1. The Capital Budget: Evaluating Capital Expenditures
Chapter 8
The Capital Budget: Evaluating Capital Expenditures
©2017 Mark Friedman and Michael Werner, Management Accounting , Friedman/Werner

2. Learning Objectives 1. Describe the overall business planning process
and where the capital budget fits in that process.
2. Explain in your own words the process of capital
budgeting.
3. Discuss the four shared characteristics of all
capital projects.
4. Describe the cost of capital and the concept
of scarce resources.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

3. Learning Objectives
5. Determine the information relevant to the capital
budgeting decision.
6. Evaluate potential capital investments using four
capital budgeting decision models: net present value,
internal rate of return, payback period method, and
accounting rate of return.
7. Determine present and future values using present
value tables and future value tables.
8. Determine present and future values using a
financial calculator.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

4. The Business Planning Process
LO1 Describe the overall business planning process
and where the capital budget fits in that process.
The business planning process involves
answering the following questions:
WHY?
WHAT?
HOW?
WHO?

5. The Business Planning Process
LO1
The Business Planning Process
Organization goals constitute the core
beliefs and values of the company.
These goals are the WHY of the business.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

6. Nonfinancial Goals Typically nonfinancial goals do not mention money.
LO1
Nonfinancial Goals
Typically nonfinancial goals do
not mention money.
The nonfinancial goals are often
highlighted in a mission statement
or a similar document.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

7. Financial Goals The main financial goal for most
LO1
Financial Goals
The main financial goal for most
businesses is to “earn a profit.”
This might be stated as “achieving
superior financial performance,”
“earning a reasonable return for
the stockholders,” or similar language.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

8. Johnson & Johnson Mission Statement
LO1
Johnson & Johnson Mission Statement
Our Credo
We believe our first responsibility is to
the doctors, nurses and patients, to
mothers and fathers and all others who
use our products and services…
We are responsible to our employees,
the men and women who work with us
throughout the world. Everyone must
be considered an individual…
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

9. The Four Perspectives of the Balanced Scorecard
LO1
The Four Perspectives of the Balanced Scorecard
Financial
Perspective
Customer
Internal
Processes
Innovation
Strategy
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

10. The Strategic Plan: The What
LO1
The Strategic Plan: The What
This plan will identify those actions that
the firm will take to achieve its goals.
It is important that these plans support, rather
than conflict with, the company’s goals.
This is the WHAT of doing business.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

11. The Capital Budget: The How
LO1
The Capital Budget: The How
The capital budget identifies scarce resource
allocations over the next several years.
This is the HOW of the business.
The capital budget focuses on acquiring and
replacing long-lived expensive assets.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

12. The Operating Budget: The Who
LO1
The Operating Budget: The Who
The operating budget establishes
who is responsible for the day-to-day
operations of the organization.
The operating budget is the
WHO of the business.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

13. Interrelationship Among the Planning Elements
LO1
Interrelationship Among the Planning Elements
Goals
Why?
Values
What we
believe in
Vision
Our hope for
the future
Strategy
Our plan
of attack
Strategic
Plan
What?
Capital
Budget
How?
Operating
Who?
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

14. The Capital Budget: What is it?
LO2 Explain in your own words the process
of capital budgeting.
Long-lived assets are commonly
referred to as capital assets.
Whenever an expenditure is made
to purchase something, the cost
of that item will either be shown
as an expense or as an asset.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

15. Capitalizing Assets Capitalizing the expenditure is the
LO2
Capitalizing Assets
Capitalizing the expenditure is the
process of recording the expenditure
as an asset rather than an expense.
There are no rules for setting the
capitalization threshold.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

16. Characteristics of Capital Projects
LO3 Discuss the four shared characteristics
of all capital projects.
What are the four shared
characteristics of capital projects?
Long lives
High cost
Quickly sunk
costs
High degree
of risk
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

17. The Cost of Capital The cost of capital represents a firm’s cost
LO4 Describe the cost of capital and the concept
of scarce resources.
The cost of capital represents a firm’s cost
of acquiring debt or equity financing.
The cost of capital is also called the
cost of capital rate, required rate
of return, or the hurdle rate.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

18. The Cost of Capital The cost of debt capital is the interest
LO4
The Cost of Capital
The cost of debt capital is the interest
a company pays to its creditors.
The cost of equity capital is what equity
investors relinquish when they invest in
one company rather than in another.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

19. Weighted Average Cost of Capital
LO4
Weighted Average Cost of Capital
Combining the cost of debt financing
with the cost of equity financing is sometimes
referred to as the blended cost of capital.
Financing % of Total Cost Rate Weighted Debt 60% × % = % Equity 40% × 20.0% = % Blended cost of capital %
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

20. Evaluating Potential Capital Projects
LO5 Determine the information relevant
to the capital budgeting decision.
Managers will evaluate capital projects by:
– determining the relevant cash
flows for alternative projects
– selecting a method of evaluating
the alternatives
– evaluating the alternatives and selecting
the capital projects to be funded
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

21. Identifying Potential Capital Projects
LO5
Identifying Potential Capital Projects
The majority of capital projects are intended
to either increase revenue or reduce costs,
or a combination of the two.
Occasionally, a project is considered
that will result in neither.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

22. Determining Relevant Cash Flows for Alternative Projects
The project’s expected cash inflows
minus its cash outflows for a
specific period equals net cash flow.
Relevant net cash flows are future
cash flows that differ between
or among alternatives.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

23. Selecting a Method of Evaluating the Alternatives
LO6 Evaluate potential capital investments using four capital
budgeting decision models: net present value, internal rate
of return, payback period method, and accounting rate of return.
Net present value
Internal rate of return
Payback period method
Accounting rate of return
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

24. Capital Budgeting Decision Methods
LO6
Capital Budgeting Decision Methods
A dollar received at some point in the
future does not have the same value
as a dollar received today.
The increase in the value of cash over
time due to investment income is
referred to as the time value of money.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

25. Discounted Cash Flow Methods
The discounted cash flows methods are:
Net present value
Internal rate of return
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

26. Net Present Value The net present value (NPV) of a capital project
LO6
Net Present Value
The net present value (NPV) of a capital project
is calculated by subtracting the present value
of future cash outflows from the present
value of future cash inflows.
The net cash flows for all years are discounted
using the firm’s blended cost of capital.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

27. NPV Example Assume that the Whitewater Adventure
LO6
NPV Example
Assume that the Whitewater Adventure
Company is considering a computer
upgrade of $100,000.
This project should result in net cash inflows
of $31,000 per year for the next five years.
The blended cost of capital is equal to 14%.
Therefore, the discount rate used is 14%.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

28. Years in the Life of the Project
LO6
NPV Example
$31,000
$(100,000)
Years in the Life of the Project 1 3 2 4 5
$ 106,423
$ 6,423
$31,000 × = $106,423
NPV = $106,423 – $100,000
NPV = $6,423
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

29. NPV Example Assume that Whitewater’s computer
LO6
NPV Example
Assume that Whitewater’s computer
upgrade will require $12,000 in
maintenance fees in year 3.
Also that the system can be sold
at the end of year 5 for $6,000.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

30. LO6
NPV Example 1 2 3 4 5
($100,000)
($12,000)
$31,000
$6,000
$ 31,000
$ 19,000
$ 37,000
Year
Initial
investment
Maintenance
Operating
costs
Residual
value
Net cash
flow
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

31. LO6
NPV Example 1 2 3 4 5
($100,000)
$ 31,000
$ 19,000
$ 37,000
0.877
0.769
0.675
0.592
0.519
27,187
23,839
12,825
18,352
19,203
Year
Net cash
flow
PV of $1,
factor at 14%
Present
value
$ 1,406
Net present
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

32. Profitability Index Example
LO6
Profitability Index Example
PI for Project A:
$105,000 ÷ $100,000 = 1.05
PI for Project B:
$206,600 ÷ $200,000 = 1.03
Using this measure, Project A
is the preferable project.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

33. Internal Rate of Return
LO6
Internal Rate of Return
The internal rate of return (IRR) is
the expected percentage return
promised by a capital project.
It is also known as the real rate of return
or the time-adjusted rate of return.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

34. IRR Example Project C requires an initial investment
LO6
IRR Example
Project C requires an initial investment
of $300,000 and will provide annual
cash inflows of $56,232 for eight years.
Project D requires an initial investment
of $330,000 and will provide annual
cash inflows of $64,900 for eight years.
What is the internal rate of return for
each project?
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

35. IRR Example Step #1: Calculate the present value factor.
LO6
IRR Example
Step #1:
Calculate the present value factor.
Initial investment ÷ Annual net cash inflow
= Present value factor
Step #2:
Find the PV factor on the appropriate row
of the present value of an annuity of $1 table.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

36. IRR Example Project C: $300,000 ÷ $56,232 = 5.335
LO6
IRR Example
Project C:
$300,000 ÷ $56,232 = 5.335
For 8 years, the factor 5.335
equals a 10% rate of return.
Project D:
$330,000 ÷ $64,900 = For 8 years, the factor is very close
to the factor for the 11% rate of return.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

37. Nondiscounted Cash Flow Methods
do not factor the time value of
money into the analysis.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

38. Payback Period Method The payback period method measures
LO6
Payback Period Method
The payback period method measures
the length of time a capital project
must generate positive net cash
flows that equal, or “pay back,”
the original investment.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

39. Payback Period Method Assume that a project’s estimated
LO6
Payback Period Method
Assume that a project’s estimated
initial outlay is $40,000.
It is expected to generate $12,500 per year.
What is the payback period?
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

40. Payback Period Method If a project has uneven cash flows,
$40,000 ÷ $12,500 = 3.2 years
If a project has uneven cash flows,
the payback period can be determined
by adding the cash inflows year by
year until the total equals the
required initial investment.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

41. Accounting Rate of Return Method
LO6
Accounting Rate of Return Method
This capital budgeting method
uses accrual accounting
information rather than cash flows.
Whitewater Company’s computer
upgrade of $100,000 would reduce
operating expenses by $31,000
per year for five years.
The computer’s useful life is five years.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

42. Accounting Rate of Return Method
LO6
Accounting Rate of Return Method
What is the accounting rate of return?
Depreciation: $100,000 ÷ 5 = $20,000
($31,000 – $20,000) ÷ $100,000
= $11,000 ÷ $100,000 = 11%
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

43. Factors Leading to Poor Capital Project Selection
LO6
Factors Leading to Poor Capital Project Selection
Natural optimism
Capital budgeting games
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

44. Time Value of Money If you have a dollar in hand today, you can
LO7 Determine present and future values using
present value tables and future value tables.
If you have a dollar in hand today, you can
invest it and earn a return on it in the future.
This is the concept of interest and is the
basis for the time value of money.
To properly understand the time value of
money, you first must be able to distinguish
between simple interest and compound interest.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

45. Simple Interest Calculation
LO7
Simple Interest Calculation
10% Simple Interest
Year 1 Year 2 Year 3
Principal 2, , ,000
Interest
Amount to be received = $2,600
Interest each year equals
principal amount times 10%.
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

46. Compound Interest Calculations
LO7
Compound Interest Calculations
10% Compound Interest
Year 1 Year 2 Year 3
Principal 2, , ,420
Interest
Amount to be received = $2,662
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

47. Future Value Assume you deposit $2,000 in an
LO7
Future Value
Assume you deposit $2,000 in an
account that you believe will earn an
average of 10% per year for 20 years.
What is the future value?
$2,000 × = $13,454
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

48. Future Value of an Annuity
LO7
Future Value of an Annuity
Assume that instead of investing
$2,000 all at once, you decide to
deposit $2,000 at the end of the
year for 4 years into the account.
At a 12% return, what is the
account worth after 4 years?
$2,000 × = $9,558
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

49. Present Value What is the present value of $1,000
LO7
Present Value
What is the present value of $1,000
to be received a year from now at 6%?
$1,000 × = $943
What is the present value of $1,000
to be received at the end of each
year for three years?
$1,000 × = $2,673
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

50. Financial Calculator Keys
LO8 Determine present and future values
using a financial calculator. n
Number of periods i
Interest rate per period PV
Present value
PMT
Amount of payments per period FV
Future value
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

51. Calculator Differences
LO8
Calculator Differences
Buttons vs. display
Determining the solution
Compounding periods
Pluses and minuses
Timing of cash flows
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman

52. End of Chapter 8
©2016 Michael Werner and Mark Friedman, Management Accounting , Werner/Friedman