11ch21.ppt

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©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Capital Budgeting
and Cost Analysis
Chapter 21

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Learning Objective 1
Recognize the multiyear focus
of capital budgeting.

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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.

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2002 2003 2004 2005 2006
Project A
Project B
Project C
Project D
Two Dimensions of Cost Analysis

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Understand the six stages of
capital budgeting for a project.

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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.

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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

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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.

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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.

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

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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.

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Time Value of Money
Compound Growth,
5 periods at 6%
Year 0: $1.00
Year 1: $1.06
Year 2: $1.124
Year 3: $1.91
Year 4: $1.262
Year 5: $1.338

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Discounted Cash Flow
There are two main DCF methods:
Net present value (NPV) method
Internal rate-of-return (IRR) method

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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?

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Year in the Life of the Project
$(250,000) $125,000 $130,000 $115,000
0 1 2 3
Net initial
investment
Annual cash
inflows

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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

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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%.

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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)

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Internal Rate of Return
Investment
= Expected annual net cash inflow
× PV annuity factor
Investment
÷ Expected annual net cash inflow
= PV annuity factor

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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)

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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.

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Comparison of NPV and IRR
The IRR of individual projects cannot be
added or averaged to derive the IRR
of a combination of projects.

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Use and evaluate the
payback method.

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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.

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Payback Method Example
Assisted Living is considering buying Machine 1.
Useful life is eleven years.
Estimated residual value is zero.

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

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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?

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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?

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

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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
+
÷
=
=

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Use and evaluate the accrual
accounting rate-of-return
(AARR) method.

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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.
AARR =
Increase in expected
average annual
operating income
÷
Initial
required
investment

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Accrual Accounting
Rate-of-Return Method Example
Useful life is five years.
IRR is 10%.
What is the average operating income?

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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%

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Identify and reduce conflicts
from using DCF for capital
budgeting decisions and
accrual accounting for
performance evaluation.

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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.

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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.

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Identify relevant cash
inflows and outflows for
capital budgeting decisions.

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

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Relevant Cash Flows
Net initial investment components
– cash outflow to purchase investment
– working-capital cash outflow
– cash inflow from disposal of old asset

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Relevant Cash Flow
Analysis Example
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%
G. T. is considering replacing old equipment.

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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

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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

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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

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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

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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

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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

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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

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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

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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?

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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

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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.

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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.

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End of Chapter 21

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