A manager using discounted cash flow methods for capital budgeting can face conflicts if accounting rate of return is used for performance evaluation. Specifically, a project with an accounting rate of return below the desired minimum threshold will be rejected, even if it has a positive net present value using discounted cash flow methods. This goal incongruence can be reduced by evaluating managers' performance on a project-by-project basis instead of using accounting rate of return.

1. 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.

2. 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.

3. Learning Objective 7
Identify relevant cash
inflows and outflows for
capital budgeting decisions.

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

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

6. 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.

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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?

16. 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
Total PV of net cash inflows $238,636
Investment 213,200
Net present value of new equipment $ 25,436

17. 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.

18. 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.