Capital Budgeting
and Cost Analysis
Chapter 21
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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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Internal Rate of Return Example
Initial investment is $303,280.
Useful life is five years.
Net cash inflows is $80,000 per year.
What is the IRR of this project?
$303,280 ÷ $80,000 = 3.791 (PV annuity factor)
10% (from the table, five-period line)
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Comparison of NPV and IRR
The NPV method has the advantage that the end
result of the computations is expressed in
dollars and not in a percentage.
Individual projects can be added.
It can be used in situations where the required
rate of return varies over the life of the project.
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Comparison of NPV and IRR
The IRR of individual projects cannot be
added or averaged to derive the IRR
of a combination of projects.
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Learning Objective 4
Use and evaluate the
payback method.
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Payback Method
Payback measures the time it will take to
recoup, in the form of expected future cash
flows, the initial investment in a project.
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Payback Method Example
Assisted Living is considering buying Machine 1.
Initial investment is $210,000.
Useful life is eleven years.
Estimated residual value is zero.
Net cash inflows is $35,000 per year.
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Payback Method Example
How long would it take to recover the investment?
$210,000 ÷ $35,000 = 6 years
Six years is the payback period.
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Payback Method Example
Suppose that as an alternative to the $210,000
piece of equipment, there is another one
(Machine 2) that also costs $210,000 but will
save $42,000 per year during its five-year life.
What is the payback period?
$210,000 ÷ $42,000 = 5 years
Which piece of equipment is preferable?
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Payback Method Example
Assisted Living is considering buying Machine 3.
Initial investment is $250,000.
Useful life is eleven years.
Cash savings are $160,000, $180,000,
and $110,000 over its life.
What is the payback period?
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Payback Method Example
Year 1 brings in $160,000.
Recovery of the amount
invested occurs in Year 2.
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Payback Method Example
Payback = 1 year
+ $ 90,000 needed to complete recovery
÷ 180,000 net cash inflow in Year 2
1 year + 0.5 year
=
= 1.5 years or 1 year and 6 months
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Learning Objective 5
Use and evaluate the accrual
accounting rate-of-return
(AARR) method.
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Accrual Accounting
Rate-of-Return Method
The accrual accounting rate-of-return (AARR)
method divides an accounting measure of
income by an accounting measure of investment.
Increase in expected
Initial
AARR =
average annual
÷ required
operating income
investment
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Accrual Accounting
Rate-of-Return Method Example
Initial investment is $303,280.
Useful life is five years.
Net cash inflows is $80,000 per year.
IRR is 10%.
What is the average operating income?
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Accrual Accounting
Rate-of-Return Method Example
Straight-line depreciation is $60,656 per year.
Average operating income is
$80,000 – $60,656 = $19,344.
What is the AARR?
AARR
= ($80,000 – $60,656) ÷ $303,280
= .638, or 6.4%
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Learning Objective 6
Identify and reduce conflicts
from using DCF for capital
budgeting decisions and
accrual accounting for
performance evaluation.
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Performance Evaluation
A manager who uses DCF methods to make capital
budgeting decisions can face goal congruence
problems if AARR is used for
performance evaluation.
Suppose top management uses the AARR to
judge performance if the minimum desired
rate of return is 10%.
A machine with an AARR of 6.4% will be rejected.
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Performance Evaluation
The conflict between using AARR and
DCF methods to evaluate performance
can be reduced by evaluating managers
on a project-by-project basis.
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End of Chapter 21
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