2. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 1 Capital Budgeting Chapter 11

3. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 2 Learning Objective 1 Describe capital budgeting decisions and use the net- present-value (NPV) method to make such decisions.

4. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 3 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.”

5. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 4 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.

6. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 5 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.

7. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 6 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.

8. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 7 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.

9. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 8 NPV Example Original investment (cash outflow): $6,075 Useful life: four years Annual income generated from investment (cash inflow): $2,000 Minimum desired rate of return: 10%

10. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 9 NPV Example YearsAmount PV Factor Present Value YearsAmount PV Factor Present Value 0($6,075)1.0000($6,075) 1 2,000.9091 1,818 2 2,000.8264 1,653 3 2,000.7513 1,503 4 2,000.6830 1,366 Net present value $ 265

11. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 10 NPV Example Years Amount PV FactorPresent Value 0($6,075) 1.0000($6,075) 0($6,075) 1.0000($6,075) 1-4 2,000 3.1699 6,340 1-4 2,000 3.1699 6,340 Net present value $ 265

12. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 11 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.

13. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 12 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.

14. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 13 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.

15. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 14 Real Option Model This model recognizes the value of contingent investments. Contingent investments are investments that a company can adjust as it learns more about their potential for success.

16. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 15 Learning Objective 2 Evaluate projects using sensitivity analysis.

17. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 16 Sensitivity Analysis Sensitivity analysis shows the financial consequences that would occur if actual cash inflows and outflows differ from those expected.

18. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 17 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?

19. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 18 Sensitivity Analysis Example (3.1699 × Cash flow) – $6,075 = 0 Cash flow = $6,075 ÷ 3.1699 = $1,916 If the annual cash flow is less than $1,916, the NPV is negative, and the project should be rejected.

20. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 19 Learning Objective 3 Calculate the NPV difference between two projects using both the total project and differential approaches.

21. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 20 Comparison of Two Projects Two common methods for comparing alternatives are: Total project approach Differentialapproach

22. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 21 Total Project Approach The total project approach computes the total impact on cash flows for each alternative and then converts these total cash flows to their present values. The alternative with the largest NPV of total cash flows is best.

23. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 22 Differential Approach The differential approach computes the differences in cash flows between alternatives and then converts these differences to their present values. This method cannot be used to compare more than two alternatives.

24. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 23 Learning Objective 4 Identify relevant cash flows for NPV analyses.

25. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 24 Relevant Cash Flows for NPV The four 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

26. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 25 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.

27. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 26 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.

28. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 27 Cash Flows for Investment in Technology What is the benefit from the investment?

29. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 28 Learning Objective 5 Compute the after-tax net present values of projects.

30. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 29 Income Taxes and Capital Budgeting What is another type of cash flow that must be considered when making capital-budgeting decisions? Income taxes

31. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 30 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.

32. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 31 Effects of Depreciation Deductions U.S. tax authorities allow accelerated depreciation. The focus is on the tax reporting rules, not those for public financial reporting. The recovery period is the number of years over which an asset is depreciated for tax purposes.

33. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 32 Effects of Depreciation Deductions Depreciation expense is a noncash 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

34. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 33 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

35. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 34 Tax Deductions, Capital Effects, and Timing What is the after-tax effect of $25,000 depreciation? $25,000 × 40% = $10,000 tax savings

36. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 35 Modified Accelerated Cost Recovery System Under U.S. income tax laws, companies depreciate most assets using the Modified Accelerated Cost Recovery System (MACRS). This system specifies a recovery period and an accelerated depreciation schedule for all types of assets.

37. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 36 Learning Objective 6 Explain the after-tax effect on cash of disposing of assets.

38. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 37 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

39. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 38 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.

40. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 39 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

41. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 40 Learning Objective 7 Use the payback model and the accounting rate-of-return model and compare them with the NPV model.

42. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 41 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

43. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 42 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

44. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 43 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÷

45. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 44 Accounting Rate-of-Return Example Assume the following:  Investment is $6,075.  Useful life is four years.  Estimated disposal value is zero.  Expected annual cash inflow from operations is $2,000. What is the annual depreciation?

46. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 45 Accounting Rate-of-Return Example $6,075 ÷ 4 = $1,518.75 (rounded to $1,519) What is the ARR? ARR = ($2,000 – $1,519) ÷ $6,075 = 7.9%

47. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 46 Learning Objective 8 Reconcile the conflict between using an NPV model for making a decision and using accounting income for evaluating the related performance

48. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 47 Performance Evaluation Many managers are reluctant to accept DFC models as the best way to make capital-budgeting decisions. Their superiors evaluate them using a non-DCF model.

49. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 48 Reconciliation of Conflict Use DCF for both capital-budgeting decisions and performance evaluation. Economic Value Added (EVA) Follow-up evaluation of capital decisions

50. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 49 Post Audit A recent survey showed that most large companies conduct a follow-up evaluation of at least some capital-budgeting decisions.

51. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 50 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.

52. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 51 Learning Objective 9 Compute the impact of inflation on a capital-budgeting project. (Appendix 11)

53. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 52 Inflation What is inflation? It is the decline in general purchasing power of the monetary unit. The key in capital budgeting is consistent treatment of the minimum desired rate of return and the predicted cash inflows and outflows.

54. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 53 Watch for Consistency Such consistency can be achieved by including an element for inflation in both the minimum desired rate of return and in the cash-flow predictions.

55. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 54 End of Chapter 11