1 PowerPointPresentation by PowerPoint Presentation by Gail B. Wright Professor Emeritus of Accounting Bryant University MANAGERIAL ACCOUNTING 10 TH EDITION BY MAHER, STICKNEY & WEIL CAPITAL EXPENDITURE DECISIONS STUDENT CHAPTER 8 © Copyright 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star Logo, and South- Western are trademarks used herein under license.

Managerial Decision Making 2 1.Explain the reasoning behind separation of investing & financing of long-term decisions. 2.Explain role of capital expenditure decisions in strategic planning process. 3.Describe steps of net present value method for making long-term decisions using discounted cash flows; explain effect of income taxes on cash flows. 4.Explain how spreadsheets help analyst conduct sensitivity analyses of capital budgeting. LEARNING OBJECTIVES Continued

Managerial Decision Making 3 5.Describe internal rate of return method of assessing investment alternatives. 6.Explain why analysts need more than cash flow analysis to justify or reject investment. 7.Explain why capital investment process requires audits. 8.Identify behavioral issues involved in capital budgeting. LEARNING OBJECTIVES

Managerial Decision Making 4 CHAPTER GOAL This chapter explains how the differential principle applies to long–term decisions where the focus is on changes in operating capacity over several future time periods. Present value analysis, also called discounted cash flow (DCF), provides analysts with the appropriate technique. ☼☼

Managerial Decision Making 5 CAPITAL BUDGETING: Definition Involves deciding which long- term investments to take involving capital (long-term) assets. LO 1

Managerial Decision Making 6 STRATEGIC PLANNING In strategic planning, an organization decides on major programs & the resources to devote to them. Strategic planning provides the context for capital expenditure decisions. LO 2

Managerial Decision Making 7 BENEFITS: Long-Term Investments  Reducing potential to make mistakes improves product  Making goods, delivering services that competitors cannot  Reducing cycle time to make product  Permanently reducing costs to provide such an advantage that competitors cannot afford to enter market LO 2

Managerial Decision Making 8 DISCOUNTED CASH FLOW (DCF): Definition Aids in evaluating investments involving cash flows over time where there is a significant difference between cash payment & receipt. LO 3

Managerial Decision Making 9 ELEMENTS OF DISCOUNT RATE The choice of a discount rate should consider the following  A pure rate of interest that reflects the productive capability of capital assets  A risk factor reflecting the riskiness of the project  An increase reflecting inflation expected to occur over the life of the project. LO 3

Managerial Decision Making 10 RISK-FREE RATE: Definition Is the pure interest rate + expected inflation. LO 3

Managerial Decision Making 11 NOMINAL INTEREST RATE: Definition Includes all 3 factors: pure interest, risk premium, & expected inflation. LO 3

Managerial Decision Making 12 If the present value of future cash inflows exceeds the present value of future cash outflows for a proposal, the firm should accept the project. LO 3 DECISION RULE

Managerial Decision Making 13 CASH FLOW VARIETIES  Initial cash flows:  Occur at beginning of project  Periodic cash flows  Occur during life of project  Terminal cash flows  Occur at end of project LO 3

Managerial Decision Making 14 3 ESTIMATES The calculation of NPV for a proposed project requires 3 types of projections  Amount of future cash flows  Timing of future cash flows  Discount rate Note: errors in predicting amounts of future cash flows will likely have the largest impact. LO 4

Managerial Decision Making 15 INTERNAL RATE OF RETURN (IRR): Definition Is the discount rate that equates the NPV of the series to 0. (Also called the time-adjusted rate of return.) LO 5

Managerial Decision Making 16 If the internal rate of return exceeds the cutoff (hurdle) rate, the project should be accepted. LO 5 DECISION RULE

Managerial Decision Making 17 LO 5 EXHIBIT 8.4 JEP’s hurdle rate is 12%. Should they accept this project? JEPJEP

Managerial Decision Making 18 JUSTIFYING INVESTMENTS Investments in computer-integrated manufacturing are often difficult because of difficulties in applying discounted cash flow methods  Hurdle rate too high  Should be cost of capital  Bias toward incremental projects  Uncertainty about operating cash flows  Exclusion of benefits that are difficult to quantify  More flexibility  Shorter cycle & lead times  Reduction of non-value-added costs LO 6

Managerial Decision Making 19 LONG-TERM INVESTMENTS 3 types of long term capital investments are  Replacement & minor improvements  Expansion  Strategic moves LO 6

Managerial Decision Making 20 AUDITING Auditing to compare estimates of capital budgeting projects to actual results provides advantages  Audits identify which estimates were wrong to correct in future  Managers can use audits to reward good planning  Audits create environment that removes the temptation to inflate estimates & benefits LO 7

Managerial Decision Making 21 BEHAVIORAL ISSUES Planners have a desire to implement a project, meet performance measures. This can influence their objectivity in making estimates. Additionally, conflicts may arise between criteria used to evaluate individual projects and criteria used to evaluate an organization’s overall or unit performance. LO 8

Managerial Decision Making 22 CHAPTER 8 THE END