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Learning Objective 1
Recognize the multiyear focus
of capital budgeting.
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2003
2004
2005
2006
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Learning Objective 2
Understand the six stages of
capital budgeting for a project.
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Capital Budgeting
Capital budgeting is the making of long-run
planning decisions for investments in
projects and programs.
It is a decision-making and control tool that
focuses primarily on projects or programs
that span multiple years.
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
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Capital Budgeting
Capital budgeting is a six-stage process:
1. Identification stage
2. Search stage
3. Information-acquisition stage
4. Selection stage
5. Financing stage
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Learning Objective 3
Use and evaluate the two main
discounted cash-flow (DCF)
methods: the net present value
(NPV) method and the internal
rate-of-return (IRR) method.
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
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Year 5: $1.338
Year 4: $1.262
Year 3: $1.91
Year 2: $1.124
Year 1: $1.06
Year 0: $1.00
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
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$(250,000)
Net initial
investment
Annual cash
inflows
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NPV of Net
Cash Inflows
$113,625
107,380
86,365
$307,370
250,000
$ 57,370
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NPV of Net
Cash Inflows
$198,960
6,759
$205,719
250,000
($ 44,281)
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Learning Objective 4
Use and evaluate the
payback method.
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Payback Method
Payback measures the time it will take to
recoup, in the form of expected future cash
flows, the initial investment in a project.
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=
=
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Learning Objective 5
Use and evaluate the accrual
accounting rate-of-return
(AARR) method.
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Accrual Accounting
Rate-of-Return Method
The accrual accounting rate-of-return (AARR)
method divides an accounting measure of
income by an accounting measure of investment.
Increase in expected
Initial
AARR =
average annual
required
operating income
investment
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
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Accrual Accounting
Rate-of-Return Method Example
Initial investment is $303,280.
Useful life is five years.
Net cash inflows is $80,000 per year.
IRR is 10%.
What is the average operating income?
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
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Accrual Accounting
Rate-of-Return Method Example
Straight-line depreciation is $60,656 per year.
Average operating income is
$80,000 $60,656 = $19,344.
What is the AARR?
AARR
= ($80,000 $60,656) $303,280
= .638, or 6.4%
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
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Learning Objective 6
Identify and reduce conflicts
from using DCF for capital
budgeting decisions and
accrual accounting for
performance evaluation.
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
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Performance Evaluation
A manager who uses DCF methods to make capital
budgeting decisions can face goal congruence
problems if AARR is used for
performance evaluation.
Suppose top management uses the AARR to
judge performance if the minimum desired
rate of return is 10%.
A machine with an AARR of 6.4% will be rejected.
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
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Performance Evaluation
The conflict between using AARR and
DCF methods to evaluate performance
can be reduced by evaluating managers
on a project-by-project basis.
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Learning Objective 7
Identify relevant cash
inflows and outflows for
capital budgeting decisions.
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$50,000
$ 3,000
0
$10,000
$ 5,000
40%
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$225,000
0
$ 45,000
$ 15,000
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$90,000
36,000
$54,000
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$45,000
10,000
$35,000
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Postinvestment Audit
A postinvestment audit compares the actual
results for a project to the costs and benefits
expected at the time the project was selected.
It provides management with feedback
about performance.
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Strategic Considerations
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End of Chapter 21
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