Chapter 14 Capital Budgeting Cost Accounting Foundations and Evolutions Kinney, Prather, Raiborn

Learning Objectives (1 of 3) Explain why most capital budgeting methods focus on cash flows Compute and describe what is measured by the payback period Explain how the net present value and profitability index of a project are measured Compute the internal rate of return and explain what it measures

Learning Objectives (2 of 3) Describe how taxation and depreciation methods affect cash flows Explain the assumptions and limitations of the various capital project evaluation methods Explain how managers rank investment projects Clarify how risk is considered in capital budgeting analyses

Learning Objectives (3 of 3) Explain a postinvestment audit of a capital project (Appendix 1) Calculate present values (Appendix 2) List the advantages and disadvantages of the accounting rate of return

Capital Budgeting Capital budgeting is the process for evaluating proposed long-range projects or courses of future activity for the purpose of allocating limited resources –Plan and prepare the capital budget –Review past investments to assess and enhance the decision process

Capital Budgeting Compare and evaluate alternative projects –financial and nonfinancial criteria –short and long-term benefits –fit with existing technology –effect on marketing and cost management

Capital Budgeting Financial Analysis Payback period Net present value Profitability index Internal rate of return Accounting rate of return Cash Flow Focus

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

Payback Period Time required for project’s cash inflows to equal the original investment –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

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

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

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

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

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

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

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

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

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

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?