©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Capital Budgeting and Cost Analysis Chapter 21

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 1 Recognize the multiyear focus of capital budgeting.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Project A Project B Project C Project D Two Dimensions of Cost Analysis

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 2 Understand the six stages of capital budgeting for a project.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Discounted Cash Flow There are two main DCF methods: Net present value (NPV) method Internal rate-of-return (IRR) method

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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?

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Net Present Value Example Year in the Life of the Project $(250,000)$125,000$130,000$115, Net initial investment Annual cash inflows

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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%.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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)

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Internal Rate of Return Investment = Expected annual net cash inflow × PV annuity factor Investment ÷ Expected annual net cash inflow = PV annuity factor