Chapter 15:
Capital Budgeting
Cost Accounting:
Foundations & Evolutions, 9e
Kinney and Raiborn
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accessible website, in whole or in part.
Learning Objectives
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Why do most capital budgeting methods focus on cash flows?
How is payback period computed, and what does it measure?
How are the net present value and profitability index of a project
computed, and what do they measure?
How is the internal rate of return on a project computed, and what
does that rate measure?
How do taxation and depreciation affect cash flows?
What are the underlying assumptions and limitations of each capital
project evaluation method?
How do managers rank investment projects?
How is risk considered in capital budgeting analyses?
How and why should management conduct a postinvestment audit
of a capital project?
(Appendix 1) How are present values calculated?
(Appendix 2) What are the advantages and disadvantages of the
accounting rate of return method?
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accessible website, in whole or in part.
Capital Budgeting
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Capital budgeting involves evaluating and
ranking alternative future investments to
effectively and efficiently allocated limited
capital
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Plan and prepare the capital budget
Review past investments to assess success of
past decisions and enhance the decision
process in the future
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accessible website, in whole or in part.
Capital Budgeting
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Compare and evaluate alternative projects
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financial and nonfinancial criteria
short- and long-term benefits
usually multiple criteria
Consider all significant stakeholders
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accessible website, in whole or in part.
Capital Budgeting Financial Analysis
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Payback period
Discounted payback period
Net present value
Profitability index
Internal rate of return
Accounting rate of return
Cash
Flow
Focus
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accessible website, in whole or in part.
Investment vs. Financing
Investment Decision
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Which assets to acquire
Made by divisional managers
and top management
Financing Decision
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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
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accessible website, in whole or in part.
Payback Period
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Time required for project’s cash inflows to
equal the original investment
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the 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
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accessible website, in whole or in part.
Discounting Future Cash Flows
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Reduce the future value of cash flows by the
portion that represents interest
Variables are
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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
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accessible website, in whole or in part.
Net Present Value
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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
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.
Profitability Index
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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
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accessible website, in whole or in part.
Internal Rate of Return
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Discount rate where
PV of cash inflows = PV of cash outflows
NPV = 0
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Hurdle rate is the lowest acceptable return on
investment (at least equal to the cost of
capital)
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If Internal Rate of Return = Hurdle Rate; Accept
If Internal Rate of Return > Hurdle Rate; Accept
If Internal Rate of Return < Hurdle Rate; Reject
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accessible website, in whole or in part.
After-Tax Cash Flows
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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
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accessible website, in whole or in part.
Comparing Techniques
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Uses time value money
Provides specific rate of
return
Uses cash flows
Considers returns during
life of project
Uses discount rate
Payback
N
NPV
Y
PI
Y
IRR
Y
N
Y
N
Y
N
Y
Y
Y
N
N
Y
Y
Y
Y
Y
N*
*often used as a hurdle rate
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accessible website, in whole or in part.
The Investment Decision
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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
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accessible website, in whole or in part.
Capital Budgeting Terms
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Screening decision
Preference decision
Mutually exclusive projects
Independent projects
Mutually inclusive projects
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accessible website, in whole or in part.
Compensating for Risk
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Judgmental method
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Risk-adjusted discount rate method
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Use logic and reasoning to decide if
acceptable rate of return will be achieved
Higher discount/hurdle rate for riskier projects
and/or cash flows
Shorter payback period for riskier projects
Higher IRR for riskier projects
Sensitivity analysis
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accessible website, in whole or in part.
Postinvestment Audit
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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
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.
Questions
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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?
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.
Potential Ethical Issues
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Ignoring the enhanced safety or detrimental
environmental impact for project decisions
Changing assumptions or estimates to meet
criteria for approval
Using a discount rate that is inappropriately low
Not conducting a postinvestment audit to hold
decision makers accountable
Choosing projects based on accounting
earnings only rather than including discounted
cash flow methods
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.