1. Capital Budgeting Decisions Chapter 11
Introduction to Managerial Accounting, Brewer, Garrison,Noreen
Power Points from website - adapted by Cynthia Fortin, CPA, CMA

2. Capital investments decisions
Accept or reject an investment project (Net present value)
Rank projects
Payback
Compute simple rate of return

3. How to select projects?
Promise
Highest return

4. Hope to realize
future profits
Invest
today
Requires spending now

5. New Equipment Plant expansion
There are always so many more projects than the company
can afford. Managers must select carefully
Projects with greatest return.

6. Change software factory planning

7. Typical Capital Budgeting Decisions
Screening decisions
Triage –
for example
does the investment meet a preset hurdle rate of return of 20%.
There are two main types of capital budgeting decisions:
Screening decisions relate to whether a proposed project passes a preset hurdle. For example, a company may have a policy of accepting projects only if they promise a return of 20% on the investment.
Preference decisions relate to selecting among several competing courses of action. For example, a company may be considering several different machines to replace an existing machine on the assembly line.
In this chapter, we initially discuss ways of making screening decisions. Preference decisions are discussed toward the end of the chapter.

8. Typical Capital Budgeting Decisions
Preference decisions
Selecting among
acceptable alternatives.
There are two main types of capital budgeting decisions:
Screening decisions relate to whether a proposed project passes a preset hurdle. For example, a company may have a policy of accepting projects only if they promise a return of 20% on the investment.
Preference decisions relate to selecting among several competing courses of action. For example, a company may be considering several different machines to replace an existing machine on the assembly line.
In this chapter, we initially discuss ways of making screening decisions. Preference decisions are discussed toward the end of the chapter.

9. An amount today is worth more than in a year from now.
Time Value of Money
An amount today is worth more than in a year from now.
Projects promising earlier returns are preferable to those that promise later returns.
The time value of money concept recognizes that a dollar today is worth more than a dollar a year from now. Therefore, projects that promise earlier returns are preferable to those that promise later returns.

10. best recognizes the time value of money
The capital budgeting techniques that best recognize the time value of money are those that involve discounted cash flows (the concepts of discounting cash flows and using present value tables are explained in greater detail in Appendix 11A).
best recognizes the time value of money

11. The Net Present Value Method
Calculate (1) Present value of cash inflows (2) Present value of cash outflows (3) (1) – (2)
The net present value method compares the present value of a project’s cash inflows with the present value of its cash outflows. The difference between these two streams of cash flows is called the net present value.

12. The Net Present Value Method
The net present value is interpreted as follows:
If the net present value is positive, then the project is acceptable.
If the net present value is zero, then the project is acceptable.
If the net present value is negative, then the project is not acceptable.

13. The Net Present Value Method
Net present value analysis emphasizes cash flows and not accounting net income.
The reason is that accounting net income is based on accruals that ignore the timing of cash flows into and out of an organization.
Net present value analysis (as well as the internal rate of return, which will be discussed shortly) emphasizes cash flows and not accounting net income. The reason is that accounting net income is based on accruals that ignore the timing of cash flows into and out of an organization.

14. Typical Cash Outflows 26000 = 50000 – 24000 Initial investment
Examples of typical cash outflows that are included in net present value calculations are as shown. Notice the term working capital, which is defined as current assets less current liabilities.
The initial investment in working capital is a cash outflow at the beginning of the project for items such as inventories. It is recaptured at the end of the project when working capital is no longer required. Thus, working capital is recognized as a cash outflow at the beginning of the project and a cash inflow at the end of the project.
At the beginning of a project
Incremental
operating
costs

15. Typical Cash Inflows 20000 = 46000 - 20000 Reduction
Salvage
value
20000 =
20000
Examples of typical cash inflows that are included in net present value calculations are as shown.
Reduction
Incremental revenue

16. Two simplifying assumptions are usually made in net present value analysis:
all cash flows other than the initial investment occur at the end of periods
all cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate.
Two simplifying assumptions are usually made in net present value analysis:
The first assumption is that all cash flows other than the initial investment occur at the end of periods.
The second assumption is that all cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate.

17. Choosing a Discount Rate
The firm’s cost of capital = minimum required rate of return.
The cost of capital = average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds.
When the cost of capital is used as the discount rate, it serves as a screening device in net present value analysis.
A company’s cost of capital, which is defined as the average rate of return a company must pay to its long-term creditors and shareholders for the use of their funds, is usually regarded as the minimum required rate of return. When the cost of capital is used as the discount rate, it serves as a screening device in net present value analysis.

18. Let’s look at an example of the net present value method!

19. The Net Present Value Method
Lester Company has been offered a five-year contract to provide component parts for a large manufacturer.
Initial investment
Assume the information as shown with respect to Lester Company.

20. The Net Present Value Method
At the end of five years the working capital will be released and may be used elsewhere by Lester.
Lester Company uses a discount rate of 10%.
Should the contract be accepted?
Also assume that at the end of five years the working capital will be released and may be used elsewhere.
Lester Company’s discount rate is 10 percent.
Should the contract be accepted?

21. Annual net cash inflow from operations
The annual net cash inflow from operations ($80,000) is computed as shown.

22. Annual net cash outflow from operations
Since the investments in equipment ($160,000) and working capital ($100,000) occur immediately, the discounting factor used is

23. Present value of an annuity of $1
factor for 5 years at 10%.
The present value factor for an annuity of $1 for five years at 10 percent is Therefore, the present value of the annual net cash inflows is $303,280.

24. Calculating the factor
One amount in the future such as Salvage value, working capital released or relining equipment use the Present value of $1 table.
If you prefer calculate the factor yourself.
For example a 10% discount rate over 4 years is equal to:
1/1.10/1.10/1.10/1.10 = Check it out in the table.
The same amount year over year such as
Annual net cash inflows or Yearly savings
Use the Present value of an annuity of $1 in arrears table.
For example a 10% discount rate over 4 years of savings is equal to:
(1/1.10)+(1/1.10/1.10)+(1/1.10/1.10/1.10)+(1/1.10/1.10/1.10/1.10)= 3.170

25. The Net Present Value Method
Present value of $1
factor for 3 years at 10%.
The present value factor of $1 for three years at 10 percent is Therefore, the present value of the cost of relining the equipment in three years is $22,530.

26. The Net Present Value Method
Present value of $1
factor for 5 years at 10%.
The present value factor of $1 for five years at 10 percent is Therefore, the present value of the salvage value of the equipment is $3,105 and the present value of the release of the working capital is $62,100.
At the end of five years the working capital will be released and may be used elsewhere by Lester.

27. The Net Present Value Method
The net present value of the investment opportunity is $85,955. Since the net present value is positive, it suggests making the investment.
Accept the contract because the project has a positive net present value.

28. Quick Check 
Denny Associates has been offered a four-year contract to supply the computing requirements for a local bank.
Assume the information provided for Denny Associates.
The working capital would be released at the end of the contract.
Denny Associates requires a 14% return.

29. Quick Check 
What is the net present value of the contract with the local bank?
a. $150,000
b. $ 28,230
c. $ 92,340
d. $132,916
What is the net present value of the contract with the local bank?

30. Quick Check 
What is the net present value of the contract with the local bank? a. $150,000 b. $ 28,230 c. $ 92,340 d. $132,916
$28,230. Take a minute and review the solution presented.

31. Expanding the Net Present Value Method
To compare competing investment projects we can use the following net present value approaches:
Total cost
Incremental cost
We will now expand the net present value method to include two alternatives and the concept of relevant costs. The net present value method can be used to compare competing investment projects in two ways – the total cost approach and the incremental cost approach.

32. The Total-Cost Approach
White Company has two alternatives:
remodel an old car wash or,
remove the old car wash and install a new one.
The company uses a discount rate of 10%.
Assume that White Company has two alternatives – remodel an old car wash or remove the old car wash and replace it with a new one.
  The company uses a discount rate of 10 percent.
The annual net cash inflows are $60,000 for the new car wash and $45,000 for the old car wash.

33. The Total-Cost Approach
If White installs a new washer . . .
In addition, assume that the information as shown relates to the installation of a new washer.
Let’s look at the present value of this alternative.

34. The Total-Cost Approach
The net present value of installing a new washer is $83,202.
If we install the new washer, the investment will yield a positive net present value of $83,202.

35. The Total Cost Approach
If White remodels the existing washer . . .
If White chooses to remodel the existing washer, the remodeling costs would be $175,000 and the cost to replace the brushes at the end of six years would be $80,000.
Let’s look at the present value of this second alternative.

36. The Total Cost Approach
The net present value of remodeling the old washer is $56,405.
If we remodel the existing washer, we will produce a positive net present value of $56,405.

37. The Total Cost Approach
Both projects yield a positive net present value.
While both projects yield a positive net present value, the net present value of the new washer alternative is $26,797 higher than the remodeling alternative.
However, investing in the new washer will produce a higher net present value than remodeling the old washer.

38. The Incremental Cost Approach
Under the incremental cost approach, only those cash flows that differ between the two alternatives are considered.
Let’s look at an analysis of the White Company decision using the incremental cost approach.
Under the incremental cost approach, only those cash flows that differ between the remodeling and replacing alternatives are considered.

39. The Incremental Cost Approach
We get the same answer under either the
total cost or incremental cost approach
Investment 300,000 – 175,000 = 125,000
Increased net cash inflows: 60,000 – 45,000 = 15,000.
The differential cash flows between the alternatives are as shown. Notice, the net present value of $26,797 is identical to the answer derived from the total cost approach.

40. Quick Check 
Consider the following alternative projects. Each project would last for five years.
Project A Project B
Initial investment $80,000 $60,000
Annual net cash inflows 20,000 16,000
Salvage value 10,000 8,000
The company uses a discount rate of 14% to evaluate projects. Which of the following statements is true?
a. NPV of Project A > NPV of Project B by $5,230
b. NPV of Project B > NPV of Project A by $5,230
c. NPV of Project A > NPV of Project B by $2,000
d. NPV of Project B > NPV of Project A by $2,000
Consider the information provided for two alternative projects. The company uses a discount rate of 14 percent to evaluate projects. Which of the following statements is true?

41. Quick Check 
Consider the following alternative projects. Each project would last for five years.
Project A Project B
Initial investment $80,000 $60,000
Annual net cash inflows 20,000 16,000
Salvage value 10,000 8,000
The company uses a discount rate of 14% to evaluate projects. Which of the following statements is true?
a. NPV of Project A > NPV of Project B by $5,230
b. NPV of Project B > NPV of Project A by $5,230
c. NPV of Project A > NPV of Project B by $2,000
d. NPV of Project B > NPV of Project A by $2,000
The net present value of Project B is greater than the NPV of Project A by $5,230. Take a minute and review the solution provided.

42. Let’s look at the Home Furniture Company.
Least Cost Decisions
In decisions where revenues are not directly involved, managers should choose the alternative that has the least total cost from a present value perspective.
Let’s look at the Home Furniture Company.
In decisions where revenues are not directly involved, managers should choose the alternative that has the least total cost from a present value perspective.

43. The company uses a discount rate of 10%.
Least Cost Decisions
Home Furniture Company is trying to decide whether to overhaul an old delivery truck now or purchase a new one.
The company uses a discount rate of 10%.
Assume the following facts:
Home Furniture Company is trying to decide whether to overhaul an old delivery truck or purchase a new one.
The company uses a discount rate of 10 percent. We will analyze this decision using the total cost approach.

44. Least Cost Decisions Here is information about the trucks . . .
The information pertaining to the old and new trucks is as shown.

45. Least Cost Decisions
The net present value of buying a new truck is ($32,883).
The net present value of overhauling the old truck is ($42,255).
Notice that both NPV numbers are negative because there is no revenue involved – this is a least cost decision.

46. Home Furniture should purchase the new truck.
Least Cost Decisions
Home Furniture should purchase the new truck.
The net present value in favor of purchasing the new truck is $9,372.

47. Quick Check 
Bay Architects is considering a drafting machine that would cost $100,000, last four years, provide annual cash savings of $10,000, and considerable intangible benefits each year. How large (in cash terms) would the intangible benefits have to be per year to justify investing in the machine if the discount rate is 14%?
a. $15,000
b. $90,000
c. $24,317
d. $60,000
Consider the information provided for Bay Architects. How large (in cash terms) would the intangible benefits have to be to justify investing in the drafting machine if the discount rate is 14 percent?

48. Quick Check 
Bay Architects is considering a drafting machine that would cost $100,000, last four years, provide annual cash savings of $10,000, and considerable intangible benefits each year. How large (in cash terms) would the intangible benefits have to be per year to justify investing in the machine if the discount rate is 14%?
a. $15,000
b. $90,000
c. $24,317
d. $60,000
$70,860/2.914 = $24,317
$24,317. Take a minute and review the detailed solution provided.

49. Net Present Value Method
The net present value of one project cannot be directly compared to the net present value of another project unless the investments are equal.
The net present value of one project cannot be directly compared to the net present value of another project, unless the investments are equal.

50. Profitability index
Although each project has a net present value of $1,000, the projects are not equally desirable if the funds available for investment are limited. The project requiring an investment of only $5,000 is much more desirable than the project requiring an investment of $10,000.

51. Ranking Investment Projects
Project Net present value of the project profitability Investment required index =
In the case of unequal investments, a profitability index can be computed as the net present value of the project divided by the investment required. Notice three things:
The profitability indexes for investments A and B are 0.10 and 0.20, respectively.
The higher the profitability index, the more desirable the project. Therefore, investment B is more desirable than investment A.
As in this type of situation, the constrained resource is the limited funds available for investment, and the profitability index is similar to the contribution margin per unit of the constrained resource as discussed in an earlier chapter.
The higher the profitability index, the
more desirable the project.

52. This section focuses on two other methods of making capital budgeting decisions – the payback method and the simple rate of return. The payback method will be discussed first, followed by the simple rate of return method.
This section focuses on two other methods of making capital budgeting decisions – the payback method and the simple rate of return. The payback method will be discussed first followed by the simple rate of return method.

53. The Payback Method
The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates.
When the annual net cash inflow is the same each year, this formula can be used to compute the payback period:
The payback method focuses on the payback period, which is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates.
When the annual net cash inflow is the same every year, the formula for computing the payback period is the investment required divided by the annual net cash inflow.
Payback period =
Investment required
Annual net cash inflow

54. The Payback Method
Management at The Daily Grind wants to install an espresso bar in its restaurant that
Costs $140,000 and has a 10-year life.
Will generate annual net cash inflows of $35,000.
Management requires a payback period of 5 years or less on all investments.
What is the payback period for the espresso bar?
Assume the management of The Daily Grind wants to install an espresso bar in its restaurant.
The cost of the espresso bar is $140,000 and it has a 10-year life.
The bar will generate annual net cash inflows of $35,000.
Management requires a payback period of five years or less.
What is the payback period on the espresso bar?

55. The Payback Method
Investment required
Annual net cash inflow
Payback period =
Payback period =
$140,000
$35,000
Payback period =
4.0 years
The payback period is 4 years. Therefore, management would choose to invest in the bar.
According to the company’s criterion, management would invest in the espresso bar because its payback period is less than 5 years.

56. Quick Check  Consider the following two investments:
Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 3–10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined
Consider the information provided for two investments. Which project has the shortest payback period?

57. Quick Check  Consider the following two investments:
Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 3–10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined
Project X has the shortest payback period of two years. But, the real question is which project do you think is better? It looks like Project Y may be the better of the two investments because it has a much higher cash inflow over the 10-year period.
Project X has a payback period of 2 years.
Project Y has a payback period of slightly more than 2 years.
Which project do you think is better?

58. Evaluation of the Payback Method
Ignores the
time value
of money.
Short-comings
of the payback
period.
Ignores cash
flows after
the payback
period.
Criticisms of the payback method include the following.
First, a shorter payback period does not always mean that one investment is more desirable than another. This is because the payback method ignores cash flows after the payback period, thus it has no inherent mechanism for highlighting differences in useful life between investments.
Second, the payback method does not consider the time value of money.

59. Evaluation of the Payback Method
Serves as screening tool.
Strengths
of the payback
period.
Identifies investments that recoup cash investments quickly.
Identifies products that recoup initial investment quickly.
Strengths of the payback method include the following.
It can serve as a screening tool to help identify which investment proposals are in the “ballpark.”
It can aid companies that are “cash poor” in identifying investments that will recoup cash investments quickly.
It can help companies that compete in industries where products become obsolete rapidly to identify products that will recoup their initial investment quickly.

60. Payback and Uneven Cash Flows
When the cash flows associated with an investment project change from year to year, the payback formula introduced earlier cannot be used.
Instead, the unrecovered investment must be tracked year by year.
When the cash flows associated with an investment project change from year to year, the payback formula introduced earlier cannot be used. Instead, the un-recovered investment must be tracked year by year. 1 2 3 4 5
$1,000 $0
$2,000
$500

61. Payback and Uneven Cash Flows
For example, if a project requires an initial investment of $4,000 and provides uneven net cash inflows in years 1–5 as shown, the investment would be fully recovered in year 4. 1 2 3 4 5
$1,000 $0
$2,000
$500
For example, if a project requires an initial investment of $4,000 and provides uneven net cash inflows in years one to five as shown, the investment would be fully recovered in year four.

62. Simple Rate of Return Method
Does not focus on cash flows – rather, it focuses on accounting net operating income.
The following formula is used to calculate the simple rate of return:
Annual incremental net operating income -
Simple rate
of return =
The simple rate of return method (also known as the accounting rate of return or the unadjusted rate of return) does not focus on cash flows, rather it focuses on accounting net operating income.
The equation for computing the simple rate of return is as shown.
Initial investment*
*Should be reduced by any salvage from the sale of the old equipment

63. Simple Rate of Return Method
Management of The Daily Grind wants to install an espresso bar in its restaurant that:
Cost $140,000 and has a 10-year life.
Will generate incremental revenues of $100,000 and incremental expenses of $65,000 including depreciation.
What is the simple rate of return on the investment project?
Simple rate
of return
$35,000
$140,000
= 25% =
Assume the management of the Daily Grind wants to install an espresso bar in its restaurant.
The cost of the espresso bar is $140,000 and it has a ten-year life.
The espresso bar will generate incremental revenues of $100,000 and incremental expenses of $65,000 including depreciation.
What is the simple rate of return on this project?
The simple rate of return is 25%

64. Criticism of the Simple Rate of Return
Ignores the
time value
of money.
Shortcomings
of the simple rate of return.
The same project may appear desirable in some years and undesirable in other years.
Criticisms of the simple rate of return include the following:
First, it does not consider the time value of money.
Second, the simple rate of return fluctuates from year to year when used to evaluate projects that do not have constant annual incremental revenues and expenses. The same project may appear desirable in some years and undesirable in others.

65. Postaudit of Investment Projects
A postaudit is a follow-up after the project has been completed to see whether or not expected results were actually realized.
A postaudit is a follow-up after the project has been completed to see whether or not expected results were actually realized.
The data used in a postaudit analysis should be actual observed data rather than estimated data.