Introduction to Corporate Finance

9: Capital Budgeting Process and Decision Criteria

example

Western Europe project ($ millions) South-eastern Australia project ($ millions)

Year PV of cash flow Cumulative PV PV of cash flow Cumulative PV

1 29.7 29.7 15.3 15.3

2 57.5 87.2 15.8 31.1

3 79.1 166.3 15.2 46.3

Recall that the initial outlay for the Western Europe expansion project is $250 million, but only $50 million

for the South-eastern Australia toehold project. After three years, neither project’s cumulative PV of cash flows

exceeds its initial outlay. Neither investment satisfies the condition that the discounted cash flows recoup the

initial investment within three years. Therefore, Global Untethered would reject both projects.

Before presenting the more sophisticated methods of capital budgeting, in the next section we

present a simple method often used to evaluate projects from an accounting perspective.

9-3 ACCOUNTING-BASED METHODS

In this section we evaluate the use of the accounting rate of return as an alternative method of assessing the

impact of capital expenditures.

9-3a ACCOUNTING RATE OF RETURN

For better or worse, managers in many companies focus as much on how a given project will influence

reported earnings as on how it will affect cash flows. Managers justify this focus by pointing to the

positive (or negative) share-price response that occurs when their companies beat (or fail to meet)

earnings forecasts made by equity analysts. Managers may also overemphasise a project’s accounting-

based earnings because their compensation is based on meeting accounting-based performance measures

such as earnings-per-share or return-on-total-assets targets. Consequently, some companies base their

investment decisions on accounting-based rate of return measures.

Companies have many different ways of defining a hurdle rate for their investments in terms of

accounting rates of return. Almost all these metrics involve two steps: (1) identifying the project’s net

income each year; and (2) measuring the project’s invested capital requirements, as shown on the

balance sheet, each year. Given these two figures, a company may calculate an accounting rate of return

by dividing net income by the book value of assets, either on a year-by-year basis or by taking an average

over the project’s life. Note that this measure is comparable to return on total assets (ROA), also called

2 What factors account for the popularity of the payback method? In what situations is it often used

as the primary decision-making technique? Why?

3 What are the major flaws of the payback period and discounted payback period approaches?

CONCEPT REVIEW QUESTIONS 9-2

LO9.3

accounting rate of return

Return on investment

calculated by dividing net

income by the book value of

assets

hurdle rate

The minimum rate of return

that must be achieved