Capital Budgeting

Chapter 11
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Capital Budgeting
Capital budgeting describes the long-term planning for making and financing major long-term projects. 1. Identify potential investments. 2. Choose an investment. 3. Follow-up or postaudit.
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Payback Model
Payback time, or payback period, is the time it will take to recoup, in the form of cash inflows from operations, the initial dollars invested in a project. P = I Incremental inflow

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Payback Model Example

Assume that $12,000 is spent for a machine with an estimated useful life of 8 years. Annual savings of $4,000 in cash outflows are expected from operations. What is the payback period P = $12,000 $4,000 = 3 years
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Accounting Rate-of-Return Model

The accounting rate-of-return (ARR) model expresses a projects return as the increase in expected average annual operating income divided by the required initial investment. Increase in expected Initial average annual ARR = required operating income investment
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Accounting Rate-of-Return Example

Assume the following: Investment is $6,075. Useful life is 4 years. Estimated disposal value is zero. Expected annual cash inflow from operations is $2,000. What is the annual depreciation?
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Accounting Rate-of-Return Example

$6,075 4 = $1,518.75 (rounded to $1,519) What is the ARR? ARR = ($2,000 $1,519) $6,075 = 7.9%

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Discounted-Cash-Flow Models (DCF)

These models focus on a projects cash inflows and outflows while taking into account the time value of money. DCF models compare the value of todays cash outflows with the value of the future cash inflows.

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Net Present Value Model

The net-present-value (NPV) method computes the present value of all expected future cash flows using a minimum desired rate of return.

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Net Present Value Model

The minimum desired rate of return depends on the risk of a proposed project the higher the risk, the higher the rate. The required rate of return (also called hurdle rate or discount rate) is the minimum desired rate of return based on the firms cost of capital.

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Applying the NPV Method

Prepare a diagram of relevant expected cash inflows and outflows. Find the present value of each expected cash inflow or outflow. Sum the individual present values.
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Net Present Value Model

Discounting cash-flow - Comparing future cash-flows in the present value Year 0 1 2 3 4

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NPV Example
Original investment (cash outflow): $6,075

Useful life: 4 years

Annual income generated from investment (cash inflow): $2,000 Minimum desired rate of return: 10%
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NPV Example (pg 475)

Years Amount 0 ($6,075) 1 2,000 2 2,000 3 2,000 4 2,000 Net present value PV Factor 1.0000 .9091 .8264 .7513 .6830 Present Value ($6,075) 1,818 1,653 1,503 1,366 $ 265

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NPV Example

Years Amount 0 ($6,075) 1-4 2,000 Net present value

PV Factor 1.0000 3.1699

Present Value ($6,075) 6,340 $ 265

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Calculating the PV Factor

At a discount rate of 10%, the PV Factor for Year 1:

1 0.9091 1 0.1
At a discount rate of 10%, the PV Factor for Year 2:

1 0.8264 2 (1 0.1)
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Calculating the Annuity Factor

At a discount rate of 10%, the Annuity PV Factor for Years 1-4:
Years PV Factor 1 .9091 2 .8264 3 .7513 4 .6830 Annuity PV Factor 3.1698
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Decision Rules
Managers determine the sum of the present values of all expected cash flows from the project. If the sum of the present values is positive, the project is desirable. If the sum of the present values is negative, the project is undesirable.
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Sensitivity Analysis
Sensitivity analysis shows the financial consequences that would occur if actual cash inflows and outflows differ from those expected.

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Sensitivity Analysis Example

Suppose that a manager knows that the actual cash inflows in the previous example could fall below the predicted level of $2,000. How far below $2,000 must the annual cash inflow drop before the NPV becomes negative?

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Sensitivity Analysis Example

(3.1699 Cash flow) $6,075 = 0 Cash flow = $6,075 3.1698 = $1,916 If the annual cash flow is less than $1,916, the NPV is negative, and the project should be rejected.
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Relevant Cash Flows for NPV

The 4 types of inflows and outflows should be considered when the relevant cash flows are arrayed: 1) Initial cash inflows and outflows at time zero 2) Investments in receivables and inventories 3) Future disposal values 4) Operating cash flows
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Operating Cash Flows

The only relevant cash flows are those that will differ among alternatives. Depreciation and book values should be ignored. A reduction in cash outflow is treated the same as a cash inflow.
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Cash Flows for Investment in Technology

Suppose a company has a $10,000 net cash inflow this year using a traditional system. Investing in an automated system will increase the net cash inflow to $12,000. Failure to invest will cause net cash inflows to fall to $8,000.
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Cash Flows for Investment in Technology

What is the benefit from the investment?

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Post Audit

Investment expenditures are on time and within budget. Comparing actual versus predicted cash flows. Improving future predictions of cash flows. Evaluating the continuation of the project.
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Exercise 11-45 (Page 506)

Bobs Big Burgers is considering a proposal to invest in a speaker system that would allow its employees to service drive-through customers. The cost of the system (including the installation of special windows and driveway modifications) is RM30,000. Jenna, manager of Bobs, expects the drive-through operations to increase annual sales by RM25,000, with a 40% contribution margin ratio. Assume that the system has an economic life of 6 years, at which time it will have no disposal value. The cost of capital (required rate of return) is 12%. Ignore taxes.
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Exercise 11-45 (Page 506)

What is the payback time? Annual addition to profit = 40% x $25,000 = $10,000. Payback period is $30,000 $10,000 = 3 years. What are the advantages/disadvantages of this method? Advantages easy to use, can be used as a rough estimate of the riskiness of a project, especially in rapid technological changes & changes in product design, where cash flows are uncertain Disadvantages does not measure profitability, ignores time value of money
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Exercise 11-45 (Page 506)

Compute rate of return on the initial investment, based on the accounting rate-of-return model. ARR = ($10,000 - $5,000) $30,000 = 16.7% depreciation What are the advantages/disadvantages of this method?

Advantages measures profitability, easy to use Disadvantages ignores time value of money

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Exercise 11-45 (Page 506)

Compute the net present value.
Year 0 1 2 3 4 5 6 Discount factor (12%) 1.0000 0.8929 0.7972 0.7118 0.6355 0.5674 0.5066 Cash inflow/ (outflow) (30,000) 10,000 10,000 10,000 10,000 10,000 10,000 NPV PV (30,000) 8,929 7,972 7,118 6,355 5,674 5,066 11,114
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2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Exercise 11-45 (Page 506)

Should Jenna accept the proposal? Why or why not? Yes, accept the proposal because of positive NPV.

What are the advantages/disadvantages of this method? Advantages considers time value of money, considers relevant cash flows Disadvantages discount factor is subjective

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