Course Name: Advanced Management Accounting
MA2
Module: 4
Module Title: Capital Budgeting
Lectures and handouts by:
Paul Jeyakumar, M.Sc., CGA
1
Capital Budgeting -Topics
Urgency method
Qualitative method
Payback method
Accounting rate of return method
Net present value method
Internal rate of return method
Performance evaluation
Assignment review
2
Short-run decisions Vs. Capital
budgeting decisions –
Major difference
Capital budgeting decisions have
significant financial effects beyond the
current year.
The long-term nature of the investments
adds new factors to our considerations.
3
1
Short-run decisions Vs. Capital
budgeting decisions –
Similarities
In both situations, we should have a good
understanding of the:
decision criteria
available alternatives
relevant qualitative and quantitative factors
decision model
4
3 phases in capital budgeting
1. Identifying potential investments
2. Selecting the investments
3. Follow-up monitoring or post-auditing the
investments
5
Long-term orientation – Factors to
consider
The first factor:
Time value of money is a factor for
consideration.
6
2
Long-term orientation – Factors to
consider (contd.)
The first factor:
Time value of money is a factor for
consideration.
The second factor:
All capital outlays involve risk and
uncertainty.
7
Course theme 1
In the identification and selection phases,
we emphasize the planning use of
accounting information.
In the post-auditing phase, we emphasize
the control use of accounting information.
8
Course theme 2
NPV and IRR models use cash basis of
accounting.
ARR model uses accrual basis of
accounting.
9
3
Course themes 3 & 4
In capital budgeting we have a long-term
orientation.
The advanced approaches to capital
budgeting consider true economic costs.
10
Models
Discounted cash flow model (NPV & IRR)
Payback model
Accounting rate of return model
11
Survey of 133 companies
Discounted cash flow methods were used in
more than 75% of the firms.
IRR was used more frequently than NPV.
ARR had an usage rate of about 20%.
More than 50% used the payback method
either alone or along with other techniques.
12
4
Qualitative factors
In the evaluation criteria, we should also
include qualitative factors.
13
Equivalent cash flow approach
The time value of money is ignored.
4 methods:
Urgency method
Qualitative method
Accounting rate of return method
Payback method
14
Multiple choice question
All the following methods can be used to
make capital budgeting decisions. Which
method does not belong to the category of
equivalent cash flow methods?
1) The accounting rate of return method
2) The internal rate of return method
3) The payback method
4) The qualitative method
Answer 2
15
5
Urgency method
Uses the emergency persuasion technique
Projects are selected because of the
persuasion skills of certain individuals
16
Qualitative method
The qualitative method is used when
organizations make decisions for reasons
other than dollar returns.
17
Payback method
Payback period:
It is the time taken to recoup, in the form of
cash inflows from operations, the initial
dollars of outlay.
Selection criterion:
If the payback period is within the required
time limit, accept the investment.
18
6
Payback – Weaknesses &
Strengths
Weaknesses:
Does not measure profitability
A project with a shorter payback time
may not be the preferable one
Ignores the time value of money
Strengths:
Provides a rough estimate of risk
Involves simpler computations
19
Payback – Even cash flows No income tax implications
Payback period = (net investment)/(annual
net cash flow)
Data:
Net investment is $20,000 and the annual net
cash inflow generated from the investment
is $4,800
Payback period =$20,000/$4,800= 4.167 years
20
Payback – Even cash flows - Income
tax implications - Handout question 1
Cash flow = change in earnings after tax +
change in non-cash expenses
Amortization = $18,000/4= $4,500/year
Earnings before tax & amortn $5,000
Less: Amortization exp
(4,500)
Earnings before tax
500
Less: Tax (40%)
( 200)
Earnings after tax
300
21
7
Payback – Even cash flows
Income tax implications (contd.)
Cash flow = change in earnings after tax + change in
non-cash expenses
Earnings before tax & amortization
Less: Amortization exp
Earnings before tax
Less: Tax (40%)
Earnings after tax
Earnings after tax
Plus: Non-cash amortization
Cash flow
$5,000
(4,500)
500
( 200)
300
$ 300
4,500
$ 4,800
22
Payback – Even cash flows
Income tax implications (contd.)
Cash flow = change in earnings after tax + change in
non-cash expenses
Earnings before tax & amortization
$5,000
Less: Amortization exp
(4,500)
Earnings before tax
500
Less: Tax (40%)
( 200)
Earnings after tax
300
Plus: Non-cash amortization
4,500
Cash flow
$4,800
Payback period =$18,000/$4,800 = 3.75 years
23
Payback – Uneven cash flows No income tax implications
Data: Investment: $90,000 Useful life: 4 years
Cash flows for the 4 years:
1: $50,000 2: $30,000 3: $15,000 4: $10,000
Year Cash flow Expenditure – Cum cash flow
0
$(90,000)
1
$50,000
(40,000)
2
30,000
(10,000)
3
15,000
5,000
4
10,000
15,000
Payback period = 2 + 10,000/15,000 =2.67 years
24
8
Payback – Uneven cash flows
No tax implications- Handout question 2
Year Cash flow Expenditure – Cum cash flow
0
$(330,000)
1
$100,000
(230,000)
2
150,000
(80,000)
3
210,000
130,000
Payback = 2 + 80,000/210,000 = 2.38 years
25
Payback – Uneven cash flows
Tax implications- Question 3a
Yr 1
Revenues
300.00
Op exp
(100.00)
Amortizn
(165.00)
Inc bef tax
35.00
Tax (35%)
(12.25)
Net inc
22.75
Add: Amtz
165.00
WC increase (50.00)
WC release
Salvage
__
Cash flow
137.75
Yr 2
Yr 3
26
Payback – Uneven cash flows
Tax implications- Question 3a
Yr 1
Revenues
300.00
Op exp
(100.00)
Amortizn
(165.00)
Inc bef tax
35.00
Tax (35%)
(12.25)
Net inc
22.75
Add: Amtz
165.00
WC increase (50.00)
WC release
Salvage
__
Cash flow
137.75
Yr 2
400.00
(100.00)
(165.00)
135.00
(47.25)
87.75
165.00
Yr 3
252.75
27
9
Payback – Uneven cash flows
Tax implications- Question 3a
Yr 1
Revenues
300.00
Op exp
(100.00)
Amortizn
(165.00)
Inc bef tax
35.00
Tax (35%)
(12.25)
Net inc
22.75
Add: Amtz
165.00
WC increase (50.00)
WC release
Salvage
__
Cash flow
137.75
Yr 2
400.00
(100.00)
(165.00)
135.00
(47.25)
87.75
165.00
Yr 3
500.00
(100.00)
(165.00)
235.00
(82.25)
152.75
165.00
252.75
317.75
28
Payback – Uneven cash flows
Tax implications- Question 3a
Yr 1
Revenues
300.00
Op exp
(100.00)
Amortizn
(165.00)
Inc bef tax
35.00
Tax (35%)
(12.25)
Net inc
22.75
Add: Amtz
165.00
WC increase (50.00)
WC release
Salvage
__
Cash flow
137.75
Yr 2
400.00
(100.00)
(165.00)
135.00
(47.25)
87.75
165.00
252.75
Yr 3
Yr 4
500.00
600.00
(100.00) (100.00)
(165.00) (165.00)
235.00
335.00
(82.25) (117.25)
152.75
217.75
165.00
165.00
317.75
50.00
140.00
572.75
29
Payback – Uneven cash flows
Tax implications- Question 3b
Capital cost allowance computation
Year
0
1
2
CCA
$800 x 0.30 x 0.5 = $120
$680 x 0.3 = $204
UCC
$800
$680
$476
30
10
Payback – Uneven cash flows
Tax implications- Question 3b
Revenues
Op exp
CCA
Taxable income
Tax (35%)
Earnings after-tax
Add: CCA
WC increase
Cash flow
Year 1
$ 300.00
(100.00)
(120.00)
80.00
(28.00)
52.00
120.00
(50.00)
Year 2
$400.00
(100.00)
(204.00)
96.00
(33.60)
62.40
204.00
$122.00
$266.40
31
Payback – Uneven cash flows
Tax implications- Question 3b
Year 1 Year 2
After-tax operating cash flow:
($300 - $100) x (1 – 0.35)
$130.00
($400 - $100) x (1 – 0.35)
$195.00
Add: CCA tax shield
$120 x 0.35
42.00
$204 x 0.35
71.40
Increase in working capital
(50.00)
Cash flow
$122.00 $266.40
32
Question 4- Initial Investment
Cost of new equipment
Installation costs
Sale of old equipment
Total initial investment
$9,600,000
147,000
( 23,000)
$9,724,000
33
11
Question 4 – Cash flows – Years 1 - 7
Income before income taxes and amortization
[52,500 units × ($349.95 – $320.00)] +
[50,000 units × ($325.00 – $320.00)]
$ 1,822,375
Amortization expense
($9,600,000 + $147,000 – $37,850) / 10
(970,915)
Income before taxes
851,460
Less: Income taxes (40%)
(340,584)
Net income
510,876
Plus: Non cash expenses
970,915
Annual net cash flow, years 1 to 7
$ 1,481,791
34
Question 4 – Payback in 7 years
Initial investment
Cash flows Years 1 to 7:
$1,481,791 x 7
$9,724,000
$10,372,537
Accept the proposal.
35
Accounting rate of return
If ARR is greater than the minimum target
rate, the investment proposal is accepted.
Method 1:
ARR = (Average increase in annual net
income) / (Net original investment outlay)
36
12
Accounting rate of return (contd.)
Method 2:
ARR = (Average increase in annual net
income) / (Average investment)
where
Average investment = (original investment +
salvage) / 2
37
ARR – Strength/weakness
Strength:
It is a profitability measure.
Weakness:
It ignores the time value of money.
38
ARR – Handout question 5
Initial investment
Useful life
Incremental revenues/year
Incremental before-tax
expenses per year
Minimum target ARR
Average investment method
$16,000
3 years
$20,000
$12,000
15%
39
13
ARR – Handout question 5 (contd.)
Yr
1 ($20,000–$16,000) × (1–0.5) =
2 ($20,000–$16,000) × (1–0.5) =
3 ($20,000–$16,000) × (1–0.5) =
Total
Net profit
$2,000
$2,000
$2,000
$6,000
Average increase in Accounting income =
$6,000/3 = $2,000
Average investment = $(30,000+0)/2 = $15,000
ARR = $2,000/ $15,000 = 13.33%
40
Net Present Value (NPV)
NPV calculations are based on cash flows.
The present value is computed using the
cost of capital, which is the minimum
acceptable rate of return.
41
Present value – Simple example
What amount should be invested now to
accumulate $5,000 in 3 years if the expected
interest rate is 8% compounded semiannually?
PV = $5,000 × (1.04)–6
PV = $3,952
OR, PV = $5,000 × 0.7903 = $3,952
42
14
NPV – Important points
Cost of capital is used as the assumed
interest rate.
Cost of capital is the minimum acceptable
rate of return.
For CCA, the half-year rule is applied.
43
NPV – Important points (contd.)
If you sell an asset, the basis on which you
calculate the tax savings goes down.
If there is only one item in the pool, the new
basis = 0.
If there is more than one item in the pool, the
new basis = old basis – salvage.
44
NPV – Important points (contd.)
Present value of tax shield
= {[(cdt)/(d+i)] x [(1+0.5i)/(1+i)]} – {[(sdt)/(d+i)
x [1/(1+i)^n]}
where
c = cost of the asset (will be discussed)
d = CCA rate t = tax rate i = cost of capital
s = salvage value
n = number of periods
45
15
NPV – Initial investment – Handout
question 6 – part a
The market price of the old asset reduces
the investment cost to $92,000 ($100,000 $8,000).
Installation costs qualify as capital
expenditures. So the investment cost is
$92,000 + $12,000 = $104,000.
The value for ‘c’ is $104,000.
46
NPV – Initial investment – Handout
question 6 – part b
The training costs are not capitalized.
Training expenses are tax deductible.
Recorded as $7,000 x (1 – 0.4) = $4,200.
47
NPV – Initial investment – Handout
question 6 – part b
• Cash balance has no tax implication
• Shown as an outflow of $10,000 at the time
of investment
At the end of 5 years, $10,000 would be
considered as a cash inflow. So PV
computation is necessary.
48
16
NPV – Initial investment – Handout
question 6 – part c
The $5,000 salvage value is considered as
cash inflow at the end of 5 years.
We compute the present value of this cash
flow using cost of capital.
We also compute the present value of the
tax shield lost.
49
Comparison of alternatives
2 NPV approaches
Total project approach:
Compares alternatives by computing their
NPVs. The alternative with the largest NPV
of cash flows is preferred.
The differential approach:
Compares by computing the differences in
cash flows and then converting these
differences to their present values.
50
NPV – Handout question 7 – part a
After-tax cash inflows = $180,000(1 – 0.4) =
$108,000
We use 15 years and a discount rate of 12%.
The factor for this ordinary annuity is 6.8109
Present value of cash inflows:
= $108,000 x 6.8109
= $735,577
51
17
NPV – Handout question 7 – part b
The training costs are not capital
expenditures. So they are not included in
the value of ‘c’.
There is no salvage value.
Present value of CCA tax saving:
[(800,000x0.40x0.10)/(0.10+0.12)] x
{[(1+0.5(0.12)]/(1+0.12)}
= $137,662
52
NPV – Handout question 8
Initial investment
$(9,724,000)
53
NPV – Handout question 8
Initial investment
PV of cash inflows: Years 1 – 7:
PV of cash inflows: Years 8 – 10
$(9,724,000)
4,549,085
564,251
54
18
NPV – Handout question 8
Initial investment
$(9,724,000)
PV of cash inflows: Years 1 – 7:
4,549,085
PV of cash inflows: Years 8 – 10
564,251
PV of tax shield:
2,077,674
Present value of lost tax shield:
(2,139)
PV of salv value: $37,850 × (1.15)-10
9,357
Net present value of the project $(2,525,772)
55
NPV – Handout question 9
Investment
Cost of the new sewing machine $2,500,000
Less: Market value of old machine (260,000)
Investment as ‘c’ value
$2,240,000
Training costs $85,000 × (1 – 0.4)
51,000
Net investment
$2,291,000
Now review the handout solution for the rest.
56
Internal Rate of Return - IRR
IRR is the interest rate that makes the net
present value of the investment equals to
zero.
If the IRR is equal to or greater than the
minimum desired rate, accept the project.
We may have to use trial and error method
to determine the IRR. Review course notes
for an illustration.
57
19
IRR – Multiple choice question
What is internal rate of return?
1) The accounting rate of return
2) The cost of capital
3) An equivalent cash flow method to
make a capital budgeting decision
4) The discount rate at which the net present
value of the cash flows equals zero
Answer: 4
58
IRR – Handout question 10
NPV (if cost of capital rate is 15%) =
–$5,000 + ($3,000 × 1.15–1 ) + ($2,000 × 1.15–2 ) +
($2,000 × 1.15–3 ) = $436
NPV (if cost of capital rate is 20%) =
–$5,000 + ($3,000 × 1.20–1 ) + ($2,000 × 1.20–2 ) +
($2,000 × 1.20–3 ) = $46
The IRR is approximately 20%.
59
IRR – Handout question 11
Net cash flows = $800 + (500,000 donuts ×
$0.05/donut) = $25,800
If i = 8%, NPV = –$90,000 + ($25,800 × 3.3121)
+ ($6,000 × 0.7350) = –$138
The IRR should be below 8%. The only
possible answer is 7.9%.
60
20
IRR & NPV Assumptions
We assume certainty. We assume that the
predicted cash flows are certain to occur at
the times specified.
We also assume perfect markets. We
assume that we can borrow or lend money
at the same interest rate. This is our
minimum desired rate of return for the NPV
method, and the internal rate of return for
the IRR method.
61
Performance Evaluation Conflict
Discounted cash flow models use cash
flows over a long-term.
Managers are often evaluated on the basis
of accrual income usually over a short
period.
62
Performance Evaluation Conflict
(contd.)
Use the same model for the decision and for
measuring performance.
63
21
Performance Evaluation Conflict
(contd.)
Use the same model for the decision and for
measuring performance.
Perform a post audit.
64
Performance Evaluation Conflict
(contd.)
Use the same model for the decision and for
measuring performance.
Perform a post audit.
Use multiple criteria (such as the balanced
scorecard) to evaluate the performance of
managers.
65
Ethics
Consider professional ethics, business
ethics in general, and personal ethics.
Consider ethics in the areas of
confidentiality, integrity, competence and
objectivity.
66
22
Assignment Question 1 – Part A
(i) NPV = $9,704
(ii) Payback period = 3.13 years
67
Assignment Question 1 – Part A
(iii)
At 19%, total present value = $90,600
At 20%, total present value = $88,536
Discount rate
At 19%
True Value
At 20%
Difference
Total Present Value
$90,600
$90,600
$90,000
$88,536
__
$ 2,064
$ 600
IRR = 19% + (600/2,064) x 1% = 19.29%
68
Assignment Question 1 – Part B
(i) Net present value = $11,944
(ii)
Net present value = $239
(iii) Payback period = 3.24 years
69
23
Assignment Question 1 – Part B
(iv)
Discuss the effect of the payback period
requirement on the long-term perspective
of the business.
70
Assignment Question 2
Multiple choice question!
No check figures are provided.
71
Assignment Question 3 – Part a
Cost to buy:
$40 per unit x 40,000 units = $1,600,000
Cost to make:
$17.60 x 40,000 = $704,000
Annual savings = $896,000
Net present value = $352,316
72
24
Assignment Question 3 – Part b
List qualitative factors.
73
Assignment Question 4
Investment = $220,000
Before-tax operating profit/per year= $40,000
Tax rate = 18%
CCA = 12%
Useful life = 10 years
Cost of capital = 14%
Net present value = $(27,048)
74
Assignment Question 5 – Part a
Investment = $336,000
Trade-in = $10,000
Increase in working capital at the time of
investment = $50,000 x 0.5 = $25,000
Cost savings/year = $100,000
Release of working capital: Year 5 = $25,000
Salvage on equipment = $50,000
NPV = -$485
75
25
Assignment Question 5 – Part b
Provide comments and suggestions, and
describe the concerns of the senior
management.
76
26