Chapter 11

Introduction to Management Accounting
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Management
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Introduction
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Horngren/Sundem/Stratton/Schatzberg/Burgstahle
Introduction to Management Accounting
Chapter
11
Capital
Budgeting
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Learning
Objective 1
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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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

1 expected cash inflows and outflows.
Find the present value of each

expected cash inflow or outflow.
3 Sum the individual present values.
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NPV Example
Original investment (cash outflow): $5,827
Useful life: four years
Annual income generated from
investment (cash inflow): $2,000
Minimum desired rate of return: 10%
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NPV Example
Present
Value
of $1
Total
Sketch of Cash
Discounted
Present
Flows at End of Year
At 10%
Value
0
1
2
3
4
Approach 1: Discounting Cash Flows
Cash flows
Annual savings .9091
$1,818
2,000
.8264
1,653
2,000
.7513
1,503
2,000
.6830
1,366
2,000
Present value of
Future inflows
$6,340
Initial Outlay
1.0000
(5,827) $(5,827)
Net present value
$ 513
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NPV Example
Approach 2: Using an Annuity Table

Sketch of Cash Flows at End of Year
0
1
2
3
4
Annual Savings
3.1699 $6,340
$2,000 $2,000 $2,000 $2,000
Initial Outlay
1.0000 (5,827) $(5,827)
Net present value
$ 513
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Assumptions of the NPV Model
There is a world
of certainty.
Predicted cash flows

occur timely.
There are perfect

capital markets.
Money can be borrowed

or loaned at the same
interest rate.
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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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Objective 7
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=IO
Assume that $12,000 is spent for a commercial
stove with an estimated useful life of 4 years.
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Payback Model Example

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
ARR = average annual required
operating income*
investment
*Average annual incremental cash inflow from operations
minus incremental average annual depreciation
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Accounting Rate-of-Return Example

Assume the following:
Investment is $5,827.
Useful life is four years.
Estimated disposal value is zero.
Expected annual cash inflow
from operations is $2,000.
nnual depreciation = (cost disposal value)/useful li

Annual depreciation = ($5,827 0)/4 = $1,456.75
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Accounting Rate-of-Return Example

ARR =
average annual incremental
Initial
cash inflow
required
Incremental annual depreciationinvestment
ARR = ($2,000 $1457) $5,827 = 9.3%
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The End
End of Chapter 11
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Chapter 11

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Chapter 11

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Introduction to Management Accounting

Introduction to Management Accounting

Capital budgeting describes the long-term

Discounted-Cash-Flow Models (DCF)

These models focus on a projects cash

Net Present Value Model

The net-present-value (NPV) method

Net Present Value Model

The minimum desired rate of return depends

Applying the NPV Method

Prepare a diagram of relevant

Find the present value of each

3 Sum the individual present values.

Approach 2: Using an Annuity Table

Assumptions of the NPV Model

Predicted cash flows

There are perfect

Money can be borrowed

Payback time, or payback period, is the

Payback Model Example

Accounting Rate-of-Return Model

Accounting Rate-of-Return Example

nnual depreciation = (cost disposal value)/useful li

Accounting Rate-of-Return Example

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