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Cost Accounting Foundations and Evolutions Kinney and Raiborn Seventh Edition Chapter 15 Capital Budgeting COPYRIGHT © 2009 South-Western, a part of Cengage Learning. South-Western is a trademark used herein under license . 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 project • (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 Cash Flow Focus Investment vs. Financing Investment Decision • Which assets to acquire • Made by divisional managers and top management Financing Decision • How to raise capital (debt/equity) to fund an investment • Made by Treasurer and top management • Interest is a financing decision 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 paid – 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 outflows • 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 = Index 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 • • • • • Payback Uses time value money N Provides specific rate of return N Uses cash flows Y Considers returns during life of project N Uses discount rate N *often used as a hurdle rate NPV PI Y Y IRR Y N Y N Y Y Y Y Y Y Y Y N* 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 expectation • Evaluate capital budgeting process, particularly original projections, problems with implementation, sponsor credibility Questions • 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 methods? 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