capital budgeting decisions. An out-of-pocket cost is a cost requiring a future outlay of resources, usually cash. Out-of-pocket costs can be avoided or changed in amount. Future labor and repair costs are examples of out-of- pocket costs.

Sunk costs are costs already incurred. Nothing can be done about sunk costs at the present time; they cannot be avoided or changed in amount. The price paid for a machine becomes a sunk cost the minute the purchase has been made (before that moment it was an out-of-pocket cost). The amount of that past outlay cannot be changed, regardless of whether the machine is scrapped or used. Thus, depreciation is a sunk cost because it represents a past cash outlay. Depletion and amortization of assets, such as ore deposits and patents, are also sunk costs.

A sunk cost is a past cost, while an out-of-pocket cost is a future cost. Only the out-of-pocket costs (the future cash outlays) are relevant to capital budgeting decisions. Sunk costs are not relevant, except for any effect they have on the cash outflow for taxes.

Initial cost and salvage value

Any cash outflows necessary to acquire an asset and place it in a position and condition for its intended use are part of the initial cost of the asset. If an investment has a salvage value, that value is a cash inflow in the year of the asset's disposal.

The cost of capital

The cost of capital is important in project selection. Certainly, any acceptable proposal should offer a return that exceeds the cost of the funds used to finance it. Cost of capital, usually expressed as a rate, is the cost of all sources of capital (debt and equity) employed by a company. For convenience, most current liabilities, such as accounts payable and federal income taxes payable, are treated as being without cost. Every other item on the right (equity) side of the balance sheet has a cost. The subject of determining the cost of capital is a controversial topic in the literature of accounting and finance and is not discussed here. We give the assumed rates for the cost of capital in this book. Next, we describe several techniques for deciding whether to invest in capital projects.

Project selection: Payback period

Project selection: Unadjusted rate of return

Project selection: Net present value method

In this section, you learn to calculate the net present value of capital projects. Then you learn how to use the profitability index to evaluate projects costing different amounts. The profitability index is a refinement of the net present value method.

The net present value method uses the company's required minimum rate of return as a discount rate and discounts all expected after-tax cash inflows and outflows from the proposed investment back to their present values. The net present value of the proposed investment is the difference between the present value of the annual net cash inflows and the present value of the required cash outflows.

In many projects, the only cash outflow is the initial investment, and since it occurs immediately, the initial investment does not need to be discounted. Therefore, in such projects, a company may compute the net present value of the proposed project as the present value of the annual net cash inflows minus the initial investment. Other types of projects require that additional investments, such as a major repair, be made at later dates in the life of the project. In those cases, the company must discount the cash outflows to their present value before comparing them to the present value of the net cash inflows.

A major issue in acknowledging the time value of money in the net present value method is determining an appropriate discount rate to use in computing the present value of cash flows. Management requires some minimum rate of return on its investments. This rate should be the company's cost of capital, but that rate is difficult to determine. Therefore, under the net present value method, management often selects a target rate that it believes to be at or above the company's cost of capital, and then uses that rate as a basis for present value calculations.

To illustrate the net present value method, assume Morris Company is considering a capital investment project that will cost USD 25,000. Morris expects net cash inflows after taxes for the next four years to be USD 8,000, USD 7,500, USD 8,000, and USD 7.500» respectively. Management requires a minimum rate of return of 14 per cent and wants to know if the project is acceptable. The following analysis uses the tables in the Appendix at the end of this text:

Because the present value of the net cash inflows, USD 22,630, is less than the initial outlay of USD 25,000, the project is not acceptable. The net present value for the project is equal to the present value of its net cash inflows less the present value of its cost (the investment amount), which in this instance is -USD 2,370, calculated as (USD 22,630 - USD 25,000).

When a company uses the net present value method to screen alternative projects, it considers the project with the higher net present value to be more desirable. In general, a proposed capital investment is acceptable if it has a positive net present value. In the previous example, if the expected net cash inflows from the investment had been USD 10,000 per year for four years, the present value of the benefits would have been (from Table A.4 in the Appendix):

USD 10.000 X 2.9137= USD29,137

This calculation yields a net present value of USD 4,137, or USD 29,137 - USD 25,000. Since the net present value is positive, the investment proposal is acceptable. However, a competing project may have an even higher net present value.

When comparing investment projects costing different amounts, the net present value method does not provide a valid means by which to rank the projects in order of desirability assuming limited financial resources. A profitability index provides this additional information to management.

Profitability index

Project selection: The time-adjusted rate of return (or internal rate of return)

The time-adjusted rate of return, also called the internal rate of return, equates the present value of expected after-tax net cash inflows from an investment with the cost of the investment. It does this by finding the rate at which the net present value of the project is zero. If the time-adjusted rate of return equals or exceeds the cost of capital or target rate of return, a firm should consider the investment further. If the proposal's time-adjusted rate of return is less than the minimum rate, the firm should reject the proposal. Ignoring other considerations, the higher the time-adjusted rate of return, the more desirable the project.
Calculators and computer software with time-adjusted rate of return functions are readily available. Present value tables also can approximate the time-adjusted rate of return. To illustrate, assume Young Company is considering a USD 90,000 investment expected to last 25 years with no salvage value. The investment yields a USD 15,000 annual after-tax net cash inflow. This USD 15,000 is referred to as an annuity, which is a series of equal cash inflows.
The first step in computing the rate of return is to determine the payback period. In this case, the payback period is six years (USD 90,000/USD 15,000). The second step is to examine Table A.4 in the Appendix (present value of an annuity) to find the present value factor that is nearest in amount to the payback period of 6. Since the investment is expected to yield returns for 25 years, look at that row in the table. In that row, the factor nearest to 6 is 5 92745. which appears under the 16.5 percent interest column. The third step is to multiply the annual return of USD 15,000 by the 5-92745 factor; the result is USD 88,912, which is just below the USD 90,000 cost of the project. Thus, the actual rate of return is slightly less than 16.5 percent. The rate of return is less than 16.5 percent but more than 16 percent because as interest rates increase, present values decrease because less investment is needed to generate the same income.

A broader perspective:
Caterpillar, Inc.

The preceding example involves uniform net cash inflows from year to year. But what happens when net cash inflows are not uniform? In such instances, a trial and error procedure is necessary if present value tables are used. For example, assume that Young Company is considering a USD 200,000 project that will last four years and yield the following returns:

The average annual cash inflow is USD 290,000/4 = USD 72,500. Based on this average net cash inflow, the payback period is USD 200,000/USD 72,500 = 2.76 years. Looking in the four-year row of Table A.4 in the Appendix, we find that the factor 2.77048 is nearest to the payback period of 2.76. In this case, however, cash flows are not uniform. The largest returns occur in the later years of the asset's life. Since the early returns have the largest present value, the rate of return is likely to be less than the 16.5 percent rate that corresponds to the present value factor 2.77048. If the returns had been greater during the earlier years of the asset's life, the correct rate of return would have been higher than 16.5 percent. To find the specific discount rate that yields a present value closest to the initial outlay of USD 200,000, we try out several interest rates less than 16 percent. The rate of return is found by trial and error. The following computation reveals the rate to be slightly higher than 12 percent:

Since the cost of capital is not a precise percentage, some financial theorists argue that the time-adjusted rate of return method is preferable to the net present value method. Under the time-adjusted rate of return method, the cost of capital is used only as a cutoff point in deciding which projects are acceptable and should be given more consideration.

No matter which time value of money concept is considered better, these methods are both theoretically superior to the payback period and the unadjusted rate of return methods. However, the time value of money methods are more difficult to compute unless you use a business calculator or a microcomputer spreadsheet program. In reality, no single method should be used by itself to make capital-budgeting decisions. Managers should consider all aspects of the investment, including such nonquantitative factors as employee morale (layoff of workers due to higher efficiency of a new machine) and company flexibility (versatility of production of one machine over another). The company commits itself to its investment in a capital project for a long time and should use the best selection techniques and judgment available.

Too often, in capital project selection decisions, investments in working capital are ignored. The next section shows how to incorporate this factor into the analysis.

An accounting perspective:

Use of technology

Investments in working capital

An investment in a capital asset usually must be supported by an investment in working capital, such as accounts receivable and inventory. For example, companies often invest in a capital project expecting to increase sales. Increased sales usually bring about an increase in accounts receivable from customers and an increase in inventory to support the higher sales level. The increases in current assets - accounts receivable and inventory - are investments in working capital that usually are recovered in full at the end of a capital project's life. Such working capital investments should be considered in capital-budgeting decisions.
To illustrate, assume that a company is considering a capital project involving a USD 50,000 investment in machinery and a USD 40,000 investment in working capital. The machine, which will produce a new product, has an estimated useful life of eight years and no salvage value. The annual cash inflows (before taxes) are estimated at USD 25,000, with annual cash outflows (before taxes) of USD 5,000. The annual net cash inflow from the project is computed as follows (assuming straight-line depreciation and a 40 per cent tax rate):

The annual net cash inflow from the machine is USD 14,500 each year for eight years. However, the working capital investment must be considered. The investment of USD 40,000 in working capital at the start of the project is an additional outlay that must be made when the project is started. The USD 40,000 would be tied up every year until the project is finished, or in this case, until the end of the life of the machine. At that point, the working capital would be released, and the USD 40,000 could be used for other investments. Therefore, the USD 40,000 is a cash outlay at the start of the project and a cash inflow at the end of the project.

The net present value of the project is computed as follows (assuming a 14 per cent minimum desired rate of
return):

The discount factor for the cash inflows, 4.63886, comes from Table A.4 in the Appendix at the end of the book, because the cash inflows in this example are a series of equal payments - an annuity. The recovery of the investment in working capital is assumed to represent a single lump sum received at the end of the project's life. As such, it is discounted using a factor (0.35056) that comes from Table A.3 in the Appendix.
The investment is not acceptable because it has a negative net present value. If the working capital investment had been ignored, the proposal would have had a rather large positive net present value of USD 17.263 (USD 67,263 - USD 50,000). Thus, it should be obvious that investments in working capital must be considered if correct capital budgeting decisions are to be made.

The next topic discussed in the chapter is the post audit. This important step improves the chances that future capital project selection decisions are based on realistic projections of benefits and costs.

The postaudit

The last step in the capital-budgeting process is a postaudit review that should be performed by a person not involved in the capital-budgeting decision-making process. Such a person can provide an impartial judgment on the project's worthiness. This step should be performed early in the project's life, but enough time should have passed for any operational bugs to have been worked out. Actual operating costs and revenues should be determined and compared with those estimated when the project was originally reviewed and accepted. The postaudit review performs these functions:

• Let management know if the projections were accurate and if the particular project is performing as expected regarding cash inflows and outflows.
• May identify additional factors for management to consider in upcoming capital-budgeting decisions, such as cash outflows that were forgotten in a particular project.
• Provides a review of the capital-budgeting process to determine how effectively and efficiently it is working.

The postaudit provides information that allows management to compare the actual results of decisions with the expectations it had during the planning and selection phases of the capital-budgeting process.

Investing in high technology projects

Many companies have found it hard to justify high technology investments. A US auto manufacturer, for example, found it difficult to justify investing in a new computer-based flexible manufacturing system because its cost savings occurred so far in the future. When discounted, the present value of these savings did not justify the initial outlay. The president of the company was convinced, however, that the new system had benefits not quantified in the cash flow estimates, so he approved the investment even though it had a negative net present value.

Companies have difficulty in justifying an investment in high technology projects for several reasons. First, often several years pass before companies see the cash inflows from the investment. Even if the cash inflows are high, their net present value is low if they come several years in the future.

Second, management has difficulty identifying and measuring all of the benefits of new technology. When personal computers replaced typewriters, for example, people learned many new ways of creating and storing documents by using the computer. These benefits occurred because people used computers and experimented with them. These benefits would have been difficult to predict, much less measure, back when companies were trying to justify investment in personal computers. Managers believe that sometimes they just have to have faith that the investment is a good one, even though they cannot justify it on quantifiable economic grounds.

Capital budgeting in not-for-profit organizations

Key terms

Annuity A series of equal cash inflows.

Capital budgeting The process of considering alternative capital projects and selecting those alternatives that provide the most profitable return on available funds, within the framework of company goals and objectives.

Capital project Any available alternative to purchase, build, lease, or renovate equipment, buildings, property, or other long-term assets.

Cost of capital The cost of all sources of capital (debt and equity) employed by a company.

Initial cost of an asset Any cash outflows necessary to acquire an asset and place it in a position and condition for its intended use.

Net cash inflow The periodic cash inflows from a project less the periodic cash outflows related to the project.

Net present value A project selection technique that discounts all expected after-tax cash inflows and outflows from the proposed investment to their present values using the company's minimum rate of return as a discount rate. If the amount obtained by this process exceeds or equals the investment amount, the proposal is considered acceptable for further consideration.

Opportunity cost The benefits or returns lost by rejecting the best alternative investment.

Out-of-pocket cost A cost requiring a future outlay of resources, usually cash.

Payback period The period of time it takes for the cumulative sum of the annual net cash inflows from a project to equal the initial net cash outlay.

Profitability index The ratio of the present value of the expected net cash inflows (after taxes) divided by the initial cash outlay (or present value of cash outlays if future outlays are required).

Sunk costs Costs that have already been incurred. Nothing can be done about sunk costs at the present time; they cannot be avoided or changed in amount.

Tax shield The total amount by which taxable income is reduced due to the deductibility of an item. 

Time-adjusted rate of return A project selection technique that finds a rate of return that will equate the present value of future expected net cash inflows (after taxes) from an investment with the cost of the investment; also called internal rate of return.

Unadjusted rate of return The rate of return computed by dividing average annual income after taxes from a project by the average amount of the investment.

*Some terms listed in earlier chapters are repeated here for your convenience.