1. 11 - 1 ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Chapter 11 Capital Budgeting

2. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 2 Learning Objective 1 Describe capital budgeting decisions and use the net present value (NPV) method to make such decisions.

3. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 3 Capital Budgeting Capital budgeting describes the long-term planning for making and financing major long-term projects. Identify potential investments. Choose an investment. Follow-up or “post audit.”

4. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 4 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.

5. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 5 Net Present Value The net-present-value (NPV) method is a discounted-cash-flow approach to capital budgeting that computes the present value of all expected future cash flows using a minimum desired rate of return.

6. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 6 Net Present Value 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.

7. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 7 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.

8. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 8 NPV Example l Original investment (cash outflow): $6,075 l Useful life: four years l Annual income generated from investment (cash inflow): $2,000 l Minimum desired rate of return: 10%

9. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 9 NPV Example YearsAmount PV Factor Present Value 0($6,075)1.0000($6,075) 1 2,000.9091 1,818 2 2,000.8264 1,653 3 2,000.7513 1,503 4 2,000.6830 1,366 Net present value $ 265

10. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 10 NPV Example Years Amount PV Factor Present Value 0($6,075)1.0000($6,075) 1-4 2,0003.1699 6,340 Net present value $ 265

11. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 11 NPV Assumptions There is a world of certainty. There are perfect capital markets. Money can be borrowed or loaned at the same interest rate. Predicted cash flows occur timely.

12. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 12 Capital Budgeting Decisions 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. Managers determine the sum of the present values of all expected cash flows from the project.

13. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 13 Learning Objective 2 Evaluate projects using sensitivity analysis.

14. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 14 Sensitivity Analysis l Actual cash inflows may differ from what was expected or predicted. l To examine uncertainty, managers often use sensitivity analysis. l Sensitivity analysis shows the financial consequences that would occur if actual cash inflows and outflows differ from those expected.

15. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 15 Sensitivity Analysis Example l Suppose that a manager knows that the actual cash inflows in the previous example could fall below the predicted level of $2,000. l How far below $2,000 must the annual cash inflow drop before the NPV becomes negative?

16. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 16 Sensitivity Analysis Example NPV = 0 If the annual cash flow is less than $1,916, the NPV is negative, and the project should be rejected. (3.1699 × Cash flow) – $6,075 = 0 Cash flow = $6,075 ÷ 3.1699 = $1,916

17. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 17 Learning Objective 3 Calculate the NPV difference between two projects using both the total project and differential approaches.

18. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 18 Comparison of Two Projects Two common methods for comparing alternatives are: Total project approach Differential approach

19. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 19 Total Project Approach l 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. l The alternative with the largest NPV of total cash flows is best.

20. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 20 Differential Approach l The differential approach computes the differences in cash flows between alternatives and then converts these differences to their present values. l This method cannot be used to compare more than two alternatives.

21. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 21 Learning Objective 4 Identify relevant cash flows for DCF analyses.

22. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 22 Relevant Cash Flows for NPV l Be sure to consider the four types of inflows and outflows: 1 Initial cash inflows and outflows at time zero 2 Investments in receivables and inventories 3 Future disposal values 4 Operating cash flows

23. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 23 Operating Cash Flows l Using relevant-cost analysis, the only relevant cash flows are those that will differ among alternatives. l Depreciation and book values should be ignored. l A reduction in cash outflow is treated the same as a cash inflow.

24. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 24 Learning Objective 5 Compute the after-tax net present values of projects.

25. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 25 Income Taxes and Capital Budgeting What is an example of another type of cash flow that must be considered when making capital-budgeting decisions? Income taxes

26. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 26 Marginal Income Tax Rate l In capital budgeting, the relevant tax rate is the marginal income tax rate. l This is the tax rate paid on additional amounts of pretax income.

27. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 27 Effects of Depreciation Deductions l For tax purposes, accelerated depreciation is generally allowed. l The focus is on the tax reporting rules, not those for public financial reporting. l The number of years over which an asset is depreciated for tax purposes is called the recovery period.

28. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 28 Depreciation Deductions for Capital Budgeting l Depreciating a fixed asset creates future tax deductions. l The present value of this deduction depends directly on its specific yearly effects on future income tax payments.

29. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 29 Depreciation Deductions for Capital Budgeting The present value is influenced by: Recovery period Depreciation method selected Tax rate Discount rate

30. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 30 Tax Effect on Cash Inflows from 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.

31. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 31 Tax Effect on Cash Inflows from Operations 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

32. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 32 Modified Accelerated Cost Recovery System l Under U.S. income tax laws, most assets purchased since 1987 are depreciated using the Modified Accelerated Cost Recovery System (MACRS). l This system specifies a recovery period and an accelerated depreciation schedule for all types of assets.

33. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 33 Learning Objective 6 Explain the after-tax effect on cash of disposing of assets.

34. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 34 Gains or Losses on Disposal Suppose a piece 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

35. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 35 Gains or Losses on Disposal l If it is sold for book value, there is no gain or loss and so there is no tax effect. l If it is sold for more than $50,000, there is a gain and an additional tax payment. l If it is sold for less than $50,000, there is a loss and a tax savings. TAX

36. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 36 Learning Objective 7 Compute the impact of inflation on a capital-budgeting project.

37. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 37 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.

38. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 38 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.

39. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 39 Learning Objective 8 Use the payback model and the accounting rate-of-return model and compare them with the NPV model.

40. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 40 Payback Model l 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

41. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 41 Payback Model Example l Assume that $12,000 is spent for a machine with an estimated useful life of 8 years. l Annual savings of $4,000 in cash outflows are expected from operations. l What is the payback period? P = I ÷ O = $12,000 ÷ $4,000 = 3 years

42. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 42 Accounting Rate-of-Return Model l 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. Initial required investment ARR = Increase in expected average annual operating income ÷

43. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 43 Accounting Rate-of-Return Model Assume the following: Investment is $6,075. Useful life is four years. Estimated disposal value is zero. Expected annual cash inflow from operations is $2,000. What is the annual depreciation?

44. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 44 Accounting Rate-of-Return Model $6,075 ÷ 4 = $1,518.75, rounded to $1,519 What is the ARR? ARR = ($2,000 – $1,519) ÷ $6,075 = 7.9%

45. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 45 Learning Objective 9 Reconcile the conflict between using an NPV model for making a decision and using accounting income for evaluating the related performance.

46. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 46 Performance Evaluation The best way to reconcile any potential conflict between capital budgeting and performance evaluation is to use a DCF for both capital-budgeting decisions and performance evaluation.

47. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 47 Post Audit l A recent survey showed that most large companies conduct a follow-up evaluation of at least some capital-budgeting decisions, often called a post audit. l The post audit focuses on actual versus predicted cash flows.

48. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 48 Learning Objective 10 Understand how companies make long-term capital investment decisions and how such decisions can affect the companies’ financial results for years to come.

49. ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 11 - 49 Long-term Capital Investments… are critical to a company’s financial success. Using a discounted cash-flow method helps managers make optimal capital budgeting decisions.

50. 11 - 50 ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton End of Chapter 11