Chapter 21. Capital Budgeting and Cost Analysis (Cost Accounting)

Capital Budgeting
and Cost Analysis

Chapter 21
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
21 - 1
Learning Objective 1
Recognize the multiyear focus
of capital budgeting.
21 - 2
Two Dimensions of Cost Analysis

1. A project dimension
2. An accounting-period dimension
The accounting system that corresponds to the
project dimension is termed life-cycle costing.
21 - 3
Two Dimensions of Cost Analysis

Project D
Project C
Project B
Project A
2002
2003
2004
2005
2006
21 - 4
Understand the six stages of
capital budgeting for a project.
21 - 5
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.
21 - 6
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

21 - 7
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.
21 - 8

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.
21 - 9

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.
21 - 10
Use and evaluate the two main
discounted cash-flow (DCF)
methods: the net present value
(NPV) method and the internal
rate-of-return (IRR) method.
21 - 11
Time Value of Money

Compound Growth,
5 periods at 6%
Year 5: $1.338
Year 4: $1.262
Year 3: $1.91
Year 2: $1.124
Year 1: $1.06
Year 0: $1.00
21 - 12
Discounted Cash Flow

There are two main DCF methods:
Net present value (NPV) method
Internal rate-of-return (IRR) method
21 - 13
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?
21 - 14

Year in the Life of the Project
0
$(250,000)
$125,000 $130,000 $115,000
Net initial
investment
Annual cash
inflows
21 - 15

Net Cash
Year
10% Col.
Inflows
1
0.909
$125,000
2
0.826
130,000
3
0.751
115,000
Total PV of net cash inflows
Net initial investment
Net present value of project
NPV of Net
Cash Inflows
$113,625
107,380
86,365
$307,370
250,000
$ 57,370
21 - 16

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%.
21 - 17

Net Cash
Years 10% Col. Inflows
1-3
2.487
$80,000
3
0.751
9,000
Net initial investment
Net present value of project
NPV of Net
Cash Inflows
$198,960
6,759
$205,719
250,000
($ 44,281)
21 - 18
Internal Rate of Return

Investment
= Expected annual net cash inflow
PV annuity factor
Investment
Expected annual net cash inflow
= PV annuity factor
21 - 19
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)
21 - 20
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.
21 - 21
Comparison of NPV and IRR

The IRR of individual projects cannot be
added or averaged to derive the IRR
of a combination of projects.
21 - 22
Use and evaluate the
payback method.
21 - 23
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.
21 - 24
Payback Method Example

Assisted Living is considering buying Machine 1.
Useful life is eleven years.
Estimated residual value is zero.
21 - 25

How long would it take to recover the investment?
$210,000 $35,000 = 6 years
Six years is the payback period.
21 - 26

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?
21 - 27

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?
21 - 28

Year 1 brings in $160,000.
Recovery of the amount
invested occurs in Year 2.
21 - 29

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
21 - 30
Use and evaluate the accrual
accounting rate-of-return
(AARR) method.
21 - 31
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
21 - 32
Accrual Accounting
Rate-of-Return Method Example
Useful life is five years.
IRR is 10%.
What is the average operating income?
21 - 33
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%
21 - 34
Identify and reduce conflicts
from using DCF for capital
budgeting decisions and
accrual accounting for
performance evaluation.
21 - 35
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.
21 - 36
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.
21 - 37
Identify relevant cash
inflows and outflows for
capital budgeting decisions.
21 - 38
Relevant Cash Flows

Relevant cash flows are expected future cash
flows that differ among the alternatives.
21 - 39
Relevant Cash Flows

Net initial investment components
cash outflow to purchase investment
working-capital cash outflow
cash inflow from disposal of old asset
21 - 40
Relevant Cash Flow

Analysis Example
G. T. is considering replacing old equipment.
Old equipment:
Current book value
Current disposal price
Terminal disposal price (5 years)
Annual depreciation
Working capital
Income tax rate
$50,000
$ 3,000
0
$10,000
$ 5,000
40%
21 - 41
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
21 - 42
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
21 - 43
Relevant Cash Flow

Analysis Example
New equipment:
Current book value
Current disposal price is irrelevant
Terminal disposal price (5 years)
Annual depreciation
Working capital
$225,000
0
$ 45,000
$ 15,000
21 - 44
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
21 - 45
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
Deduct income tax (40%)
Annual after-tax flow from operations
$90,000
36,000
$54,000
21 - 46
Relevant Cash Flow

Analysis Example
What is the difference in depreciation deduction?
Annual depreciation
of new equipment
Deduct annual depreciation
of old equipment
Difference
$45,000
10,000
$35,000
21 - 47
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
21 - 48
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
21 - 49
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?
21 - 50
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
$238,636
Investment
213,200
Net present value of new equipment $ 25,436
21 - 51
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.
21 - 52
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.
21 - 53
End of Chapter 21
21 - 54

Chapter 21. Capital Budgeting and Cost Analysis (Cost Accounting)

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Chapter 21. Capital Budgeting and Cost Analysis (Cost Accounting)

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Capital Budgeting

and Cost Analysis

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

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

Two Dimensions of Cost Analysis

Two Dimensions of Cost Analysis

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

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

6. Implementation and control stage

Capital Budgeting Example

Capital Budgeting Example

Capital Budgeting Example

Time Value of Money

Discounted Cash Flow

Net Present Value Example

Only projects with a zero or positive

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

Net Present Value Example

$125,000 $130,000 $115,000

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

Net Present Value Example

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

Net Present Value Example

Net Present Value Example

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

Internal Rate of Return

Internal Rate of Return Example

Comparison of NPV and IRR

Comparison of NPV and IRR

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

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

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

Payback Method Example

Payback Method Example

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

Payback Method Example

Payback Method Example

Payback Method Example

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

Payback Method Example

$ 90,000 needed to complete recovery

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

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

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

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

Relevant Cash Flows

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

Relevant Cash Flows

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

Relevant Cash Flow

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

Relevant Cash Flow

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

Relevant Cash Flow

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

Relevant Cash Flow

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

Relevant Cash Flow

Relevant Cash Flow

Relevant Cash Flow

Relevant Cash Flow

Relevant Cash Flow

Relevant Cash Flow

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