HBSP Product Number TCG 324

THE CRIMSON PRESS CURRICULUM CENTER

THE CRIMSON GROUP, INC.
Note on Capital Budgeting


There are two aspects of organizational planning: programming and budgeting. Both are phases of the management control process, with the former representing long-range planning and the latter short-range planning.
Programming decisions frequently involve investments in fixed assets that senior management expects will be
used for several years, and that will result in a financial return. Ordinarily, the end result of the programming
phase is a capital budget, and often there are some commitments to initiate new programmatic endeavors, such
as a new product line.

By contrast, the budgeting phase typically has a one-year focus and is concerned only with operating activities. The end results usually are an operating budget and a cash budget. This note focuses on programming, although it is important to keep in mind that a companys programming decisions have an impact on its operating
and cash budgets.
ORGANIZATION OF THE NOTE

The note begins with an overview of the programming phase of the management control process, positioning it as a key activity in implementing an organizations strategy. Programming decisions that call for the purchase of a new fixed asset (such as a new plant or new piece of equipment) usually rely on one or more analytical techniques that incorporate the multi-year period over which the new asset will be used. We look at three of
these techniques (payback period, net present value, and internal rate of return). Although there are some instances where an organization may decide to make a capital investment without giving much formal consideration to the analysis, most organizations use at least one of these analytical techniques in the programming phase.

Next, we examine the choice of a rate of return (or discount rate, as it frequently is called). This segues into
the issue of risk and how companies deal with risk in assessing investment proposals. The note then discusses
some non-quantitative considerations that can influence senior managements decision about a programming
proposal. It concludes with a description of ways that programming relates to several other organizational activities.
PROGRAMMING: AN OVERVIEW

Properly done, programming takes place within the context of an organizations overall strategy, coupled
with whatever information is available concerning new opportunities, increased competition, new or pending
legislation that might affect the organizations efforts, and other similar considerations. During the programming phase, senior management makes a variety of decisions of a long-term nature concerning the companys
product lines, the programs it will undertake, the new fixed assets it will acquire, and the approximate resources
it will devote to each.

Decisions made in the programming phase involve long-term commitments. For example, a new piece of
equipment usually will last for three to five years, sometimes longer. A new or renovated facility may last ten to
twenty years. Thus, the programming phase of the management control process frequently looks ahead by as
much as 5 or 10 years. In some large organizations there is a lengthy program document that describes each
program proposal in detail, estimates the resources needed to accomplish it, and calculates the expected returns.
Resources and Returns

The decision to purchase a fixed asset usually is assessed in terms of its long-term impact on financial status,
but it also has some short-term consequences. In particular, it will affect cash management via either the use of
cash to purchase it or an increase in equity or debt to finance it. In this latter instance, assuming the debt is of a
____________________________________________________________________________________________________________
This note was prepared by Professor David W. Young.
Copyright 2014 by David W. Young and The Crimson Group, Inc. To order copies or request permission to reproduce this document, contact The Crimson Press Curriculum Center at 617-497-9600 (Voice) or 617-576-7693 (Fax), or go to
www.thecrimsongroup.net. Under provisions of United States and international copyright laws, no part of this document may be reproduced, stored, or transmitted in any form or by any means without written permission from The Crimson Group.
If you believe that you have an illegal copy of this document, please notify the Crimson Press Curriculum Center of this fact immediately. Thank you.

TCG 324 Note on Capital Budgeting

2 of 15
____________________________________________________________________________________________________________

long-term nature, the short-term impact on cash is mitigated, resulting in a series of annual debt service outlays
(principal and interest payments) rather than the initial cash outlay that otherwise would be necessary.
Resources and Returns

The decision to purchase a fixed asset usually is assessed in terms of its long-term impact on financial status,
but it also has some short-term consequences. In particular, it will affect cash management via either the use of
cash to purchase it or an increase in equity or debt to finance its acquisition. In this latter instance, assuming the
debt is of a long-term nature, the short-term impact on cash is mitigated, resulting in a series of annual debt
service outlays (principal and interest payments) rather than the initial cash outlay that otherwise would be necessary.
CAPITAL INVESTMENT ANALYSES

A typical capital investment proposal involves an outlay of money at the present time (the investment) so as
to realize a stream of benefits (cash inflows) over some future period of time. That is, the acquisition of a fixed
assetgenerally a piece of equipment or machinery, but occasionally a new or renovated facility of some sort
will almost always result in some future cash inflows. These inflows generally come about as a result of the assets ability to decrease operating expenses or increase revenues by an amount that exceeds the associated increase in expenses. The period during which these effects are felt is known as the economic life of the asset.

Three basic techniques can be used to determine whether the cash flows are sufficient to justify the initial
outlay of funds: the payback period, net present value, and internal rate of return.
Technique #1. Payback Period

The payback period is the easiest technique. It consists of dividing the net investment amount by the estimated annual cash inflows attributable to the investment. The net investment amount is the purchase price of the
new asset, plus installation costs, plus disposal costs of the asset being replaced, minus any revenue received
from its sale. Annual cash flows are the reduced expenses or increased contribution attributable to the new asset.
The quotient of the two is the number of years of cash inflows necessary to recover the investment.
Example: Nido Escondido Bank is considering the purchase of a $100,000 piece of equipment for its check processing activities. The new equipment will replace an existing piece of equipment, which the vendor has offered to repurchase for $20,000.
It will also result in labor savings of approximately $40,000 a year. Thus, the net investment amount is $80,000 ($100,000 $20,000 for the old equipment). The labor savings of $40,000 a year constitute the cash inflows attributable to the investment.
The resulting payback period is two years ($80,000 $40,000).

The principal advantage of the payback period is its simplicity, and it frequently is used to gain a rough
sense of the feasibility of an investment opportunity. Its two main disadvantages are that it excludes the time
value of money and does not permit comparisons among competing projects unless all have the same economic
lives.

These disadvantages are related, and rest on the idea that a dollar saved a year from today is worth less than
a dollar saved today, a dollar saved two years from today is worth even less, and so on. If the payback period is
relatively short, as it was in the above example, this is not a particularly serious limitation, but with longer time
horizons, the payback periods utility is quite limited.
Technique #2. Net Present Value (NPV)

The NPV technique avoids the time-related disadvantage of the payback period by incorporating the time
value of money into the analysis. It does so, as its name implies, by calculating the value in todays terms of the
future cash inflows resulting from the investment. In effect, it discounts cash flows received in the future to their
present value.(If you do not understand present value, you should work through Appendix A at the end of the
note before reading any further.)

A capital investment analysis using the technique of net present value involves five steps:
1.
Determine the estimated annual cash inflows from the investment. These may be either increased
contribution (increased revenues less the associated expenses from, say, a new product line) or decreased expenses from, say, a labor-saving piece of equipment. In either case, they must result exclusively from the investment itself and not from activities that would have taken place anyway.
2.
Estimate the economic life of the investment. This is not the physical life of the new asset, but rather
the time period over which it will generate the cash flows. This distinction has become quite important in purchasing personal computers, which tend to have long physical lives but quite short (2 to 3
years) economic lives.

TCG 324 Note on Capital Budgeting

3 of 15
____________________________________________________________________________________________________________

3.
Determine the net amount of the investment. This is its purchase price, plus installation costs, plus
disposal costs for the old asset, less any cash received from selling the old asset.
4.
Determine the required rate of return. Ordinarily, this is the organizations weighted cost of capital,
increased to reflect the mix of assets on the balance sheet and the level of risk associated with the investment. This issue is discussed in detail later in the note.
5.
Compute the net present value according to the following formula:
Net present value = Present value of cash inflows - Net investment amount

Many hand-held calculators and spreadsheet software packages have present-value functions that can be
used to make these computations. For our purposes here, we will use the present-value factors in Tables A and B
in Appendix A. As a result, the formula is slightly different from above:
Net present value = (Cash inflows x present value factor) - Net investment amount
or
NPV = (CF x pvf) - I

Present-value factors for one-time cash flows are in Table A, and present-value factors for even annual cash
flows are in Table B. In both tables, the appropriate present-value factor lies at the intersection of the year row
and percent column selected in steps 2 and 4 above.
Example: Nido Escondido Bank has an opportunity to purchase some equipment that will result in labor savings of approximately $33,000 a year. The equipment has a purchase price of $120,000 (net) and is expected to produce the labor savings for
approximately 5 years. The banks board has decided that an acceptable project must have a rate of return of at least 8 percent
a year. To determine if the proposed investment is financially feasible, the bank would do the following analysis:
1.

2.

3.

4.

5.

Annual cash flows = $33,000

Economic life = 5 years
Net investment amount = $120,000
Rate of return = 8 percent
NPV

= (CF x pvf) - I
= $33,000 x 3.993) - $120,000
= $131,769- $120,000
= $11,769

The investment, therefore, is financially feasible, i.e. the present value of the annual cash flows is greater than the amount of
the investment.

It is important to note that once we have determined our desired rate of return a project that yields a net present value of zero or greater should be acceptable. That is, it is not important for the project to produce a present
value greater than zero since, if this were the case, the implication would be that the required rate of return is
too low.
Technique #3. Internal Rate of Return

The internal rate of return (IRR) method is similar to that of net present value; however, instead of specifying a required rate of return for making the calculations (8 percent in the above example), we set net present
value equal to zero and calculate the effective rate of return for the investment. Although this method is slightly
more complicated than the net present value approach, it has the advantage of giving an exact rate of return
rather than simply concluding that a proposed project meets (or fails to meet) an organizations stipulated rate of
return.

The IRR approach begins with the net present value formula: NPV = (CF x pvf) - I, but sets NPV equal to
zero, so that CF x pvf = I, or
pvf = I CF

Once the present value factor has been determined, it can then be located on Table B in the row corresponding to the number of years of economic life of the project. The resulting rate of return, can be determined from
the column in which the pvf is found. Again, some calculators and spreadsheet programs have functions that can
compute IRR quite easily, so our approach here is a bit more cumbersome than it would be in practice.

TCG 324 Note on Capital Budgeting

4 of 15
____________________________________________________________________________________________________________
Example: If Nido Escondido Bank wanted to determine the IRR for the project described in the last problem, it would make
the following computations:
pvf
=
I CF
pvf
=
$120,000 33,000
pvf =
3.636
Looking in the row for 5 years (the economic life of the investment) in Table B, we find the present value factor of 3.791 in
the column for an interest rate of 10%, and a present value factor of 3.605 in the column for an interest rate of 12%. Thus, our
projects IRR is about 11%.

Effect of Taxes

Since an increase in income will be taxed, the tax effects of a proposed project are important considerations.
In effect, they mean that an organization will not receive the full amount of a projects cash flows. At the same
time, however, depreciation serves as a tax shield, reducing the amount of taxes that otherwise would be paid.
It does so by increasing the organizations expenses which, other things equal, reduces income before taxes.1
Example: Nido Escondido is in a 37 percent tax bracket. Therefore, of the $33,000 in anticipated cost savings, $12,210
($33,000 x .37) will be taxed. Additionally, however, with annual depreciation of $24,000 (120,000 5), $8,880 ($24,000 x
.37) of tax savings will be realized. The net effect of $3,330 ($12,210 - $8,880) can be computed in one of two ways. The first
uses the above numbers, as follows: $33,000 - $12,210 + $8,880 = $29,670. The second, is perhaps somewhat more intuitive,
and can be calculated as follows:










1. Annual cash flows

Income Statement
Cash Flow
Annual increase in before-tax income from cost savings

$33,000

Annual cash flows from cost savings (assuming all are in cash)



$33,000
Less: Depreciation expense for the investment

24,000
Equals: incremental taxable income

$ 9,000
3,330

Less: Incremental income tax (at 37%)

3,330

Equals: incremental after tax effect

$ 5,670

$29,670
2.

3.

4.

5.

Economic life

Net investment amount

Rate of return

NPV= (CF x pvf) - I

=
5 years
=
$120,000
=
8 percent
=
($29,670 x 3.993) - $120,000
=
$118,472 - $120,000
=
($1,528)

Conclusion: When taxes are considered, the investment is no longer financially feasible.

Impact of Accelerated Depreciation

Accelerated depreciation often is advocated by economists as a public policy measure that will stimulate
investment. Lets look at how accelerated depreciation would affect this decision.

Example: Assume that Nido Escondido Bank uses the sum-of-years-digits method to calculate its depreciation for tax
purposes.2 The result is the following annual depreciation expense figures:








Year

Rate

Beginning Book Value
Depreciation Expense
Ending Book Value
1

5/15 =.333

$120,000

$39,960

$80,040
2

4/15 =.267

80,040

32,040

48,000
3

3/15 =.200

48,000

24,000

24,000
4

2/15 =.133

24,000

15,960

8,040
5

1/15 =.067

8,040

8,040

0

Recall that depreciation is a non-cash expense, which is why we do not include it in the cash flows from the project. (We also
would be double counting if we did so since the investment is what we depreciate). However, it is a legitimate operating expense
and thus can serve, other things equal, to reduce taxes.
2
Sum-of-years-digits is one of several approaches to computing accelerated depreciation. Other approaches can be found in almost
any financial accounting textbook. Note that the denominator for computing each years rate is the sum of the digits of the assets economic life (i.e., 1+2+3+4+5 = 15)

TCG 324 Note on Capital Budgeting

5 of 15
____________________________________________________________________________________________________________
This will change the banks analysis of the proposed investment as follows:3








Cash

Depreciation
Taxable

Income

Net Cash

Year

Flow

Expense

Income

Tax Expense

Flow

1

$33,000

39,960

2

33,000

32,040

3

33,000

24,000

4

33,000

15,960

8,040

5

33,000

Totals

$165,000

$120,000


Less amount of investment



Net present value

$(6,960)

960

9,000

17,040

24,960

$45,000

$(2,575)

355

3,330

6,305

9,235

$16,650

$35,575

32,645

29,670

26,695

23,765

$148,350

pvf

Gross
Present Value

.926

.857

.794

.735

.681

$32,943
27,977
23,558
19,621
16,184
$120,282
120,000
$ 282

Conclusion: When accelerated depreciation is used, the investment again becomes financially feasible.

There are several points worth noting about this example.

The totals are the same whether we use straight line or accelerated depreciation. Under accelerated
depreciation, the depreciation expense is $120,000, taxable income is $45,000, income tax expense is
$16,650, and net cash flow is $148,350. Under straight line, the totals are the annual amounts multiplied by five. So, for example, taxable income is $45,000 ($9,000 x 5), income tax expense is
$16,650 ($3,330 x 5), and net cash flow is $148,350 ($29,670 x 5).

Over a five year period, the only differences between the two approaches are the gross and net present values. The gross present value is higher under accelerated depreciation because of the earlier
cash flows ($32,943 in year 1 for accelerated depreciation, for example, as compared to $29,670 under straight line).

Because of the earlier cash flows, the total gross present value is $120,280 under accelerated depreciation, compared to $118,472 under straight line. The difference of $1,808 is enough to make the
project feasible with accelerated depreciation and infeasible with straight line.

This difference explains why accelerated depreciation is considered to be an incentive to spur investment.
Other things equal, its use will shift some projects from infeasible to feasiblenot because the totals change,
however, but because the cash flows come earlier in a projects life.


Issues to Consider

Several important issues arise in conducting analyses of this sort. First, although all the analyses may appear
to be quite precise, most of their significant elements are estimates or guesses, and may, in fact, be quite imprecise. Cash flow projections beyond two to three years ordinarily are not very accurate, nor are estimates of the
economic lives of most investments. Thus, we should be careful about attributing too much credence to the precision that the formula seems to give us. Because of this, many senior managers look for the NPV to be a comfortable margin above zero. Of course, what is comfortable for one manager may not be so for another.

Second, inflation is a factor. It is quite likely, for instance, that potential increases in wage rates, will cause
labor savings from an investment to be greater five years from now than they are today. However, if we are to
adjust our cash flow factor for the effects of inflation, we also need to adjust the required rate of return to reflect
our need for a return that exceeds the rate of inflation. By excluding an inflation effect from both the cash flow
calculations and the required rate of return, we neutralize its effects. We thus do not need to undertake the rather
complex calculations that otherwise might be necessary.4

Finally, the financial analysis is only one aspect of the decision-making process. Clearly, there are many
non-quantitative considerations,. Managers must be careful not to let the financial analysis dominate a decision
that has, say, strategic consequences that are difficult to quantify. In these instances, a managers judgment and
feel for the situation may be as important as the quantitative factors. Moreover, if a project is required to satisfy environmental, safety, or other regulatory mandates, its net present value is all but irrelevant. In short, almost all capital budgeting proposals involve a variety of non-quantitative considerations that will influence the
final decision. The use of present value serves only to formalize the quantitative aspects of the analysis. We examine some of the non-quantitative factors later in the note.
3
4

Because the depreciation expense is different each year, we now must compute GPV on an annual basis.

An exception to this simplifying approach is made when there are varying inflation rates for different elements of the proposal
(e.g., labor versus raw materials), or when the inflation rate differs considerably from the required rate of return. Most textbooks
on finance discuss this issue in some detail.

TCG 324 Note on Capital Budgeting

6 of 15
____________________________________________________________________________________________________________

Project Ranking

Since most organizations do not have sufficient funds to undertake all financially feasible projects, senior
management must devise a method to rank projects by their desirability. One approach is to compute the IRR
for each proposal and then to rank them from highest to lowest. Another is to calculate each projects ratio of
Gross Present Value to the Investment amount, as follows:

GPV/I ratio

=

Gross present value

Investment

To illustrate this approach, suppose we have two proposals. Proposal A requires an investment of $2,000 and
yields a cash inflow of $2,400 one year from now; Proposal B requires an investment of $3,000 and yields cash
inflows of $900 a year for five years. If the required rate of return is 8 percent, the GPV/I ratio indicates that
Proposal B is preferable, as shown below:













Investment

Cash Inflow

pvf at 8%

GPV

GPV/I Ratio

Proposal





A

$2,000

$2,400, Year 1

0.926

$2,222

1.11


B

$3,000

$900, Years 1-5

3.993

$3,594

1.20
CHOOSING A DISCOUNT RATE

In the examples so far, we have been using a discount rate of 8 percent. A question that may have occurred
to you is How does management determine this number? Clearly, the discount rate can have a significant impact on a projects financial feasibility. Thus, the way it is determined is of considerable importance to the
decision-making effort.
Weighted Cost of Capital

As a first step in determining a discount rate, many companies calculate their weighted cost of capital, or
WCC. This approach is based on the fact that an organizations assets are financed by a combination of liabilities and equity. Although some liabilities, such as accounts payable, are usually interest free, others, such as
short- and long-term debt, bonds, mortgages, and the like carry an interest rate that the organization must pay.

Unlike debt, equity does not have a stipulated interest rate, and agreeing on a rate to use for it in computing
the WCC can be somewhat controversial. Conceptually, this interest rate should be the amount that the companys shareholders expect to earn on their investment. Thus, it would be higher in a company in a high risk industry than one in a low risk industry. However, these rates are not easily determined. Many companies use an
opportunity cost approach, looking, for example, at what their investments have earned historically, and using
that rate as the interest rate for equity. Others use a somewhat more arbitrary approach, although always, one
would hope, with the interests of the shareholders in mind.

Once an interest rate for equity has been determined, the approach to computing an organizations WCC begins by identifying the interest rate for each liability. We then (1) determine the percentage of the total liabilities
and equity that each source represents, (2) multiply this by the associated interest rate, and (3) add the resulting
totals together. A sample set of calculations, using a 12 percent interest rate for equity, is shown in Exhibit 1. As
it shows, the WCC is just over 10 percent.
____________________________________________________________________________________________________________

Exhibit 1. Sample Computation of a Weighted Cost of Capital (In $000)

% of Total
Interest Rate
Weighted Rate
Item

Amount

Accounts payable


$ 3,000

0.6

0.0%

0.00%

Accrued salaries


2,000

0.5

0.0

0.00

2.3

12.0

0.28
Short-term note payable


10,000


Total current liabilities

15,000
Long-term note payable


75,000

17.0

10.0

1.70
34.1

8.0

2.73
Mortgage payable


150,000


Total liabilities


240,000
Contributed capital


150,000

34.1

12.0

4.09

11.4

12.0

1.37

Retained earnings


50,000

Total liabilities and equity

$440,000

100.0



10.17

____________________________________________________________________________________________________________

TCG 324 Note on Capital Budgeting

7 of 15
____________________________________________________________________________________________________________

Current versus Projected Weighted Cost of Capital

If the programming effort were carried out using an organizations current WCC, it would fail to incorporate
the cost of borrowing or equity increases that senior management might be planning for the upcoming year. For
this reason, many organizations use a projected WCC. That is, senior management determines the magnitude of
additional debt that the organization will incur, as well as the amount of additional stock sales it will make and
its projected increase (or decrease) in retained earnings. In calculating its projected WCC, it uses the interest it
will pay on the additional debt, and applies the interest rate is has chosen for its equity. The result is the WCC
that it will use for the upcoming programming decisions, which are the ones that result in new assets being acquired during the next year.
Weighted Cost of Capital versus Weighted Return on Assets

Since liabilities and equity effectively finance an organizations assets, the WCC indicates the minimum return on assets (ROA) the organization needs if it is to remain financially viable. Because ROA is zero for some
assets (such as inventory), however, investments in new plant and equipment generally must earn more than the
WCC if the overall ROA is to be at least equal to the WCC. To illustrate, consider the example in Exhibit 2.

A

s this exhibit illustrates, the company has a WCC of 9.6 percent. However, since most of its current assets
do not earn a return, it needs a return of 20 percent on its property, plant, and equipment (PP&E) to achieve a
weighted ROA of 9.6 percent. If it earns less than 20 percent on its PP&E, it effectively is atrophyingit is not
earning a sufficiently high return on its assets overall to cover the interest on its liabilities and achieve an 18
percent return on equity for its shareholders.
____________________________________________________________________________________________________________

Exhibit 2. Weighted Cost of Capital and Weighted ROA (In $000)

Weighted Cost of Capital















Liabilities and Equity

Amount

Weight

Current liabilities
















Accounts payable

$ 12,307

0.279


Current portion of bonds payable

800

0.018

0.008


Current portion of mortgage payable

360


Total current liabilities

13,467



Long-term liabilities





Bonds payable

8,300

0.188


Mortgage payable

5,339

0.121

Equity





Contributed capital

11,000

0.249

0.137


Retained earnings

6,054

Total

$ 44,160

1.000

* Assumed to be the company's desired return on equity

Rate
Weighted Rate

.00

.07

.09





.07

.09



.18*

.18*

.000
.001
.001








.013
.011




.045
.025
.096

Weighted Return on Assets

Amount

Assets

Current Assets




Cash

$ 1,155


Accounts receivable

7,742


Inventory

10,010


Prepaids

4,644


Total current

23,551

Non-current assets




Property, Plant and Equipment (net)
20,146


Bond issuance costs

463

Total

$ 44,160

Weight



0.026

0.175

0.227

0.105





0.456

0.010

1.000

Rate
Weighted Rate

.10*

.003
.00

.000
.00

.000
.00

.000












.20

.093
.00

.000


.096

*
Assumed to be the return on the company's cash

____________________________________________________________________________________________________________

In making the computations in Exhibit 2, the rate for PP&E is the unknown in the equation. That is, the
weighted ROA is set equal to the WCC, and the rates of return for all assets except PP&E are determined (e.g.,
10 percent for invested cash). The unweighted rate for PP&E is what is needed to achieve an overall ROA equal
to the WCC (9.6 percent in this example).

TCG 324 Note on Capital Budgeting

8 of 15
____________________________________________________________________________________________________________

Of course, some PP&E projects will not yield the required return. For instance, expenditures to meet some
regulatory requirements may have a very low return. When this is the case, the organization will need some
high return projects to subsidize those that fall short of the required PP&E percentage (20 percent in Exhibit 2).
INCORPORATING RISK INTO THE ANALYSIS

Capital investment proposals are not risk free. Since they involve future cash flows, there is always the possibility that the future will not be as anticipated. If this risk element is not incorporated into the analysis, a very
risky proposal would be evaluated in the same way as one that has a high probability of success.

There are several ways to incorporate risk into an analysis. With all of them, as a proposals risk increases,
its NPV or IRR decreases.

Increase the Discount Rate. Some organizations increase the discount rate for projects with a high perceived risk. The problem with this approach is the difficulty in establishing a meaningful risk scale. Statistical
techniques are available for incorporating the relative riskiness of a project, but they require analysts to estimate
the probabilities of possible outcomes. This is quite difficult to do.

Shorten the Economic Life. Many organizations heavily discount any projected cash flows beyond a predetermined time period, such as 5 years. They use the regular discount rate for all cash flows in, say, the first five
years of an investment, but use a much higher rate for subsequent years. Some even exclude all cash flows beyond a certain number of years. Their reasoning is that the future is highly uncertain, and the farther out the projections the greater the uncertainty. This approach tends to bias decisions in favor of projects with short payback
periods, which many organizations in industries experiencing rapid technological change believe is justified.

Distinguish Among Sources of Cash Flows. Some organizations give greater weight to cash flow projections that are based on cost savings rather than additional revenues. For example, when a particular technological improvement has demonstrated an ability to produce some quantifiable cost savings, senior management
usually will conclude that the associated projections are quite reliable. By contrast, a project proposing an investment that will result in new business and hence additional revenue has far more uncertain cash flows. It is
quite difficult to predict factors such as customers willingness to purchase the new product, competition, manufacturing costs, and a variety of other items. To deal with the resulting uncertainty, some organizations raise the
discount rate for projects that forecast additional revenues.

In summary, when we consider the formula NPV = (CF x pvf) - I, the only element that is reasonably certain
is the amount of the investment. Both cash flow estimates and economic life can be highly speculative. Organizations can include adjustments for uncertainty by either shortening the economic life or raising the required
rate of return. Even so, when it comes to risk, managers and analysts need to exercise considerable judgment.
NON-QUANTITATIVE CONSIDERATIONS

NPV or IRR computations are only one aspect of the programming phase. There usually are a variety of
considerations that are difficult to quantify, but that can influence a programming decision. They include strategic and competitive concerns, employee morale, union grievances, the need to make quality improvements, a
desire to expand the range of products or services, a requirement to abide by the policies of a regulatory agency
(such as the Occupational Health and Safety Administration or the Environmental Protection Agency), and
many others.
Benefit/Cost Analyses

In some organizations, a benefit/cost analysis is used in an attempt to incorporate non-quantitative considerations into the decision-making process. To do so, senior management must consider several factors.

Focus on Organizational Goals. Perhaps most importantly, a non-quantitative benefit must be related to the
organizations goals. Clearly, there is no point in making a benefit/cost analysis unless all concerned agree on
these goals. Because various members of the senior management team and/or various staff analysts may have
different ideas of an organizations goals, these individuals must reconcile their views. Otherwise, middle managers will find it difficult to formulate program proposals designed to help reach the goals.
Example. Several years ago, the U.S. government began to support local transportation for handicapped people. Since the U.S.
Department of Transportation then subsidized local bus and subway lines, its natural inclination was to modify buses to provide lifts that would permit easy access for wheelchairs. The extra capital and maintenance costs of such equipment turned out
to be huge, and usage was not high because handicapped people had no way of getting from their homes to the buses. The
resulting cost per passenger was high$1,283 per trip in one city. Subsequently, transportation was provided by vans that
picked up handicapped people at their doors and took them directly to their destinations. This was both more convenient and
less expensivebetween $5 and $14 per passenger trip in most cities that tried it.

TCG 324 Note on Capital Budgeting

9 of 15
____________________________________________________________________________________________________________

A focus on the goal of transporting handicapped people, rather than one of modifying existing modes of transportation,
might have avoided the costly installation of passenger lifts in buses. Moreover, speculating on alternative ways of reaching
the goal could also have produced a more effective solution.5

Secondary Benefits. For proposals that involve the introduction of a new product or product line, analysts
may have difficulty estimating the monetary effects of a variety of associated benefits. For example, in addition
to the revenue inflows from a new product line (less the costs associated with those inflows), there may be a variety of secondary revenues and costs that arise from the new products impact on existing or related products.
Example. A project to introduce a new line of laser-jet printers may not look attractive if the only benefits are the revenues
(minus costs) from with the printers alone. If, however, the analysis incorporated the secondary benefits from the sale of toner
cartridges, the project would become more attractive.

Secondary benefits from existing products can cut the other way, however, and may impede an organization
from introducing a strategically important new product.
Example. Both Kodak and Polaroid delayed the introduction of digital cameras for several years, largely, one might imagine,
because of the impact such cameras would have had on the sale of film for non-digital cameras. Only when it became abundantly clear that digital photography was here to stay did they begin to make the strategic shift. For Polaroid it was too late,
and the company filed for bankruptcy. For Kodak it was almost too late, but the company managed to survive.

Alternative Ways of Reaching the Same Objective. Even if benefits cannot be quantified, a benefit/cost
analysis can be useful in situations where an objective has been determined to be strategically important, and
there is more than one way to achieve it. If several alternatives would achieve the objective, then management
ordinarily will prefer the lowest cost one. This approach is useful because it does not require that the objectives
be stated in monetary terms, or even that they be quantified. Nor is there a need to measure the degree to which
each alternative meets the objective; only to determine which of several proposed alternatives will achieve it. Of
these, the least costly is the preferred one.
Example. The objective of one benefit/cost analysis was to provide the optimal airport and ground transportation facilities for
passengers arriving and departing Washington, D.C. by air. Analysts estimated the costs of various airport locations and associated ground transport services. Senior management chose the proposal that provided adequate service with the lowest cost.
There was no need to measure the benefits of adequate service in monetary terms.

Constrained Tradeoffs. Since funds are limited, there is an opportunity cost associated with any given investment. However, it may not be feasible to make tradeoffs across divisions or other organizational units, especially when the units have been established as investment centers.
Example. In a multidivisional organization, where each division is an investment center, funds that are used for new equipment in, say, the home appliance division most likely would not have been available for another division unless all capital
decisions, even the smallest, were made centrally. In many large multidivisional corporations, only capital decisions above a
significant amount are made centrally.

Causal Connections. Many benefit/cost analyses implicitly assume that there is a causal relationship between costs and benefits, such that spending X dollars produces Y benefits. If there is no such relationship,
however, the benefit/cost analysis is fallacious.
Example. A human resources department defended its personnel training program with an analysis indicating that the program
would lead participants to advance more quickly in the organization. The more rapid advancement would increase their lifetime contribution to the company by $1,000,000 per person. Thus, the $50,000 average cost per person trained seemed well
justified. However, the assertion that the proposed program would indeed generate these benefits was completely unsupported;
it was strictly a guess. There was no plausible link between the amount requested and the projected results.

LINKS TO OTHER ORGANIZATIONAL ACTIVITIES

Beyond its role as a phase of the management control process, programming is directly or indirectly linked
to several other activities of importance to senior management. Recognizing these linkages is essential if the
programming phase is to be as effective as possible.

See Alice L. London, Transportation Services for the Disabled, The GAO Review, Spring 1986, pp. 21-27.

TCG 324 Note on Capital Budgeting

10 of 15
____________________________________________________________________________________________________________

Link to Strategy Formulation

Programs and product lines are among the most readily observable aspects of an organizations strategy.
Thus, if new programs and large capital expenditures are to remain consistent with strategy, line managers must
understand the linkages between their programs or product lines and the organization's overall strategic directions. Indeed, if an organizations strategy is to evolve over time because of shifting environmental opportunities and threats, and changing organizational strengths and weaknesses, senior management must find ways to
monitor and manage the organizations programs so they remain consistent with, and supportive of, the evolving strategy.
Link to Culture

Programming also can be an especially important tool for managing an organizations culture, in that senior
management can use it to influence the basic assumptions of decision-making.6 Specifically, the constraints senior management establishes on programming, and the way it makes use of the programming purse, can have a
profound impact on line managers understanding of what is acceptable and unacceptable in the organization.
This, in turn, can help to either maintain or change the organizations culture.7
Link to Conflict Management

Because many of the benefits of new program proposals are difficult to quantify, and because line managers
(especially profit and investment center managers) tend to be quite optimistic about their program proposals, a
new program bias tends to characterize the programming phase of the management control process. In particular, many proposals tend to overestimate sales volume and prices. Some may underestimate costs.

Senior management typically counteracts this bias by using its own staff to analyze the proposals. When this
happens, there can be considerable friction between line managers and members of the corporate staff. Designing a conflict management process to deal with this friction so that the final result is a tough but realistic analysis is one of the most challenging tasks senior management faces in programmatic decision making.
Link to Authority and Influence

While many large companies have decentralized considerable decision making authority to their divisions,
frequently establishing them as investment centers, most companies stipulate that programming decisions for
amounts that exceed some ceiling require corporate approval. Their reasoning is that large programming decisions, if not carefully managed, may lead the firm in strategic directions that senior management does not want
to take.8 Thus, there are constraints on the authority of almost all division general managers.

In addition, there is an internal political dimension to programming, which is not always well understood.
For a variety of reasons, some managers may have the ear of senior management, or they may run divisions
that are seen as key to the companys future, or they may simply be more articulate or more forceful than some
of their colleagues. As a result, they may receive a favorable decision on a proposed project that has a much
lower IRR than a project in another division with a manger who, for one reason or another, is not seen in such a
favorable light. There is not much that can be done about this; it is simply a reality of organizational life.
NEXT STEPS

You are now ready to work a practice case, Erie Chemical Company. Although the first two questions are
largely mechanical, the remaining questions ask you to consider some fairly tricky issues, including some nonquantitative considerations.

For a discussion of culture, see Edgar H. Schein, Organizational Culture and Leadership, Second Edition, San Francisco, Jossey
Bass Publishers, 1992. In Sheins model, basic assumptions about decision making are at the core of an organizations culture.
For additional discussion on this point, see David W. Young, Managing Organizational Culture, Business Horizons, SeptemberOctober 2000.
For additional discussion of this issue, see David Solomons, Divisional Performance: Measurement and Control, Homewood,
Illinois, Dow Jones-Irwin, Inc., 1965.

TCG 324 Note on Capital Budgeting

11 of 15
____________________________________________________________________________________________________________

Appendix A. The Concept of Present Value

The concept of present value rests on the basic principle that money has a time value. That is, $1 received
one year from today is worth less than $1 received today. To illustrate the concept, consider the following situations:
Question: A colleague offers to pay you $1,000 one year from today. How much would you lend her today?

Presumably, unless you were a good friend or somewhat altruistic, you would not lend her $1,000 today.
You could invest your $1,000, earn something on it over the course of the year, and have more than $1,000 a
year from now. If, for example, you could earn 10 percent on your money, you could invest your $1,000 and
have $1,100 in a year. Alternatively, if you had $909, and invested it at 10 percent, you would have $1,000 a
year from today.

Thus, if your colleague offers to pay you $1,000 a year from today, and you are an investor expecting a 10
percent return, you would most likely lend her only $909 today. With a 10 percent interest rate, $909 is the present value of $1,000 received one year hence.
Question: Under the same circumstances as the previous question, how much would you lend your colleague if she
offered to pay you $1,000 two years from today?

Here we must incorporate compound interest; that is, the fact that interest is earned on the interest itself. For
example, at a 10 percent rate, $826 invested today would accumulate to roughly $1,000 in two years, as shown
by the following:

Year 1 $826 x .10

Year 2 ($826 + $82.60) x .10

Total at end of Year 2 = $826 + $82.60 + $90.86

=

=

=

$ 82.60
$ 90.86
$ 999.46

Thus, you would be willing to lend her $826.

Question: The previous question consisted of a promise to pay a given amount two years from today, with no intermediate payments. Another possibility to consider is the situation in which your colleague offers to pay you $1,000 a
year from today, and another $1,000 two years from today. How much would you lend her now?

The answer requires combining the analyses in each of the above two examples. Specifically, for the $1,000
received two years from now, you would lend her $826, and for the $1,000 received one year from now you
would lend her $909. Thus, the total you would lend would be $1,735.

Our ability to make these determinations is simplified by present value tables. Two such tables, A and B, are
contained on the next page. Table A, Present Value of $1, is the table we would use to determine the present
value of a single payment received at some specified time in the future. For instance, in the first example above,
we could find the answer to the problem by looking in the column for 10% and the row for one year; this gives
us 0.909. Multiplying 0.909 by $1,000 gives us the $909 we would lend our colleague. Similarly, if we look in
the row for two years and multiply the entry of 0.826 by $1,000, we arrive at the answer to the second example:
$826.

Table B, Present Value of $1 Received Annually for N Years, is used for even payments received over a
given period. Looking at Table B, we can see that the present value of 1.735 (for a payment of $1 received each
year for two years at 10 percent) multiplied by $1,000 is $1,735. This is the amount we calculated in the third
example above. We also can see that the 1.735 is the sum of the two amounts shown on Table A (.909 for one
year hence, and .826 for two years hence). Thus, Table B simply sums the various elements in Table A to facilitate calculations.

Table A. Present Value of $1

Years
Hence

1%

2%

4%

6%

8%

10%

12%

14%

15%

16%

18%

20%

22%

24%

25%

26%

28%

30%

1
2
3
4
5

0.990
0.980
0.971
0.961
0.951

0.980
0.961
0.942
0.924
0.906

0.962
0.925
0.889
0.855
0.822

0.943
0.890
0.840
0.792
0.747

0.926
0.857
0.794
0.735
0.681

0.909
0.826
0.751
0.683
0.621

0.893
0.797
0.712
0.636
0.567

0.877
0.769
0.675
0.592
0.519

0.870
0.756
0.658
0.572
0.497

0.862
0.743
0.641
0.552
0.476

0.847
0.718
0.609
0.516
0.437

0.833
0.694
0.579
0.482
0.402

0.820
0.672
0.551
0.451
0.370

0.806
0.650
0.524
0.423
0.341

0.800
0.640
0.512
0.410
0.328

0.794
0.630
0.500
0.397
0.315

0.781
0.610
0.477
0.373
0.291

0.769
0.592
0.455
0.350
0.269

6
7
8
9
10

0.942
0.933
0.923
0.914
0.905

0.888
0.871
0.853
0.837
0.820

0.790
0.760
0.731
0.703
0.676

0.705
0.665
0.627
0.592
0.558

0.630
0.583
0.540
0.500
0.463

0.564
0.513
0.467
0.424
0.386

0.507
0.452
0.404
0.361
0.322

0.456
0.400
0.351
0.308
0.270

0.432
0.376
0.327
0.284
0.247

0.410
0.354
0.305
0.263
0.227

0.370
0.314
0.266
0.225
0.191

0.335
0.279
0.233
0.194
0.162

0.303
0.249
0.204
0.167
0.137

0.275
0.222
0.179
0.144
0.116

0.262
0.210
0.168
0.134
0.107

0.250
0.198
0.157
0.125
0.099

0.227
0.178
0.139
0.108
0.085

0.207
0.159
0.123
0.094
0.073

11
12
13
14
15

0.896
0.887
0.879
0.870
0.861

0.804
0.788
0.773
0.758
0.743

0.650
0.625
0.601
0.577
0.555

0.527
0.497
0.469
0.442
0.417

0.429
0.397
0.368
0.340
0.315

0.350
0.319
0.290
0.263
0.239

0.287
0.257
0.229
0.205
0.183

0.237
0.208
0.182
0.160
0.140

0.215
0.187
0.163
0.141
0.123

0.195
0.168
0.145
0.125
0.108

0.162
0.137
0.116
0.099
0.084

0.135
0.112
0.093
0.078
0.065

0.112
0.092
0.075
0.062
0.051

0.094
0.076
0.061
0.049
0.040

0.086
0.069
0.055
0.044
0.035

0.079
0.062
0.050
0.039
0.031

0.066
0.052
0.040
0.032
0.025

0.056
0.043
0.033
0.025
0.020

Table B. Present Value of $1 Received Annually for N Years

Years
N

1%

2%

4%

6%

8%

10%

12%

14%

15%

16%

18%

20%

22%

24%

25%

26%

28%

30%

1
2
3
4
5

0.990
1.970
2.941
3.902
4.853

0.980
1.941
2.883
3.807
4.713

0.962
1.887
2.776
3.631
4.453

0.943
1.833
2.673
3.465
4.212

0.926
1.783
2.577
3.312
3.993

0.909
1.735
2.486
3.169
3.790

0.893
1.690
2.402
3.038
3.605

0.877
1.646
2.321
2.913
3.432

0.870
1.626
2.284
2.856
3.353

0.862
1.605
2.246
2.798
3.274

0.847
1.565
2.174
2.690
3.127

0.833
1.527
2.106
2.588
2.990

0.820
1.492
2.043
2.494
2.864

0.806
1.456
1.980
2.403
2.744

0.800
1.440
1.952
2.362
2.690

0.794
1.424
1.924
2.321
2.636

0.781
1.391
1.868
2.241
2.532

0.769
1.361
1.816
2.166
2.435

6
7
8
9
10

5.795
6.728
7.651
8.565
9.470

5.601
6.472
7.325
8.162
8.982

5.243
6.003
6.734
7.437
8.113

4.917
5.582
6.209
6.801
7.359

4.623
5.206
5.746
6.246
6.709

4.354
4.867
5.334
5.758
6.144

4.112
4.564
4.968
5.329
5.651

3.888
4.288
4.639
4.947
5.217

3.785
4.161
4.488
4.772
5.019

3.684
4.038
4.343
4.606
4.833

3.497
3.811
4.077
4.302
4.493

3.325
3.604
3.837
4.031
4.193

3.167
3.416
3.620
3.787
3.924

3.019
3.241
3.420
3.564
3.680

2.952
3.162
3.330
3.464
3.571

2.886
3.084
3.241
3.366
3.465

2.759
2.937
3.076
3.184
3.269

2.642
2.801
2.924
3.018
3.091

11
12
13
14
15

10.366
11.253
12.132
13.002
13.863

9.786 8.763 7.886

10.574 9.388 8.383
11.347 9.989 8.852
12.105 10.566 9.294
12.848 11.121 9.711

7.138
7.535
7.903
8.243
8.558

6.494
6.813
7.103
7.366
7.605

5.938
6.195
6.424
6.629
6.812

5.454
5.662
5.844
6.004
6.144

5.234
5.421
5.584
5.725
5.848

5.028
5.196
5.341
5.466
5.574

4.655
4.792
4.908
5.007
5.091

4.328
4.440
4.533
4.611
4.676

4.036
4.128
4.203
4.265
4.316

3.774
3.850
3.911
3.960
4.000

3.657
3.726
3.781
3.825
3.860

3.544
3.606
3.656
3.695
3.726

3.335
3.387
3.427
3.459
3.484

3.147
3.190
3.223
3.248
3.268

TCG 324 Note on Capital Budgeting

13 of 15
____________________________________________________________________________________________________________

PRACTICE CASE. ERIE CHEMICAL COMPANY

Dr. Christian Larson, Chief of Research at Erie Chemical Company, was contemplating a proposal submitted to him by Dr. Francesca Michaels, head of the Garden Products Lab. Her request was to purchase some new
equipment to perform operations currently being performed on different, less efficient equipment. The purchase
price was $300,000 delivered and installed.
Background

Erie Chemical Company was a diversified conglomerate, specializing in consumer products. It was located
on the shores of Lake Erie in Cleveland, Ohio, and had been in existence for some 40 years. Although it manufactured a variety of products for homeowners, its distinguishing specialty was garden products, where it prided
itself on having the latest in technology and up-to-date facilities, and where it conducted state-of-the-art research. Because of the rapid changes taking place in the field of garden products, maintaining the companys
cutting-edge position required constant upgrading of its facilities and equipment.

In recent years, with the advent of environmental regulation, there had been increasing pressures on the
companys profits. Because of this, the companys senior management was taking an increasingly hard look at
all capital equipment proposals.
The Request

Dr. Michaels had worked closely with the equipment manufacturer to determine the potential benefits of the
new equipment. She estimated that it would result in annual savings of $60,000 in labor and other direct costs,
as compared with the present equipment. She also estimated that the new equipments economic life would be
10 years, with zero salvage value.

The company had recently borrowed long-term to finance another project. Paul Hershey, Eries Chief Financial Officer, had informed Dr. Larson that, because of this, he was certain the company could obtain additional
funds at 12 percent, although he would not plan to negotiate a loan specifically for the purchase of Dr. Michaels equipment. He did feel, however, that an investment of the type Dr. Michaels was proposing should have
a return of at least 20 percent.
Complicating Factors

There were three complications associated with the proposed investment. First, the present equipment was
in good working order and probably would last, physically, for at least 8 more years. Second, the request was
for what Dr. Michaels called even better equipment, to replace some equipment purchased two years ago involving the same projected economic life and dollar amounts. Dr. Michaels had informed Dr. Larson that the
new equipment would render the existing equipment completely obsolete with no resale value.

The third complicating factor had arisen at a recent board meeting, when the chairman of the boards finance
committee had discussed some inconsistencies between Eries capital structure and the 20 percent rate of return
that Mr. Hershey was recommending. The finance committee chairman had pointed out that Eries shareholder
equity and retained earnings had no interest charges. As a result, he thought the proper discount rate to use for
capital investment proposals was not 20 percent, but only about 5 percent, as shown below:

Debt

Equity

Total

Weighted Cost of Capital

Percent

Interest

Weighted
Rate

Interest Rate
of Total

40.0

12.0%

4.8%
60.0

0.0

0.0
100.0



4.8%

The Decision

Although funds were available to finance Dr. Michaels proposed new equipment purchase, Dr. Larson and
Mr. Hershey were both concerned about the mistake made two years ago, and wanted to be sure that a similar
mistake would not be made again.
Assignment
1.

What is the proposals net present value, using a discount rate of 20 percent? 5 percent?

2.

What is the proposals internal rate of return?

3.

What is the appropriate discount rate to use? Why?

TCG 324 Note on Capital Budgeting

14 of 15
____________________________________________________________________________________________________________
4.

If the company decides to purchase the new equipment for Dr. Larson, a mistake has been made somewhere, because good
equipment bought only two years ago is being scrapped. How did this mistake come about?

5.

What non-quantitative factors should the company consider in making this decision? How important are they? Would it make a
difference if the proposal were for new technology rather than replacement of existing technology? If it were for new technology with the same dollar amounts, but in the Maintenance Department? Why?

ANALYSIS OF PRACTICE CASE

Erie Chemical Company

This case, requires several present value calculations to give you some practice in the technique. It also
deals with the weighted cost of capital and the appropriate interest rate to use for equity.
Question 1

Part A. As a discount rate of 20 percent, the net present value is calculated as follows:

Cash Flows:

Economic Life:

Investment Amount:

Net Present Value:

$ 60,000
10 years
$300,000
= ($60,000 x 4.192) - $300,000
= $251,520 - $300,000 = ($48,480)

Conclusion: At 20 percent, the investment is not financially feasible.

Part B. At a discount rate of 5 percent, the net present value is calculated as follows:

Cash Flows:

Economic Life:

Investment Amount:

Net Present Value

$ 60,000
10 years
$300,000
= ($60,000 x 7.735*) - $300,000
= $464,130 - $300,000 = $164,130

* At 5 percent, we need to estimate the pvf by using the midpoint between 4 and 6 percent.

Conclusion: At 5 percent the investment is financially feasible.

Question 2

The internal rate of return of Dr. Michaels' proposal is calculated as follows:

Investment annual cash flows = present value factor

$300,000 $60,000 = 5.000

Economic life = 10 years
Internal rate of return = 15%*
* The pvf that lies at the intersection of the 10-year row and the 15% column is 5.019.

Question 3

Since we dont know the mix of assets, we cannot compute a weighted ROA and determine the return
needed from PP&E. However, the rate certainly should be no less than the weighted cost of capital, or, more
specifically, the weighted cost of capital after the additional borrowing takes place (which is not the same as the
interest rate on the incremental borrowing).

In terms of equity, the key point is that it is not free, as the boards finance chair suggests. Shareholders expect a return on their invested funds, and, in general, the higher the companys risk , the higher their expected
return. The result will be a figure that is somewhat higher than 4.8 percent but probably not as high as 20 percent.

TCG 324 Note on Capital Budgeting

15 of 15
____________________________________________________________________________________________________________

Question 4

The mistake came about because the economic life was estimated at 10 years when it in fact was only two
years. If Dr. Michaels' proposed equipment also has an economic life of only two years, it would have an internal rate of return of less than one percent, as the following calculations show:

Investment annual cash flows = present value factor

$300,000 $60,000 = 5.000

Economic life = 2 years
Internal rate of return = <1%*
*The present value factor that lies at the intersection of the 2-year row and the 1% column is 1.970. Therefore, the internal
rate of return is less than 1 percent. Thus, if a two year economic life had been used for the previous request, it would not
have been financially feasible, even with a WCC of 5 percent.

The fact that a mistake was made in the past does not change the conclusion that the new investment is financially feasible at 15 percent, assuming that the economic life and cash flows have been estimated accurately.
Since, we cannot change the past, we simply must move on. The mistake should not be incorporated into the
calculations for the present decision since this would distort them

What is relevant here, however, is Dr. Michaels' ability to estimate economic lives. Dr. Larson should question Dr. Michaels' 10-year estimate carefully, to satisfy himself that it is as accurate as possible. No matter how
much he questions Dr. Michaels, though, it is impossible to predict the future with certainty, and thus a similar
mistake may be made again. While each decision must stand on its own, unaffected by prior mistakes, a series
of mistakes of the sort made two years ago will soon result in the company facing some serious financial difficulties.

Additionally, if the companys PP&E needs a return of, say, 15 percent, Dr. Michaels proposal is financially
feasible only if its economic life is 10 years. If it is 6 years, the IRR would be about 5 percent, just slightly
above the absurdly low WCC proposed by the chair of the finance committee. At a 5-year economic life, the
IRR falls to slightly below 1 percent. Given even a slight doubt about Dr. Michaels ability to predict economic
lives, this project is probably financially infeasible from an IRR perspective.
Question 5

There are a variety of non-quantitative factors to consider in this decision. Product quality, competition, researcher satisfaction, image as an company with the latest in technology, and others. Indeed, non-quantitative
factors would usually tip the scales if a choice were being made between replacement technology and new technology, or between research technology and technology for a service center, such as the maintenance department. On the other hand, if the company has the funds to invest, and if it is convinced that the estimates of cash
flows and economic lives are accurate, then an investment that is financially feasible in the maintenance department has just as much financial payoff as one in a research department.

Where the process becomes complicated is in a situation where the investment in, say, the maintenance department has an internal rate of return that is higher than one in a research department. It is here where nonquantitative factors may influence the institution to make the investment in research. Ultimately, the question of
the feasibility of Dr. Michaels proposal may rest on the opportunity cost to Erie of having her resign to take a
similar position with a competitor!