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
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