Managerial Accounting: An Introduction To Concepts, Methods, And Uses Chapter 9 Capital Expenditure Decisions Maher, Stickney and Weil

C9 - 2 Learning Objectives (Slide 1 of 2)  Explain the reasoning behind the separation of the investing and financing aspects of making long-term decisions.  Explain the role of capital expenditure decisions in the strategic planning process.  Describe the steps of the net present value method for making long-term decisions using discounted cash flows, and explain the effect of income taxes on cash flows.

C9 - 3 Learning Objectives (Slide 2 of 2)  Explain how spreadsheets help the analyst to conduct sensitivity analyses of capital budgeting.  Describe the internal rate of return method of assessing investment alternatives.  Explain why analysts will need more than cash flow analysis to justify or reject an investment.  Explain why the capital investment process requires audits.  Identify the behavioral issues involved in capital budgeting.

C9 - 4 Capital Budgeting Involves decisions regarding which long-term investments to undertake and how to finance them Involves estimating future cash flows, selecting an appropriate discount rate to discount those cash flows, and deciding how to finance the project

C9 - 5 Discounted Cash Flow Discounted cash flow (DCF) methods aid in evaluating investments involving cash flows over time Two DCF methods used Net present value method Internal rate of return method

C9 - 6 Discount Rate Discount rate is the interest rate used to compute the present value of future cash flows Appropriate discount rate has three elements Pure rate of interest (riskless rate) Risk factor reflecting the project’s riskiness An increase reflecting future inflation

C9 - 7 Net Present Value Method (Slide 1 of 2) Involves the following steps: Estimate future cash inflows and outflows in each period under consideration Discount the future cash flows to the present Accept or reject the project

C9 - 8 Net Present Value Method (Slide 2 of 2) Decision rule: If the present value (PV) of cash inflows exceeds the PV of future cash outflows, the project should be accepted Reject projects that have a negative net present value If one project is to be chosen from a set of alternatives, select the project with the highest net present value

C9 - 9 Estimating Cash Flows (Slide 1 of 4) When using the net present value (NPV) method, the following cash flows must be considered: Initial cash flows occurring at the beginning of the project Periodic cash flows during the life of the project Terminal cash flows at the end of the project

C Estimating Cash Flows (Slide 2 of 4) Initial cash flows - include cost of purchasing the asset as well as freight and installation May include cash flows from disposal of existing assets, including tax effect of gain or loss on disposal

C Estimating Cash Flows (Slide 3 of 4) Periodic cash flows during the life of the project include: Cash from sales and for fixed and variable production, selling, general, and administrative costs Should factor in savings in these items arising from the project under consideration Tax savings from the depreciation deduction should be factored in to the analysis Do not include noncash items such as depreciation expense

C Estimating Cash Flows (Slide 4 of 4) Terminal cash flows at the end of the project often include: Cash from the salvage value of the asset Tax arising on the gain (loss) on disposal of the project

C Tax Effects Depreciation expense is not a cash flow, however it is a tax deductible expense Reduces the amount of taxes that must be paid, so should be considered in NPV analysis Simplifying assumptions (such as use of straight line method of depreciation) can be used in NPV analysis but may have a significant impact on discounted cash flows

C Sensitivity of NPV Estimates NPV analysis is based on three types of estimates: The amount of future cash flows The timing of the cash flows The discount rate Spreadsheet programs, such as Microsoft Excel, can be used to determine how sensitive the NPV analysis is to changes in estimates

C Internal Rate of Return The internal rate of return (IRR) is the discount rate that yields a net present value of 0 Essentially, discounts the future cash flows of a project to a present value equal to the initial investment When used to evaluate investment options, a cutoff rate (or hurdle rate) is specified Generally, a project is accepted if the IRR exceeds the hurdle rate

C Investments in Advanced Production Systems Difficult to justify these types of investments using DCF methods because: Hurdle rate is too high Bias toward incremental projects Uncertainty about operating cash flows Benefits of project may be excluded from analysis because they are difficult to quantify

C Audits and Capital Budgeting Capital budgeting relies heavily on estimates Comparing budgeting estimates with actual results (called auditing) provides several advantages Identifies estimates that were wrong so planners can avoid similar mistakes in future budgeting Identifies and rewards those who are good at making capital budgeting decisions Reduces temptation to inflate estimates associated with a project

C If you have any comments or suggestions concerning this PowerPoint Presentation for Managerial Accounting, An Introduction To Concepts, Methods, And Uses, please contact: Dr. Donald R. Trippeer, CPA Colorado State University-Pueblo