Capital Budgeting: Click To Edit Master Subtitle Style

Capital Budgeting
Chapter 11 Click to edit Master subtitle style
2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
11 - 1
Capital Budgeting
Capital budgeting describes the long-term planning for making and financing major long-term projects.
1. Identify potential investments. 2. Choose an investment. 3. Follow-up or postaudit.
11 - 2
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 Incremental inflow
11 - 3
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 = $12,000 $4,000 = 3 years
11 - 4
Accounting Rate-of-Return Model

The accounting rate-of-return (ARR) model expresses a projects 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
11 - 5
Accounting Rate-of-Return Example

Assume the following: Investment is $6,075. Useful life is 4 years. Estimated disposal value is zero. Expected annual cash inflow from operations is $2,000.
What is the annual depreciation?
11 - 6
Accounting Rate-of-Return Example

$6,075 4 = $1,518.75 (rounded to $1,519)
What is the ARR?
ARR = ($2,000 $1,519) $6,075 = 7.9%
11 - 7
Discounted-Cash-Flow Models (DCF)

These models focus on a projects cash inflows and outflows while taking into account the time value of money.
DCF models compare the value of todays cash outflows with the value of the future cash inflows.
11 - 8
Net Present Value Model

The net-present-value (NPV) method computes the present value of all expected future cash flows using a minimum desired rate of return.
11 - 9
Net Present Value Model

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 firms cost of capital.
11 10
Applying the NPV Method

1 2 3
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.
11 11
NPV Example
Original investment (cash outflow): $6,075
Useful life: 4 years
Annual income generated from investment (cash inflow): $2,000
Minimum desired rate of return: 10%
11 12
NPV Example
Years Amount 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 PV Factor 0 ($6,075) 1.0000 1-4 2,000 3.1699 Net present value Present Value ($6,075) 6,340 $ 265
11 14
Assumptions of the NPV Model

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.
11 15
Decision Rules
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.
11 16
Internal Rate of Return Model

The IRR determines the interest rate at which the NPV equals zero.
If IRR > minimum desired rate of return, then NPV > 0 and accept the project.
If IRR < minimum desired rate of return, then NPV < 0 and accept the project.
11 17
Sensitivity Analysis
Sensitivity analysis shows the financial consequences that would occur if actual cash inflows and outflows differ from those expected.
11 18
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?
11 19
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.
11 20
Relevant Cash Flows for NPV

The 4 types of inflows and outflows should be considered when the relevant cash flows are arrayed:
1) 2)
Initial cash inflows and outflows at time zero Investments in receivables and inventories 3) Future disposal values 4) Operating cash flows
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Operating Cash Flows

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.
11 22
Cash Flows for Investment in Technology

Suppose a company has a $10,000 net cash inflow this year using a traditional system.
Investing in an automated system will increase the net cash inflow to $12,000.
Failure to invest will cause net cash inflows to fall to $8,000.
11 23
Cash Flows for Investment in Technology

What is the benefit from the investment?
$12,000 $8,000 = $4,000
11 24
Income Taxes and Capital Budgeting

What is another type of cash flow that must be considered when making capital-budgeting decisions?
Income taxes
11 25
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.
11 26
Effects of Depreciation Deductions

Depreciation expense is a non-cash 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.
TAX
11 27
Tax Deductions, Capital Effects, and Timing

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
11 28
Tax Deductions, Capital Effects, and Timing

What is the after-tax effect of $25,000 depreciation?
$25,000 40% = $10,000 tax savings
11 29
Gains or Losses on Disposal

Suppose a 5-year piece of 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
11 30

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.
11 31

Assume that it is sold for $70,000 and the tax rate is 40%.
What is the cash inflow?
($70,000 $50,000) 40% = $8,000
$70,000 $8,000 = $62,000
11 32
Post Audit
Focus:
Investment expenditures are on time and within budget.
Comparing actual versus predicted cash flows. Improving future predictions of cash flows. Evaluating the continuation of the project.
11 33
Exercise 11-45 (Page 506)

Bobs Big Burgers is considering a proposal to invest in a speaker system that would allow its employees to service drive-through customers. The cost of the system (including the installation of special windows and driveway modifications) is RM30,000. Jenna, manager of Bobs, expects the drive-through operations to increase annual sales by RM25,000, with a 40% contribution margin ratio. Assume that the system has an economic life of 6 years, at which time it will have no disposal value. The cost of capital (required rate of return) is 12%. Ignore taxes.
2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 34

What is the payback time? Annual addition to profit = 40% x $25,000 = $10,000. Payback period is $30,000 $10,000 = 3 years. What are the advantages/disadvantages of this method? Advantages easy to use, can be used as a rough estimate of the riskiness of a project, esp in rapid technological changes & changes in product design, where cash flows are uncertain Disadvantages does not measure profitability, ignores time value of money
11 35

Compute rate of return on the initial investment, based on the accounting rate-of-return model. ARR = ($10,000 - $5,000) $30,000 = 16.7% depreciation What are the advantages/disadvantages of this method? Advantages measures profitability, easy to use Disadvantages ignores time value of money
11 36

Compute the net present value.
Year 0 1 2 3 4 5 6 Discount factor 1.0000 0.8929 0.7972 0.7118 0.6355 0.5674 0.5066 Cash inflow/ (outflow) (30,000) 10,000 10,000 10,000 10,000 10,000 10,000 Net NPV NPV (30,000) 8,929 7,972 7,118 6,355 5,674 5,066 11,114
11 37

Should Jenna accept the proposal? Why or why not? Yes, accept the proposal because of positive NPV. What are the advantages/disadvantages of this method? Advantages considers time value of money, considers relevant cash flows Disadvantages discount factor is subjective
11 38

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Capital Budgeting

Chapter 11 Click to edit Master subtitle style

1. Identify potential investments. 2. Choose an investment. 3. Follow-up or postaudit.

Payback Model Example

Annual savings of $4,000 in cash outflows are expected from operations.

What is the payback period

Accounting Rate-of-Return Model

Increase in expected average annual operating income

Initial required investment

Accounting Rate-of-Return Example

What is the annual depreciation?

Accounting Rate-of-Return Example

What is the ARR?

ARR = ($2,000 $1,519) $6,075 = 7.9%

Discounted-Cash-Flow Models (DCF)

Net Present Value Model

Net Present Value Model

Applying the NPV Method

Useful life: 4 years

Annual income generated from investment (cash inflow): $2,000

Minimum desired rate of return: 10%

Assumptions of the NPV Model

Predicted cash flows occur timely.

There are perfect capital markets.

Money can be borrowed or loaned at the same interest rate.

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.

Internal Rate of Return Model

Sensitivity Analysis Example

Sensitivity Analysis Example

Cash flow = $6,075 3.1699 = $1,916

Relevant Cash Flows for NPV

Operating Cash Flows

Depreciation and book values should be ignored.

A reduction in cash outflow is treated the same as a cash inflow.

Cash Flows for Investment in Technology

Failure to invest will cause net cash inflows to fall to $8,000.

Cash Flows for Investment in Technology

$12,000 $8,000 = $4,000

Income Taxes and Capital Budgeting

Marginal Income Tax Rate

This is the tax rate paid on additional amounts of pretax income.

Effects of Depreciation Deductions

Tax Deductions, Capital Effects, and Timing

What is the after-tax inflow from operations?

$60,000 (1 tax rate) = $60,000 .6 = $36,000

Tax Deductions, Capital Effects, and Timing

$25,000 40% = $10,000 tax savings

Gains or Losses on Disposal

What is the book value?

$125,000 (3 $25,000) = $50,000

Gains or Losses on Disposal

Gains or Losses on Disposal

What is the cash inflow?

($70,000 $50,000) 40% = $8,000

$70,000 $8,000 = $62,000

Exercise 11-45 (Page 506)

Exercise 11-45 (Page 506)

Exercise 11-45 (Page 506)

Exercise 11-45 (Page 506)

Exercise 11-45 (Page 506)

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