Beruflich Dokumente
Kultur Dokumente
A
Problems
B
Problems
1, 2, 7, 8
1A, 2A
1B, 2B
4, 5, 6, 7
2, 3, 4, 5
1, 2, 3, 8
8, 9
4A
4B
5.
10
3A
3B
6.
11
7.
12, 13, 16
7, 8
4, 5
3A, 5A
3B, 5B
8.
3, 14, 15
6, 7, 8
1A, 2A
1B, 2B
Brief
Exercises
2, 3
4.
Study Objectives
Questions
1.
2.
3.
12-1
Description
Difficulty
Level
Time
Allotted (min.)
1A
Moderate
3040
2A
Complex
3040
3A
Moderate
2030
4A
Moderate
2030
5A
Moderate
3040
1B
Moderate
3040
2B
Complex
3040
3B
Moderate
2030
4B
Moderate
3040
5B
Moderate
3040
12-2
12-3
2.
3.
4.
5.
6.
7.
8.
1.
Study Objective
Q12-14
Q12-15
Q12-12
Q12-13
Q12-11
Q12-8
Q12-9
BE12-9
E12-6
Q12-3
E12-7
E12-8
Real-World Focus Exploring the Web
Decision Making
Across the
Organization
BE12-7
BE12-3
E12-8
BE12-1
E12-7
E12-8
Application
Q12-16
Q12-10
Q12-4
Q12-7
Q12-5
Q12-6
Q12-2
Q12-3
Q12-1
Knowledge Comprehension
P12-5A
P12-5B
BE12-4
BE12-4
P12-5A
P12-5B
P12-1A
P12-1B
BE12-8
E12-4
E12-5
BE12-6
BE12-5
E12-3
P12-4A
P12-4B
BE12-2
BE12-5
E12-1
E12-2
E12-3
P12-1A
P12-2A
E12-1
E12-2
P12-1A
P12-2A
P12-2B
P12-3A
P12-3B
P12-3A
P12-3B
P12-3A
P12-4A
P12-1B
P12-2B
P12-3B
P12-4B
P12-2A
P12-1B
P12-2B
Evaluation
Analysis Synthesis
Correlation Chart between Blooms Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems
STUDY OBJECTIVES
1. DISCUSS CAPITAL BUDGETING EVALUATION, AND
EXPLAIN INPUTS USED IN CAPITAL BUDGETING.
2. DESCRIBE THE CASH PAYBACK TECHNIQUE.
3. EXPLAIN THE NET PRESENT VALUE METHOD.
4. IDENTIFY THE CHALLENGES PRESENTED BY INTANGIBLE BENEFITS IN CAPITAL BUDGETING.
5. DESCRIBE THE PROFITABILITY INDEX.
6. INDICATE THE BENEFITS OF PERFORMING A POSTAUDIT.
7. EXPLAIN THE INTERNAL RATE OF RETURN METHOD.
8. DESCRIBE THE ANNUAL RATE OF RETURN METHOD.
12-4
CHAPTER REVIEW
The Capital Budgeting Evaluation Process
1.
(S.O. 1) The capital budgeting evaluation process generally has the following steps:
a. Project proposals are requested from departments, plants, and authorized personnel.
b. Proposals are screened by a capital budget committee.
c. Officers determine which projects are worthy of funding; and
d. Board of directors approves capital budget.
While accrual accounting has advantages over cash accounting in many contexts, for purposes of
capital budgeting, estimated cash inflows and outflows are preferred for inputs into the capital
budgeting decision tools.
3.
Sometimes cash flow information is not available, in which case adjustments can be made to
accrual accounting numbers to estimate cash flows.
4.
The capital budgeting decision, under any technique, depends in part on a variety of considerations:
a. The availability of funds;
b. Relationships among proposed projects;
c. The companys basic decision-making approach; and
d. The risk associated with a particular project.
Cash Payback
5.
(S.O. 2) The cash payback technique identifies the time period required to recover the cost of
the capital investment from the net annual cash inflow produced by the investment. The formula
for computing the cash payback period is:
Cost of Capital Investment Net Annual Cash Flow = Cash Payback Period
Net annual cash flow can be approximated by adding depreciation expense to net income.
6.
The evaluation of the payback period is often related to the expected useful life of the asset.
a. With this technique, the shorter the payback period, the more attractive the investment.
b. This technique is useful as an initial screening tool.
c. This technique ignores both the expected profitability of the investment and the time value of
money.
(S.O. 3) Under the net present value (NPV) method, cash flows are discounted to their present
value and then compared with the capital outlay required by the investment. The difference
between these two amounts is the net present value (NPV).
a. The interest rate used in discounting the future net cash flows is the required minimum
rate of return.
b. A proposal is acceptable when NPV is zero or positive.
c. The higher the positive NPV, the more attractive the investment.
12-5
8.
When there are equal annual cash inflows, the table showing the present value of an annuity of
1 can be used in determining present value. When there are unequal annual cash inflows, the
table showing the present value of a single future amount must be used in determining present
value.
9.
The discount rate used by most companies is its cost of capitalthat is, the rate that the
company must pay to obtain funds from creditors and stockholders.
10.
The net present value method demonstrated in the text requires the following assumptions:
a. All cash flows come at the end of each year;
b. All cash flows are immediately reinvested in another project that has a similar return; and
c. All cash flows can be predicted with certainty.
Intangible Benefits
11.
(S.O. 4) By ignoring intangible benefits, such as increased quality or improved safety, capital
budgeting techniques might incorrectly eliminate projects that could be financially beneficial to the
company. To avoid rejecting projects that actually should be accepted, two possible approaches
are suggested;
a. Calculate net present value ignoring intangible benefits, and then, if the NPV is negative, ask
whether the intangible benefits are worth at least the amount of the negative NPV.
b. Project rough, conservative estimates of the value of the intangible benefits, and incorporate
these values into the NPV calculation.
(S.O. 5) In theory, all projects with positive NPVs should be accepted. However, companies
rarely are able to adopt all positive-NPV proposals because (1) the proposals are mutually
exclusive (if the company adopts one proposal, it would be impossible to also adopt the other
proposal), and (2) companies have limited resources.
13.
In choosing between two projects, one method that takes into account both the size of the original
investment and the discounted cash flows is the profitability index. The profitability index
formula is as follows:
Present Value of
Initial
Investment
Future Cash Flows
Profitability
Index
The project with the greater profitability index should be the one chosen.
14.
Another consideration made by financial analysts is uncertainty or risk. One approach for
dealing with uncertainty is sensitivity analysis. Sensitivity analysis uses a number of outcome
estimates to get a sense of the variability among potential returns. In general, a higher risk project
should be evaluated using a higher discount rate.
16.
A post-audit involves the same evaluation techniques that were used in making the original capital
budgeting decisionfor example, use of the net present value method. The difference is that, in
the post-audit, actual figures are inserted where known, and estimation of future amounts is
revised based on new information.
(S.O. 7) The internal rate of return method results in finding the interest yield of the potential
investment. This 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.
Determining the internal rate of return can be done with a financial (business) calculator,
computerized spreadsheet, or by employing a trial-and-error procedure.
18.
The decision rule is: Accept the project when the internal rate of return is equal to or greater than
the required rate of return, and reject the project when the internal rate of return is less than the
required rate.
(S.O. 8) The annual rate of return method indicates the profitability of a capital expenditure and
its formula is:
Expected Annual Net Income Average Investment = Annual Rate of Return
Average investment is based on the following:
The annual rate of return is compared with managements required minimum rate of return for
investments of similar risk. The minimum rate of return (the hurdle rate or cutoff rate) is generally
based on the companys cost of capital. The decision rule is: A project is acceptable if its rate of
return is greater than managements minimum rate of return; it is unacceptable when the reverse
is true.
21.
When the rate of return technique is used in deciding among several acceptable projects, the
higher the rate of return for a given risk, the more attractive the investment.
12-7
LECTURE OUTLINE
A.
TEACHING TIP
B.
Cash Payback.
1. The cash payback technique identifies the time period required to
recover the cost of the capital investment from the net annual cash flow
produced by the investment.
2. Net annual cash flow is computed by adding back depreciation expense
to net income. Depreciation expense is added back because it is an
expense that does not require an outflow of cash.
12-8
TEACHING TIP
The formula when net annual cash flows are equal is: Cost of
Capital Investment Net Annual Cash FIow = Cash Payback
Period.
b.
The shorter the payback period, the more attractive the investment.
c.
C.
d.
In the case of uneven net annual cash flows, the company determines
the cash payback period when the cumulative net cash flows from
the investment equal the cost of the investment.
e.
f.
It should not ordinarily be the only basis for the capital budgeting
decision because it ignores the expected profitability of the project.
2. These techniques consider both the time value of money and the
estimated net cash flow from the investment.
3. The primary discounted cash flow technique is the net present value
method.
4. The net present value method in values discounting net cash flows to
their present value and then comparing that present value with the
capital outlay required by the investment. The difference between these
two amounts is referred to as net present value (NPV).
TEACHING TIP
ILLUSTRATION 12-3 presents a diagram of the decision criteria for the net
present value method.
a.
b.
c.
The higher the positive net present value, the more attractive the
investment.
TEACHING TIP
ILLUSTRATION 12-4 provides a short example of applying the net present value
method.
Also available as teaching transparency.
12-10
D.
Intangible Benefits.
1. Intangible benefits, such as increased quality, improved safety, or
enhanced employee loyalty, are difficult to quantify, and thus often are
ignored in capital budgeting decisions.
2. To avoid rejecting projects that should actually be accepted, managers
can either
E.
a.
b.
F.
b.
c.
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 net annual cash flows.
TEACHING TIP
b.
c.
d.
The formula for determining the internal rate of return factor is:
Capital Investment Net Annual Cash Flows = Internal Rate of
Return Factor.
e.
f.
The decision rule is: Accept the project when the internal rate
of return is equal to or greater than the required rate of return.
Reject the project when the internal rate of return is less than the
required rate.
TEACHING TIP
ILLUSTRATION 12-6 provides a diagram of the decision criteria for the internal
rate of return method.
2. The two discounted cash flow methods differ as follows:
a.
Objective:
(1) Net present value: compute net present value (a dollar amount).
(2) Internal rate of return: compute internal rate of return
(a percentage).
12-13
b.
Decision rule:
(1) Net present value (NPV): If NPV is zero or positive, accept the
proposal. If NPV is negative, reject the proposal.
(2) Internal rate of return (IRR): If IRR is equal to or greater than
the required rate of return, accept the proposal. If IRR is less
than the required rate of return, reject the proposal.
H.
TEACHING TIP
b.
c.
d.
12-14
e.
The higher the rate of return for a given risk, the more attractive the
investment.
f.
g.
A major limitation of this method is that it does not consider the time
value of money.
12-15
20 MINUTE QUIZ
Circle the correct answer.
True/False
1.
For purposes of capital budgeting, estimated cash inflows and outflows are the preferred
inputs.
True
2.
The cash payback technique is relatively easy to compute and considers the expected
profitability of the project.
True
3.
False
The internal rate of return method does not recognize the time value of money.
True
9.
False
8.
False
The profitability index takes into account both the size of the original investment and the
discounted cash flows.
True
7.
False
6.
False
A companys cost of capital is the rate that it must pay to obtain funds from creditors and
stockholders.
True
5.
False
The primary discounted cash flow technique is the net present value method.
True
4.
False
False
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 net annual cash
flows.
True
False
12-16
10.
The annual rate of return is computed by dividing net annual cash flow by the average
investment.
True
False
Multiple Choice
1.
All of the capital budgeting methods use cash flow except the
a. cash payback method.
b. annual rate of return method.
c. internal rate of return method.
d. profitability index method.
2.
3.
4.
5.
If capital investment is $800,000 and equal annual cash inflows are $200,000, the
internal rate of return factor is
a. 25.0.
b. 4.0.
c. 5.0.
d. .25.
12-17
ANSWERS TO QUIZ
True/False
1.
2.
3.
4.
5.
True
False
True
True
False
6.
7.
8.
9.
10.
True
True
False
True
False
Multiple Choice
1.
2.
3.
4.
5.
b.
c.
c.
d.
b.
12-18
ILLUSTRATION 12-1
CAPITAL BUDGET AUTHORIZATION PROCESS
12-19
ILLUSTRATION 12-2
CASH PAYBACK PERIOD
Cash Payback
Period*
Cost of Capital
Investment
Net Annual
Cash Flow
$200,000
$50,000
12-20
4 years
ILLUSTRATION 12-3
NET PRESENT VALUE METHOD DECISION CRITERIA
Present Value of
Net Cash Flows
Less
Capital
Investment
Equals
Net
Present Value
If Zero
or Positive
If
Negative
Accept
Proposal
Reject
Proposal
12-21
ILLUSTRATION 12-4
DISCOUNTED CASH FLOWS
8%
.93
1.78
2.58
3.31
3.99
10%
.91
1.74
2.49
3.17
3.79
Cash
Flow
$83,750
25,000
15%
.87
1.63
2.28
2.85
3.35
10%
Factor
1.00
3.79
Present
Value
$(83,750)
94,750
$11,000
Event
Period
Investment
0
Annual net cash inflow 1 5
Net present value
The project is acceptable because it has a positive net present
value and therefore earns more than the 10% required rate of
return.
12-22
ILLUSTRATION 12-5
PROFITABILITY INDEX
Profitability
Index
Present Value of
Net Cash Flows
Initial
Investment
Profitability
Index
= $100,000
12-23
$80,000 =
1.25
ILLUSTRATION 12-6
INTERNAL RATE OF RETURN METHOD DECISION CRITERIA
Internal
Rate of Return
Compared to
Required
Rate of Return
(the Discount Rate)
If equal to
or greater than:
If less
than:
Accept
Proposal
Reject
Proposal
12-24
ILLUSTRATION 12-7
ANNUAL RATE OF RETURN
A company wishes to invest $160,000 and provides the following
projected cost data:
$250,000
Sales
Manufacturing costs
(150,000)
(exclusive of depreciation)
(16,000)
Depreciation expense ($160,000 10 years)
(56,000)
Selling and administrative expenses
(8,000)
Income tax expense
$ 20,000
Net income
Provide the formula and computation for the (a) average investment,
and (b) annual rate of return.
Compute average investment (assume no salvage value)
Average
Investment
Investment at End
of Useful Life
Original Investment +
2
$160,000 + 0
2
= $80,000
Average
Investment
$80,000
=
=
Annual Rate
of Return
25%
12-25