©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Introduction to Management Accounting

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler CapitalBudgeting Introduction to Management Accounting Chapter 11

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Capital Budgeting Capital budgeting describes the long-term planning for making and financing major long-term projects. 1. Identify potential investments. 2. Choose an investment. 3. Follow-up or “postaudit.” Learning Objective 1

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Discounted-Cash-Flow Models (DCF) These models focus on a project’s cash inflows and outflows while taking into account the time value of money. DCF models compare the value of today’s cash outflows with the value of the future cash inflows.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Net Present Value Model The net-present-value (NPV) method computes the present value of all expected future cash flows using a minimum desired rate of return.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Net Present Value Model The minimum desired rate of return depends on the risk of a proposed project – the higher the risk, the higher the rate. The required rate of return (also called hurdle rate or discount rate) is the minimum desired rate of return based on the firm’s cost of capital.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Applying the NPV Method Prepare a diagram of relevant expected cash inflows and outflows. Find the present value of each expected cash inflow or outflow. Sum the individual present values.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler NPV Example Original investment (cash outflow): $5,827 Useful life: four years Annual income generated from investment (cash inflow): $2,000 Minimum desired rate of return: 10%

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler NPV Example Present PresentValue of $1 TotalSketch of Cash of $1 TotalSketch of Cash DiscountedPresent Flows at End of Year At 10% Value At 10% Value Approach 1: Discounting Cash Flows Cash flows Annual savings.9091$1,818 2, ,653 2, ,503 2, ,366 2,000 Present value of Future inflows $6,340 Initial Outlay (5,827) $(5,827) Net present value $ 513

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler NPV Example Approach 2: Using an Annuity Table Sketch of Cash Flows at End of Year Sketch of Cash Flows at End of Year Annual Savings $6,340 $ 2,000 $2,000 $2,000 $2,000 Initial Outlay (5,827) $(5,827) Net present value $ 513

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Assumptions of the NPV Model There is a world of certainty. There are perfect capital markets. Predicted cash flows occur timely. Money can be borrowed or loaned at the same interest rate.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Decision Rules Managers determine the sum of the present values of all expected cash flows from the project. If the sum of the present values is positive, the project is desirable. If the sum of the present values is negative, the project is undesirable.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Internal Rate of Return Model The IRR determines the interest rate at which the NPV equals zero. If IRR > minimum desired rate of return, then NPV > 0 and accept the project. If IRR < minimum desired rate of return, then NPV < 0 and reject the project.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Real Option Model This model recognizes the value of contingent investments. Contingent investments are investments that a company can adjust as it learns more about their potential for success.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Sensitivity Analysis Sensitivity analysis shows the financial consequences that would occur if actual cash inflows and outflows differ from those expected. Learning Objective 2

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Sensitivity Analysis Example Suppose that a manager knows that the actual cash inflows in the previous example could fall below the predicted level of $2,000. How far below $2,000 must the annual cash inflow drop before the NPV becomes negative?

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Sensitivity Analysis Example ( × Cash flow) – $5,827 = 0 Cash flow = $5,827 ÷ = $1,838 If the annual cash flow is less than $1,838, the NPV is negative, and the project should be rejected. Annual cash inflows can drop only $2,000 – $1,838 = $162 or 8.1%

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Comparison of Two Projects Two common methods for comparing alternatives are: Total project approach Differentialapproach Learning Objective 3

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Total Project Approach The total project approach computes the total impact on cash flows for each alternative and then converts these total cash flows to their present values. The alternative with the largest NPV of total cash flows is best.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Differential Approach The differential approach computes the differences in cash flows between alternatives and then converts these differences to their present values. This method cannot be used to compare more than two alternatives.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Relevant Cash Flows for NPV The four types of inflows and outflows should be considered when the relevant cash flows are arrayed: 1)Initial cash inflows and outflows at time zero 2)Investments in receivables and inventories 3)Future disposal values 4)Operating cash flows Learning Objective 4

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Operating Cash Flows The only relevant cash flows are those that will differ among alternatives. Depreciation and book values should be ignored. A reduction in cash outflow is treated the same as a cash inflow.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Income Taxes and Capital Budgeting Another type of cash flow (outflow) that must be considered when making capital-budgeting decisions: Income taxes Learning Objective 5 In capital budgeting, the relevant tax rate is the marginal income tax rate. This is the tax rate paid on additional amounts of pretax income.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Effects of Depreciation Deductions U.S. tax authorities allow accelerated depreciation. The focus is on the tax reporting rules, not those for public financial reporting. The recovery period is the number of years over which an asset is depreciated for tax purposes.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Effects of Depreciation Deductions Depreciation expense is a noncash expense and so is ignored for capital budgeting, except that it is an expense for tax purposes and so will provide a cash inflow from income tax savings. TAX

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Tax Deductions, Cash Effects, and Timing Assume the following: Cash inflow from operations: $60,000 Tax rate: 40% What is the after-tax inflow from operations? $60,000 × (1 – tax rate) = $60,000 ×.6 = $36,000

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Tax Deductions, Cash Effects, and Timing What is the after-tax effect of $25,000 depreciation? $25,000 × 40% = $10,000 tax savings

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Modified Accelerated Cost Recovery System Under U.S. income tax laws, companies depreciate most assets using the Modified Accelerated Cost Recovery System (MACRS). This system specifies a recovery period and an accelerated depreciation schedule for all types of assets.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Gains or Losses on Disposal Suppose a 5-year piece of equipment purchased for $125,000 is sold at the end of year 3 after taking three years of straight-line depreciation. What is the book value? $125,000 – (3 × $25,000) = $50,000 Learning Objective 6

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Gains or Losses on Disposal If the equipment is sold for $50,000 (book value), there is no gain or loss and so there is no tax effect. If it is sold for more than $50,000, there is a gain and an additional tax payment. If it is sold for less than $50,000, there is a loss and a tax savings.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Gains or Losses on Disposal Assume that the equipment is sold for $70,000 and the tax rate is 40%. What is the net cash inflow from the sale? ($70,000 – $50,000) = 20,000 × 40% = $8,000 $70,000 – $8,000 = $62,000 What is the tax savings on the sale?

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Payback Model Payback time, or payback period, is the time it will take to recoup, in the form of cash inflows from operations, the initial dollars invested in a project. P = I ÷ O Learning Objective 7 Assume that $12,000 is spent for a commercial stove with an estimated useful life of 4 years.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Payback Model Example Annual savings of $4,000 in cash outflows are expected from operations. P = $12,000 ÷ $4,000 = 3 years What is the payback period

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Accounting Rate-of-Return Model The accounting rate-of-return (ARR) model expresses a project’s return as the increase in expected average annual operating income divided by the required initial investment. ARR= Increase in expected average annual operating income* Initialrequiredinvestment÷ *Average annual incremental cash inflow from operations minus incremental average annual depreciation

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Accounting Rate-of-Return Example  Assume the following:  Investment is $5,827.  Useful life is four years.  Estimated disposal value is zero.  Expected annual cash inflow  from operations is $2,000. Annual depreciation = ($5,827 – 0)/4 = $1, Annual depreciation = (cost – disposal value)/useful life

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Accounting Rate-of-Return Example ARR = ARR = ($2,000 – $1457) ÷ $5,827 = 9.3% average annual incremental cash inflow – Incremental annual depreciation Initialrequiredinvestment÷

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Performance Evaluation Many managers are reluctant to accept DFC models as the best way to make capital-budgeting decisions. Their superiors evaluate them using a non-DCF model. Learning Objective 8

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Reconciliation of Conflict Use DCF for both capital-budgeting decisions and performance evaluation. Use Economic Value Added (EVA) Follow-up evaluation of capital decisions

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Post Audit Most large companies conduct a follow-up evaluation of selected capital-budgeting decisions.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Post Audit Investment expenditures are on time and within budget. Comparing actual versus predicted cash flows. Improving future predictions of cash flows. Evaluating the continuation of the project.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Inflation What is inflation? It is the decline in general purchasing power of the monetary unit. The key in capital budgeting is consistent treatment of the minimum desired rate of return and the predicted cash inflows and outflows. Learning Objective 9

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Watch for Consistency Such consistency can be achieved by including an element for inflation in both the minimum desired rate of return and in the cash-flow predictions. Many firms base their minimum desired rate of return on market interest rates (nominal rates) that include an inflation element.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler End of Chapter 11 The End