1. 1 Copyright © 2008 Cengage Learning South-Western Heitger/Mowen/Hansen Capital Investment Decisions Chapter Twelve Fundamental Cornerstones of Managerial Accounting

2. 2 Capital Investment Decisions Long range decisions involving opportunities to invest in new assets or projects Among the most important decisions made by managers Place large amounts of resources at risk for long periods of time Affect the future development of the firm Decision making process is called “Capital Budgeting”

3. 3 Capital Budgeting Two types: ◦Independent projects (“Mutually exclusive projects”) ∙If accepted or rejected, do not affect the cash flows of other projects ◦Competing projects ∙Acceptance of one alternative precludes the acceptance of another

4. 4 Capital Budgeting Managers must decide whether or not a capital investment will: ◦Earn back its original outlay ◦Provide a reasonable return ∙Covering the opportunity cost of the funds invested To make a capital investment decision, managers must: ◦Make estimates of the quantity and timing of a fter- tax cash flows ◦Assess the risk of the investment ◦Consider the impact of the project on the firm’s profits

5. 5 Making Capital Investment Decisions Managers must: ◦Set goals and priorities set for capital investments ◦Establish basic criteria for acceptance or rejection of proposed investments Two types of methods: 1.Nondiscounting models ∙Do not consider time value of money ∙Two methods ∙Payback period ∙Accounting rate of return (ARR) 2.Discounting models ∙Use time value of money ∙Two methods ∙Net present value (NPV) ∙Internal rate of return (IRR) Most companies use both types of methods

6. 6 Definition =Original investment / Annual cash flow Payback period

7. 7 Accounting Rate of Return Measures the return on a project in terms of income as opposed to using cash flow ◦Formula: Average income / Initial investment Accounting Rate of Return = Average income is not the same as cash flows ◦Formula: ∙Add net income for each year of the project and divide by the number of years

8. 8 Definition =Average Net Income / Initial Investment Accounting Rate of Return

9. 9 Net Present Value (NPV) Difference between the present value of the cash inflows and outflows associated with a project Measures the net cash flows of the project Size of the positive NPV measures the increase in value of the firm resulting from an investment To use NPV method, a required rate of return must be defined ◦Minimum acceptable rate of return

10. 10 Evaluating Net Present Value (NPV) If NPV is positive: ◦Rate of return on the investment is greater than the required rate of return ◦Investment, the minimum rate of return, and a return in excess of profit are all recovered ◦Investment is acceptable If NPV is zero: ◦Rate of return on the investment is exactly the required rate of return ◦Investment and the minimum rate of return are recovered ◦Decision maker will be ambivalent regarding acceptance or rejection

11. 11 Evaluating Net Present Value (NPV) If NPV is negative: ◦Rate of return on the investment is less than the required rate of return ◦Investment cost may or may not be recovered, and the minimum rate or return is not recovered ◦Initial investment should be rejected

12. 12 Internal Rate of Return (IRR) Interest rate that sets the project’s NPV to zero ◦Formula: Can be found using trial and error, or Using PV tables Compared to required rate of return ◦If IRR > Required rate of return… ∙Project is deemed acceptable ◦If IRR < Required rate of return ∙Project is rejected I = ∑CF t / (1 + i) t

13. 13 Definition Internal Rate of Return Discount factor = Investment / Annual Cash Flow

14. 14 Post Audit of Capital Projects Follow-up analysis of project once it is implemented Should be completed by independent party ◦Often internal audit staff Compares: ◦Actual benefits to estimated benefits ◦Actual operating costs to estimated costs Evaluates the overall outcome of the investment Proposes corrective action if needed

15. 15 Benefits of a Postaudit By evaluating profitability and cash flows, firms ensure that assets are used wisely Managers held accountable for results of capital investment decisions ◦More likely to make decisions in the best interest of the firm ◦Feedback is gained and used in future decision making

16. 16 Drawbacks of a Postaudit Costly Limitations: ◦Assumption driving original analysis may often be invalidated by changes in the actual operating environment Accountability must be qualified: ◦By the impossibility of foreseeing every possible eventuality

17. 17 Mutually Exclusive Projects Net Present Value (NPV) and Internal Rate of Return (IRR) can produce different results NPV Assumes that each cash flow received is reinvested at the required rate of return Measures cash flow profitability in absolute terms ◦IRR ◦Assumes that each cash flow is reinvested at the computed IRR ◦Measures cash flow profitability in relative terms ◦NPV consistently selects the project which maximizes the firm’s wealth

18. 18 Steps in Selecting Best Project 1.Assess the flow pattern for each project 2.Compute the net present value (NPV) for each project 3.Identify the project with the greatest NPV