Cost Accounting
Foundations and Evolutions
Kinney and Raiborn
Seventh Edition
Chapter 15
Capital Budgeting
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Learning Objectives (1 of 3)
• Explain why most capital budgeting methods
focus on cash flows
• Compute and describe what is measured by the
payback period
• Explain how the net present value and
profitability index of a project are measured
• Compute the internal rate of return and explain
what it measures
Learning Objectives (2 of 3)
• Describe how taxation and depreciation
methods affect cash flows
• Explain the assumptions and limitations of the
various capital project evaluation methods
• Explain how managers rank investment projects
• Clarify how risk is considered in capital
budgeting analyses
Learning Objectives (3 of 3)
• Explain a postinvestment audit of a capital
• (Appendix 1) Calculate present values
• (Appendix 2) List the advantages and
disadvantages of the accounting rate of return
Capital Budgeting
• Capital budgeting is the process for
evaluating and ranking alternative longrange projects for the purpose of allocating
limited resources
– Plan and prepare the capital budget
– Review past investments to assess success of
past decisions and enhance the decision process
in the future
Capital Budgeting
• Compare and evaluate alternative projects
– financial and nonfinancial criteria
– short and long-term benefits
– usually multiple criteria
-- consider all significant stakeholders
Capital Budgeting
Financial Analysis
Payback period
Net present value
Profitability index
Internal rate of return
Accounting rate of return
Investment vs. Financing
Investment Decision
• Which assets to
• Made by divisional
managers and top
Financing Decision
• How to raise capital
(debt/equity) to fund
an investment
• Made by Treasurer
and top management
• Interest is a financing
First justify the acquisition
Then justify how to finance it
Payback Period
• Time required for project’s cash inflows to
equal the original investment
– longer it takes to recover the original investment,
the greater the risk
– the faster capital is returned, the more rapidly it
can be invested in other projects
– management sets a maximum payback period
Discounting Future Cash Flows
• Reduce the future value of cash flows by
the portion that represents interest
• Variables are
– length of time until the cash flow is received or
– required rate of return on capital - discount rate
• Present value is stated in a common base of
current dollars
Net Present Value
• Evaluates if project rate of return is greater
than, equal to, or less than the desired rate
of return
• Present value equals the cash flows
discounted using the desired rate of return
• Net present value equals present value of
cash inflows minus present value of cash
• Does not calculate the rate of return
Profitability Index
• Compares present value of net cash flows to
net investment
• Measures efficiency of the use of capital
• Should be greater than or equal to 1
• Does not calculate the rate of return
Profitability =
PV of Net Cash Flows
Net Investment
Internal Rate of Return
• Discount rate where
PV of cash inflows = PV of cash outflows
NPV = 0
• Hurdle rate is the lowest acceptable return on
investment (at least equal to the cost of capital)
– If Internal Rate of Return = Hurdle Rate; Accept
– If Internal Rate of Return > Hurdle Rate; Accept
– If Internal Rate of Return < Hurdle Rate; Reject
After-Tax Cash Flows
• Depreciation is not a cash flow item
• Depreciation on capital assets affects cash
flows by reducing the tax obligation
• Depreciation is a tax shield that provides a
tax benefit
depreciation tax benefit =
depreciation expense * tax rate
Comparing Techniques
Uses time value money
Provides specific rate of
Uses cash flows
Considers returns
during life of project
Uses discount rate
*often used as a hurdle rate
The Investment Decision
• Is the activity worthy of an investment?
• Which assets can be used for the activity?
• Of the available assets for each activity,
which is the best investment?
• Of the “best investments” for all worthwhile
activities, in which ones should the
company invest?
Consider Quantitative and Qualitative Factors
Capital Budgeting Terms
Screening decision
Preference decision
Mutually exclusive projects
Independent projects
Mutually inclusive projects
Compensating for Risk
• Judgmental method
– Use logic and reasoning to decide if acceptable
rate of return will be achieved
• Risk-adjusted discount rate method
– Higher discount/hurdle rate for riskier projects
and/or cash flows
– Shorter payback period for riskier projects
– Higher IRR for riskier projects
• Sensitivity analysis
Postinvestment Audit
Complete after project has stabilized
Compare actual results to expected results
Use same analysis techniques
Identify areas where results differ from
• Evaluate capital budgeting process,
particularly original projections, problems
with implementation, sponsor credibility
• Why do most capital budgeting methods
focus on cash flows?
• What is the relationship between the net
present value and the profitability index?
• What are the assumptions and limitations of
the various capital project evaluation
Potential Ethical Issues
• Ignoring detrimental environmental
impact of project decisions
• Changing assumptions or estimates to
meet criteria for approval
• Using a discount rate that is
inappropriately low
Potential Ethical Issues
• Not conducting a post-investment audit
to hold decision makers accountable
• Choosing projects based on accounting
earnings only rather than including
discounted cash flow methods