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 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 (w/c)
Future disposal values
Operating cash flows
(w/c) – working capital
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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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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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Learning Objective 6
Explain the after-tax effect on
cash of disposing of assets.
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Gains or Losses on Disposal
Suppose an equipment with a 5-year life
was purchased for $125,000 and is now
sold at the end of year 3 after taking 3
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
1. If it is sold for book value, there is no gain
or loss and so there is no tax effect.
2. If it is sold for more than $50,000, there is
a gain and an additional tax payment.
3. If it is sold for less than $50,000, there is
a loss and a tax savings.
TAX
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Example 1
Sales
= $50,000
Book Value = $50,000
Profit
=
0
Taxes @30% =
0
Cash Flow from Sale = $50,000
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Example 2
Sales
= $70,000
Book Value = $50,000
Profit
= $20,000
Taxes @30% = $6,000
Cash Flow from Sale = $64,000
(70,000-6,000)
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Example 3
Sales
= $30,000
Book Value = $50,000
Profit
= ($20,000)
Taxes @30% = ($6,000)
(taxes saved)
Cash Flow from Sale = $36,000
(30,000 - -6,000)
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Comprehensive Example:







Machine Cost = $100,000
Required increase in inventory $10,000
Depreciation, straight-line for 5 years
Sold after 3 years for $65,000 and inventory fully
recouped
Annual cash revenue is $50,000
Annual cash expenses is $12,000
Tax rate 30%, desired rate of return 10%
Required - NPV ?
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Year 0
$
Machine Cost
100,000
Increase in inventory 10,000
Initial Investment
110,000
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Year 1, 2 & 3
Cash Revenues
$50,000
Cash Expenses
12,000
Net Operating Cash before tax 38,000
x (1- 0.30)
Net Operating Cash after tax = 26,600
Tax savings from depreciation:
20,000 x 0.30
= 6,000
Total net cash flow
= 32,600
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Also in Year 3
Sales
= $65,000
Book Value = $40,000
Profit
= $25,000
Taxes @30% = $7,500
Cash Flow from Sale = $57,500
Inventory recouped = $10,000
Terminal Cash Flow = $67,500
(65,000- 7,500)
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NPV
Year
0
Initial Investment
Annual Cash Flow
Terminal Cash Flow
x
(Pvif 10%,n)
1
2
3 _
(110,000)
32,600
32,600
32,600
67,500
(110,000)
32,600
32,600 100,100
1
0.9091
0.8264
0.7513
(110,000)
29,637
26,941
75,205
 = 21, 783
 NPV = $21,783  Go ahead and purchase machine
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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.
Simply put, one has to factor in
inflation in estimating future cash
flows
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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
(If the cash flows represent an annuity)
The payback model has some deficiencies!
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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.

We will NOT go any further in this because it is
also has deficiencies!
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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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