© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Cost Accounting: Foundations & Evolutions, 9e Kinney and Raiborn Chapter 15: Capital Budgeting

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. 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 and profitability index of a project computed, and what do they measure? How is the internal rate of return 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 postinvestment audit of a capital project? (Appendix 1) How are present values calculated? (Appendix 2) What are the advantages and disadvantages of the accounting rate of return method?

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Capital Budgeting Capital budgeting involves evaluating and ranking alternative future investments to effectively and efficiently allocated 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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Capital Budgeting Compare and evaluate alternative projects  financial and nonfinancial criteria  short- and long-term benefits  usually multiple criteria Consider all significant stakeholders

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Capital Budgeting Financial Analysis Payback period Discounted payback period Net present value Profitability index Internal rate of return Accounting rate of return Cash Flow Focus

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. 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 First justify the acquisition Then justify how to finance it

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. 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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Discounting Future Cash Flows Reduce the future value 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 Present value is stated in a common base of current dollars

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Net Present Value Evaluates if project rate of return is greater than, equal to, or less than the desired rate of return Present value equals the cash flows discounted using the desired rate of return Net present value equals present value of cash inflows minus present value of cash outflows Does not calculate the rate of return

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Profitability Index Compares present value 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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. 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 Internal Rate of Return = Hurdle Rate; Accept  If Internal Rate of Return > Hurdle Rate; Accept  If Internal Rate of Return < Hurdle Rate; Reject

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. 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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Comparing Techniques Uses time value money Provides specific rate of return Uses cash flows Considers returns during life of project Uses discount rate Payback NPVPIIRR NYYYNYYY NNN Y YYYYYYYY NYYYNYYY NYYN* *often used as a hurdle rate

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. 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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Capital Budgeting Terms Screening decision Preference decision Mutually exclusive projects Independent projects Mutually inclusive projects

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Compensating for Risk 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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Postinvestment 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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Questions Why do most capital budgeting methods focus on cash flows? What is the relationship between the net present value and the profitability index? What are the assumptions and limitations of the various capital project evaluation methods?

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Potential Ethical Issues Ignoring the 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 postinvestment audit to hold decision makers accountable Choosing projects based on accounting earnings only rather than including discounted cash flow methods