Capital Budgeting: Long Range Planning

The concepts discussed in this chapter also apply to not-for-profit organizations, such as universities, school districts, cities, and not-for-profit hospitals. Since these organizations are not subject to as many taxes as profit-making organizations, the cash flows related to taxes are usually zero or near zero.

Understanding the learning objectives

• 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.
• Poor capital budgeting decisions can cause a company to lose all or part of the funds originally invested in a project and can harm the company's competitive position in world markets.
• Asset addition:

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

• Asset replacement:

Net cash inflow after taxes = ( Annual net cash inflows! savings) before taxes X( 1 - Tax rate ))+(Additional annual depreciation expense X Tax rate)

• $\text{Payback period} = \dfrac{\text{Initial cash outlay}}{\text{Annual net cash inflows ( benefits)}}$
• $\text{Unadjusted rate of return} = \dfrac{\text{Average annual income after taxes}}{\text{Average amount of investment}}$
• All expected after-tax cash inflows and outflows from the proposed investment are discounted to their present values using the company's required minimum rate of return as a discount rate. The net present value of the proposed investment is the difference between the present value of the annual net cash in flows and the present value of the required cash outflows
• $\text{Profitability index} = \dfrac{\text{Present value of net cash inflows}}{\text{Initial cash outlay ( present value of cash outlays if future outlays are required )}}$
• The time-adjusted rate of return equates the present value of expected after-tax net cash inflows from an investment with the cost of the investment 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 the target rate of return, the project should be considered. If the rate is less than the minimum rate, the project should be rejected.
• The investment in working capital causes the net present value to be lower than it would be if the working capital investment is ignored. Therefore, the required return of a project must be higher to account for the investment in working capital.

Demonstration problem

Barkley Company is considering three different investments; the following data relate to these investments:

 *No estimated salvage value. Use straight-line depreciation.

The income tax rate is 40 per cent. The salvage value of each investment is zero. Management requires a minimum return on investments of 14 per cent.

Rank these proposals using the following selection techniques:

1. Payback period.
2. Unadjusted rate of return.
3. Profitability index.
4. Time-adjusted rate of return.

Solution to demonstration problem

1. Payback period:

 b. Unadjusted rate of return:

The proposals in order of desirability are A, C, and B.

c. Profitability index:

*This amount was given. However, the amount can also be calculated as follows:

The proposals in order of desirability are A, C, and B. (But neither B nor C should be considered acceptable since each has a profitability index of less than one.)

d. Time-adjusted rate of return:

 The proposals in order of desirability are A, C, and B. (But neither B nor C earns the minimum rate of return.)