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John Wiley & Sons, Inc. Prepared by Karleen Nordquist.. The College of St. Benedict... and St. John’s University.... Managerial Accounting Weygandt, Kieso, & Kimmel

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Chapter 10 Capital Budgeting

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After studying this chapter, you should be able to: 1Discuss the capital budgeting evaluation process and explain what inputs are used in capital budgeting. 2Describe the cash payback technique. 3Explain the net present value method. 4Identify the challenges presented by intangible benefits in capital budgeting. Chapter 10 Capital Budgeting

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After studying this chapter, you should be able to: 5Describe the profitability index. 6Indicate the benefits of performing a post-audit. 7Explain the internal rate of return method. 8Describe the annual rate of return method. Chapter 10 Capital Budgeting

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Preview of Chapter 10 Capital Budgeting Evaluation Process Cash Flow Information Illustrative Data Net Present Value Method Equal Cash Flows Unequal Cash Flows Choosing a Discount Rate Simplifying Assumptions Comprehensive Example CAPITAL BUDGETING Cash Payback

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Preview of Chapter 10 Additional Considerations Intangible Benefits Mutually Exclusive Projects Risk Analysis Post-audit of Projects Other Capital Budgeting Techniques Internal Rate of Return Comparing Discounted Cash Flow Methods Annual Rate of Return CAPITAL BUDGETING

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Capital Budgeting The process of making capital expenditure decisions is known as capital budgeting. Capital budgeting involves choosing among various capital projects to find one(s) that will maximize a company’s return on its financial investment.

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Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting. Study Objective 1

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The Capital Budgeting Evaluation Process Many companies follow a carefully prescribed process in capital budgeting. The process usually includes the following steps: 1Project proposals are requested from departments, plants, and authorized personnel. 2Proposals are screened by a capital budget committee. 3Officers determine which projects are worthy of funding. 4Board of directors approves capital budget.

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Cash Flow Information Most capital budgeting decision methods employ cash flow numbers rather than accrual accounting revenues and expenses. Revenues and expenses often differ significantly from cash inflow and outflows. Although accrual accounting has its advantages over cash-basis accounting, for purposes of capital budgeting, estimated cash inflows and outflows are preferred as inputs into capital budgeting decision tools.

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Capital Budgeting Considerations The capital budgeting decision, under any technique, depends in part on a variety of considerations: The availability of funds The relationships among proposed projects The company’s basic decision-making approach The risk associated with a particular project

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Illustrative Data The following data will be used in a continuing example. This will allow for comparison of the results of the various capital budgeting techniques. Stewart Soup Company is considering an investment of $130,000 in new equipment. The new equipment is expected to last 10 years and have a zero salvage value at the end of its useful life. The annual cash inflows are $200,000, and the annual net cash outflows are $176,000. The data are summarized below: Initial investment$130,000 Estimated useful life10 years Estimated salvage value - 0 - Estimated annual cash flows Cash inflow from customers$200,000 Cash outflows for operating costs 176,000 Net annual cash inflow$ 24,000 Illustration 10-13

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Describe the cash payback technique. Study Objective 2

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Cash Payback The cash payback technique identifies the time period required to recover the cost of the capital investment from the annual cash inflow produced by the investment. The formula for computing the cash payback period is: Cost of Capital Investment = Net Annual Cash Inflow Cash Payback Period Illustration 10-4 The shorter the payback period, the more attractive the investment. Also, the payback period is usually related to the estimated useful life of the asset.

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Cash Payback Example The cash payback period in the Stewart Soup example is 5.42 years, computed as follows: Assume that at Stewart Soup a project is unacceptable if the payback period is longer than 60% of the asset’s expected useful life. Thus, this project is acceptable. The 5.42-year payback period is just over 50% of the project’s 10-year expected useful life. $130,000 $24,000 = 5.42 years

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Cash Payback: Advantages and Disadvantages The cash payback technique may be useful as an initial screening tool. It may also be the most critical factor in the capital budgeting decision for a company that desires a fast turnaround of its investment. It is easy to compute and understand. However, it should not normally be the only basis for a capital budgeting decision because it ignores the profitability of the project. It also ignores the time value of money. + –

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Explain the net present value method. Study Objective 3

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Discounted Cash Flow Techniques Capital budgeting techniques that take into account both the time value of money and the estimated total cash flows from an investment are called discounted cash flow techniques. They are generally recognized as the most informative and best conceptual approaches to making capital budgeting decisions.

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Discounted Cash Flow Techniques The primary capital budgeting method that uses discounted cash flow techniques is called net present value. A second method, to be discussed later, is the internal rate of return. Appendix C reviews the time value of money concepts upon which these methods are based. (All of the PV factors in the following examples come from Appendix C.)

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Net Present Value Method Under the net present value (NPV) method, cash inflows are discounted to their present value and then compared with the capital outlay required by the investment. The difference between these two amounts is referred to as the net present value. The interest rate to be used in discounting the future cash flows is the required minimum rate of return. A proposal is acceptable when the NPV is zero or positive. The higher the NPV, the more attractive the investment.

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Net Present Value Decision Criteria Present Value of Future Cash Inflows Capital Investment Net Present Value Accept Proposal Reject Proposal If zero or positive: If negative: Less Equals Illustration 10-5

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Equal Annual Cash Flows Example Stewart’s annual cash inflows are $24,000. If we assume this amount is uniform over the asset’s useful life, the present value of its annual cash flows can be computed as shown: PV at 12% Discount factor for annuity of $1 for 10 periods5.65022 Present value of cash flows: $24,000 x 5.65022$135,605 Illustration 10-6 Therefore, the analysis of the proposal by the NPV method is: 12% Present value of cash flows:$135,605 Capital investment 130,000 Net present value$ 5,605 Illustration 10-7 The proposed capital expenditure is acceptable at the 12% required rate of return because the NPV is positive.

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Unequal Cash Flows Example When annual cash flows are unequal, it is not possible to use annuity tables to calculate their PV. Instead tables showing the PV of a single amount must be applied to each annual cash flow. Assume Stewart Soup expects the same aggregate cash flows ($240,000), but a declining market demand for the new product over the life of the equipment. The PV of the annual cash flows is calculated to the right: Assumed Discount Annual Factor PV YearCash Flows at 12% at 12% (1) (2) (1 x 2) 1$ 34,000.89286$ 30,357 230,000.7971923,916 327,000.7117819,218 425,000.6355215,888 524,000.5674313,618 622,000.5066311,146 721,000.452359,499 820,000.403888,078 919,000.360616,852 10 18,000.32197 5,795 $240,000$144,367 Illustration 10-8

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Unequal Cash Flows Example Therefore, the analysis of the proposal by the NPV method is: 12% Present value of cash flows:$144,367 Capital investment 130,000 Net present value$ 14,367 Illustration 10-9 The proposed capital expenditure is acceptable at the 12% required rate of return because the NPV is positive.

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Choosing a Discount Rate In most cases, a company uses a discount rate (also known as hurdle rate, cutoff rate, or required rate of return) that is equal to its cost of capital, which is the rate it must pay to obtain funds from creditors and stockholders. The cost of capital is a weighted average of the rates paid on borrowed funds and funds from investors in the company’s stock. A discount rate has two elements: – a cost of capital element, and – a risk element. Companies often assume the risk element is zero.

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Choosing a Discount Rate Using an incorrect discount rate can lead to incorrect capital budgeting decisions. Suppose Stewart Soup’s 12% discount rate did not take into account the fact that this project is riskier than most of the company’s investments. Given the risk, a 15% discount rate would have been more appropriate. 12% 15% Discount factor for annuity for 10 periods5.650225.01877 Present value of cash flows: $24,000 x factor$135,605$120,450 Capital investment 130,000 130,000 Positive (negative) NPV$ 5,605$ (9,550) Illustration 10-10 As shown on the right, a 15% discount rate would cause Stewart to reject the project because of its negative NPV.

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Simplifying Assumptions In the examples of the NPV method, a number of simplifying assumptions have been made: All cash flows come at the 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. Because these assumptions are rarely all true in the “real world,” NPV provides estimated analysis. Some of these assumptions are relaxed in more advanced capital budgeting techniques.

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Comprehensive Example Best Taste Foods is considering investing in new equipment to produce fat-free snack foods. The following information was determined in consultation with various company departments: 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 capital15% Estimated annual cash flows: 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 Illustration 10-11

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Comprehensive Example The computation of the net annual cash inflows for the project is shown below: 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 inflow$230,000 Illustration 10-12 The computation of the NPV is as follows: TimeCash 15% Present EventPeriod Flow x Factor = Value Equipment purchase0$1,000,0001.00000$(1,00,000) Equipment overhaul5200,000.49718(99,436) Net annual cash flows1-10230,0005.018771,154,317 Salvage value1020,000.24719 4,944 Net present value$ 59,825 Illustration 10-13 Because the NPV is positive, the project should be accepted.

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Identify the challenges presented by intangible benefits in capital budgeting. Study Objective 4

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Intangible Benefits The NPV evaluation techniques discussed so far rely on tangible, relatively easily quantified costs and benefits. By ignoring intangible benefits such as increased quality or safety or employee loyalty, capital budgeting techniques might incorrectly eliminate projects that could be financially beneficial to the company. To avoid rejecting projects that should be accepted, two possible approaches are suggested: – Calculate NPV ignoring intangible benefits and if NPV is negative, ask if intangible benefits are worth at least the negative NPV. – Project rough, conservative estimates of the value of the intangible benefits and include those in NPV calculation.

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Mutually Exclusive Projects In theory, all projects with positive NPVs should be accepted. However, companies rarely are able to adopt all positive-NPV proposals. Proposals are often mutually exclusive, meaning that if the company adopts one proposal, it would be impossible to adopt the other proposal. Even in cases where projects are not mutually exclusive, mangers must often choose between various positive-NPV projects because of limited resources. When choosing between alternatives, it is tempting to choose the project with the highest NPV, but the investment required by the projects should also be considered.

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Describe the profitability index. Study Objective 5

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Mutually Exclusive Projects: Profitability Index One relatively simple method of comparing alternative projects that takes into account both the size of the original investment and the discounted cash flows is the profitability index. The profitability index is computed with the following formula: Present Value of Cash Flows = Initial Investment Profitability Index Illustration 10-17

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Profitability Index Example A company must choose between two mutually exclusive projects. Each project has a 10-year life and a 12% discount rate can be assumed. Data related to the two projects is as shown: Project AProject B Initial investment$40,000$90,000 Net annual cash inflows10,00019,000 Salvage value5,00010,000 Net present value18,11220,574 Illustration 10-16 As shown, both projects have positive NPVs. Project B’s NPV is higher, but that project also requires more than two times the initial investment that Project A does. Which of the mutually exclusive projects should the company accept?

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Profitability Index Example Data for the two projects is shown below in a slightly altered form: Project AProject B Initial investment$40,000$90,000 Net annual cash inflows10,00019,000 Salvage value5,00010,000 Present value of cash flows: ($10,000 x 5.65022) + ($5,000 x.32197)58,112 ($19,000 x 5.65022) + ($10,000 x.32197)110,574 Illustration 10-18 With the data in this form, profitability indexes for the two projects can be computed. Profitability Index = Present Value of Cash Flows Initial Investment Project A Project B $58,112 = 1.45$110,574 = 1.23 $40,000 $90,000 Illustration 10-19 Project A is more desirable because it has the higher profitability index.

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Risk Analysis A simplifying assumption made by many financial analysts is that the projected results are known with certainty. In reality, this is seldom true. One approach for dealing with uncertainty is sensitivity analysis, which uses a number of outcome estimates to get a sense of the variability among potential returns. The earlier example of comparing NPVs using different discount rates was a form of sensitivity analysis.

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Indicate the benefits of performing a post-audit. Study Objective 6

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Post-Audit of Investment Projects Organizations should perform a post-audit of its investment projects after their completion. A post-audit is a thorough evaluation of how well a project’s actual performance matches the projections made when the project was proposed. Post-audits, while not foolproof, are important for many reasons: – Managers that know their estimates will eventually be compared to actual results are more likely to submit realistic data when making investment proposals. – Post-audits provide a formal mechanism for helping to decide whether existing projects should be continued. – Post-audits can help managers improve their estimation techniques, thereby improving the development of future investment proposals.

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Explain the internal rate of return method. Study Objective 7

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Internal Rate of Return Method The internal rate of return method results in finding the interest yield of the potential investment. The internal rate of return is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows (i.e., a NPV of zero).

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Internal Rate of Return Method Determining the internal rate of return involves three steps: (These steps assume that annual cash flows are equal; an alternative method of computing the internal rate of return must be used when cash flows are unequal.) Tampa Company will be used as an example. Tampa Company is considering a new project with an 8-year estimated life, an initial cost of $249,000, and a net annual cash inflow of $45,000.

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Internal Rate of Return Step 1: Compute the internal rate of return factor using the following formula: Capital Investment = Net Annual Cash Inflow Internal Rate of Return Factor Illustration 10-20 Using the Tampa Company data, the internal rate of return factor is computed as follows: $249,000 $45,000 = 5.5333

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Internal Rate of Return Step 2: Use the factor and the present value of an annuity of 1 table to find the internal rate of return. For Tampa, the net annual cash inflow is expected to continue for 8 years. Thus, it is necessary to read across the period-8 row in the present value of an annuity table to find the discount factor that is closest to the internal rate of return factor. Periods5%6%8%9%10%11%12%15% 86.463216.209795.746645.534825.334935.146124.967644.8732 The closest discount factor to 5.53333 is 5.53482, which represents an interest rate of approximately 9%.

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Internal Rate of Return Step 3: Compare the internal rate of return to management’s required rate of return. The decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return, and reject the project when the internal rate of return is less than the required rate. This decision rule is shown graphically on the next slide. Assuming the minimum required rate of return is 8% for Tampa Company, the project is accepted because the 9% internal rate of return is greater than the required rate.

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Internal Rate of Return Decision Criteria Internal Rate of Return Minimum Rate of Return Accept Proposal Reject Proposal If equal to or greater than: If less than: Compared to: Illustration 10-21

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Comparing Discounted Cash Flow Methods A comparison of the two discounted cash flow methods (net present value and internal rate of return) is presented below. When used properly, either method will provide management with relevant quantitative data for making capital budget decisions. Net Present Value Internal Rate of Return 1. ObjectiveCompute net presentCompute internal rate of value (a dollar amount). return (a percentage). 2. Decision ruleIf net present value isIf internal rate of return is equal zero or positive, accept to or greater than the the proposal; if net minimum required rate of present value is return, accept the proposal; negative, reject the if internal rate of return is proposal. less than the minimum rate, reject the proposal. Illustration 10-22

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Describe the annual rate of return method. Study Objective 8

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Annual Rate of Return Method The annual rate of return technique is based on accrual accounting data. It indicates the profitability of a capital expenditure. The formula is: The annual rate of return is compared to management’s required minimum rate of return for investments of similar risk. A project is acceptable under this method if the annual rate of return is greater than the required rate of return. Expected Annual Net Income = Average Investment Annual Rate of Return Illustration 10-23

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Annual Rate of Return Example Assume that Reno Company is considering an investment of $130,000 in new equipment. The new equipment is expected to last 5 years and have zero salvage value. The straight-line depreciation method is used for accounting purposes. The expected annual revenues and costs of the new product that will be produced from the investment are: Sales$200,000 Less: Cost and expenses Manufacturing costs $132,000 Depreciation expense ($130,000 5) 26,000 Selling and administrative expenses 22,000 180,000 Income before income taxes20,000 Income tax expense 7,000 Net income$ 13,000 Illustration 10-24

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Annual Rate of Return Example Average investment is computed as follows: Average investment = Original investment + Investment at end of useful life 2 Illustration 10-25 The investment at the end of the useful life is equal to the asset’s salvage value. For Reno, average investment is $65,000 [($130,000 + $0) 2]. The expected annual rate of return for Reno’s investment is therefore 20%, computed as follows: $13,000 $65,000 = 20%

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Annual Rate of Return: Advantages & Disadvantages The principal advantages of this method are the simplicity of its calculation and management’s familiarity with the accounting terms it uses. A major limitation is that it does not consider the time value of money. Also, this method relies on accrual accounting numbers instead of actual cash flows. + –

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Copyright © 1999 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that named in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. Copyright

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Chapter 10 Capital Budgeting

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