1. Capital Budgeting and Cost Analysis
Lecture 30
Chapter 21-Continued
Capital Budgeting and Cost Analysis
Readings
Chapter 21, Cost Accounting, Managerial Emphasis, 14th edition by Horengren
Chapter 14, Managerial Accounting 6th edition by Weygandt, kimmel, kieso

2. Learning Objectives
Evaluate the acceptability of an investment project using the net present value method.
Evaluate the acceptability of an investment project using the internal rate of return method.
Evaluate an investment project that has uncertain cash flows
Rank investment projects in order of preference.
Determine the payback period for an investment.
Compute the simple rate of return for an investment.
Understand present value concepts and the use of present value tables
Include income taxes in a capital budgeting analysis.

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

4. The Net Present Value Method
3-4
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?

5. The Net Present Value Method
3-5
The Net Present Value Method
Annual net cash inflow from operations
The annual net cash inflow from operations of $80,000 is computed as shown.

6. The Net Present Value Method
3-6
The Net Present Value Method
Since the investments in equipment and working capital occur immediately, the discounting factor used is

7. The Net Present Value Method
3-7
The Net Present Value Method
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.

8. The Net Present Value Method
3-8
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.

9. The Net Present Value Method
3-9
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.

10. The Net Present Value Method
3-10
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.

11. 3-11
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.

12. 3-12
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?

13. 3-13
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.

14. Internal Rate of Return Method
3-14
Internal Rate of Return Method
The internal rate of return is the rate of return promised by an investment project over its useful life. It is computed by finding the discount rate that will cause the net present value of a project to be zero.
It works very well if a project’s cash flows are identical every year. If the annual cash flows are not identical, a trial and error process must be used to find the internal rate of return.
The internal rate of return is the rate promised by an investment project over its useful life. It is sometimes referred to as the yield on a project.
The internal rate of return is the discount rate that will result in a net present value of zero.
The internal rate of return works very well if a project’s cash flows are identical every year. If the cash flows are not identical every year, a trial-and-error process can be used to find the internal rate of return.

15. Internal Rate of Return Method
3-15
Internal Rate of Return Method
General decision rule . . .
If the internal rate of return is equal to or greater than the minimum required rate of return, then the project is acceptable. If it is less than the required rate of return, then the project is rejected.
When using internal rate of return, the cost of capital acts as a hurdle rate that a project must clear for acceptance.
When using the internal rate of return, the cost of capital acts as a hurdle rate that a project must clear for acceptance.

16. Internal Rate of Return Method
3-16
Internal Rate of Return Method
Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs.
The machine has a 10-year life.
Assume the facts as shown with respect to the Decker Company.

17. Internal Rate of Return Method
3-17
Internal Rate of Return Method
Future cash flows are the same every year in this example, so we can calculate the internal rate of return as follows:
Investment required
Net annual cash flows
PV factor for the internal rate of return =
Since the cash flows are the same every year, the equation shown can be used to compute the appropriate present value factor of
$104, 320
$20,000 =

18. Internal Rate of Return Method
3-18
Internal Rate of Return Method
Using the present value of an annuity of $1 table . . .
Find the 10-period row, move across until you find the factor Look at the top of the column and you find a rate of 14%.
Using the present value of an annuity of $1 table, the internal rate of return is equal to 14 percent.

19. Internal Rate of Return Method
3-19
Internal Rate of Return Method
Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs.
The machine has a 10-year life.
The internal rate of return on this project is 14%.
If Decker’s minimum required rate of return is equal to or greater than 14 percent, then the machine should be purchased.
If the internal rate of return is equal to or greater than the company’s required rate of return, the project is acceptable.

20. Quick Check  a. 10% b. 12% c. 14% d. Cannot be determined
3-20
Quick Check 
The expected annual net cash inflow from a project is $22,000 over the next 5 years. The required investment now in the project is $79,310. What is the internal rate of return on the project?
a. 10%
b. 12%
c. 14%
d. Cannot be determined
Assume the facts given for this project. What is the internal rate of return on the project?

21. Quick Check  a. 10% b. 12% c. 14% d. Cannot be determined
3-21
Quick Check 
The expected annual net cash inflow from a project is $22,000 over the next 5 years. The required investment now in the project is $79,310. What is the internal rate of return on the project?
a. 10%
b. 12%
c. 14%
d. Cannot be determined
$79,310/$22,000 = 3.605,
which is the present value factor for an annuity over five years when the interest rate is 12%.
12 percent. Take a minute and review the solution to the problem.

22. Net Present Value vs. Internal Rate of Return
3-22
Net Present Value vs. Internal Rate of Return
NPV is easier to use.
Questionable assumption:
Internal rate of return method assumes cash inflows are reinvested at the internal rate of return.
The net present value method offers two important advantages over the internal rate of return method.
The net present value method is often simpler to use.
The internal rate of return method makes a questionable assumption – that cash inflows can be reinvested at the internal rate of return.

23. Net Present Value vs. Internal Rate of Return
3-23
Net Present Value vs. Internal Rate of Return
NPV is easier to use.
Questionable assumption:
Internal rate of return method assumes cash inflows are reinvested at the internal rate of return.
If the internal rate of return is high, this assumption may be unrealistic. It is more realistic to assume that the cash flows can be reinvested at the discount rate, which is the underlying assumption of the net present value method.

24. Expanding the Net Present Value Method
3-24
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.

25. The Total-Cost Approach
3-25
The Total-Cost Approach
White Company has two alternatives:
(1) remodel an old car wash or,
(2) remove it 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 net annual cash inflows are $60,000 for the new car wash and $45,000 for the old car wash.

26. The Total-Cost Approach
3-26
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.

27. The Total-Cost Approach
3-27
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.

28. The Total-Cost Approach
3-28
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.

29. The Total-Cost Approach
3-29
The Total-Cost Approach
If we remodel the existing washer, we will produce a positive net present value of $56,405.
The net present value of remodeling the old washer is $56,405.

30. The Total-Cost Approach
3-30
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.

31. The Incremental-Cost Approach
3-31
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.

32. The Incremental-Cost Approach
3-32
The Incremental-Cost Approach
We get the same answer under either the
total-cost or incremental-cost approach.
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.

33. 3-33
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?

34. 3-34
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.

35. Let’s look at the Home Furniture Company.
3-35
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.

36. 3-36
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.

37. Least Cost Decisions Here is information about the trucks . . . 3-37
The information pertaining to the old and new trucks is as shown.

38. 3-38
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.

39. Home Furniture should purchase the new truck.
3-39
Least Cost Decisions
Home Furniture should purchase the new truck.
The net present value in favor of purchasing the new truck is $9,372.

40. 3-40
Quick Check 
Bay Architects is considering a drafting machine that would cost $100,000, last four years, and 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 machine if the discount rate is 14 percent?

41. 3-41
Quick Check 
Bay Architects is considering a drafting machine that would cost $100,000, last four years, and 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.

42. Uncertain Cash Flows – An Example
3-42
Uncertain Cash Flows – An Example
Assume that all of the cash flows related to an investment in a supertanker have been estimated, except for its salvage value in 20 years.
Using a discount rate of 12%, management has determined that the net present value of all the cash flows, except the salvage value is a negative $1.04 million.
Assume that all of the cash flows related to an investment in a supertanker have been estimated, except for its salvage value in 20 years.
Using a discount rate of 12 percent, management has determined that the net present value of all the cash flows, except the salvage value is a negative $1.04 million.
This negative net present value will be offset by the salvage value of the supertanker.
How large would the salvage value need to be to make this investment attractive?
How large would the salvage value need to be to make this investment attractive?

43. Uncertain Cash Flows – An Example
3-43
Uncertain Cash Flows – An Example
This equation can be used to determine that if the salvage value of the supertanker is at least $10,000,000, the net present value of the investment would be positive and therefore acceptable.
The equation shown can be used to determine that if the salvage value of the supertanker is at least $10 million, the net present value of the investment would be positive and therefore acceptable.
While the salvage value is not known with certainty, the $10 million figure offers a useful reference point for making the decision.

44. Real Options Delay the start of a project
3-44
Real Options
Delay the start of a project
Expand a project if conditions are favorable
Cut losses if conditions are unfavorable
The analysis in this chapter has assumed that an investment cannot be postponed and that, once started, nothing can be done to alter the course of the project.
The ability to delay the start of a project, to expand it if conditions are favorable, and to cut losses if they are unfavorable adds value to many investments.
The value of these real options can be quantified using what is called real options analysis, which is beyond the scope of the book.
The ability to consider these real options adds value to many investments. The value of these options can be quantified using what is called real options analysis, which is beyond the scope of the book.

45. Preference Decision – The Ranking of Investment Projects
3-45
Preference Decision – The Ranking of Investment Projects
Screening Decisions
Preference Decisions
Pertain to whether or not some proposed investment is acceptable; these decisions come first.
Attempt to rank acceptable alternatives from the most to least appealing.
Recall that when considering investment opportunities, managers must make two types of decisions – screening decisions and preference decisions.
Screening decisions, which come first, pertain to whether or not some proposed investment is acceptable.
Preference decisions, which come after screening decisions, attempt to rank acceptable alternatives from the most to least appealing.
Preference decisions need to be made because the number of acceptable investment alternatives usually exceeds the amount of available funds.

46. Internal Rate of Return Method
3-46
Internal Rate of Return Method
When using the internal rate of return method to rank competing investment projects, the preference rule is:
The higher the internal rate of return, the more desirable the project.
When using the internal rate of return method to rank competing investment projects, the preference rule is: the higher the internal rate of return, the more desirable the project.

47. Net Present Value Method
3-47
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.

48. Ranking Investment Projects
3-48
Ranking Investment Projects
Profitability Present value of cash inflows index Investment required =
In the case of unequal investments, a profitability index can be computed as the present value of cash inflows divided by the investment required. Notice three things:
The profitability indexes for investments A and B are 1.01 and 1.20, 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, the profitability index is similar to the contribution margin per unit of the constrained resource as discussed in Chapter 13.
The higher the profitability index, the
more desirable the project.

49. 3-49
End of Lecture 30
End of chapter 14.