Capital Budgeting

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Chapter 10
Managerial Accounting Weygandt, Kieso, Kimmel

• Capital Budgeting

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Capital Budgeting

• The process of making capital expenditure
  decisions is known as capital budgeting.
• Capital budgeting involves choosing among various
  capital projects to find one(s) that will
  maximize a companys return on its financial
  investment.

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The Capital Budgeting Evaluation Process

• Many companies follow a carefully prescribed
  process in capital budgeting. The process
  usually includes the following steps
• 1 Project proposals are requested from
  departments, plants, and authorized personnel.
• 2 Proposals are screened by a capital budget
  committee.
• 3 Officers determine which projects are worthy of
  funding.
• 4 Board of directors approves capital budget.

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Cash Flow Information

• Most capital budgeting decision methods employ
  cash flow numbers rather than accrual accounting
  revenues and expenses.
• Revenues and expenses often differ significantly
  from cash inflow and outflows.
• For purposes of capital budgeting, estimated cash
  inflows and outflows are preferred as inputs into
  capital budgeting decision tools.

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Capital Budgeting Considerations

• The capital budgeting decision, under any
  technique, depends in part on a variety of
  considerations
• The availability of funds
• The relationships among proposed projects
• The companys basic decision-making approach
• The risk associated with a particular project

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Illustrative Data

• The following data will be used in a continuing
  example. This will allow for comparison of the
  results of the various capital budgeting
  techniques.

• Stewart Soup Company is considering an investment
  of 130,000 in new equipment. The new equipment
  is expected to last 10 years and have a zero
  salvage value at the end of its useful life. The
  annual cash inflows are 200,000, and the annual
  net cash outflows are 176,000. The data are
  summarized below

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Cash Payback

• The cash payback technique identifies the time
  period required to recover the cost of the
  capital investment from the annual cash inflow
  produced by the investment.

• The shorter the payback period, the more
  attractive the investment.

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Cash Payback Example

• The cash payback period in the Stewart Soup
  example is 5.42 years, computed as follows

130,000 ? 24,000 5.42 years

• Assume that at Stewart Soup a project is
  unacceptable if the payback period is longer than
  60 of the assets expected useful life. Thus,
  this project is acceptable. The 5.42-year
  payback period is just over 50 of the projects
  10-year expected useful life.

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Cash Payback Advantages and Disadvantages

• The cash payback technique may be useful as an
  initial screening tool. It is easy to compute and
  understand.
• However, it should not normally be the only basis
  for a capital budgeting decision because it
  ignores the profitability of the project. It
  also ignores the time value of money.

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Discounted Cash Flow Techniques

• Capital budgeting techniques that take into
  account both the time value of money and the
  estimated total cash flows from an investment are
  called discounted cash flow techniques.
• They are generally recognized as the most
  informative and best conceptual approaches to
  making capital budgeting decisions.

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Discounted Cash Flow Techniques

• The primary capital budgeting method that uses
  discounted cash flow techniques is called net
  present value.
• A second method, to be discussed later, is the
  internal rate of return.
• Appendix C reviews the time value of money
  concepts upon which these methods are based.
  (All of the PV factors in the following examples
  come from Appendix C.)

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Net Present Value Method

• Under the net present value (NPV) method, cash
  inflows are discounted to their present value and
  then compared with the capital outlay required by
  the investment.
• The difference between these two amounts is
  referred to as the net present value.
• The interest rate to be used in discounting the
  future cash flows is the required minimum rate of
  return.
• A proposal is acceptable when the NPV is zero or
  positive.
• The higher the NPV, the more attractive the
  investment.

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Net Present Value Decision Criteria
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Equal Annual Cash Flows Example

• Stewarts annual cash inflows are 24,000. If we
  assume this amount is uniform over the assets
  useful life, the present value of its annual cash
  flows can be computed as shown

• Therefore, the analysis of the proposal by the
  NPV method is

• The proposed capital expenditure is acceptable at
  the 12 required rate of return because the NPV
  is positive.

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Unequal Cash Flows Example

• When annual cash flows are unequal, it is not
  possible to use annuity tables to calculate their
  PV. Instead tables showing the PV of a single
  amount must be applied to each annual cash flow.

• Assume Stewart Soup expects the same aggregate
  cash flows (240,000), but a declining market
  demand for the new product over the life of the
  equipment. The PV of the annual cash flows is
  calculated to the right

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Unequal Cash Flows Example

• Therefore, the analysis of the proposal by the
  NPV method is

• The proposed capital expenditure is acceptable at
  the 12 required rate of return because the NPV
  is positive.

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Choosing a Discount Rate

• In most cases, a company uses a discount rate
  (also known as hurdle rate, cutoff rate, or
  required rate of return) that is equal to its
  cost of capital, which is the rate it must pay to
  obtain funds from creditors and stockholders.
• The cost of capital is a weighted average of the
  rates paid on borrowed funds and funds from
  investors in the companys stock.
• A discount rate has two elements
• a cost of capital element, and
• a risk element.
• Companies often assume the risk element is zero.

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Choosing a Discount Rate

• Using an incorrect discount rate can lead to
  incorrect capital budgeting decisions.
• Suppose Stewart Soups 12 discount rate did not
  take into account the fact that this project is
  riskier than most of the companys investments.
  Given the risk, a 15 discount rate would have
  been more appropriate.

As shown on the right, a 15 discount rate would
cause Stewart to reject the project because of
its negative NPV.
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Simplifying Assumptions

• In the examples of the NPV method, a number of
  simplifying assumptions have been made
• All cash flows come at the end of each year.
• All cash flows are immediately reinvested in
  another project that has a similar return.
• All cash flows can be predicted with certainty.
• Because these assumptions are rarely all true in
  the real world, NPV provides estimated
  analysis. Some of these assumptions are relaxed
  in more advanced capital budgeting techniques.

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Comprehensive Example

• Best Taste Foods is considering investing in new
  equipment to produce fat-free snack foods. The
  following information was determined in
  consultation with various company departments

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Comprehensive Example

• The computation of the net annual cash inflows
  for the project is shown below

• The computation of the NPV is as follows

• Because the NPV is positive, the project should
  be accepted.

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Intangible Benefits

• Intangible benefits such as increased quality or
  safety or employee loyalty may also influence the
  decision. To avoid rejecting projects that
  should be accepted, two possible approaches are
  suggested
• Calculate NPV ignoring intangible benefits and if
  NPV is negative, ask if intangible benefits are
  worth at least the negative NPV.
• Project rough, conservative estimates of the
  value of the intangible benefits and include
  those in NPV calculation.

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Mutually Exclusive Projects

• In theory, all projects with positive NPVs should
  be accepted. However, companies rarely are able
  to adopt all positive-NPV proposals.
• Proposals are often mutually exclusive because of
  limited resources.
• When choosing between alternatives, it is
  tempting to choose the project with the highest
  NPV, but the investment required by the projects
  should also be considered.

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Mutually Exclusive Projects Profitability Index

• One relatively simple method of comparing
  alternative projects that takes into account both
  the size of the original investment and the
  discounted cash flows is the profitability index.
  The profitability index is computed with the
  following formula

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Profitability Index Example

• A company must choose between two mutually
  exclusive projects. Each project has a 10-year
  life and a 12 discount rate can be assumed.
  Data related to the two projects is as shown

• As shown, both projects have positive NPVs.
  Project Bs NPV is higher, but that project also
  requires more than two times the initial
  investment that Project A does.

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Profitability Index Example

• Data for the two projects is shown below in a
  slightly altered form

• With the data in this form, profitability indexes
  for the two projects can be computed.

• Project A may be more desirable because it has
  the higher profitability index.

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Internal Rate of Return Method

• The internal rate of return method results in
  finding the interest yield of the potential
  investment.
• The internal rate of return is the interest rate
  that will cause the present value of the proposed
  capital expenditure to equal the present value of
  the expected annual cash inflows (i.e., a NPV of
  zero).

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Internal Rate of Return Method

• Determining the internal rate of return involves
  three steps (These steps assume that annual
  cash flows are equal an alternative method of
  computing the internal rate of return must be
  used when cash flows are unequal.)
• Tampa Company will be used as an example. Tampa
  Company is considering a new project with an
  8-year estimated life, an initial cost of
  249,000, and a net annual cash inflow of 45,000.

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Internal Rate of Return

• Step 1 Compute the internal rate of return
  factor using the following formula

• Using the Tampa Company data, the internal rate
  of return factor is computed as follows

249,000 ? 45,000 5.5333
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Internal Rate of Return

• Step 2 Use the factor and the present value of
  an annuity of 1 table to find the internal rate
  of return.

• For Tampa, the net annual cash inflow is expected
  to continue for 8 years. Thus, it is necessary
  to read across the period-8 row in the present
  value of an annuity table to find the discount
  factor that is closest to the internal rate of
  return factor.

Periods 5 6 8 9 10 11 12 15
8 6.46321 6.20979 5.74664 5.53482 5.33493 5.14612
4.96764 4.8732

• The closest discount factor to 5.53333 is
  5.53482, which represents an interest rate of
  approximately 9.

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Internal Rate of Return Decision Criteria
Step 3 Compare the internal rate of return to
managements required rate of return.
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Annual Rate of Return Method

• The annual rate of return technique is based on
  accrual accounting data. It indicates the
  profitability of a capital expenditure.
• The formula is

• The annual rate of return is compared to
  managements required minimum rate of return for
  investments of similar risk.
• A project is acceptable under this method if the
  annual rate of return is greater than the
  required rate of return.

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Annual Rate of Return Example

• Assume that Reno Company is considering an
  investment of 130,000 in new equipment. The new
  equipment is expected to last 5 years and have
  zero salvage value. The straight-line
  depreciation method is used for accounting
  purposes. The expected annual revenues and costs
  of the new product that will be produced from the
  investment are

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Annual Rate of Return Example

• Average investment is computed as follows

• The investment at the end of the useful life is
  equal to the assets salvage value.
• For Reno, average investment is 65,000
  (130,000 0) ? 2.
• The expected annual rate of return for Renos
  investment is therefore 20, computed as follows

13,000 ? 65,000 20
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Annual Rate of Return Advantages Disadvantages

• The principal advantages of this method are the
  simplicity of its calculation and managements
  familiarity with the accounting terms it uses.
• A major limitation is that it does not consider
  the time value of money.

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