Kinney ● Raiborn Cost Accounting: Foundations and Evolutions, 9e © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 15: Capital Budgeting

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objectives Why do most capital budgeting methods focus on cash flows? How is payback period computed, and what does it measure? How are the net present value (NPV) and profitability index (PI) of a project computed, and what do they measure? How is the internal rate of return (IRR) on a project computed, and what does that rate measure? How do taxation and depreciation affect cash flows? What are the underlying assumptions and limitations of each capital project evaluation method? How do managers rank investment projects? How is risk considered in capital budgeting analyses? How and why should management conduct a post- investment audit of a capital project? (Appendix 1) How are present values (PV) calculated? (Appendix 2) What are the advantages and disadvantages of the accounting rate of return method?

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Capital Assets Capital assets are long-term assets used to:  Generate future revenues or cost savings  Provide distribution, service, or production capacity Tangible fixed assets  Land, building, machinery, etc. Intangible assets  Capital lease, patent, etc.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Capital Budgeting Capital budgeting involves evaluating and ranking alternative future investments to effectively and efficiently allocate limited capital.  Plan and prepare the capital budget  Review past investments to assess success of past decisions and enhance the decision process in the future Compare and evaluate alternative projects  Financial and nonfinancial criteria  Short- and long-term benefits  Usually multiple criteria  Consider all significant stakeholders

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Capital Budgeting as Part of the Financial Budget Operating Budget Cash Budget Capital Budget Income Statement Statement of Retained Earnings Balance Sheet Statement of Cash Flows

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

Capital Budgeting: Quantitative versus Qualitative Quantitative  Accounting rate of return  Payback period  Discounted payback period  Net Present Value (NPV)  Internal Rate of Return (IRR)  Profitability Index (PI) Qualitative  Employee morale, safety, and responsibility  Corporate image  Social responsibility  Market share  Growth  Strategic planning  Sustainability

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Capital Budgeting: Financial Analysis Payback period NPV PI IRR Accounting rate of return Cash Flow Focus

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Cash Flow Cash Receipts  Revenues earned and collected  Savings generated by reducing operating costs  Proceeds from sale of assets Cash Disbursements  Expenditures for asset acquisition  Working capital investments  Costs for direct material, direct labor, and overhead

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Investment vs. Financing Investment decision  Which assets to acquire  Made by divisional managers and top management Financing decision  How to raise capital (debt/equity) to fund an investment  Made by treasurer and top management  Interest is a financing decision Interest cost  Cash flow associated with debt financing  Not part of the project selection process First justify the acquisition. Then justify how to finance it.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Payback Period Time required for project’s cash inflows to equal the original investment  The longer it takes to recover the original investment, the greater the risk  The faster capital is returned, the more rapidly it can be invested in other projects  Management sets a maximum payback period Ignores  Cash inflows that occur after payback has been reached  Desired rate of return  Time value of money

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Payback Period Illustration Original Investment Annual Cash Inflows (assuming equal cash flows) Payback Period Example: Original Investment$25,000 Annual Cash Inflows$10,000 Payback Period2.5 years =

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Discounting Future Cash Flows Reduce the future value (FV) of cash flows by the portion that represents interest Variables are  Length of time until the cash flow is received or paid  Required rate of return on capital—discount rate PV is stated in a common base of current dollars

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Discount Rate and Returns Discount rate  Discount rate should equal or exceed the cost of capital  Cost of Capital— weighted average cost for the debt and equity that comprise a firm’s financial structure Return OF Capital  Recovery of the initial investment Return ON Capital  Represents income  Original investment multiplied by the discount rate $100,000 * 12% = $12,000 return on capital

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Discounted Cash Flow Methods Net Present Value (NPV) Profitability Index (PI) Internal Rate of Return (IRR)

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Net Present Value Evaluates if project rate of return is greater than, equal to, or less than the desired rate of return PV equals the cash flows discounted using the desired rate of return NPV equals PV of cash inflows minus PV of cash outflows Does not calculate the rate of return Minus Investment made currently PlusPV of future cash inflows or cost savings Minus PV of future cash outflows Equals NPV

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Interpreting NPV NPV = 0  Actual rate of return equals desired rate of return NPV > 0  Actual rate of return is greater than desired rate of return NPV < 0  Actual rate of return is less than desired rate of return

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Net Present Value Function of two factors  Discount rate  Amount and timing of cash flows Useful to select best project among investments that can perform the same task or achieve the same objective When comparing independent projects requiring different initial investments, use the PI

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Profitability Index Compares PV of net cash flows to net investment Measures efficiency of the use of capital Should be greater than or equal to 1 Does not calculate the rate of return Profitability =PV of Net Cash Flows Index Net Investment

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Profitability Index Illustration Project12 PV of net cash flows$900,000 $580,000 Net investment$720,000 $425,000 NPV$180,000 $155,000 PI $900,000/$720, $580,000/$425, Assuming limited funds, which project would you choose?

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Internal Rate of Return Discount rate where PV of cash inflows = PV of cash outflows NPV = 0 Hurdle rate is the lowest acceptable return on investment (at least equal to the cost of capital)  If IRR = Hurdle Rate; Accept  If IRR > Hurdle Rate; Accept  If IRR < Hurdle Rate; Reject Computed using  Financial calculators  Computers  Annuity tables (assuming equal cash flows)  Trial and error

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Income Taxes An integral part of the business planning and decision-making process Operating income is taxed, which reduces the cash inflows from projects Depreciation reduces operating income, which reduces the taxes paid

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. After-Tax Cash Flows Depreciation is not a cash flow item Depreciation on capital assets affects cash flows by reducing the tax obligation Depreciation is a tax shield that provides a tax benefit Depreciation tax benefit = Depreciation expense * Tax rate

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Tax Depreciation Deprecation tax shield is affected by  Changes in tax laws  Different depreciation methods  Changes in tax rates

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Capital Budgeting Methods Understand similarities and differences of capital budgeting methods Use several techniques Limitations of all methods  Management preferences regarding timing of cash flows are not included  Single, deterministic measures of cash flow are used rather than probabilities

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Payback Assumptions  Speedy recovery of investment is key  Cash flows can be accurately predicted  Risk is lower for the shorter payback project Limitations  Ignores cash flows after payback  Cash flow and project life are deterministic, not subject to probabilities  Ignores time value of money  Does not consider recognized cash flow pattern preferences

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Net Present Value Assumptions  Discount rate is valid  Timing and size of cash flows can be predicted  Life of project can be predicted  If shorter-lived project is selected, proceeds of shorter project will earn the discount rate through theoretical completion of longer project Limitations  Cash flow and project life are deterministic, not subject to probabilities  Alternative project rates of return are not known  Does not consider recognized cash flow pattern preferences  IRR on project is not reflected

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Profitability Index Assumptions (same as NPV)  Measures efficient use of capital  Discount rate is valid  Timing and size of cash flows can be predicted  Life of project can be predicted  If shorter project selected, proceeds of shorter project will earn the discount rate through theoretical completion of longer project Limitations (same as NPV)  Cash flow and project life are deterministic, not subject to probabilities  Alternative project rates of return are not known  Does not consider cash flow pattern preferences  IRR on project is not reflected  A relative answer is given but dollars of NPV are not reflected

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Internal Rate of Return Assumptions  Hurdle rate is valid  Timing and size of cash flows can be predicted  Project life can be predicted  If shorter project selected, proceeds of shorter project will continue to earn the IRR through theoretical completion of longer project Limitations  Projects are ranked by IRR and not dollar size  NPV dollars are not reflected  Cash flow and project life are deterministic, not subject to probabilities  Does not consider cash flow pattern preferences  Multiple rates of return can be calculated on the same project

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Comparing Techniques Pay- back NPVPIIRR Uses time value moneyNYYY Provides specific rate of returnNNNY Uses cash flowsYYYY Considers returns during life of project NYYY Uses discount rateNYYN*N* *often used as a hurdle rate

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. The Investment Decision Is the activity worthy of an investment? Which assets can be used for the activity? Of the available assets for each activity, which is the best investment? Of the “best investments” for all worthwhile activities, in which ones should the company invest? Consider Quantitative and Qualitative Factors

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Capital Budgeting Terms Screening decision Preference decision Mutually exclusive projects Independent projects Mutually inclusive projects

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Ranking Capital Projects For the projects under consideration  NPV is nonnegative  PI of 1 or more  IRR equals or exceeds hurdle rate Selection ranking of multiple projects  Results can vary depending on evaluation techniques and whether dollars or percentages are used

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Reinvestment Assumptions NPV and PI assume that released cash flows are reinvested at the discount rate  At least the cost of capital IRR assumes that released cash flows are reinvested at the expected IRR  Could be substantially different than the cost of capital

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. NPV Compared to IRR More realistic reinvestment assumption Results measured in dollars not rates Do you prefer a 100% return on $1, or a 10% return on $100? ??

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Compensating for Risk (slide 1 of 2) Judgmental method  Use logic and reasoning to decide if acceptable rate of return will be achieved Risk-adjusted discount rate method  Higher discount/hurdle rate for riskier projects and/or cash flows  Shorter payback period for riskier projects  Higher IRR for riskier projects Sensitivity analysis

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Compensating for Risk (slide 2 of 2) Sensitivity Analysis—the amount of change that must occur in a variable before a different decision would be made  Discount rate—What increases could occur in the cost of capital and related discount rate before a project becomes unacceptable?  Cash flows—How small can the net cash inflows be before a project becomes undesirable?  Asset life—What is the minimum time the cash flows must be received for the project to remain acceptable?

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Post-Investment Audit Complete after project has stabilized Compare actual results to expected results Use same analysis techniques Identify areas where results differ from expectation Evaluate capital budgeting process, particularly original projections, problems with implementation, sponsor credibility

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Time Value of Money (Appendix 1) Future value (FV) and present value (PV) depend on  Amount of cash flow  Rate of interest  Timing of cash flow Simple vs. compound interest Single cash flow Annuity  Ordinary annuity or annuity due

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Accounting Rate of Return Measures rate of return on earnings for average capital investment over project’s life Consistent with accounting model Uses profits shown on accrual-based financial statements Not based on cash flows Accounting=Average Annual Profits Rate of Return Average Investment

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Questions Why do most capital budgeting methods focus on cash flows? What is the relationship between the NPV and the PI? What are the assumptions and limitations of the various capital project evaluation methods?

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Potential Ethical Issues Ignoring enhanced safety or detrimental environmental impact for project decisions Changing assumptions or estimates to meet criteria for approval Using a discount rate that is inappropriately low Not conducting a post-investment audit to hold decision makers accountable Choosing projects based on accounting earnings only rather than including discounted cash flow methods