1. Accounting Principles
Thirteenth Edition
Weygandt ● Kimmel ● Kieso
Chapter 27
Planning for Capital Investments
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2. Copyright ©2018 John Wiley & Sons, Inc.
Chapter Outline
Learning Objectives L O 1 Describe capital budgeting inputs and apply the cash payback technique. L O 2 Use the net present value method. L O 3 Identify capital budgeting challenges and refinements. L O 4 Use the internal rate of return method. L O 5 Use the annual rate of return method.
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3. Capital Budgeting and Cash Payback
LEARNING OBJECTIVE 1
Describe capital budgeting inputs and apply the cash payback technique
Corporate capital budget authorization process:
Proposals for projects are requested from each department, plants, and authorized personnel.
Proposals are screened by a capital budget committee.
Officers determine which projects are worthy of funding.
Board of directors approves capital budget.
L O 1
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4. Cost Flow Information (1 of 3)
Ultimately, the value of all financial investments is determined by the value of cash flows received and paid.
For purposes of capital budgeting, estimated cash inflows and outflows are the preferred inputs. Why?
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L O 1

5. Cost Flow Information (2 of 3)
Cash Outflows Initial investment Repairs and maintenance Increased operating costs Overhaul of equipment Cash Inflows Proceeds from sale of old equipment Increased cash received from customers Reduced cash outflows related to operating costs Salvage value of equipment
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L O 1

6. Cost Flow Information (3 of 3)
Capital budgeting decisions depend on:
Availability of funds
Relationships among proposed projects
Company’s basic decision-making approach
Risk associated with a particular project
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L O 1

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Illustrative Data
Stewart Shipping Company is considering an investment of $130,000 in new equipment.
Initial investment
$130,000
Estimated useful life
10 years
Estimated salvage value
- 0 -
Estimated annual cash flows
Cash inflows from customers
$200,000
Cash outflows for operating costs
176,000
Net annual cash flow
$ 24,000
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L O 1

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Cash Payback (1 of 5)
Cash payback technique identifies time period required to recover cost of capital investment from net annual cash inflow produced by investment. Cash payback period for Stewart is …
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L O 1

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Cash Payback (2 of 5)
Shorter payback period = More attractive investment In case of uneven net annual cash flows, company determines cash payback period when:
Cumulative net cash flows from investment = Cost of investment
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L O 1

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Cash Payback (3 of 5)
Illustration: Chen Company proposes an investment in a new website that is estimated to cost $300,000.
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L O 1

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Cash Payback (4 of 5)
A $100,000 investment with a zero scrap value has an 8- year life. Compute the payback period if straight-line depreciation is used and net income is determined to be $20,000. a years. b years. c years. d years.
L O 1
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Cash Payback (5 of 5)
A $100,000 investment with a zero scrap value has an 8- year life. Compute the payback period if straight-line depreciation is used and net income is determined to be $20,000. a years. b. Answer: 3.08 years. c years. d years.
L O 1
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13. DO IT! 1: Cash Payback Period
Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual cash inflows would increase by $400,000 and that annual cash outflows would increase by $190,000. Compute the cash payback period.
Estimated annual cash inflows
$400,000
Estimated annual cash outflows
190,000
Net annual cash flow
$210,000
Cash payback period
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L O 1

14. Net Present Value Method
LEARNING OBJECTIVE 2
Use the net present value method
Discounted cash flow technique:
Generally recognized as best approach
Considers both estimated total cash inflows and time value of money
Two methods:
Net present value (N P V)
Internal rate of return (I R R)
L O 2
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15. Net Present Value Method (1 of 2)
Cash inflows are discounted to their present value and then compared with capital outlay required by investment
Interest rate used in discounting is required minimum rate of return
Proposal is acceptable when N P V is zero or positive
Higher positive N P V, more attractive investment
L O 2
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16. Net Present Value Method (2 of 2)
Proposal is acceptable when net present value is zero or positive.
L O 2
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17. Equal Annual Cash Flows (1 of 2)
Illustration: Stewart Shipping Company example, the company’s net annual cash flows are $24,000. If we assume this amount is uniform over the asset’s useful life, we can compute the present value of the net annual cash flows.
Present Value at 12%
Discounted factor for 10 periods
Present value of net cash flows:
$24,000 ×
$135,605
L O 2
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18. Equal Annual Cash Flows (2 of 2)
Illustration: Calculate the net present value.
12%
Present value of net cash flows
$135,605
Less: Capital investment
130,000
Net present value
$ 5,605
Proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive.
L O 2
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19. Unequal Annual Cash Flows (1 of 3)
Illustration: Stewart Shipping Company expects the same total net cash flows of $240,000 over the life of the investment. Because of a declining market demand for the new product the net annual cash flows are higher in the early years and lower in the later years. The present value of the net annual cash flows is calculated as follows.
L O 2
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20. Unequal Annual Cash Flows (2 of 3)
Year
Assumed Net Annual Cash Flows
Discount Factor 12%
Present Value 12%
(1)
(2)
(1) × (2) 1
$34,000
$30,357 2
30,000
23,916 3
27,000
19,218 4
25,000
15,888 5
24,000
13,618 6
22,000
11,146 7
21,000
9,499 8
20,000
8,078 9
19,000
6,852 10
18,000
5,795
$240,000
$144,367
L O 2
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21. Unequal Annual Cash Flows (3 of 3)
Illustration: Calculate the net present value.
12%
Present value of net cash flows
$144,367
Less: Capital investment
130,000
Net present value
$ 14,367
Proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive.
L O 2
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22. Choosing a Discount Rate (1 of 2)
In most instances a company uses a required rate of return equal to its cost of capital — that is, the rate that it must pay to obtain funds from creditors and stockholders.
Discount rate has two elements:
Cost of capital
Risk
Rate also know as required rate of return, hurdle rate, and cutoff rate.
L O 2
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23. Choosing a Discount Rate (2 of 2)
Illustration: Stewart Shipping used a discount rate of 12%. Suppose this rate does not take into account the risk of the project. A more appropriate rate might be 15%.
L O 2
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24. Simplifying Assumptions
All cash flows come at end of each year
All cash flows are immediately reinvested in another project that has a similar return
All cash flows can be predicted with certainty
L O 2
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25. Net Present Value (N P V) Method (1 of 2)
Compute the net present value of a $260,000 investment with a 10-year life, annual cash inflows of $50,000 and a discount rate of 12%. a. $(9,062) b. $22,511 c. $9,062 d. $9,062
L O 2
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26. Net Present Value (N P V) Method (2 of 2)
Compute the net present value of a $260,000 investment with a 10-year life, annual cash inflows of $50,000 and a discount rate of 12%. a. $(9,062) b. Answer: $22,511 c. $9,062 d. $9,062
L O 2
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27. Comprehensive Example (1 of 3)
Best Taste Foods is considering investing in new equipment to produce fat-free snack foods.
Initial investment
$1,000,000
Cost of equipment overhaul in 5 years
$200,000
Salvage value of equipment in 10 years
$20,000
Cost of capital (discount rate)
15%
Estimated annual cash flows
Cash inflows received from sales
$500,000
Cash outflows for cost of goods sold
Maintenance costs
$30,000
Other direct operating costs
$40,000
L O 2
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28. Comprehensive Example (2 of 3)
Compute the net annual cash flows for this project.
Cash inflows received from sales
$ 500,000
Cash outflows for cost of goods sold
(200,000)
Maintenance costs
(30,000)
Other direct operating costs
(40,000)
Net annual cash flow
$ 230,000
L O 2
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29. Comprehensive Example (3 of 3)
Compute the net present value for this proposed investment.
Event
Time
Period
Cash
Flow ×
15%
Discount
Factor =
Present
Value
Net annual cash flow
1 to 10
$ 230,000
$1,154,317
Salvage value 10
20,000
.24719
4,944
Less: Equipment purchase
1,000,000
Less: Equipment overhaul 5
200,000
.49718
99,436
Net present value
$ ,825
L O 2
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30. DO IT! 2: Net Present Value (1 of 3)
Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual cash inflows would increase by $400,000 and that annual cash outflows would increase by $190,000. Management has a required rate of return of 9%. Calculate the net present value on this project and discuss whether it should be accepted.
L O 2
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31. DO IT! 2: Net Present Value (2 of 3)
Calculate the net present value on this project and discuss whether it should be accepted.
Estimated annual cash inflows
$400,000
Estimated annual cash outflows
190,000
Net annual cash flow
$210,000
Cash Flow 9%
Discount
Factor
Present
Value
Present value of net annual cash flows
$210,000
$942,043
Less: Capital investment
900,000
Net present value
$42,043
NPV is [blank], Waterton [blank] accept the project.
L O 2
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32. DO IT! 2: Net Present Value (3 of 3)
Calculate the net present value on this project and discuss whether it should be accepted.
Estimated annual cash inflows
$400,000
Estimated annual cash outflows
190,000
Net annual cash flow
$210,000
Cash Flow 9%
Discount
Factor
Present
Value
Present value of net annual cash flows
$210,000
$942,043
Less: Capital investment
900,000
Net present value
$42,043
NPV is greater than zero, Waterton should accept the project.
L O 2
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33. Capital Budgeting Challenges and Refinements
LEARNING OBJECTIVE 3
Identify capital budgeting challenges and refinements
Intangible Benefits
Might include increased quality, improved safety, or enhanced employee loyalty.
To avoid rejecting projects with intangible benefits:
Calculate N P V ignoring intangible benefits
Project conservative estimates of value of intangible benefits, and incorporate these values into N P V calculation
L O 3
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Intangible Benefits
Example: Berg Company is considering the purchase of a new mechanical robot.
Initial investment
$200,000
Annual cash inflows
$ 50,000
Annual cash outflows
20,000
Net annual cash flow
$ 30,000
Estimated life of equipment
10 years
Cash Flows ×
12% Discount Factor =
Present Value
Present value of net annual cash flows
$ 30,000
$169,507
Initial investment
200,000
Net present value
$ (30,493)
L O 3
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35. Intangible Benefits Example (1 of 2)
Berg estimates that improved sales will increase cash inflows by $10,000 annually as a result of an increase in perceived quality. Berg also estimates that annual cost outflows would be reduced by $5,000 as a result of lower warranty claims, reduced injury claims, and fewer missed work days. Using these conservative estimates of the value of the additional benefits, should Berg accept the project?
L O 3
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36. Intangible Benefits Example (2 of 2)
Berg would accept the project.
Initial investment
$200,000
Annual cash inflows (revised)
$ 60,000
($50,000 + $10,000)
Annual cash outflows (revised)
15,000
($20,000 − $5,000)
Net annual cash flow
$ 45,000
Estimated life of equipment
10 years
Cash Flows ×
12% Discount Factor =
Present Value
Present value of net annual cash flows
$ 45,000
$254,260
Initial investment
200,000
Net present value
$ 54,260
L O 3
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37. Profitability Index for Mutually Exclusive Projects (1 of 2)
Proposals are often mutually exclusive
Managers choose between various positive-N P V projects because of limited resources
Tempting to choose project with higher N P V
L O 3
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38. Profitability Index for Mutually Exclusive Projects (2 of 2)
Illustration: Two mutually exclusive projects, each assumed to have a 10-year life and a 12% discount rate.
Project A
Project B
Net annual cash flow
$10,000
$19,000
Salvage value
5,000
10,000
Present value of net cash flows
($10,000 × ) + ($5,000 × )
58,112
($19,000 × ) + ($10,000 × )
110,574
Less: Initial investment
40,000
90,000
Net present value
$18,112
$20,574
L O 3
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39. Profitability Index (1 of 3)
Illustration: One method of comparing alternative projects is the profitability index.
Project A
Project B
Present value of net cash flows
$58,112
$110,574
Less: Initial investment
40,000
90,000
Net present value
$18,112
$20,574
Project A
Project B
L O 3
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40. Profitability Index (2 of 3)
Assume Project A has a present value of net cash inflows of $79,600 and an initial investment of $60,000. Project B has a present value of net cash inflows of $82,500 and an initial investment of $75,000. Assuming the projects are mutually exclusive, which project should management select? a. Project A b. Project B c. Project A or B d. There is not enough data to answer the question
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L O 3

41. Profitability Index (3 of 3)
Assume Project A has a present value of net cash inflows of $79,600 and an initial investment of $60,000. Project B has a present value of net cash inflows of $82,500 and an initial investment of $75,000. Assuming the projects are mutually exclusive, which project should management select? a. Answer: Project A b. Project B c. Project A or B d. There is not enough data to answer the question
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L O 3

42. Copyright ©2018 John Wiley & Sons, Inc.
Risk Analysis
A simplifying assumption made by many financial analysts is that projected results are known with certainty.
Projected results are only estimates
Sensitivity analysis is used to deal with uncertainty
Uses a number of outcome estimates to get a sense of variability among potential returns
L O 3
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43. Post-Audit of Investment Projects
Performing a post-audit is important.
If managers know their estimates will be compared to actual results they will be more likely to submit reasonable and accurate data when making investment proposals
Provides a formal mechanism to determine whether existing projects should be supported or terminated
Improve future investment proposals
L O 3
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44. DO IT! 3: Profitability Index (1 of 2)
Taz Corporation has decided to invest in renewable energy sources to meet part of its energy needs for production. It is considering solar power versus wind power. After considering cost savings as well as incremental revenues from selling excess electricity into the power grid, it has determined the following.
Solar
Wind
Present value of annual cash flows
$78,580
$168,450
Initial investment
$45,500
$125,300
Determine the net present value and profitability index of each project. Which energy source should it choose?
L O 3
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45. DO IT! 3: Profitability Index (2 of 2)
Solar
Wind
Present value of annual cash flows
$78,580
$168,450
Initial investment
45,500
125,300
Net present value
$33,080
$ 43,150
Profitability index
1.73*
1.34**
*$78,580 ÷ $45, **$168,450 ÷ $125,300
The investment in wind power generates higher net present value and requires a substantially higher initial investment. The profitability index favors solar power, which suggests that the additional net present value of wind is outweighed by the cost of the initial investment. The company should choose solar power.
L O 3
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46. Internal Rate of Return
LEARNING OBJECTIVE 4
Use the internal rate of return method
Differs from net present value method in that it finds interest yield of potential investment
Internal rate of return (I R R) - interest rate that will cause present value of proposed capital expenditure to equal present value of expected net annual cash flows (N P V equal to zero)
How does one determine internal rate of return?
L O 4
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47. Internal Rate of Return (1 of 3)
Stewart Shipping Company is considering the purchase of a new front-end loader at a cost of $244,371. Net annual cash flows from this loader are estimated to be $100,000 a year for three years. To determine the internal rate of return on this front-end loader, the company finds the discount rate that results in a net present value of zero.
Year
Net Annual
Cash Flows
Discount
Factor
10%
Present
Value 10%
11%
Value 11%
12%
Value 12% 1
$100,000
.90909
$ 90,909
.90090
$ 90,090
.89286
$ 89,286 2
.82645
82,645
.81162
81,162
.79719
79,719 3
.75132
75,132
.73119
73,119
.71178
71,178
248,686
244,371
240,183
Less: Initial investment
Net present value
$ 4,315 $
$ (4,188)
L O 4
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48. Internal Rate of Return (2 of 3)
An easier approach to solving for internal rate of return when net annual cash flows are equal.
L O 4
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49. Internal Rate of Return (3 of 3)
L O 4
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50. Comparing Discounted Cash Flow Methods
Net Present Value
Internal Rate of Return
1. Objective
Compute net present value (a dollar amount).
Compute internal rate of return (a percentage)
2. Decision Rule
If net present value is zero or positive, accept the proposal.
If net present value is negative, reject the proposal.
If internal rate of return is equal to or greater than the required rate of return, accept the proposal.
If internal rate of return is less than the required rate of return, reject the proposal.
L O 4
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51. DO IT! 4: Internal Rate of Return (1 of 3)
Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual cash inflows would increase by $400,000 and that annual cash outflows would increase by $190,000. Management has a required rate of return of 9%. Calculate the internal rate of return on this project and discuss whether it should be accepted.
L O 4
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52. DO IT! 4: Internal Rate of Return (2 of 3)
Calculate the internal rate of return on this project.
Estimated annual cash inflows
$400,000
Estimated annual cash outflows
190,000
Net annual cash flow
$210,000
Machine cost
$900,000
÷ $210,000
Present value factor
Now, find the rate that corresponds to the present value factor.
L O 4
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53. DO IT! 4: Internal Rate of Return (3 of 3)
Find the rate that corresponds to the present value factor of for 6 periods.
Required rate of return is only 9%, project should be accepted.
L O 4
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54. Expected Annual Net Income
Annual Rate of Return
LEARNING OBJECTIVE 5
Use the annual rate of return method
Indicates profitability of a capital expenditure by dividing expected annual net income by average investment.
Expected Annual Net Income ÷
Average Investment =
Annual Rate of Return
L O 5
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55. Annual Rate of Return (1 of 2)
Illustration: Reno Company is considering an investment of $130,000 in new equipment. The equipment is expected to last five years and have zero salvage value at the end of its useful life. Reno uses straight-line depreciation.
Sales
$200,000
Less: Costs and expenses
Manufacturing costs (exclusive of depreciation)
$132,000
Depreciation expense ($130,000 ÷ 5)
26,000
Selling and administrative expenses
22,000
180,000
Income before income taxes
20,000
Income tax expense
7,000
Net income
$ 13,000
L O 5
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56. Annual Rate of Return (2 of 2)
A project is acceptable if its rate of return is greater than management’s required rate of return.
L O 5
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57. DO IT! 5: Annual Rate of Return (1 of 2)
Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual revenues would increase by $400,000 and that annual expenses excluding depreciation would increase by $190,000. It uses the straight-line method to compute depreciation expense. Management has a required rate of return of 9%. Compute the annual rate of return.
L O 5
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58. DO IT! 5: Annual Rate of Return (2 of 2)
Compute the annual rate of return.
Revenues
$400,000
Less:
Expenses (excluding depreciation)
$190,000
Depreciation expense ($900,000 ÷ 6 years)
150,000
340,000
Annual net income
$ 60,000
The proposed project is acceptable.
L O 5
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