Transcript Capital Budgeting

Chapter 11
Capital
Budgeting
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Learning Objective 1
Describe capital budgeting
decisions and use the net
present value (NPV)
method to make
such decisions.
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Capital Budgeting
Capital budgeting describes the long-term
planning for making and financing
major long-term projects.
Identify potential investments.
Choose an investment.
Follow-up or “post audit.”
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Discounted-Cash-Flow
Models (DCF)
These models focus on a project’s cash
inflows and outflows while taking into
account the time value of money.
DCF models compare the value of today’s
cash outflows with the value of the future
cash inflows.
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Net Present Value
The net-present-value (NPV) method is a
discounted-cash-flow approach to capital
budgeting that computes the present value
of all expected future cash flows using a
minimum desired rate of return.
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Net Present Value
The minimum desired rate of return depends
on the risk of a proposed project; the higher
the risk, the higher the rate.
The required rate of return (also called hurdle
rate or discount rate) is the minimum desired
rate of return based on the firm’s cost of capital.
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Applying the NPV Method
Prepare a diagram of relevant
expected cash inflows and outflows.
Find the present value of each
expected cash inflow or outflow.
Sum the individual present values.
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NPV Example
Original investment (cash outflow): $6,075
 Useful life: four years
 Annual income generated from investment
(cash inflow): $2,000
 Minimum desired rate of return: 10%

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NPV Example
YearsAmount
PV Factor Present Value
0
($6,075)
1.0000
($6,075)
1
2,000
.9091
1,818
2
2,000
.8264
1,653
3
2,000
.7513
1,503
4
2,000
.6830
1,366
Net present value
$ 265
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NPV Example
Years Amount
0
($6,075)
1-4
2,000
Net present value
PV Factor
1.0000
3.1699
Present Value
($6,075)
6,340
$ 265
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NPV Assumptions
There is a world of
certainty.
Predicted cash flows
occur timely.
There are perfect
capital markets.
Money can be borrowed
or loaned at the same
interest rate.
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Capital Budgeting Decisions
Managers determine the sum of the present values
of all expected cash flows from the project.
If the sum of the present values is positive, the
project is desirable.
If the sum of the present values is negative, the
project is undesirable.
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Learning Objective 2
Evaluate projects using
sensitivity analysis.
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Sensitivity Analysis
Actual cash inflows may differ from what
was expected or predicted.
 To examine uncertainty, managers often use
sensitivity analysis.
 Sensitivity analysis shows the financial
consequences that would occur if actual
cash inflows and outflows differ from those
expected.

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Sensitivity Analysis Example
Suppose that a manager knows that the
actual cash inflows in the previous example
could fall below the predicted level of
$2,000.
 How far below $2,000 must the annual cash
inflow drop before the NPV becomes
negative?

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Sensitivity Analysis Example
NPV = 0
(3.1699 × Cash flow) – $6,075 = 0
Cash flow = $6,075 ÷ 3.1699 = $1,916
If the annual cash flow is less than $1,916,
the NPV is negative, and the project
should be rejected.
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Learning Objective 3
Calculate the NPV difference
between two projects using
both the total project and
differential approaches.
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Comparison of Two Projects
Two common methods for comparing
alternatives are:
Total project approach
Differential approach
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Total Project Approach
The total project approach computes the
total impact on cash flows for each
alternative and then converts these total
cash flows to their present values.
 The alternative with the largest NPV of total
cash flows is best.

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Differential Approach
The differential approach computes the
differences in cash flows between
alternatives and then converts these
differences to their present values.
 This method cannot be used to compare
more than two alternatives.

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Learning Objective 4
Identify relevant cash flows
for DCF analyses.
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Relevant Cash Flows for NPV

1
2
3
4
Be sure to consider the four types of inflows
and outflows:
Initial cash inflows and outflows at time
zero
Investments in receivables and inventories
Future disposal values
Operating cash flows
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Operating Cash Flows
Using relevant-cost analysis, the only
relevant cash flows are those that will differ
among alternatives.
 Depreciation and book values should be
ignored.
 A reduction in cash outflow is treated the
same as a cash inflow.

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Learning Objective 5
Compute the after-tax net
present values of projects.
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Income Taxes and
Capital Budgeting
What is an example of another type of
cash flow that must be considered
when making capital-budgeting decisions?
Income taxes
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Marginal Income Tax Rate
In capital budgeting, the relevant tax rate
is the marginal income tax rate.
 This is the tax rate paid on additional
amounts of pretax income.

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Effects of
Depreciation Deductions
For tax purposes, accelerated depreciation
is generally allowed.
 The focus is on the tax reporting rules, not
those for public financial reporting.
 The number of years over which an asset is
depreciated for tax purposes is called the
recovery period.

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Depreciation Deductions for
Capital Budgeting
Depreciating a fixed asset creates future tax
deductions.
 The present value of this deduction depends
directly on its specific yearly effects on
future income tax payments.

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Depreciation Deductions for
Capital Budgeting
The present value is influenced by:
Depreciation method selected
Recovery period
Discount rate
Tax rate
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Tax Effect on Cash Inflows from
Depreciation Deductions
Depreciation expense is a noncash expense and
so is ignored for capital budgeting, except that
it is an expense for tax purposes and so will
provide a cash inflow from income tax savings.
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Tax Effect on
Cash Inflows from Operations
Assume the following:
Cash inflow from operations $60,000
Tax rate 40%
What is the after-tax inflow from operations?
$60,000 × (1 – tax rate) = $60,000 × .6 = $36,000
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Modified Accelerated Cost
Recovery System
Under U.S. income tax laws, most assets
purchased since 1987 are depreciated using
the Modified Accelerated Cost Recovery
System (MACRS).
 This system specifies a recovery period and
an accelerated depreciation schedule for all
types of assets.

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Learning Objective 6
Explain the after-tax effect on
cash of disposing of assets.
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Gains or Losses on Disposal
Suppose a piece equipment purchased
for $125,000 is sold at the end of year
3 after taking three years of straight-line
depreciation.
What is the book value?
$125,000 – (3 × $25,000) = $50,000
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Gains or Losses on Disposal
If it is sold for book value, there is no gain
or loss and so there is no tax effect.
 If it is sold for more than $50,000, there is a
gain and an additional tax payment.
 If it is sold for less than $50,000, there is
a loss and a tax savings.

TAX
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Learning Objective 7
Compute the impact of inflation
on a capital-budgeting project.
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Inflation
What is inflation?
It is the decline in general
purchasing power of the monetary unit.
The key in capital
budgeting is consistent
treatment of the minimum
desired rate of return and the
predicted cash inflows and outflows.
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Watch for Consistency
Such consistency can be achieved by
including an element for inflation in
both the minimum desired rate of
return and in the cash-flow predictions.
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Learning Objective 8
Use the payback model
and the accounting
rate-of-return model
and compare them
with the NPV model.
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Payback Model

Payback time, or payback period, is the
time it will take to recoup, in the form of
cash inflows from operations, the initial
dollars invested in a project.
P= I ÷ O
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Payback Model Example
Assume that $12,000 is spent for a machine
with an estimated useful life of 8 years.
 Annual savings of $4,000 in cash outflows
are expected from operations.
 What is the payback period?

P = I ÷ O = $12,000 ÷ $4,000 = 3 years
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Accounting Rate-of-Return
Model

The accounting rate-of-return (ARR) model
expresses a project’s return as the increase
in expected average annual operating
income divided by the required initial
investment.
ARR
=
Increase in expected
average annual
operating income
÷
Initial
required
investment
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Accounting Rate-of-Return
Model
Assume the following:
Investment is $6,075.
Useful life is four years.
Estimated disposal value is zero.
Expected annual cash inflow
from operations is $2,000.
What is the annual depreciation?
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Accounting Rate-of-Return
Model
$6,075 ÷ 4 = $1,518.75, rounded to $1,519
What is the ARR?
ARR = ($2,000 – $1,519) ÷ $6,075 = 7.9%
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Learning Objective 9
Reconcile the conflict between
using an NPV model for making
a decision and using accounting
income for evaluating the
related performance.
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Performance Evaluation
The best way to reconcile any potential conflict
between capital budgeting and performance
evaluation is to use a DCF for both
capital-budgeting decisions and
performance evaluation.
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Post Audit
A recent survey showed that most large
companies conduct a follow-up evaluation
of at least some capital-budgeting decisions,
often called a post audit.
 The post audit focuses on actual versus
predicted cash flows.

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Learning Objective 10
Understand how companies
make long-term capital
investment decisions and how
such decisions can affect the
companies’ financial results
for years to come.
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Long-term Capital Investments…
are critical to a company’s financial success.
Using a discounted cash-flow method helps
managers make optimal capital budgeting
decisions.
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End of Chapter 11
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