Kinney9eChapter-15-Capital-Budgeting.pptx

Kinney ● Raiborn
Cost Accounting:
Foundations and Evolutions, 9e
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accessible website, in whole or in part.
Chapter 15:
Capital Budgeting

Learning Objectives
 Why do most capital budgeting methods focus on cash flows?
 How is payback period computed, and what does it measure?
 How are the net present value (NPV) and profitability index (PI) of a
project computed, and what do they measure?
 How is the internal rate of return (IRR) on a project computed, and what
does that rate measure?
 How do taxation and depreciation affect cash flows?
 What are the underlying assumptions and limitations of each capital
project evaluation method?
 How do managers rank investment projects?
 How is risk considered in capital budgeting analyses?
 How and why should management conduct a post-investment audit of a
capital project?
 (Appendix 1) How are present values (PV) calculated?
 (Appendix 2) What are the advantages and disadvantages of the
accounting rate of return method?

Capital Assets
 Capital assets are long-term assets used to:
 Generate future revenues or cost savings
 Provide distribution, service, or production
capacity
 Tangible fixed assets
 Land, building, machinery, etc.
 Intangible assets
 Capital lease, patent, etc.

Capital Budgeting
 Capital budgeting involves evaluating and ranking
alternative future investments to effectively and
efficiently allocate limited capital.
 Plan and prepare the capital budget
 Review past investments to assess success of past
decisions and enhance the decision process in the future
 Compare and evaluate alternative projects
 Financial and nonfinancial criteria
 Short- and long-term benefits
 Usually multiple criteria
 Consider all significant stakeholders

Capital Budgeting as Part of the
Financial Budget
Operating Budget
Cash Budget
Capital
Budget
Income
Statement
Statement of
Retained Earnings Balance Sheet
Statement of
Cash Flows

Capital Budgeting: Quantitative
versus Qualitative
 Quantitative
 Accounting rate of
return
 Payback period
 Discounted payback
period
 Net Present Value
(NPV)
 Internal Rate of Return
(IRR)
 Profitability Index (PI)
 Qualitative
 Employee morale,
safety, and
responsibility
 Corporate image
 Social responsibility
 Market share
 Growth
 Strategic planning
 Sustainability

Capital Budgeting: Financial
Analysis
 Payback period
 NPV
 PI
 IRR
 Accounting rate of return
Cash
Flow
Focus

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

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

Payback Period
 Time required for project’s cash inflows to equal the
original investment
 The 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
 Ignores
 Cash inflows that occur after payback has been reached
 Desired rate of return
 Time value of money

Payback Period Illustration
Original Investment
Annual Cash Inflows
(assuming equal cash
flows)
Payback Period
Example:
Original Investment $25,000
Annual Cash Inflows $10,000
Payback Period 2.5 years
=

Discounting Future Cash Flows
 Reduce the future value (FV) 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
 PV is stated in a common base of current
dollars

Discount Rate and Returns
 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
 Return OF Capital
 Recovery of the initial investment
 Return ON Capital
 Represents income
 Original investment multiplied by the discount rate
$100,000 * 12% =
$12,000 return on capital

Discounted Cash Flow Methods
 Net Present Value (NPV)
 Profitability Index (PI)
 Internal Rate of Return (IRR)

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

Interpreting NPV
 NPV = 0
 Actual rate of return equals desired rate of
return
 NPV > 0
 Actual rate of return is greater than desired
rate of return
 NPV < 0
 Actual rate of return is less than desired
rate of return

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
PI

Profitability Index
 Compares PV 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

Profitability Index Illustration
Project 1 2
PV of net cash flows $900,000
$580,000
Net investment $720,000
$425,000
NPV $180,000
$155,000
PI
$900,000/$720,000 1.25
$580,000/$425,000 1.36
Assuming limited funds, which project would you choose?

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 IRR = Hurdle Rate; Accept
 If IRR > Hurdle Rate; Accept
 If IRR < Hurdle Rate; Reject
 Computed using
 Financial calculators
 Computers
 Annuity tables (assuming equal cash flows)
 Trial and error

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

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 * Tax rate

Tax Depreciation
 Deprecation tax shield is affected by
 Changes in tax laws
 Different depreciation methods
 Changes in tax rates

Capital Budgeting Methods
 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

Payback
 Assumptions
 Speedy recovery of investment is key
 Cash flows can be accurately predicted
 Risk is lower for the shorter payback project
 Limitations
 Ignores cash flows after payback
 Cash flow and project life are deterministic, not subject to
probabilities
 Ignores time value of money
 Does not consider recognized cash flow pattern
preferences

Net Present Value
 Assumptions
 Discount rate is valid
 Timing and size of cash flows can be predicted
 Life of project can be predicted
 If shorter-lived project is selected, proceeds of shorter
project will earn the discount rate through theoretical
completion of longer project
 Limitations
probabilities
 Alternative project rates of return are not known
 Does not consider recognized cash flow pattern
preferences
 IRR on project is not reflected

Profitability Index
 Assumptions (same as NPV)
 Measures efficient use of capital
 Discount rate is valid
 Life of project can be predicted
 If shorter project selected, proceeds of shorter project will earn
the discount rate through theoretical completion of longer project
 Limitations (same as NPV)
probabilities
 Alternative project rates of return are not known
 Does not consider cash flow pattern preferences
 IRR on project is not reflected
 A relative answer is given but dollars of NPV are not reflected

Internal Rate of Return
 Assumptions
 Hurdle rate is valid
 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
 NPV dollars are not reflected
probabilities
 Does not consider cash flow pattern preferences
 Multiple rates of return can be calculated on the same
project

Comparing Techniques
Pay-
back
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

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

Capital Budgeting Terms
 Screening decision
 Preference decision
 Mutually exclusive projects
 Independent projects
 Mutually inclusive projects

Ranking Capital Projects
 For the projects under consideration
 NPV is nonnegative
 PI of 1 or more
 IRR equals or exceeds hurdle rate
 Selection ranking of multiple projects
 Results can vary depending on evaluation
techniques and whether dollars or percentages
are used

Reinvestment Assumptions
 NPV and PI assume that released cash flows
are reinvested at the discount rate
 At least the cost of capital
 IRR assumes that released cash flows are
reinvested at the expected IRR
 Could be substantially different than the cost of
capital

NPV Compared to IRR
 More realistic reinvestment assumption
 Results measured in dollars not rates
Do you prefer
a 100% return on $1, or
a 10% return on $100?
? ?

Compensating for Risk (slide 1 of 2)
 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

Compensating for Risk (slide 2 of 2)
 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?

Post-Investment 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

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

Accounting Rate of Return
 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

Questions
 Why do most capital budgeting methods
focus on cash flows?
 What is the relationship between the NPV
and the PI?
 What are the assumptions and limitations of
the various capital project evaluation
methods?

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

Kinney9eChapter-15-Capital-Budgeting.pptx

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