Week10-CapitalBudgeting

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

Capital BudgetingCapital Budgeting

Chapter 11Chapter 11

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

Capital BudgetingCapital Budgeting

Capital budgetingCapital budgeting describes the long-term describes the long-termplanning for making and financingplanning for making and financing

major long-term projects.major long-term projects.

1. Identify potential investments.1. Identify potential investments.

2. Choose an investment.2. Choose an investment.

3. Follow-up or “postaudit.”3. Follow-up or “postaudit.”


Payback ModelPayback Model

Payback time, or payback period, is thetime it will take to recoup, in the formof cash inflows from operations, theinitial dollars invested in a project.

P = I ÷ Incremental inflowP = I ÷ Incremental inflow


Payback Model ExamplePayback Model Example

Assume that $12,000 is spent for a machineAssume that $12,000 is spent for a machinewith an estimated useful life of 8 years.with an estimated useful life of 8 years.

Annual savings of $4,000 in cash outflowsAnnual savings of $4,000 in cash outflowsare expected from operations.are expected from operations.

P = $12,000 ÷ $4,000 = 3 yearsP = $12,000 ÷ $4,000 = 3 years

What is the payback periodWhat is the payback period


Accounting Rate-of-Return Accounting Rate-of-Return ModelModel

The accounting rate-of-return (ARR) modelexpresses a project’s return as the increase

in expected average annual operating incomedivided by the required initial investment.

ARRARR ==Increase in expectedIncrease in expected

average annualaverage annualoperating incomeoperating income

InitialInitialrequiredrequired

investmentinvestment÷÷


Accounting Rate-of-Return Accounting Rate-of-Return ExampleExample

Assume the following:Assume the following: Investment is $6,075.Investment is $6,075. Useful life is 4 years.Useful life is 4 years.

Estimated disposal value is zero.Estimated disposal value is zero. Expected annual cash inflowExpected annual cash inflow

from operations is $2,000.from operations is $2,000.

What is the annual depreciation?What is the annual depreciation?


Accounting Rate-of-Return Accounting Rate-of-Return ExampleExample

$6,075 ÷ 4 = $1,518.75 (rounded to $1,519)$6,075 ÷ 4 = $1,518.75 (rounded to $1,519)

What is the ARR?What is the ARR?

ARR = ($2,000 – $1,519) ÷ $6,075 = 7.9%ARR = ($2,000 – $1,519) ÷ $6,075 = 7.9%


Discounted-Cash-FlowDiscounted-Cash-FlowModels (DCF)Models (DCF)

These models focus on a project’s cashThese models focus on a project’s cashinflows and outflows while taking intoinflows and outflows while taking intoaccount the account the time value of moneytime value of money..

DCF models compare the valueDCF models compare the valueof today’s cash outflows with theof today’s cash outflows with thevalue of the future cash inflows.value of the future cash inflows.


Net Present Value ModelNet Present Value Model

The net-present-value (NPV) methodThe net-present-value (NPV) methodcomputes the present value of allcomputes the present value of allexpected future cash flows usingexpected future cash flows usinga minimum desired rate of return.a minimum desired rate of return.


Net Present Value ModelNet Present Value Model

The minimum desired rate of return dependsThe minimum desired rate of return dependson the risk of a proposed project –on the risk of a proposed project –

the higher the risk, the higher the rate.the higher the risk, the higher the rate.

The The required rate of returnrequired rate of return (also called hurdle (also called hurdlerate or discount rate) is the minimum desiredrate or discount rate) is the minimum desired

rate of return based on the firm’s cost of capital.rate of return based on the firm’s cost of capital.


Applying the NPV MethodApplying the NPV Method

Prepare a diagram of relevantPrepare a diagram of relevantexpected expected cashcash inflows and outflows. inflows and outflows.

Find the present value of eachFind the present value of eachexpected cash inflow or outflow.expected cash inflow or outflow.

Sum the individual present values.Sum the individual present values.


Net Present Value ModelNet Present Value ModelDiscounting cash-flowDiscounting cash-flow- Comparing future cash-flows in the present value- Comparing future cash-flows in the present value

YearYear

00 11 22 33 44


NPV ExampleNPV Example

Original investment (cash outflow): $6,075Original investment (cash outflow): $6,075

Useful life: 4 yearsUseful life: 4 years

Annual income generated fromAnnual income generated frominvestment (cash inflow): $2,000investment (cash inflow): $2,000

Minimum desired rate of return: 10%Minimum desired rate of return: 10%


NPV Example (pg 475)NPV Example (pg 475)

YearsYears AmountAmount PV FactorPV Factor Present ValuePresent Value00 ($6,075)($6,075) 1.00001.0000 ($6,075)($6,075)11 2,000 2,000 .9091 .9091 1,818 1,81822 2,000 2,000 .8264 .8264 1,653 1,65333 2,000 2,000 .7513 .7513 1,503 1,50344 2,000 2,000 .6830 .6830 1,366 1,366

Net present valueNet present value $ 265 $ 265


NPV ExampleNPV Example

YearsYears AmountAmount PV FactorPV Factor Present ValuePresent Value 00 ($6,075)($6,075) 1.0000 1.0000 ($6,075)($6,075) 1-41-4 2,000 2,000 3.1699 3.1699 6,340 6,340Net present valueNet present value $ 265 $ 265


Calculating the PV Factor

1 0.90911 0.1

At a discount rate of 10%, the PV Factor for Year 1:

21 0.8264

(1 0.1)

At a discount rate of 10%, the PV Factor for Year 2:


Calculating the Annuity Calculating the Annuity FactorFactor

At a discount rate of 10%, the Annuity PV Factor for Years 1-4:

Years PV Factor 1 .90912 .82643 .7513 4 .6830

Annuity PV Factor 3.1698


Decision RulesDecision Rules

Managers determine the sum ofManagers determine the sum ofthe present values of all expectedthe present values of all expected

cash flows from the project.cash flows from the project.

If the sum of the present values isIf the sum of the present values ispositivepositive, the project is desirable., the project is desirable.

If the sum of the present values isIf the sum of the present values isnegativenegative, the project is undesirable., the project is undesirable.


Sensitivity AnalysisSensitivity Analysis

Sensitivity analysis shows the financialSensitivity analysis shows the financialconsequences that would occur ifconsequences that would occur ifactual cash inflows and outflowsactual cash inflows and outflows

differ from those expected.differ from those expected.


Sensitivity Analysis Sensitivity Analysis ExampleExample

Suppose that a manager knows that theSuppose that a manager knows that theactual cash inflows in the previous exampleactual cash inflows in the previous example

could fall below the predicted level of $2,000.could fall below the predicted level of $2,000.

How far below $2,000 must the annual cashHow far below $2,000 must the annual cashinflow drop before the NPV becomes negative?inflow drop before the NPV becomes negative?


Sensitivity Analysis Sensitivity Analysis ExampleExample

(3.1699 × Cash flow) – $6,075 = 0(3.1699 × Cash flow) – $6,075 = 0

Cash flow = $6,075 ÷ 3.1698 = $1,916Cash flow = $6,075 ÷ 3.1698 = $1,916

If the annual cash flow is less thanIf the annual cash flow is less than$1,916, the NPV is negative, and$1,916, the NPV is negative, and

the project should be rejected.the project should be rejected.


Relevant Cash Flows for Relevant Cash Flows for NPVNPVThe 4 types of inflows and outflowsThe 4 types of inflows and outflows

should be considered when theshould be considered when therelevant cash flows are arrayed:relevant cash flows are arrayed:

1)1) Initial cash inflows and outflows at time zeroInitial cash inflows and outflows at time zero2)2) Investments in receivables and inventoriesInvestments in receivables and inventories

3)3) Future disposal valuesFuture disposal values4)4) Operating cash flowsOperating cash flows


Operating Cash FlowsOperating Cash Flows

The only relevant cash flows areThe only relevant cash flows arethose that will differ among alternatives.those that will differ among alternatives.

Depreciation and bookDepreciation and bookvalues should be ignored.values should be ignored.

A reduction in cash outflow isA reduction in cash outflow istreated the same as a cash inflow.treated the same as a cash inflow.


Cash Flows for InvestmentCash Flows for Investmentin Technologyin TechnologySuppose a company has a $10,000Suppose a company has a $10,000

net cash inflow this yearnet cash inflow this yearusing a traditional system.using a traditional system.

Investing in an automated system willInvesting in an automated system willincrease the net cash inflow to $12,000.increase the net cash inflow to $12,000.

Failure to invest will cause netFailure to invest will cause netcash inflows to fall to $8,000.cash inflows to fall to $8,000.


Cash Flows for InvestmentCash Flows for Investmentin Technologyin Technology

What is the benefit from the investment?What is the benefit from the investment?


Post AuditPost Audit

Investment expenditures areInvestment expenditures areon time and within budget.on time and within budget.

Comparing actual versus predicted cash flows.Comparing actual versus predicted cash flows.

Improving future predictions of cash flows.Improving future predictions of cash flows.

Evaluating the continuation of the project.Evaluating the continuation of the project.


Exercise 11-45 (Page 506)Exercise 11-45 (Page 506)Bob’s Big Burgers is considering a proposal to Bob’s Big Burgers is considering a proposal to invest in a speaker system that would allow its invest in a speaker system that would allow its employees to service drive-through customers. employees to service drive-through customers. The cost of the system (including the installation of The cost of the system (including the installation of special windows and driveway modifications) is special windows and driveway modifications) is RM30,000RM30,000. Jenna, manager of Bob’s, expects the . Jenna, manager of Bob’s, expects the drive-through operations to increase annual sales drive-through operations to increase annual sales by by RM25,000, with a 40% contribution margin ratioRM25,000, with a 40% contribution margin ratio. . Assume that the system has an economic life of Assume that the system has an economic life of 66 years, at which time it will have years, at which time it will have no disposal valueno disposal value. . The cost of capital (required rate of return) is The cost of capital (required rate of return) is 12%.12%. Ignore taxes.Ignore taxes.


Exercise 11-45 (Page 506)Exercise 11-45 (Page 506)What is the payback time?What is the payback time?

Annual addition to profit = 40% x $25,000 = $10,000.Annual addition to profit = 40% x $25,000 = $10,000.

Payback period is $30,000 ÷ $10,000 = 3 years. Payback period is $30,000 ÷ $10,000 = 3 years.

What are the advantages/disadvantages of this method?What are the advantages/disadvantages of this method?AdvantagesAdvantages easy to use, can be used as a rough easy to use, can be used as a rough estimate of the riskiness of a project, especially in rapid estimate of the riskiness of a project, especially in rapid technological changes & changes in product design, where technological changes & changes in product design, where cash flows are uncertaincash flows are uncertain

DisadvantagesDisadvantages does not measure profitability, ignores does not measure profitability, ignores time value of moneytime value of money


Exercise 11-45 (Page 506)Exercise 11-45 (Page 506)Compute rate of return on the initial investment, based Compute rate of return on the initial investment, based on the accounting rate-of-return model.on the accounting rate-of-return model.

ARRARR = ($10,000 - $5,000) ÷ $30,000 = 16.7%= ($10,000 - $5,000) ÷ $30,000 = 16.7%depreciationdepreciation

What are the advantages/disadvantages of this method?What are the advantages/disadvantages of this method?

AdvantagesAdvantages measures profitability, easy to usemeasures profitability, easy to useDisadvantagesDisadvantages ignores time value of moneyignores time value of money


Exercise 11-45 (Page 506)Exercise 11-45 (Page 506)Compute the net present value. Compute the net present value.

YearYear Discount factorDiscount factor(12%)(12%)

Cash inflow/Cash inflow/(outflow)(outflow)

PVPV

00 1.00001.0000 (30,000)(30,000) (30,000)(30,000)11 0.89290.8929 10,00010,000 8,9298,92922 0.79720.7972 10,00010,000 7,9727,97233 0.71180.7118 10,00010,000 7,1187,11844 0.63550.6355 10,00010,000 6,3556,35555 0.56740.5674 10,00010,000 5,6745,67466 0.50660.5066 10,00010,000 5,0665,066

NPVNPV 11,11411,114


Exercise 11-45 (Page 506)Exercise 11-45 (Page 506)Should Jenna accept the proposal? Why or why not?Should Jenna accept the proposal? Why or why not?

Yes, accept the proposal because of positive NPV.Yes, accept the proposal because of positive NPV.

What are the advantages/disadvantages of this method?What are the advantages/disadvantages of this method?

AdvantagesAdvantages considers time value of money, considers considers time value of money, considers relevant cash flowsrelevant cash flows

DisadvantagesDisadvantages discount factor is subjective discount factor is subjective

Week10-CapitalBudgeting

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