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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 1 Recognize the multiyear focus of capital budgeting.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Project A Project B Project C Project D Two Dimensions of Cost Analysis

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 2 Understand the six stages of capital budgeting for a project.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Capital Budgeting Capital budgeting is a six-stage process: 1. Identification stage2. Search stage 3. Information-acquisition stage 4. Selection stage5. Financing stage 6. Implementation and control stage

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Capital Budgeting Example 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Capital Budgeting Example 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 3 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Discounted Cash Flow There are two main DCF methods: Net present value (NPV) method Internal rate-of-return (IRR) method

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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?

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Net Present Value Example Year in the Life of the Project $(250,000)$125,000$130,000$115, Net initial investment Annual cash inflows

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Net Present Value Example Net Cash NPV of Net Year 10% Col. Inflows Cash Inflows $125,000$113, , , ,000 86,365 Total PV of net cash inflows$307,370 Net initial investment 250,000 Net present value of project$ 57,370

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Net Present Value Example The company is considering another investment. Initial investment is $245,000. 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%.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Net Present Value Example Net Cash NPV of Net Years 10% Col. Inflows Cash Inflows $80,000$198, ,000 6,759 Total PV of net cash inflows$205,719 Net initial investment 250,000 Net present value of project ($ 44,281)

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Internal Rate of Return Investment = Expected annual net cash inflow × PV annuity factor Investment ÷ Expected annual net cash inflow = PV annuity factor

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Internal Rate of Return Example Initial investment is $303,280. Useful life is five years. Net cash inflows is $80,000 per year. What is the IRR of this project? $303,280 ÷ $80,000 = (PV annuity factor) 10% (from the table, five-period line)

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Comparison of NPV and IRR The IRR of individual projects cannot be added or averaged to derive the IRR of a combination of projects.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 4 Use and evaluate the payback method.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Payback Method Example Assisted Living is considering buying Machine 1. Initial investment is $210,000. Useful life is eleven years. Estimated residual value is zero. Net cash inflows is $35,000 per year.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Payback Method Example How long would it take to recover the investment? $210,000 ÷ $35,000 = 6 years Six years is the payback period.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Payback Method Example 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?

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Payback Method Example Assisted Living is considering buying Machine 3. Initial investment is $250,000. Useful life is eleven years. Cash savings are $160,000, $180,000, and $110,000 over its life. What is the payback period?

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Payback Method Example Year 1 brings in $160,000. Recovery of the amount invested occurs in Year 2.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Payback Method Example Payback = 1 year $ 90,000 needed to complete recovery 180,000 net cash inflow in Year 2 1 year year 1.5 years or 1 year and 6 months + ÷ = =

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 5 Use and evaluate the accrual accounting rate-of-return (AARR) method.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Accrual Accounting Rate-of-Return Method Example Initial investment is $303,280. Useful life is five years. Net cash inflows is $80,000 per year. IRR is 10%. What is the average operating income?

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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%

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 6 Identify and reduce conflicts from using DCF for capital budgeting decisions and accrual accounting for performance evaluation.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 7 Identify relevant cash inflows and outflows for capital budgeting decisions.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Cash Flows Relevant cash flows are expected future cash flows that differ among the alternatives.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Cash Flows Net initial investment components – cash outflow to purchase investment – working-capital cash outflow – cash inflow from disposal of old asset

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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?

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Cash Flow Analysis Example Net Cash NPV of Net Years 14% Col.Inflows Cash Inflows $68,000$233, ,000 5,190 Total PV of net cash inflows$238,636 Investment 213,200 Net present value of new equipment$ 25,436

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster End of Chapter 21