1. Financial and Managerial Accounting
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John J. Wild
Third Edition
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Capital Budgeting & Investment Analysis
Chapter 24
Capital Budgeting & Investment Analysis
This chapter focuses on evaluating capital budgeting decisions. Several methods are described and illustrated that help identify projects with the greater return on investment

3. Conceptual Learning Objectives
C1: Explain the importance of capital budgeting.
C2: Describe the selection of a hurdle rate for an investment.
In this chapter, you will learn the following conceptual objectives:
C1: Explain the importance of capital budgeting.
C2: Describe the selection of a hurdle rate for an investment.

4. Analytical Learning Objectives
A1: Analyze a capital investment project using break-even time.
In this chapter, you will learn the following analytical objectives:
A1: Analyze a capital investment project using break-even time.

5. Procedural Learning Objectives
P1: Compute payback period and describe its use.
P2: Compute accounting rate of return and explain its use.
P3: Compute net present value and explain its use.
P4: Compute internal rate of return and explain its use.
In this chapter, you will learn the following procedural objectives:
P1: Compute payback period and describe its use.
P2: Compute accounting rate of return and explain its use.
P3: Compute net present value and explain its use.
P4: Compute internal rate of return and explain its use.

6. Capital Budgeting Large amounts of money are usually involved.
Outcome is uncertain.
Large amounts of money are usually involved.
Investment involves a long-term commitment.
Decision may be difficult or impossible to reverse.
Capital budgeting: Analyzing alternative long- term investments and deciding which assets to acquire or sell.
Capital budgeting is the process of analyzing alternative long-term investments and deciding which assets to acquire or sell. Careful analysis is necessary as future outcomes of today’s investments may by very uncertain. The amounts of money involved are usually large and the investment period is typically many years. Capital budgeting decisions often involve plant expansion issues, equipment selection, and equipment replacement.

7. Managers prefer investing in projects with shorter payback periods.
The payback period of an investment is the time expected to recover the initial investment amount.
Payback
period =
Cost of Investment
Annual Net Cash Flow
The payback period is the length of time it takes a project to recover its initial cost. When the annual net cash inflows are equal in each year, we can calculate the payback period by dividing the investment required by the net annual cash inflows. All other things equal, a shorter payback period is better than a longer payback period.
Managers prefer investing in projects with shorter payback periods.

8. Payback Period with Even Cash Flows
FasTrac is considering buying a new machine that will be used in its manufacturing operations. The machine costs $16,000 and is expected to produce annual net cash flows of $4,100. The machine is expected to have an 8-year useful life with no salvage value.
Calculate the payback period.
Payback
period =
Cost of Investment
Annual Net Cash Flow
Part I
The management at FasTrac is considering a new machine to use in its manufacturing operations. The new machine will cost sixteen thousand dollars and is expected to generate annual net cash flow of four thousand, one hundred dollars. Let’s calculate the payback period for the new machine.
Part II
Because the net annual cash inflows are the same each year, we can calculate the payback period easily by dividing the machine’s cost by its annual net cash flows. The payback period is three point nine years. The new machine will return its original cost in annual net cash flows in three point nine years, less than half of its expected useful life of eight years.
Management at FasTrac may have an investment decision rule such as: invest only in projects with a payback period of five years or less. If so, they would invest in the new machine because its payback period is less than five years.
Payback
period =
$16,000
$4,100
= years

9. Payback Period with Uneven Cash Flows
In the previous example, we assumed that the increase in cash flows would be the same each year. Now, let’s look at an example where the cash flows vary each year.
Let’s complicate the payback computation a bit by using unequal annual net cash flows for the same machine.
$4,100
$5,000

10. Payback Period with Uneven Cash Flows
FasTrac wants to install a machine that costs $16,000 and has an 8-year useful life with zero salvage value. Annual net cash flows are:
Instead of a constant amount of four thousand, one hundred dollars per year, net annual cash flows for the new machine now vary from a low of two thousand dollars to a high of five thousand dollars per year. We can no longer divide the cost of the new machine by an equal annual net cash inflow to get the payback period.

11. Payback Period with Uneven Cash Flows
We recover the $16,000
purchase price between
years 4 and 5, about 4.2 years for the payback period.
To get the payback period when we have unequal annual net cash flows, we must add the cash flows each year until the total equals the cost of the investment. FasTrak recovers the sixteen thousand dollar investment cost between four and five years. So, we can estimate the payback period at about four point two years.
4.2

12. Using the Payback Period
Ignores the
time value
of money.
Unacceptable for projects with long lives where time value of money effects are major.
There are several short-comings of the payback method. First, and foremost, the method ignores the time value of money. Second, it ignores any cash inflows after the payback period. For these reasons we would probably want to use the more sophisticated net present value or internal rate of return methods on projects requiring a significant commitment of company resources. We will discuss those methods later in the chapter.
Ignores cash
flows after
the payback
period.

13. Using the Payback Period
Consider two projects, each with a five-year life and each costing $6,000.
This example illustrates the shortcomings of the payback method. Calculate the payback period for each investment. Did you find that Project One has the shorter payback period? Would you select Project One or would you select Project Two and patiently wait for the one million dollars cash flow?
Would you invest in Project One just because it has a shorter payback period?

14. Accounting Rate of ReturnP2
The accounting rate of return focuses on annual income instead of cash flows.
Accounting Annual after-tax net income rate of return Annual average investment =
The accounting rate of return method looks to accounting income rather than cash flows. We calculate the accounting rate of return by dividing annual after-tax net income by the annual average investment in assets used to generate the annual after-tax net income. The annual average investment in assets is the average book value. Recall that the book value of an asset is its cost minus accumulated depreciation.
Beginning book value + Ending book value 2

15. Accounting Rate of ReturnP2
Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the accounting rate of return.
Accounting Annual after-tax net income rate of return Annual average investment =
Let’s return to the FasTrack example. The new machine machine costs sixteen thousand dollars and is expected to produce annual net cash flows of four thousand, one hundred dollars. First, we will see how the two thousand, one hundred dollars income figure is computed before we compute the accounting rate of return.
Beginning book value + Ending book value 2

16. Accounting Rate of ReturnP2
Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the accounting rate of return.
Accounting Annual after-tax net income rate of return Annual average investment =
Since the salvage value for the new machine is zero, the annual depreciation is the sixteen thousand dollar cost divided by the useful life of eight years. Income is the annual net cash flow less depreciation. Recall that depreciation is an expense on the income statement, but since depreciation expense is a non-cash expense, it was not included in the four thousand, one hundred dollars annual net cash flow. Now let’s compute the annual average investment and the accounting rate of return
Beginning book value + Ending book value 2

17. Accounting Rate of ReturnP2
Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the accounting rate of return.
Accounting $2,100 rate of return $8,000 =
= %
The average annual investment is the average book value. Book value is cost minus accumulated depreciation. The beginning book value is sixteen thousand dollars, the cost of the new machine, since accumulated depreciation is zero at the beginning of the eight-year life of the machine. Because salvage value is zero, the accumulated depreciation at the end of the eight-year life will be sixteen thousand dollars, exactly equal to the sixteen thousand dollars cost. So the book value is zero after eight years. Dividing annual after-tax net income of two thousand, one hundred dollars by the average annual investment of eight thousand dollars results in an accounting rate of return of twenty six point twenty-five percent.
$16,000 + $0 2

18. Using Accounting Rate of ReturnP2
So why
would I ever want to use this method anyway?
Depreciation may be calculated several ways.
Income may vary from year to year.
Time value of money is ignored.
The accounting rate of return has just as many shortcomings as the payback period method. In addition to ignoring the time value of money, the accounting rate of return is affected by the choice of depreciation methods and potential variations in income from year to year.

19. Net Present Value P3
Now let’s look at a capital budgeting model that considers the time value of cash flows.
Decisions that will impact operations over a long period should recognize the time value of money. Investments that promise early returns are preferable to those that promise later returns because of the time value of money. In other words, a dollar that we receive relatively soon is more valuable than a dollar we are to receive at some distant time. Net present value is the first capital budgeting tool that we will study that considers the time value of money. We will use cash flows with the net present value method instead of accounting income.

20. Net Present Value P3
Discount the future net cash flows from the investment at the required rate of return.
Subtract the initial amount invested from sum of the discounted cash flows.
FasTrac is considering the purchase of a conveyor costing $16,000 with an 8-year useful life with zero salvage value that promises annual net cash flows of $4,100. FasTrac requires a 12 percent compounded annual return on its investments.
Net present value is the present value of future cash inflows less the cost of the investment. We find the present value of future cash flow using an interest rate referred to as the required rate of return. The process of computing the present value of future cash flows is called discounting future cash flows.
Reconsider the earlier example where FasTrac is considering the purchase of a new machine costing sixteen thousand dollars with an eight-year useful life and zero salvage value, that promises annual net cash flows of four thousand, one hundred dollars. Since we are considering the time value of money, we have a new piece of information, the required rate of return. FasTrac requires a twelve percent compounded annual return on its investments.

21. Net Present Value with Even Cash Flows
To find the present value of a future cash flow, we multiply the cash flow by the present value of one dollar for twelve percent and the year in which the cash flow occurs. You will find these interest factors in Table B.1 of Appendix B of your textbook. At this point you should turn to Appendix B and verify the interest factors.
If it has been awhile since you have worked with present value computations, or if this topic is new to you, you will probably want to read Appendix B and work some of the exercises found there before continuing.

22. Net Present Value with Even Cash Flows
Present value factors for 12 percent
Did you find the twelve percent interest factors in Appendix B for each year?

23. Net Present Value with Even Cash Flows
To find the net present value, we sum the present values for each year and then subtract the cost of the new machine from the sum. The sum of present values is greater than the cost of the investment, resulting in a net present value of four thousand, three hundred sixty seven dollars. A positive net present value indicates that this project earns more than twelve percent on the investment of sixteen thousand dollars.
A positive net present value indicates that this project earns more than 12 percent on the investment.

24. Using Net Present Value
General decision rule . . .
As a general rule, if the net present value is positive or zero, the project is acceptable since the promised return is equal to or greater than the required rate of return. When we have a negative net present value, the project is not acceptable.

25. Net Present Value with Uneven Cash Flows
In this example, we see why investments that have larger returns in the early years are preferable to investments that have larger returns in later years. Each investment returns fifteen thousand dollars in total cash flows over a three-year period. Each investment costs twelve thousand dollars. But investment B has a larger cash flow in the first year and therefore has a larger net present value.
Although all projects require the same investment and have the same total net cash flows, project B has a higher net present value because of a larger net cash flow in year 1.

26. Internal Rate of Return (IRR)P4
The interest rate that makes . . .
Present value of cash inflows
Present value of cash outflows = 
The internal rate of return is the interest rate that will cause the net present value of a project to be equal to zero. Stated another way, the internal rate of return is the interest rate that will make the present value of future cash inflows equal to the present value of outflows (cost of the investment).
The net present value equal zero.

27. Internal Rate of Return (IRR)P4
Projects with even annual cash flows
Project life = 3 years Initial cost = $12,000 Annual net cash inflows = $5,000
Determine the IRR for this project.
1. Compute present value factor.
2. Using present value of annuity table . . .
Consider this example where a project is being considered that costs twelve thousand dollars, returns annual net cash flows of five thousand dollars, and has a useful life of three years. We must first compute an interest factor to use in the interest tables of Appendix B, where we will find the internal rate of return.

28. Internal Rate of Return (IRR)P4
Projects with even annual cash flows
Project life = 3 years Initial cost = $12,000 Annual net cash inflows = $5,000
Determine the IRR for this project.
1. Compute present value factor $12,000 ÷ $5,000 per year = 2.4
2. Using present value of annuity table . . .
We divide the cost of the investment by the annual net cash inflow to get the interest factor of two point four. We will use this interest factor to find the internal rate of return in the present value of an annuity table, Table B.3 in Appendix B. Recall that the term annuity means an equal annual cash flow amount.

29. Internal Rate of Return (IRR)P4
1. Determine the present value factor $12,000 ÷ $5,000 per year =
2. Using present value of annuity table . . .
Locate the row whose number equals the periods in the project’s life.
Here’s a portion of Table B.3 from Appendix B. First, locate the row whose number equals the life of the project. You may actually want to turn to Appendix B to work through this exercise.

30. Internal Rate of Return (IRR)P4
1. Determine the present value factor $12,000 ÷ $5,000 per year =
2. Using present value of annuity table . . .
In that row, locate the interest factor closest in amount to the present value factor.
Now look across to the right on the three period row until you find an interest factor that is equal to or close to the two point four that we calculated earlier.

31. Internal Rate of Return (IRR)P4
1. Determine the present value factor $12,000 ÷ $5,000 per year =
2. Using present value of annuity table . . .
IRR is approximately 12%.
IRR is the interest rate of the column in which the present value factor is found.
Next, look to the top of the column where you found the interest factor closest to two point four, and you will find that it is the twelve percent column. The internal rate of return is approximately twelve percent. If the factor falls between two interest rate columns, we interpolate to approximate the internal rate of return.

32. Internal Rate of Return – Uneven Cash FlowsP4
If cash inflows are unequal, trial and error solution will result if present value tables are used.
Sophisticated business calculators and electronic spreadsheets can be used to easily solve these problems.
Calculating the internal rate of return becomes much more difficult when a project has unequal cash flows. Hand calculations using interest rate tables involve multiple trial and error solutions. For this reason, electronic spreadsheets such as Excel or advanced hand-held calculators should be used for projects with unequal cash flows.

33. Using Internal Rate of ReturnC2
Internal Rate of Return
Compare the internal rate of return on a project to a predetermined hurdle rate (cost of capital).
To be acceptable, a project’s rate of return cannot be less than the cost of capital.
If the internal rate of return is greater than our required rate of return, the project is an acceptable investment.

34. Comparing Methods C2
On this screen, we see a summary comparing the strengths and limitations of each of the four capital budgeting methods that we have studied. Recall that the major limitation of the payback method and the accounting rate of return method is that they neglect the time value of money. This limitation is overcome by using either the net present value or internal rate of return methods.

35. Break-Even Time A1
Break-even time incorporates time value of money into the payback period method of evaluating capital investments.
The payback example that we saw earlier in the chapter neglected the time value of money. Break-even time is a variation of the payback method that incorporates the time value of money by telling us the number of years an investment requires for its net present value to equal its initial cost.

36. End of Chapter 24
Now that we have mastered some of the basic concepts and principles of managerial accounting, we are ready to put this knowledge to work.