Cost Accounting

Foundations and Evolutions

Kinney and Raiborn
Seventh Edition
Chapter 15
Capital Budgeting

COPYRIGHT © 2009 South-Western, a part of Cengage Learning. South-Western is a trademark used herein

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under license

1
 Learning Objectives (1 of 3)
• Explain why most capital budgeting methods
focus on cash flows
• Compute and describe what is measured by the
payback period
• Explain how the net present value and
profitability index of a project are measured
• Compute the internal rate of return and explain
what it measures
2
 Learning Objectives (2 of 3)
• Describe how taxation and depreciation
methods affect cash flows
• Explain the assumptions and limitations of the
various capital project evaluation methods
• Explain how managers rank investment projects
• Clarify how risk is considered in capital
budgeting analyses

3
 Learning Objectives (3 of 3)
• Explain a postinvestment audit of a capital
project
• (Appendix 1) Calculate present values
• (Appendix 2) List the advantages and
disadvantages of the accounting rate of return

4
 Capital Assets
• Capital assets are long-term assets used to
– Generate future revenues or cost savings
– Provide distribution, service, or production
capabilities
• Tangible fixed assets
– Land, building, machinery, etc.
• Intangible assets
– Capital lease, patent, etc.

5
 Capital Budgeting
• Capital budgeting is the process for
evaluating and ranking alternative long-
range projects for the purpose of allocating
limited resources
– Plan and prepare the capital budget
– Review past investments to assess success of
past decisions and enhance the decision process
in the future

6
 Capital Budgeting
Part of the Financial Budget
Statement of
Cash Budget
Cash Flows

Capital
Income Operating Budget Budget
Statement

Statement of
Retained Earnings Balance Sheet
7
 Capital Budgeting
• Compare and evaluate alternative projects
– financial and nonfinancial criteria
– short and long-term benefits
– usually multiple criteria
-- consider all significant stakeholders

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9
Capital Budgeting --Quantitative
• Accounting rate of return
• Payback period
• Discounted payback period
• Internal rate of return
• Profitability index

Management Accounting 2004

10
 Capital Budgeting --Qualitative
• Employee morale, safety, and responsibility
• Corporate image
• Social responsibility
• Market share
• Growth
• Strategic planning
• Insure wood supply Management Accounting 2004
11
 Capital Budgeting
Financial Analysis
• Payback period
• Net present value Cash
Flow
• Profitability index Focus
• Internal rate of return
• Accounting rate of return

12
 Cash Flow
• Cash Receipts
– Revenues earned and collected
– Savings generated by reducing operating costs
– Proceeds from sale of assets
• Cash Disbursements
– Expenditures for asset acquisition
– Working capital investments
– Costs for direct material, direct labor, and overhead

13
 Investment vs. Financing
Investment Decision Financing Decision
• Which assets to • How to raise capital
acquire (debt/equity) to fund
• Made by divisional an investment
managers and top • Made by Treasurer
management and top management
• Interest is a financing
decision
First justify the acquisition
Then justify how to finance it 14
$ Interest Cost $
• Cash flow associated with debt financing
• Not part of the project selection process

15
 Payback Period
• Time required for project’s cash inflows to
equal the original investment
– longer it takes to recover the original investment,
the greater the risk
– the faster capital is returned, the more rapidly it
can be invested in other projects
– management sets a maximum payback period

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 Payback Period
Original Investment
= Payback Period
Annual Cash Inflows
(assuming equal cash flows)

Example:
Original Investment $25,000
Annual Cash Inflows $10,000
Payback Period 2.5 years

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 Payback Period
• Ignores
– cash inflows that occur after payback
has been reached
– desired rate of return
– time value of money

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 Discounting Future Cash Flows
• Reduce the future value of cash flows by
the portion that represents interest
• Variables are
– length of time until the cash flow is received or
paid
– required rate of return on capital - discount rate
• Present value is stated in a common base of
current dollars
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 % Discount Rate %
• Discount rate should equal or exceed the
cost of capital
• Cost of Capital - weighted average cost for
the debt and equity that comprise a firm’s
financial structure

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 Returns
• Return OF Capital
– Recovery of the initial investment
• Return ON Capital
– Represents income
– Original investment multiplied by the discount
rate

$100,000 x 12% = $12,000 return on capital

21
Discounted Cash Flow Methods
• Net Present Value
• Profitability Index
• Internal Rate of Return

22
 Net Present Value
• Evaluates if project rate of return is greater
than, equal to, or less than the desired rate
of return
• Present value equals the cash flows
discounted using the desired rate of return
• Net present value equals present value of
cash inflows minus present value of cash
outflows
• Does not calculate the rate of return
23
 Net Present Value
Minus Investment made currently
Plus PV of future cash inflows or
cost savings
Minus PV of future cash outflows
EqualsNet present value

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 Net Present Value
• Net present value = 0
– actual rate of return equals desired rate of
return
• Net present value > 0
– actual rate of return is greater than desired rate
of return
• Net present value < 0
– actual rate of return is less than desired rate of
return 25
 Net Present Value
• Function of two factors
– Discount rate
– Amount and timing of cash flows
• Useful to select best project among
investments that can perform the same task
or achieve the same objective
• When comparing independent projects
requiring different initial investments, use
the Profitability Index
26
 Profitability Index
• Compares present value of net cash flows to
net investment
• Measures efficiency of the use of capital
• Should be greater than or equal to 1
• Does not calculate the rate of return

Profitability = PV of Net Cash Flows Index

Net Investment

27
 Profitability Index
Project 1 2
PV of net cash flows $900,000 $580,000
Net investment 720,000 425,000
Net present value $180,000 $155,000
Profitability Index
$900,000/$720,000 1.25
$580,000/$425,000 1.36
Assuming limited funds,
which project would you choose? 28
 Internal Rate of Return
• Discount rate where
PV of cash inflows = PV of cash outflows
NPV = 0
• Hurdle rate is the lowest acceptable return on
investment (at least equal to the cost of capital)
– If Internal Rate of Return = Hurdle Rate; Accept
– If Internal Rate of Return > Hurdle Rate; Accept
– If Internal Rate of Return < Hurdle Rate; Reject

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 Internal Rate of Return
• Computed using
– Financial calculators
– Computers
– Annuity tables (assuming equal cash
flows)
– Trial and error

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 Income Taxes
An integral part of the business planning
and decision-making process

Operating income is taxed which reduces

the cash inflows from projects

Depreciation reduces operating income

which reduces the taxes paid

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 After-Tax Cash Flows
• Depreciation is not a cash flow item
• Depreciation on capital assets affects cash
flows by reducing the tax obligation
• Depreciation is a tax shield that provides a
tax benefit

depreciation tax benefit =

depreciation expense x tax rate
32
 Tax Depreciation
• Deprecation tax shield is affected by
– Changes in tax laws
– Different depreciation methods
– Changes in tax rates

33
 Capital Budgeting
• Understand similarities and differences of
capital budgeting methods
• Use several techniques
• Limitations of all methods
– Management preferences regarding timing of
cash flows are not included
– Single, deterministic measures of cash flow are
used rather than probabilities
34
 Payback
Assumptions Limitations
• •Speedy
Ignores
recovery
cash flows
of after payback
•investment is key
Ignores time value of money
• Cash flows can be
accurately predicted
• Risk is lower for the
shorter payback
project
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 Net Present Value
Assumptions Limitations
• Discount rate is valid • Alternative project
• Timing and size of cash flows rates of return are not
can be predicted known
• Life of project can be • Internal rate of return
predicted on project is not
• If shorter-lived project reflected
selected, proceeds of shorter
project will earn the discount
rate through theoretical
completion of longer project 36
 Profitability Index
Assumptions Limitations
• Measures efficient use of • A relative answer is
capital given but dollars of
• Discount rate is valid NPV are not reflected
• Timing and size of cash • Alternative project rates
flows can be predicted of return are not known N
P
N • Life of project can be • Internal rate of return on
V
P predicted project is not reflected
V • If shorter project selected,
proceeds of shorter project
will earn the discount rate
through theoretical
completion of longer project
 Internal Rate of Return (IRR)
Assumptions
• Hurdle rate is valid
• Timing and size of cash
flows can be predicted
• Project life can be
predicted
• If shorter project selected,
proceeds of shorter project
will continue to earn the
IRR through theoretical
completion of longer
project
Limitations
• Projects are ranked by
IRR and not dollar size
• Net present value dollars
are not reflected
• Multiple rates of return
can be calculated on the
same project
 Comparing Techniques
Payback NPV PI IRR
• Uses time value money N Y Y Y
• Provides specific rate of
return N N N Y
• Uses cash flows Y Y Y Y
• Considers returns
during life of project N Y Y Y
• Uses discount rate N Y Y N*
*often used as a hurdle rate
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 The Investment Decision
• Is the activity worthy of an investment?
• Which assets can be used for the activity?
• Of the available assets for each activity,
which is the best investment?
• Of the “best investments” for all
worthwhile activities, in which ones should
the company invest?
Consider Quantitative and Qualitative Factors
40
 Capital Budgeting Terms
• Screening decision
• Preference decision
• Mutually exclusive projects
• Independent projects
• Mutually inclusive projects

41
 Ranking Capital Projects
• For the projects under consideration
– Net present value is nonnegative
– Profitability index of 1 or more
– Internal rate of return equals or exceeds hurdle
rate
• Selection ranking of multiple projects
– Results can vary depending on evaluation
techniques and whether dollars or percentages
are used
42
 Ranking Capital Projects
• Reinvestment Assumptions
– Net present value and profitability index
assume that released cash flows are reinvested
at the discount rate
• at least the cost of capital
– Internal rate of return assumes that released
cash flows are reinvested at the expected
internal rate of return
• could be substantially different than the cost of
capital
43
 Ranking Capital Projects
• Net present value compared to internal rate
of return
– more realistic reinvestment assumption
– results measured in dollars not rates

? ?
Do you prefer
a 100% return on $1, or
a 10% return on $100?

44
 Compensating for Risk
• Judgmental method
– Use logic and reasoning to decide if acceptable
rate of return will be achieved
• Risk-adjusted discount rate method
– Higher discount/hurdle rate for riskier projects
and/or cash flows
– Shorter payback period for riskier projects
– Higher IRR for riskier projects
• Sensitivity analysis
45
 Compensating for Risk
• Sensitivity Analysis - the amount of change that
must occur in a variable before a different
decision would be made
– Discount rate - What increases could occur in the
cost of capital and related discount rate before a
project becomes unacceptable?
– Cash flows - How small can the net cash inflows be
before a project becomes undesirable?
– Asset life - What is the minimum time the cash flows
must be received for the project to remain
acceptable?
46
 Postinvestment Audit
• Complete after project has stabilized
• Compare actual results to expected results
• Use same analysis techniques
• Identify areas where results differ from
expectation
• Evaluate capital budgeting process,
particularly original projections, problems
with implementation, sponsor credibility

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Time Value of Money (Appendix 1)
• Future value (FV) and present value (PV)
depend on
– amount of cash flow
– rate of interest
– timing of cash flow
• Simple vs. compound interest
• Single cash flow
• Annuity
– Ordinary annuity or annuity due
48
Accounting Rate of Return (Appendix 2)
• Measures rate of return on earnings for
average capital investment over project’s
life
• Consistent with accounting model
• Uses profits shown on accrual-based
financial statements
• Not based on cash flows
Accounting = Average Annual Profits
Rate of Return Average Investment
49
 Questions
• Why do most capital budgeting methods
focus on cash flows?
• What is the relationship between the net
present value and the profitability index?
• What are the assumptions and limitations of
the various capital project evaluation
methods?

50
 Potential Ethical Issues
• Ignoring detrimental environmental
impact of project decisions
• Changing assumptions or estimates to
meet criteria for approval
• Using a discount rate that is
inappropriately low

51
 Potential Ethical Issues
• Not conducting a post-investment audit
to hold decision makers accountable
• Choosing projects based on accounting
earnings only rather than including
discounted cash flow methods

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