Capital Budgeting and Cost Analysis Chapter 21

Learning Objective 1 Recognize the multiyear focus of capital budgeting.

Two Dimensions of Cost Analysis 1. A project dimension 2. An accounting-period dimension The accounting system that corresponds to the project dimension is termed life-cycle costing.

Project A Project B Project C Project D Two Dimensions of Cost Analysis

Learning Objective 2 Understand the six stages of capital budgeting for a project.

Capital Budgeting Capital budgeting is the making of long-run planning decisions for investments in projects and programs. It is a decision-making and control tool that focuses primarily on projects or programs that span multiple years.

Capital Budgeting Capital budgeting is a six-stage process: 1. Identification stage2. Search stage 3. Information-acquisition stage 4. Selection stage5. Financing stage 6. Implementation and control stage

Capital Budgeting Example One of the goals of Assisted Living is to improve the diagnostic capabilities of its facility. Management identifies a need to consider the purchase of new equipment. The search stage yields several alternative models, but management focuses on one particular machine.

Capital Budgeting Example The administration acquires information. Initial investment is $245,000. Investment in working capital is $5,000. Useful life is three years. Estimated residual value is zero. Net cash savings is $125,000, $130,000, and $110,000 over its life.

Capital Budgeting Example Working capital is expected to be recovered at the end of year 3 with an expected return of 10%. In the selection stage, management must decide whether to purchase the new machine. Operating cash flows are assumed to occur at the end of the year.

Learning Objective 3 Use and evaluate the two main discounted cash-flow (DCF) methods: the net present value (NPV) method and the internal rate-of-return (IRR) method.

Time Value of Money Compound Growth, 5 periods at 6% Year 0: $1.00 Year 1: $1.06 Year 2: $1.124 Year 3: $1.91 Year 4: $1.262 Year 5: $1.338

Discounted Cash Flow There are two main DCF methods: Net present value (NPV) method Internal rate-of-return (IRR) method

Net Present Value Example Only projects with a zero or positive net present value are acceptable. What is the the net present value of the diagnostic machine?

Net Present Value Example Year in the Life of the Project $(250,000)$125,000$130,000$115, Net initial investment Annual cash inflows

Net Present Value Example Net Cash NPV of Net Year 10% Col. Inflows Cash Inflows $125,000$113, , , ,000 86,365 Total PV of net cash inflows$307,370 Net initial investment 250,000 Net present value of project$ 57,370

Net Present Value Example The company is considering another investment. Initial investment is $245,000. Investment in working capital is $5,000. Working capital will be recovered. Useful life is three years. Estimated residual value is $4,000. Net cash savings is $80,000 per year. Expected return is 10%.

Net Present Value Example Net Cash NPV of Net Years 10% Col. Inflows Cash Inflows $80,000$198, ,000 6,759 Total PV of net cash inflows$205,719 Net initial investment 250,000 Net present value of project ($ 44,281)

Internal Rate of Return Investment = Expected annual net cash inflow × PV annuity factor Investment ÷ Expected annual net cash inflow = PV annuity factor

Internal Rate of Return Example Initial investment is $303,280. Useful life is five years. Net cash inflows is $80,000 per year. What is the IRR of this project? $303,280 ÷ $80,000 = (PV annuity factor) 10% (from the table, five-period line)

Comparison of NPV and IRR The NPV method has the advantage that the end result of the computations is expressed in dollars and not in a percentage. Individual projects can be added. It can be used in situations where the required rate of return varies over the life of the project.

Comparison of NPV and IRR The IRR of individual projects cannot be added or averaged to derive the IRR of a combination of projects.

Learning Objective 4 Use and evaluate the payback method.

Payback Method Payback measures the time it will take to recoup, in the form of expected future cash flows, the initial investment in a project.

Payback Method Example Assisted Living is considering buying Machine 1. Initial investment is $210,000. Useful life is eleven years. Estimated residual value is zero. Net cash inflows is $35,000 per year.

Payback Method Example How long would it take to recover the investment? $210,000 ÷ $35,000 = 6 years Six years is the payback period.

Payback Method Example Suppose that as an alternative to the $210,000 piece of equipment, there is another one (Machine 2) that also costs $210,000 but will save $42,000 per year during its five-year life. What is the payback period? $210,000 ÷ $42,000 = 5 years Which piece of equipment is preferable?

Payback Method Example Assisted Living is considering buying Machine 3. Initial investment is $250,000. Useful life is eleven years. Cash savings are $160,000, $180,000, and $110,000 over its life. What is the payback period?

Payback Method Example Year 1 brings in $160,000. Recovery of the amount invested occurs in Year 2.

Payback Method Example Payback = 1 year $ 90,000 needed to complete recovery 180,000 net cash inflow in Year 2 1 year year 1.5 years or 1 year and 6 months + ÷ = =

Learning Objective 5 Use and evaluate the accrual accounting rate-of-return (AARR) method.

Accrual Accounting Rate-of-Return Method The accrual accounting rate-of-return (AARR) method divides an accounting measure of income by an accounting measure of investment. AARR = Increase in expected average annual operating income ÷ Initial required investment

Accrual Accounting Rate-of-Return Method Example Initial investment is $303,280. Useful life is five years. Net cash inflows is $80,000 per year. IRR is 10%. What is the average operating income?

Accrual Accounting Rate-of-Return Method Example Straight-line depreciation is $60,656 per year. Average operating income is $80,000 – $60,656 = $19,344. What is the AARR? AARR = ($80,000 – $60,656) ÷ $303,280 =.638, or 6.4%

Learning Objective 6 Identify and reduce conflicts from using DCF for capital budgeting decisions and accrual accounting for performance evaluation.

Performance Evaluation A manager who uses DCF methods to make capital budgeting decisions can face goal congruence problems if AARR is used for performance evaluation. Suppose top management uses the AARR to judge performance if the minimum desired rate of return is 10%. A machine with an AARR of 6.4% will be rejected.

Performance Evaluation The conflict between using AARR and DCF methods to evaluate performance can be reduced by evaluating managers on a project-by-project basis.

Learning Objective 7 Identify relevant cash inflows and outflows for capital budgeting decisions.

Relevant Cash Flows Relevant cash flows are expected future cash flows that differ among the alternatives.

Relevant Cash Flows Net initial investment components – cash outflow to purchase investment – working-capital cash outflow – cash inflow from disposal of old asset

Relevant Cash Flow Analysis Example Old equipment: Current book value$50,000 Current disposal price$ 3,000 Terminal disposal price (5 years) 0 Annual depreciation$10,000 Working capital$ 5,000 Income tax rate 40% G. T. is considering replacing old equipment.

Relevant Cash Flow Analysis Example Current disposal price of old equipment$ 3,000 Deduct current book value of old equipment 50,000 Loss on disposal of equipment$47,000 How much are the tax savings? $47,000 × 0.40 = $18,800

Relevant Cash Flow Analysis Example What is the after-tax cash flow from current disposal of old equipment? Current disposal price$ 3,000 Tax savings on loss 18,800 Total$21,800

Relevant Cash Flow Analysis Example New equipment: Current book value$225,000 Current disposal price is irrelevant Terminal disposal price (5 years) 0 Annual depreciation$ 45,000 Working capital$ 15,000

Relevant Cash Flow Analysis Example How much is the net investment for the new equipment? Current cost$225,000 Add increase in working capital 10,000 Deduct after-tax cash flow from current disposal of old equipment – 21,800 Net investment$213,200

Relevant Cash Flow Analysis Example Assume $90,000 pretax annual cash flow from operations (excluding depreciation effect). What is the after-tax flow from operations? Cash flow from operations$90,000 Deduct income tax (40%) 36,000 Annual after-tax flow from operations$54,000

Relevant Cash Flow Analysis Example What is the difference in depreciation deduction? Annual depreciation of new equipment$45,000 Deduct annual depreciation of old equipment 10,000 Difference$35,000

Relevant Cash Flow Analysis Example What is the annual increase in income tax savings from depreciation? Increase in depreciation$35,000 Multiply by tax rate.40 Income tax cash savings from additional depreciation$14,000

Relevant Cash Flow Analysis Example What is the cash flow from operations, net of income taxes? Annual after-tax flow from operations$54,000 Income tax cash savings from additional depreciation 14,000 Cash flow from operations, net of income taxes$68,000

Relevant Cash Flow Analysis Example G. T. requires a 14% rate of return on its investments. What is the net present value of the new equipment incorporating income taxes?

Relevant Cash Flow Analysis Example Net Cash NPV of Net Years 14% Col.Inflows Cash Inflows $68,000$233, ,000 5,190 Total PV of net cash inflows$238,636 Investment 213,200 Net present value of new equipment$ 25,436

Postinvestment Audit A postinvestment audit compares the actual results for a project to the costs and benefits expected at the time the project was selected. It provides management with feedback about performance.

Strategic Considerations Capital investment decisions that are strategic in nature require managers to consider a broad range of factors that may be difficult to estimate.

End of Chapter 21