1. Capital Budgeting and Cost Analysis

2. Recognize the multiyear focus
Learning Objective 1
Recognize the multiyear focus
of capital budgeting.

3. 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.

4. Two Dimensions of Cost Analysis
Project D
Project C
Project B
Project A
2002
2003
2004
2005
2006

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

6. 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.

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

8. 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.

9. 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.

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

11. Use and evaluate the two main discounted cash-flow (DCF)
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.

12. Time Value of Money Compound Growth, Year 5: $1.338 5 periods at 6%

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

14. 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?

15. Net Present Value Example
Year in the Life of the Project 1 2 3
$(250,000) $125,000 $130,000 $115,000
Net initial
investment
Annual cash
inflows

16. Net Present Value Example
Net Cash NPV of Net
Year % Col. Inflows Cash Inflows
$125,000 $113,625
, ,380
, ,365
Total PV of net cash inflows $307,370
Net initial investment ,000
Net present value of project $ 57,370

17. 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%.

18. Net Present Value Example
Net Cash NPV of Net
Years 10% Col. Inflows Cash Inflows
$80, $198,960
, ,759
Total PV of net cash inflows $205,719
Net initial investment ,000
Net present value of project ($ 44,281)

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

20. 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)

21. 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.

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

23. Learning Objective 4
Use and evaluate the
payback method.

24. 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.

25. 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.

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

27. 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?

28. 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?

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

30. 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

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

32. 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

33. 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?

34. 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%

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

36. 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.

37. 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.

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

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

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

41. Relevant Cash Flow Analysis Example
G. T. is considering replacing old equipment.
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 %

42. 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

43. 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 ,800
Total $21,800

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

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

46. 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%) ,000
Annual after-tax flow from operations $54,000

47. 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 ,000
Difference $35,000

48. 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
Income tax cash savings
from additional depreciation $14,000

49. 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 ,000
Cash flow from operations,
net of income taxes $68,000

50. 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?

51. Relevant Cash Flow Analysis Example
Net Cash NPV of Net
Years 14% Col. Inflows Cash Inflows
$68, $233,444
, ,190
Total PV of net cash inflows $238,636
Investment ,200
Net present value of new equipment $ 25,436

52. 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.

53. 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.

54. End