Managerial Accounting
Tenth Canadian Edition
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What You Really Need To Know
Chapter 13: Capital Budgeting Decisions
A. Capital budgeting is the process of planning significant investments in projects that
have long-term implications such as the purchase of new equipment or the introduction of
a new product.
1. Capital budgeting usually involves investment; i.e., committing funds now so
as to obtain cash inflows in the future.
2. Capital budgeting decisions fall into two broad categories:
a. Screening decisions: Potential projects are categorized as acceptable or
unacceptable.
b. Preference decisions: After screening out all of the unacceptable
projects, more projects may remain than can be funded. Consequently,
projects must be ranked in order of preference.
3. The time value of money is a central consideration in capital budgeting. A
dollar in the future is worth less than a dollar today for the simple reason that
a dollar today can be invested to yield more than a dollar in the future.
a. Discounted cash flow methods give full recognition to the time value
of money.
b. Two of the methods presented in the chapter discount cash flows—the
net present value method and the internal rate of return method.
B. The net present value method is illustrated in Exhibit 13-1, Exhibit 13-2, Exhibit 13-3,
and Exhibit 13-4. The basic steps in this method are:
1. Determine the required investment.
2. Determine the future cash inflows and outflows that result from the
investment.
3. Use the present value formulas (or tables) in Appendix 13A to find the
appropriate present value factors.
a. The values (or factors) in the present value tables depend on the
discount rate and the number of periods.
b. The discount rate in present value analysis is the company’s required
rate of return, which is often the company’s cost of capital. The cost of
capital is the average rate of return the company must pay its long-
term creditors and shareholders for the use of their funds. The details
of the cost of capital are covered in finance courses.
4. Multiply each cash flow by the appropriate present value factor and then sum
the results. The end result (which is net of the initial investment) is called the
net present value of the project.
5. In a screening decision, the investment is acceptable if the net present value is
positive. If the net present value is negative, the investment should be
rejected.
C. Discounted cash flow analysis is based on cash flows—not accounting net operating
income.
1. Typical cash flows associated with an investment are:
a. Outflows include initial investment, installation costs, increased
working capital needs, repairs and maintenance, and incremental
operating costs.
b. Inflows include incremental revenues, reductions in costs, salvage
value, and release of working capital at the end of the project.
2. Depreciation is not a cash flow and therefore is not included in net present
value calculations. (However, depreciation can affect taxes, which is a cash
flow. This aspect of depreciation is covered in the section “Appendix 13B:
Income Taxes in Capital Budgeting Decisions”.)
3. Projects frequently require an infusion of cash (i.e., working capital) to
finance inventories, receivables, and other working capital items. Typically, at
the end of the project this working capital can be recovered. Thus, working
capital is counted as a cash outflow at the beginning of a project and as a cash
inflow at the end of the project.
4. We usually assume that all cash flows, other than the initial investment, occur
at the end of a period.
D. The total-cost or the incremental-cost approach can be used in conjunction with the
net present value method to compare projects.
1. The total-cost approach is the most flexible and the most widely used method.
Exhibit 13-5 illustrates the total cost approach. Note in Exhibit 13-5 that all
cash inflows and all cash outflows for each alternative are included in the
solution.
2. The incremental-cost approach is a simpler and more direct route to a decision
since it ignores all cash flows that are the same under both alternatives. The
incremental-cost approach focuses on differential costs. Exhibit 13-6
illustrates this approach.
3. If done correctly, both the total-cost and incremental-cost approaches will lead
to the same decision.
E. Sometimes no revenue or cash inflow is directly involved in a decision. In this
situation, the alternative with the least cost should be selected. The least cost alternative
can be determined using either the total-cost approach or the incremental approach.
Exhibits 13-7 and 13-8 illustrate least-cost decisions.
F. It is often difficult to quantify all the costs and benefits involved in a decision. An
investment in automation provides a good example.
1. The reduction in direct labour cost from automation may be easy to quantify.
Intangible benefits, such as greater throughput or greater flexibility in
operations, are usually very difficult to quantify. It would be a mistake to
ignore these intangible benefits simply because they are difficult to quantify.
2. The difficulty can often be resolved by computing how large the intangible
benefits would have to be to make the investment attractive. The steps in this
approach are:
a. Compute the net present value of the tangible costs and benefits. If the
result is positive, the investment is acceptable because the intangible
benefits simply make it even more attractive.
b. If the net present value of the tangible costs and benefits is negative,
compute the additional net annual cash inflows that would make the
net present value positive.
c. If the intangible benefits are likely to be at least as large as the
required additional net annual cash inflows computed in (b), accept the
project.
G. The internal rate of return method is another discounted cash flow method used in
capital budgeting decisions.
1. The internal rate of return is the rate of return promised by an investment
project over its useful life; it is the discount rate for which the net present
value of the project is zero.
2. When the cash flows are the same every year, the following formula can be
used to find the internal rate of return:
Factor of the
internal rate of return
=
Investment required
Net annual cash inflows
3. For example, assume an investment of $3,791 is made in a project that will
last five years and has no salvage value. Also assume that the annual cash
inflow from the project will be $1,000.
Factor of the
internal rate of return
=
$3,791
$1,000
= 3.791
The same cash inflow is received at the end of every year beginning with the
first year, so use a present value table which contains the present value factors
for annuities, or alternatively, use the IRR formula in Microsoft Excel.
Because this is a project with a five-year life, use the 5-year row in the table.
Scanning along the 5-year row, it can be seen that this factor represents a 10%
rate of return. Therefore, the internal rate of return is 10%.
4. If the cash inflows are not the same every year, the internal rate of return is
found using trial and error or a software application. The internal rate of return
is whatever discount rate makes the net present value of the project equal zero.
5. In a screening decision, the internal rate of return is compared to the required
rate of return. If the internal rate of return is less than the required rate of
return, the project is rejected. If it is greater than or equal to the required rate
of return, the project is accepted.
H. Some projects have cash flows that are difficult to estimate. Intangible benefits that
may result from upgrading production equipment such as improved quality or reliability
can be difficult to quantify with any degree of certainty. However, management can cope
with this uncertainty by estimating the dollar amount of intangible benefits that would be
required to make a project attractive. If management believes the value of the intangible
benefits will meet or exceed the required amount, the project should proceed.
I. Preference decisions come after screening decisions and involve ranking investment
projects. Such a ranking is necessary whenever there are limited funds available for
investment.
1. Preference decisions are sometimes called ranking decisions or rationing
decisions because they ration limited investment funds among competing
investment opportunities.
2. When using the internal rate of return to rank competing investment projects,
the preference rule is: The higher the internal rate of return, the more
desirable the project.
3. If the net present value method is used to rank competing investment projects,
the net present value of one project should not be compared directly to the net
present value of another project, unless the investments in the projects are of
equal size.
a. To make a valid comparison across projects that require different
investment amounts, a profitability index is computed. The formula for
the profitability index is:
Profitability index =
Present value of cash inflows
Investment required
The profitability index is an application of the idea of contribution
margin per unit of a constrained resource from Chapter 12. In this
case, the scarce resource is the investment funds.
b. The preference rule when using the profitability index is: The higher
the profitability index, the more desirable the project.
J. The present value method is generally superior to the internal rate of return method,
although both are used in practice. The internal rate of return method assumes that any
cash flows received during the life of the project can be reinvested at rate of return equal
to the internal rate of return. This assumption is questionable if the internal rate of return
is high. In contrast, the net present value method assumes that any cash flows received
during the life of the project are reinvested at a rate of return equal to the discount rate.
Ordinarily, this is a more realistic assumption.
K. Post-audit appraisals of investment projects involve a post-approval review to
evaluate whether the estimated benefits (incremental revenues, cost savings, etc.) have
been realized. The post-appraisal review can reveal any tendencies managers may have
had to overstate benefits or understate additional costs when seeking original approval.
The key in post-appraisal analysis is to use actual data.
L. Two capital budgeting methods are considered in the chapter that do not involve
discounting cash flows. One of these is the payback method.
1. The payback period is the number of years required for an investment project
to recover its cost out of the cash receipts it generates.
a. When the cash inflows from the project are the same every year, the
following formula can be used to compute the payback period:
Payback period =
Investment required
Net annual cash inflows
b. If new equipment is replacing old equipment, the “investment
required” should be reduced by any salvage value obtained from the
disposal of old equipment. And in this case, in computing the “net
annual cash inflows,” only the incremental cash inflow provided by
the new equipment over the old equipment should be used.
2. The payback period is not a measure of profitability. Rather it is a measure of
how long it takes for a project to recover its investment cost.
3. The payback method ignores the time value of money and all cash flows that
occur once the initial cost has been recovered. Therefore, this method is very
crude and should be used only with a great deal of caution. Nevertheless, the
payback method can be useful in industries where project lives are very short
and uncertain.
M. The simple rate of return method is another capital budgeting method that does not
involve discounted cash flows.
1. The simple rate of return method focuses on accounting net operating income
rather than on cash flows:
Simple rate
of return
=
Annual
Annual
incremental _ incremental
revenue
expenses
Initial investment
If new equipment is replacing old equipment, then the “initial investment” in
the new equipment is the cost of the new equipment reduced by any salvage
value obtained from the old equipment.
2. Like the payback method, the simple rate of return method does not consider
the time value of money. Therefore, the rate of return computed by this
method is not an accurate guide to the profitability of an investment project.
Appendix 13A: The Concept of Present Value
A. Since most business investments extend over long periods, it is important to recognize
the time value of money in capital budgeting analysis. Essentially, a dollar received today
is more valuable than a dollar to be received in the future for the simple reason that a
dollar received today can be invested—yielding more than a dollar in the future.
B. Present value analysis recognizes the time value of money.
1. Present value analysis involves expressing a future cash flow in terms of
present dollars. When a future cash flow is expressed in terms of its present
value, the process is called discounting.
2. Use Exhibit 13A formulas, a financial calculator, or Microsoft Excel, to
determine the present value of a single sum to be received in the future. This
table contains factors for various rates of interest for various periods, which
when multiplied by a future sum, will give the sum’s present value.
3. Use Exhibit 13A formulas, a financial calculator, or Microsoft Excel, to
determine the present value of an annuity, or stream, of cash flows. This table
contains factors that, when multiplied by the stream of cash flows, will give
the stream’s present value. Be careful to note that this annuity table is for a
very specific type of annuity in which the first payment occurs at the end of
the first year.
Appendix 13B: Income Taxes in Capital Budgeting Decisions
A. Income taxes affect cash flows and therefore should usually be considered in capital
budgeting. However, nonprofit entities such as hospitals, schools, or governmental units
are not subject to income taxes and may use the simpler approach in Chapter 13 that
ignores taxes.
B. Both the costs and benefits of a project should be estimated on an after-tax basis.
1. The true cost of a tax-deductible item is the amount of the payment net of any
reduction in income taxes due to the payment. An expenditure net of its tax
effects is known as an after-tax cost. For example, assume that a company
needs to repair a machine at a cost of $6,000. The cost of the repairs is a
tax-deductible expense. If the income tax rate is 30%, the after-tax cost of the
repairs is:
Cost of repairs
Reduction in taxes due to the overhaul
(30% × $6,000) ..................................
After-tax cost
$6,000)
(1,800)
$4,200)
2. The net after-tax cost (cash outflow) for any tax-deductible expenditure can be
computed as follows:
After-tax cost = (1 – Tax rate ) ×
Tax deductible
cash expense
3. Not all cash outflows are tax deductible expenses.
a. An investment in working capital is not tax-deductible; it is not an
expense.
b. The cost of a depreciable asset is not tax deductible in the period in
which it is purchased. However, CCA on the asset is tax deductible.
(See section D and E below.)
C. As with cash expenditures, taxable cash receipts must be placed on an after-tax basis.
1. A cash receipt net of its tax effect is known as an after-tax benefit. For
example, assume that a company receives $100,000 from sale of services. If
the tax rate is 30%, the after-tax benefit is:
Revenue
Income tax payment required
(30% × $100,000) ....................
After-tax benefit
$100,000)
(30 000)
$ 70,000)
2. The net after-tax cash inflow from revenue or other taxable cash receipts can
be computed as follows:
After - tax benefits = (1 – Tax rate ) ×
Taxable cash
receipt
3. This formula can be used for a project that does not bring in any additional
revenue but saves cost. The cost savings can be treated the same as a cash
receipt. The formula can also be applied to net taxable cash receipts, which is
the difference between taxable cash receipts and tax-deductible cash expenses.
4. Not all cash receipts are taxable. For example, the release of working capital
at the termination of an investment project is not a taxable cash inflow.
D. Accounting depreciation is not an allowable expense for tax purposes. Instead, an
allowance referred to as capital cost allowance (CCA) is permitted by the Canadian
Income Tax Act. CCA is the Tax Act’s counterpart to accounting depreciation. Although
CCA involves no outflow of cash directly, because it is fully deductible in arriving at
taxable income, it does have an effect on the amount of taxes that a firm pays. Therefore,
CCA indirectly has an effect on cash flows.
1. The CCA deduction acts as a shield (or protection) against tax payments. In
effect, CCA deductions shield profits from taxation and thereby lower the
amount of income taxes that a company has to pay.
2. The formula used to compute the CCA tax shield is:
CCA
deduction
×
Tax
rate
=
Tax savings
from the CCA
tax shield
E. The present value of these tax savings from the CCA tax shield is required for the
discounted cash flow analysis.
1. For tax purposes, all capital assets are grouped into prescribed asset classes or
pools. For each class, a specific maximum CCA rate is prescribed. The size of
the rate is influenced by a combination of several factors including social,
economic, and political.
2. With few exceptions, the maximum annual CCA deduction is computed by
the declining balance method. It is equal to the prescribed CCA rate for the
class multiplied by the year-end declining balance of the assets in the class,
called the undepreciated capital cost (UCC).
3. Because the CCA deduction is calculated on a declining balance of a pool of
assets, and not a single asset, a company is able to claim CCA deductions and
thus tax savings from an asset even after the asset has been disposed of.
4. In the year an asset is acquired, only one-half the prescribed rate is permitted
for calculating CCA. Thereafter the full rate is used.
5. On the disposal of an asset the lesser of the original cost of the asset and the
proceeds is deducted from the pool.
F. A comprehensive example of income taxes and capital budgeting is given in Exhibit
13B-3. Carefully review this example including the accompanying explanation of the
individual items in the exhibit.
1. Notice that all cash flows involving tax deductible expenses and taxable
receipts have been placed on an after-tax basis by multiplying the cash flow in
each case by one minus the tax rate.
2. Also notice that the present value of the CCA tax shield has been calculated using
the CCA tax shield formula introduced earlier in the chapter in Examples 1 and 2.
Recall that the CCA rate is applied on a declining balance basis and therefore the
CCA tax shields represent an infinite stream. Thus, calculating the tax shield in
any other way is not only impractical but will only give an approximation.
a. The first part of the formula,
(
Cdt
d+k
×
1 + 0.5 k
1+k
)
represents the present value of all CCA tax shields that would be
derived from the asset if it were never disposed of, given that only
one-half the normal CCA amount is deductible in the first year. The
term, (1 + 0.5k)/(1 + k), is a correction factor for the half-year rule.
b. The second part of the formula,
( (dS+dtk)
n
× (1 + k)-n
)
represents the CCA tax shield lost because the disposal of the asset for
its salvage value results in a lower CCA deduction for the year of
disposal and future years. Again this can be viewed as a correction
factor to the term (Cdt)/(d + k), which assumes that the asset is never
disposed of.
3. These two above points should be studied with great care until both are
thoroughly understood.
What To Watch Out For (Hints, Tips and Traps)

Consider the following illustration to demonstrate the limitations of the payback
method. You are asked to choose between two alternatives that each require an
initial investment of $4,000. Option A returns $1,000 at the end of each of four
years. Option B returns $4,000 at the end of the fourth year. Under the payback
method, Option A and Option B are equally preferable. Note, however, that
Option A is really better since the cash flows come earlier. Now add the
information that in Year 5, Option A will produce an additional cash inflow of
$500,000 but that Option B will never generate another dollar after the fourth
year. Reconsider the question of preference of Option A or Option B using only
the payback method. The payback method ignores the time value of money and
does not measure profitability; it just measures the time required to recapture the
original investment and will ignore any cash flows after the original investment
has been recaptured (i.e., in this example it will ignore all the cash flows after
Year 4 for both Option A and Option B since both have a payback of exactly 4
years, thus, the fact that you will receive an additional $500,000 from Option A in
Year 5 is not taken into consideration with the payback method).

The role of working capital in capital budgeting often confuses students. The
initial investment in working capital at the beginning of the project for items such
as inventories is recaptured at the end of the project when the working capital is
no longer required. Thus, working capital is recognized as a cash outflow at the
beginning of the project and as a cash inflow at the end of the project (a common
error is to omit the release the working capital at the end of the project).

Any decision always has at least two alternatives. Often one of these alternatives
is the status quo. In problems evaluating a single project, the incremental-cost
approach is usually used. The incremental costs and benefits of the project
relative to the status quo are the focus of the analysis.

While studying the effects of income taxes on capital budgeting it is important to
remember that not all receipts (cash inflows) or disbursements (cash outflows) are
taxable. For instance, for example the working capital needed at the beginning of
the project and the eventual release of working capital at the end of the project are
cash flows but are not counted as income for financial accounting purposes or
income tax reporting purposes. Try to think of other non-taxable cash receipts
and non-tax deductible cash disbursements (such as proceeds from loans, issue of
share capital, repayment of the principal portion of loans, the sale of fixed assets
at book value, etc). Second, recall that when an asset is purchased, a cash outflow
occurs. Depreciation (and the CCA tax shield) is just the allocation of that
purchase price over some estimated life.