1 Capital Expenditure Decisions CHAPTER 8 Managerial Accounting 11E Maher/Stickney/Weil PowerPointPresentation by PowerPoint Presentation by LuAnn Bean Professor of Accounting Florida Institute of Technology © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 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. ☼☼

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

4 STRATEGIC PLANNING In strategic planning, an organization decides on major programs and the resources to devote to them. Strategic planning provides the context for capital expenditure decisions. LO 2

5 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

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

7 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

8 RISK-FREE RATE: Definition Is the pure interest rate plus expected inflation. LO 3

9 What is the real interest rate? The real interest rate is the pure interest rate plus a premium for risk but no increase for inflation. LO 3

10 NOMINAL INTEREST RATE: Definition Includes all three factors: pure interest, risk premium, and expected inflation. LO 3

11 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 with the largest NPV. Reject any negative PV. LO 3 DECISION RULE Estimate the amounts of future cash inflows and future cash outflows in each period for each alternative Discount the future cash flows to the present using the project’s discount rate.

12 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

13 EXAMPLE: JEP Realty Syndicators JEP Reality Syndicators, Inc. (JEP) is considering acquisition of computer hardware with a 5-year life. Disposal of current hardware occurs in Year 0 with no gain or loss and no tax consequences. LO 3 Continued Cost$ 100,000 Market value of present equipment$ 10,000 Scrap value$ 5,000 JEPJEP

14 LO 3 EXHIBIT 8.1 Projected cash flows over life of project. JEPJEP

15 LO 3 EXHIBIT 8.2 JEPJEP Depreciation is subtracted before tax Year 0 & Year 1

16 LO 3 EXHIBIT 8.2 JEPJEP Pretax net cash inflow (outflow) – tax payable = Net cash inflow (outflow) X PV factor (12%) = NPV Year 0 & Year 1

17 JEPJEP EXHIBIT = LO 3 Projected cash flows over life of project is positive $12,469. >>>ACCEPT Projected cash flows over life of project is positive $12,469. >>>ACCEPT

18 THREE ESTIMATES for Calculating NPV The calculation of NPV for a proposed project requires three 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

19 LO 4 JEPJEP EXHIBIT 8.3 = $350,000 in revenues ++++ Base case

20 LO 4 JEPJEP EXHIBIT Amount of future cash flows = $344,000 in revenues, less than projected

21 LO 4 JEPJEP EXHIBIT 8.3 = $350,000 in revenues, not received as expected. + Timing of future cash flows +++

22 LO 4 JEPJEP EXHIBIT Discount rate changed to 13% + = $350,000 in revenues, but discount rate changed.

23 LO 5 DECISION RULE Net Present Value Method Internal Rate of Return Method 1. Compute the investment’s net present value, using the organization’s cost of capital adjusted for project-specific risk as the discount rate (hurdle rate). 2. Undertake the investment if its net present value is positive. Reject the investment if its net present value is negative. 1. Compute the investment’s internal rate of return. 2. Undertake the investment if its internal rate of return is equal to or greater than the organization’s cost of capital adjusted for project-specific risk (hurdle rate). If not, reject the investment. The decision to accept or reject an investment proposal can be made using either the internal rate of return method or the net present value method under most circumstances.

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

25 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 and lead times  Reduction of non-value-added costs LO 6

26 LONG-TERM INVESTMENTS Three types of long term capital investments are:  Replacement and minor improvements  Expansion  Strategic moves LO 6

27 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 and benefits LO 7

28 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

29 End of CHAPTER 8