Capital Budgeting
and Cost Analysis
Chapter 21
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
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Learning Objective 1
Recognize the multiyear focus
of capital budgeting.
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Two Dimensions of Cost Analysis
1. A project dimension
2. An accounting-period dimension
The accounting system that corresponds to the
project dimension is termed life-cycle costing.
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Two Dimensions of Cost Analysis
Project D
Project C
Project B
Project A
2002
2003
2004
2005
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2006
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Learning Objective 2
Understand the six stages of
capital budgeting for a project.
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Capital Budgeting
Capital budgeting is the making of long-run
planning decisions for investments in
projects and programs.
It is a decision-making and control tool that
focuses primarily on projects or programs
that span multiple years.
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Capital Budgeting
Capital budgeting is a six-stage process:
1. Identification stage
2. Search stage
3. Information-acquisition stage
4. Selection stage
5. Financing stage
6. Implementation and control stage
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Capital Budgeting Example
One of the goals of Assisted Living is to improve
the diagnostic capabilities of its facility.
Management identifies a need to consider the
purchase of new equipment.
The search stage yields several alternative
models, but management focuses on
one particular machine.
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Capital Budgeting Example
The administration acquires information.
Initial investment is $245,000.
Investment in working capital is $5,000.
Useful life is three years.
Estimated residual value is zero.
Net cash savings is $125,000,
$130,000, and $110,000 over its life.
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Capital Budgeting Example
Working capital is expected to be recovered at
the end of year 3 with an expected return of 10%.
Operating cash flows are assumed to occur
at the end of the year.
In the selection stage, management must decide
whether to purchase the new machine.
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Learning Objective 3
Use and evaluate the two main
discounted cash-flow (DCF)
methods: the net present value
(NPV) method and the internal
rate-of-return (IRR) method.
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Time Value of Money
Compound Growth,
5 periods at 6%
Year 5: $1.338
Year 4: $1.262
Year 3: $1.91
Year 2: $1.124
Year 1: $1.06
Year 0: $1.00
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Discounted Cash Flow
There are two main DCF methods:
Net present value (NPV) method
Internal rate-of-return (IRR) method
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Net Present Value Example
Only projects with a zero or positive
net present value are acceptable.
What is the the net present value of
the diagnostic machine?
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Net Present Value Example
Year in the Life of the Project
0
1
2
3
$(250,000)
$125,000 $130,000 $115,000
Net initial
investment
Annual cash
inflows
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Net Present Value Example
Net Cash
Year
10% Col.
Inflows
1
0.909
$125,000
2
0.826
130,000
3
0.751
115,000
Total PV of net cash inflows
Net initial investment
Net present value of project
NPV of Net
Cash Inflows
$113,625
107,380
86,365
$307,370
250,000
$ 57,370
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Net Present Value Example
The company is considering another investment.
Initial investment is $245,000.
Investment in working capital is $5,000.
Working capital will be recovered.
Useful life is three years.
Estimated residual value is $4,000.
Net cash savings is $80,000 per year.
Expected return is 10%.
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Net Present Value Example
Net Cash
Years 10% Col. Inflows
1-3
2.487
$80,000
3
0.751
9,000
Total PV of net cash inflows
Net initial investment
Net present value of project
NPV of Net
Cash Inflows
$198,960
6,759
$205,719
250,000
($ 44,281)
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Internal Rate of Return
Investment
= Expected annual net cash inflow
× PV annuity factor
Investment
÷ Expected annual net cash inflow
= PV annuity factor
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