Capital Budgeting

Capital Budgeting
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 1
Capital Budgeting
Capital budgeting is the making of long-run

planning decisions for investments in
projects and programs.
It is a decision-making and control tool that
focuses primarily on projects or programs
that span multiple years.

Capital Budgeting
Capital budgeting is a six-stage process:

1. Identification stage 2. Search stage
3. Information-acquisition stage
4. Selection stage 5. Financing stage
6. Implementation and control stage
Capital Budgeting Example
One of the goals of Assisted Living is to improve

the diagnostic capabilities of its facility.
Management identifies a need to consider the
purchase of new equipment.
The search stage yields several alternative
models, but management focuses on
one particular machine.

The administration acquires information.
Initial investment is $245,000.
Investment in working capital is $5,000.
Useful life is three years.
Estimated residual value is zero.
Net cash savings is $125,000,
$130,000, and $110,000 over its life.
Working capital is expected to be recovered at

the end of year 3 with an expected return of 10%.
Operating cash flows are assumed to occur
at the end of the year.
In the selection stage, management must decide
whether to purchase the new machine.

Time Value of Money
Compound Growth,
Year 5: $1.338
5 periods at 6%
Year 4: $1.262
Year 3: $1.91
Year 2: $1.124
Year 1: $1.06
Year 0: $1.00
Discounted Cash Flow
There are two main DCF methods:
Net present value (NPV) method
Internal rate-of-return (IRR) method

Net Present Value Example
Only projects with a zero or positive

net present value are acceptable.
What is the the net present value of
the diagnostic machine?
Year in the Life of the Project
0 1 2 3
$(250,000) $125,000 $130,000 $115,000
Net initial Annual cash

investment inflows

Net Cash NPV of Net
Year 10% Col. Inflows Cash Inflows
1 0.909 $125,000 $113,625
2 0.826 130,000 107,380
3 0.751 115,000 86,365
Total PV of net cash inflows $307,370
Net initial investment 250,000
Net present value of project $ 57,370

The company is considering another investment.
Investment in working capital is $5,000.
Working capital will be recovered.
Useful life is three years.
Estimated residual value is $4,000.
Net cash savings is $80,000 per year.
Expected return is 10%.

Net Cash NPV of Net

Years 10% Col. Inflows Cash Inflows
1-3 2.487 $80,000 $198,960
3 0.751 9,000 6,759
Net initial investment 250,000
Net present value of project ($ 44,281)
Internal Rate of Return
Investment
= Expected annual net cash inflow
× PV annuity factor
Investment
÷ Expected annual net cash inflow
= PV annuity factor

Internal Rate of Return Example

Useful life is five years.
Net cash inflows is $80,000 per year.
What is the IRR of this project?
$303,280 ÷ $80,000 = 3.791 (PV annuity factor)
10% (from the table, five-period line)
Comparison of NPV and IRR
The NPV method has the advantage that the end

result of the computations is expressed in
dollars and not in a percentage.
Individual projects can be added.
It can be used in situations where the required
rate of return varies over the life of the project.

Comparison of NPV and IRR
The IRR of individual projects cannot be

added or averaged to derive the IRR
of a combination of projects.
Payback Method
Payback measures the time it will take to

recoup, in the form of expected future cash
flows, the initial investment in a project.

Payback Method Example
Assisted Living is considering buying Machine 1.

Useful life is eleven years.
Estimated residual value is zero.
How long would it take to recover the investment?

$210,000 ÷ $35,000 = 6 years
Six years is the payback period.

Suppose that as an alternative to the $210,000

piece of equipment, there is another one
(Machine 2) that also costs $210,000 but will
save $42,000 per year during its five-year life.
What is the payback period?
$210,000 ÷ $42,000 = 5 years
Which piece of equipment is preferable?
Assisted Living is considering buying Machine 3.

Useful life is eleven years.
Cash savings are $160,000, $180,000,
and $110,000 over its life.
What is the payback period?

Year 1 brings in $160,000.

Recovery of the amount
invested occurs in Year 2.
Payback = 1 year
+ $ 90,000 needed to complete recovery
÷ 180,000 net cash inflow in Year 2
= 1 year + 0.5 year
= 1.5 years or 1 year and 6 months

Accrual Accounting
Rate-of-Return Method
The accrual accounting rate-of-return (AARR)

method divides an accounting measure of
income by an accounting measure of investment.
Increase in expected Initial

AARR = average annual ÷ required
operating income investment
Accrual Accounting
Rate-of-Return Method Example

Useful life is five years.
IRR is 10%.
What is the average operating income?

Accrual Accounting
Rate-of-Return Method Example
Straight-line depreciation is $60,656 per year.

Average operating income is
$80,000 – $60,656 = $19,344.
What is the AARR?
AARR
= ($80,000 – $60,656) ÷ $303,280
= .638, or 6.4%
Performance Evaluation
A manager who uses DCF methods to make capital
budgeting decisions can face goal congruence
problems if AARR is used for
performance evaluation.
Suppose top management uses the AARR to
judge performance if the minimum desired
rate of return is 10%.
A machine with an AARR of 6.4% will be rejected.

Performance Evaluation
The conflict between using AARR and
DCF methods to evaluate performance
can be reduced by evaluating managers
on a project-by-project basis.
Relevant Cash Flows
Relevant cash flows are expected future cash

flows that differ among the alternatives.

Relevant Cash Flows
Net initial investment components

– cash outflow to purchase investment
– working-capital cash outflow
– cash inflow from disposal of old asset
Relevant Cash Flow

Analysis Example
G. T. is considering replacing old equipment.
Old equipment:
Current book value $50,000
Current disposal price $ 3,000
Terminal disposal price (5 years) 0
Annual depreciation $10,000
Working capital $ 5,000
Income tax rate 40%

Relevant Cash Flow
Analysis Example
Current disposal price of old equipment $ 3,000

Deduct current book value of old equipment 50,000
Loss on disposal of equipment $47,000
How much are the tax savings?
$47,000 × 0.40 = $18,800
Relevant Cash Flow

Analysis Example
What is the after-tax cash flow from

current disposal of old equipment?
Current disposal price $ 3,000
Tax savings on loss 18,800
Total $21,800

Relevant Cash Flow
Analysis Example
New equipment:
Current book value $225,000
Current disposal price is irrelevant
Terminal disposal price (5 years) 0
Annual depreciation $ 45,000
Working capital $ 15,000
Relevant Cash Flow

Analysis Example
How much is the net investment

for the new equipment?
Current cost $225,000
Add increase in working capital 10,000
Deduct after-tax cash flow from
current disposal of old equipment – 21,800
Net investment $213,200

Relevant Cash Flow
Analysis Example
Assume $90,000 pretax annual cash flow from

operations (excluding depreciation effect).
What is the after-tax flow from operations?
Cash flow from operations $90,000
Deduct income tax (40%) 36,000
Annual after-tax flow from operations $54,000
Relevant Cash Flow

Analysis Example
What is the difference in depreciation deduction?

Annual depreciation
of new equipment $45,000
Deduct annual depreciation
of old equipment 10,000
Difference $35,000

Relevant Cash Flow
Analysis Example
What is the annual increase in income tax

savings from depreciation?
Increase in depreciation $35,000
Multiply by tax rate .40
Income tax cash savings
from additional depreciation $14,000
Relevant Cash Flow

Analysis Example
What is the cash flow from operations,

net of income taxes?
Annual after-tax flow from operations $54,000
Income tax cash savings from
additional depreciation 14,000
Cash flow from operations,
net of income taxes $68,000

Relevant Cash Flow
Analysis Example
G. T. requires a 14% rate of return

on its investments.
What is the net present value of the new
equipment incorporating income taxes?
Relevant Cash Flow

Analysis Example
Net Cash NPV of Net

Years 14% Col. Inflows Cash Inflows
1-5 3.433 $68,000 $233,444
5 0.519 10,000 5,190
Investment 213,200
Net present value of new equipment $ 25,436

Postinvestment Audit
A postinvestment audit compares the actual

results for a project to the costs and benefits
expected at the time the project was selected.
It provides management with feedback
about performance.
Strategic Considerations
Capital investment decisions

that are strategic in nature
require managers to consider
a broad range of factors that
may be difficult to estimate.

Capital Budgeting

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Capital Budgeting

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Capital Budgeting

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 1

Capital budgeting is the making of long-run

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 2

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 1

Capital budgeting is a six-stage process:

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 3

Capital Budgeting Example

One of the goals of Assisted Living is to improve

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 2

Capital Budgeting Example

Working capital is expected to be recovered at

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 6

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 3

Discounted Cash Flow

There are two main DCF methods:

Net present value (NPV) method

Internal rate-of-return (IRR) method

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 8

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 4

Only projects with a zero or positive

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 9

Net Present Value Example

Year in the Life of the Project

Net initial Annual cash

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 5

Net Present Value Example

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 6

Net Cash NPV of Net

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 13

Internal Rate of Return

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 14

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 7

Initial investment is $303,280.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 15

Comparison of NPV and IRR

The NPV method has the advantage that the end

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 16

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 8

The IRR of individual projects cannot be

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 17

Payback measures the time it will take to

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 18

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 9

Assisted Living is considering buying Machine 1.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 19

Payback Method Example

How long would it take to recover the investment?

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 20

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 10

Suppose that as an alternative to the $210,000

Payback Method Example

Assisted Living is considering buying Machine 3.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 11

Year 1 brings in $160,000.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 23

Payback Method Example

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 24

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 12

The accrual accounting rate-of-return (AARR)

Increase in expected Initial

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 25

Initial investment is $303,280.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 21 - 26