©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Capital Budgeting Chapter 11

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Capital Budgeting Capital budgeting describes the long-term planning for making and financing major long-term projects. 1. Identify potential investments. 2. Choose an investment. 3. Follow-up or “postaudit.”

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Payback Model Payback time, or payback period, is the time it will take to recoup, in the form of cash inflows from operations, the initial dollars invested in a project. P = I ÷ Incremental inflow

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Payback Model Example Assume that $12,000 is spent for a machine with an estimated useful life of 8 years. Annual savings of $4,000 in cash outflows are expected from operations. P = $12,000 ÷ $4,000 = 3 years What is the payback period

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Accounting Rate-of-Return Model The accounting rate-of-return (ARR) model expresses a project’s return as the increase in expected average annual operating income divided by the required initial investment. ARR= Increase in expected average annual operating income Initialrequiredinvestment÷

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Accounting Rate-of-Return Example Assume the following:  Investment is $6,075.  Useful life is 4 years.  Estimated disposal value is zero.  Expected annual cash inflow from operations is $2,000. What is the annual depreciation?

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Accounting Rate-of-Return Example $6,075 ÷ 4 = $1, (rounded to $1,519) What is the ARR? ARR = ($2,000 – $1,519) ÷ $6,075 = 7.9%

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Discounted-Cash-Flow Models (DCF) These models focus on a project’s cash inflows and outflows while taking into account the time value of money. DCF models compare the value of today’s cash outflows with the value of the future cash inflows.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Net Present Value Model The net-present-value (NPV) method computes the present value of all expected future cash flows using a minimum desired rate of return.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Net Present Value Model The minimum desired rate of return depends on the risk of a proposed project – the higher the risk, the higher the rate. The required rate of return (also called hurdle rate or discount rate) is the minimum desired rate of return based on the firm’s cost of capital.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Applying the NPV Method Prepare a diagram of relevant expected cash inflows and outflows. Find the present value of each expected cash inflow or outflow. Sum the individual present values.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton NPV Example Original investment (cash outflow): $6,075 Useful life: 4 years Annual income generated from investment (cash inflow): $2,000 Minimum desired rate of return: 10%

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton NPV Example YearsAmount PV Factor Present Value YearsAmount PV Factor Present Value 0($6,075)1.0000($6,075) 1 2, , , , , , , ,366 Net present value $ 265

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton NPV Example Years Amount PV FactorPresent Value 0($6,075) ($6,075) 0($6,075) ($6,075) 1-4 2, , , ,340 Net present value $ 265

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Assumptions of the NPV Model There is a world of certainty. There are perfect capital markets. Predicted cash flows occur timely. Money can be borrowed or loaned at the same interest rate.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Decision Rules Managers determine the sum of the present values of all expected cash flows from the project. If the sum of the present values is positive, the project is desirable. If the sum of the present values is negative, the project is undesirable.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Internal Rate of Return Model The IRR determines the interest rate at which the NPV equals zero. If IRR > minimum desired rate of return, then NPV > 0 and accept the project. If IRR < minimum desired rate of return, then NPV < 0 and accept the project.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Sensitivity Analysis Sensitivity analysis shows the financial consequences that would occur if actual cash inflows and outflows differ from those expected.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Sensitivity Analysis Example Suppose that a manager knows that the actual cash inflows in the previous example could fall below the predicted level of $2,000. How far below $2,000 must the annual cash inflow drop before the NPV becomes negative?

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Sensitivity Analysis Example ( × Cash flow) – $6,075 = 0 Cash flow = $6,075 ÷ = $1,916 If the annual cash flow is less than $1,916, the NPV is negative, and the project should be rejected.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Relevant Cash Flows for NPV The 4 types of inflows and outflows should be considered when the relevant cash flows are arrayed: 1)Initial cash inflows and outflows at time zero 2)Investments in receivables and inventories 3)Future disposal values 4)Operating cash flows

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Operating Cash Flows The only relevant cash flows are those that will differ among alternatives. Depreciation and book values should be ignored. A reduction in cash outflow is treated the same as a cash inflow.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Cash Flows for Investment in Technology Suppose a company has a $10,000 net cash inflow this year using a traditional system. Investing in an automated system will increase the net cash inflow to $12,000. Failure to invest will cause net cash inflows to fall to $8,000.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Cash Flows for Investment in Technology What is the benefit from the investment?

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Income Taxes and Capital Budgeting What is another type of cash flow that must be considered when making capital-budgeting decisions? Income taxes

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Marginal Income Tax Rate In capital budgeting, the relevant tax rate is the marginal income tax rate. This is the tax rate paid on additional amounts of pretax income.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Effects of Depreciation Deductions Depreciation expense is a non-cash expense and so is ignored for capital budgeting, except that it is an expense for tax purposes and so will provide a cash inflow from income tax savings. TAX

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Tax Deductions, Capital Effects, and Timing Assume the following: Cash inflow from operations: $60,000 Tax rate: 40% What is the after-tax inflow from operations? $60,000 × (1 – tax rate) = $60,000 ×.6 = $36,000

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Tax Deductions, Capital Effects, and Timing What is the after-tax effect of $25,000 depreciation? $25,000 × 40% = $10,000 tax savings

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Gains or Losses on Disposal Suppose a 5-year piece of equipment purchased for $125,000 is sold at the end of year 3 after taking three years of straight-line depreciation. What is the book value? $125,000 – (3 × $25,000) = $50,000

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Gains or Losses on Disposal If it is sold for book value, there is no gain or loss and so there is no tax effect. If it is sold for more than $50,000, there is a gain and an additional tax payment. If it is sold for less than $50,000, there is a loss and a tax savings.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Gains or Losses on Disposal Assume that it is sold for $70,000 and the tax rate is 40%. What is the cash inflow? ($70,000 – $50,000) × 40% = $8,000 $70,000 – $8,000 = $62,000

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Post Audit Investment expenditures are on time and within budget. Comparing actual versus predicted cash flows. Improving future predictions of cash flows. Evaluating the continuation of the project.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Exercise (Page 506) Bob’s Big Burgers is considering a proposal to invest in a speaker system that would allow its employees to service drive-through customers. The cost of the system (including the installation of special windows and driveway modifications) is RM30,000. Jenna, manager of Bob’s, expects the drive-through operations to increase annual sales by RM25,000, with a 40% contribution margin ratio. Assume that the system has an economic life of 6 years, at which time it will have no disposal value. The cost of capital (required rate of return) is 12%. Ignore taxes.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Exercise (Page 506) What is the payback time? Annual addition to profit = 40% x $25,000 = $10,000. Payback period is $30,000 ÷ $10,000 = 3 years. What are the advantages/disadvantages of this method? Advantages  easy to use, can be used as a rough estimate of the riskiness of a project, esp in rapid technological changes & changes in product design, where cash flows are uncertain Disadvantages  does not measure profitability, ignores time value of money

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Exercise (Page 506) Compute rate of return on the initial investment, based on the accounting rate-of-return model. ARR= ($10,000 - $5,000) ÷ $30,000 = 16.7% depreciation What are the advantages/disadvantages of this method? Advantages  measures profitability, easy to use Disadvantages  ignores time value of money

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Exercise (Page 506) Compute the net present value. Year Discount factor Cash inflow/ (outflow)NPV (30,000)(30,000) ,0008, ,0007, ,0007, ,0006, ,0005, ,0005,066 Net NPV 11,114

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Exercise (Page 506) Should Jenna accept the proposal? Why or why not? Yes, accept the proposal because of positive NPV. What are the advantages/disadvantages of this method? Advantages  considers time value of money, considers relevant cash flows Disadvantages  discount factor is subjective