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($180,000  $150,000)(1  0.46) $16,200
Increase in cash charges X (1  tax rate):
(5,400)
($60,000 $70,0OO)( 1 0.46)
+Increase in depreciation expense X
tax rate: ($50,000  $30,000)(0.46) 9,200
$30,800
Terminal Cash Flow
Cash flows associated with a projectâ€™s termination generally include the disposal value of the project
plus or minus any taxable gains or losses associated with its sale. The way in which to compute these
gains or losses is very similar to the method for computing the taxes on the sale of an old asset. In most
cases, the disposal value at the end of the projectâ€™s useful life results in a taxable gain since its book value
(or undepreciated value) is usually zero. The terminal cash flow must include the recapture of working
capital investments required in the initial outlay.
8.3 CAPITAL BUDGETING TECHNIQUES
Several methods of evaluating investment projects are as follows:
1. Payback period
2. Accounting rate of return (ARR)
3. Net present value (NPV)
4. Internal rate of return (IRR)
5. Profitability index (or benefitkost ratio)
The NPV method and the IRR method are called discounted cash flow (DCF) methods. Each of these
methods is discussed below.
203
CAPITAL BUDGETING (INCLUDING LEASING)
CHAP. 81
Payback Period
The payback period measures the length of time required to recover the amount of initial
investment. It is computed by dividing the initial investment by the cash inflows through increased
revenues or cost savings.
Assume:
EXAMPLE 8.5
Cost of investment $18,000
Annual aftertax cash savings $ 3,000
Then, the payback period is:
initial investment cost 
=
$18â€™ooo 6 years
Payback period =
increased revenues or lost savings $3,000
Decision rule: Choose the project with the shorter payback period. The rationale behind this choice
is: The shorter the payback period, the less risky the project, and the greater the liquidity.
Consider two projects whose aftertax cash inflows are not even. Assume each project costs
EXAMPLE 8.6
$1,m.
Cash M o w
B ($1
A ($)
Year
100 500
1
2 200 400
300 300
3
4 400 100
5 500
600
6
When cash inflows are not even, the payback period has to be found by trial and error. The payback
period of project A is ($1,000 = $100 + $200 + $300 t$400) 4 years. The payback period of project B is
($1,000 = $500 + $400 + $100):
$100
2 years + = 2 years
5
$300
Project B is the project of choice in this case, since it has the shorter payback period.
The advantages of using the payback period method of evaluating an investment project are that
(1) it is simple to compute and easy to understand, and (2) it handles investment risk effectively.
The shortcomings of this method are that (1) it does not recognize the time value of money, and (2)
it ignores the impact of cash inflows received after the payback period; essentially, cash flows after the
payback period determine profitability of an investment.
Accounting Rate of Return
Accounting rate of return (ARR) measures profitability from the conventional accounting
standpoint by relating the required investmentor sometimes the average investment to the future
annual net income.
Decision rule: Under the ARR method, choose the project with the higher rate of return.
204 CAPITAL BUDGETING (INCLUDING LEASING) [CHAP. 8
EXAMPLE 8.7 Consider the following investment:
Initial investment $6,500
Estimated life 20 years
Cash inflows per year $1,OOo
$325
Depreciation per year (using straight line)
The accounting rate of return for this project is:
net income  $1,000  $325 = 10.4%

ARR =
investment $6,500
If average investment (usually assumed to be onehalf of the original investment) is used, then:
$l,OOO  $325
ARR = = 20.8%
$3,250
The advantages of this method are that it is easily understandable, simple to compute, and
recognizes the profitability factor.
The shortcomings of this method are that it fails to recognize the time value of money, and it uses
accounting data instead of cash flow data.
Net Present Value
Net present value (NPV) is the excess of the present value (PV) of cash inflows generated by the
project over the amount of the initial investment (I):
NPV=PVI
The present value of future cash flows is computed using the socalled cost of capital (or minimum
required rate of return) as the discount rate. In the case of an annuity, the present value would be
PV = A * PVIFA
where A is the amount of the annuity. The value of PVIFA is found in Appendix D.
Decision rule: If NPV is positive, accept the project. Otherwise, reject it.
EXAMPLE 8.8 Consider the following investment:
Initial investment $12,950
Estimated life 10 years
$3,000
Annual cash inflows
Cost of capital (minimum required rate of return) 12%
Present value of the cash inflows is
PV = APVIFA = $3,000 X PVIFAIz%,Io
$3,000 (5.6502) $16,950.60
=
Initial investment (I) 12,950.00
Net present value (NPV = PV  I) $4,000.60
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