Capital Budgeting. Strategic Cost Management. Acctg 5.

1. CAPITAL BUDGETING

2. CAPITAL BUDGETING
-process of identifying, evaluating, planning and
financing capital investment projects of an organization
-process of making capital investment decisions

3. CAPITAL INVESTMENT DECISIONS
-concerned with the process of planning, setting goals
and priorities, arranging financing, and using certain
criteria to select long-term assets

4. CHARACTERISTICS OF CAPITAL
INVESTMENT DECISIONS
1. It usually requires large commitments of resources.
2. It involves long-term commitments.
3. It is more difficult to reverse than short-term
decisions.

5. CAPITAL BUDGETING PROCESS
1. Identification of potential projects
2. Estimation of costs and benefits
3. Evaluation
4. Development of the capital budget
5. Re-evaluation

6. TYPES OF CAPITAL INVESTMENT PROJECTS
1. Replacement
2. Improvement
3. Extension

7. TWOTYPES OF CAPITAL BUDGETING
PROJECTS

8. CAPITAL INVESTMENT FACTORS
1. Net investment
2. Net returns
3. Cost of capital

9. TWO MAJOR CATEGORIES OF BASIC
CAPITAL INVESTMENT DECISION MODELS
 Nondiscounting models- ignore the time value of money
 Payback Period
 Accounting Rate of Return (ARR)
 Discounting models- explicitly consider the time value of
money
 Net PresentValue
 Internal Rate of Return (IRR)

10. PAYBACK PERIOD
 The payback period provides information to managers that can
be used as follows:
 To help control the risks associated with the uncertainty of
future cash flows.
 To help minimize the impact of an investment on a firm’s
liquidity problems.
 To help control the risk of obsolescence.
 To help control the effect of the investment on performance
measures.

11. PAYBACK PERIOD
Deficiencies of the payback period:
Ignores the time value of money
Ignores the performance of the investment beyond the payback period
Payback Period = Original Investment/Annual Cash Flow

12. PAYBACK PERIOD
Information:
Suppose that a new car wash facility requires an investment of $100,000
and either has: (a) even cash flows of $50,000 per year or (b) the following
expected annual cash flows: $30,000, $40,000, $50,000, $60,000, and
$70,000.
Required: Calculate the payback period for each case.

13. PAYBACK PERIOD
Solution:
a. Payback Period = Original Investment/Annual Cash Flow
= $100,000/$50,000= 2 years
b. Year Unrecovered Investment
(beginning of year)
Annual Cash Flow Time Needed for
Payback (years)
1 $100,000 $30,000 1.0
2 70,000 40,000 1.0
3 30,000 50,000 0.6
4 0 60,000 0.0
5 0 70,000 0.0
2.6

14. ACCOUNTING RATE OF RETURN
- Second commonly used nondiscounting model
- Measures the return on a project in terms of income, as
opposed to using a project’s cash flow.
Accounting Rate of Return = Average Income/Initial Investment

15. ACCOUNTING RATE OF RETURN
Information:
An investment requires an initial outlay of $100,000 and has a 5-year life with no
salvage value.The yearly cash flows are $50,000, $50,000, $60,000, $50,000 and
$70,000.
Required:
1. Calculate the annual net income for each of the 5 years.
2. Calculate the accounting rate of return.

16. ACCOUNTING RATE OF RETURN
Solution:
1. Yearly Depreciation Expense = ($100,000-$0)/5 years = $20,000
Annual Net Income = Net Cash Flow - Depreciation Expense
Year 1 Net Income = $50,000 – $20,000 = $30,000
Year 2 Net Income = $50,000 – $20,000 = $30,000
Year 3 Net Income = $60,000 – $20,000 = $40,000
Year 4 Net Income = $50,000 – $20,000 = $30,000
Year 5 Net Income = $70,000 – $20,000 = $50,000
2. Total Net Income (5 years) = $180,000
Average Net Income = $180,000/5 = $36,000
Accounting Rate of Return = $36,000/$100,000 = 0.36

17. NET PRESENTVALUE (NPV)
-Difference between the present value of the cash
inflows and outflows associated with a project
NPV = P – I
Where:
P – present value of the project’s future cash inflows
I – the present value of the project’s cost (usually the initial outlay)

18. NET PRESENTVALUE (NPV)
Information:
A detailed market study revealed expected annual revenues of $300,000 for new
earphones. Equipment to produce earphones will cost $320,000. After 5 years, the
equipment can be sold for $40,000. In addition to equipment, working capital is
expected to increase by $40,000 because of increases in inventories and
receivables.The firm expects to recover the investment n working capital at the end
of the project’s life. Annual cash operating expenses are estimated at $180,000.The
required rate of return is 12%.
Required: Estimate the annual cash flows, and calculate the NPV.

19. NET PRESENTVALUE (NPV)

20. NET PRESENTVALUE (NPV)

21. NET PRESENTVALUE (NPV)

22. INTERNAL RATE OF RETURN
The internal rate of return (IRR) is the interest rate that
sets the project’s NPV at zero.Thus, P = I for the IRR.

23. INTERNAL RATE OF RETURN
Information:
Assume that a hospital has the opportunity to invest $205,570.50 in a new ultrasound
system that will produce net cash inflows of $50,000 at the end of each of the next 6 years.
Required:
Calculate the IRR for the ultrasound system.
Solution:
df = I/CF
= $205,570.50/$50,000
= 4.11141
Interest rate corresponding to 4.11141 is 12%

24. REFERENCES:
https://slideplayer.com/slide/8756861/
Maryanne M. Mowen, D. R. (2017). Managerial Accounting.Taguig
City: Cengage Learning Asia Pte Ltd.