Capital Budgeting

Report
Chapter 15:
Capital Budgeting
Cost Accounting:
Foundations and Evolutions, 9e
Kinney ● Raiborn
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accessible website, in whole or in part.
Learning Objectives
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Why do most capital budgeting
methods focus on cash flows?
How is payback period
computed, and what does it
measure?
How are the net present value
(NPV) and profitability index (PI)
of a project computed, and what
do they measure?
How is the internal rate of return
(IRR) on a project computed,
and what does that rate
measure?
How do taxation and
depreciation affect cash flows?
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What are the underlying
assumptions and limitations of
each capital project evaluation
method?
How do managers rank
investment projects?
How is risk considered in capital
budgeting analyses?
How and why should
management conduct a postinvestment audit of a capital
project?
(Appendix 1) How are present
values (PV) calculated?
(Appendix 2) What are the
advantages and disadvantages
of the accounting rate of return
method?
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accessible website, in whole or in part.
Capital Assets
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Capital assets are long-term assets used to:
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Tangible fixed assets
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Generate future revenues or cost savings
Provide distribution, service, or production
capacity
Land, building, machinery, etc.
Intangible assets

Capital lease, patent, etc.
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accessible website, in whole or in part.
Capital Budgeting

Capital budgeting involves evaluating and ranking
alternative future investments to effectively and
efficiently allocate limited capital.
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Plan and prepare the capital budget
Review past investments to assess success of past
decisions and enhance the decision process in the future
Compare and evaluate alternative projects
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Financial and nonfinancial criteria
Short- and long-term benefits
Usually multiple criteria
Consider all significant stakeholders
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accessible website, in whole or in part.
Capital Budgeting as Part of the
Financial Budget
Cash Budget
Income
Statement
Statement of
Cash Flows
Operating Budget
Statement of
Retained Earnings
Capital
Budget
Balance Sheet
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accessible website, in whole or in part.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.
Capital Budgeting: Quantitative
versus Qualitative
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Quantitative
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Accounting rate of return
Payback period
Discounted payback
period
Net Present Value (NPV)
Internal Rate of Return
(IRR)
Profitability Index (PI)
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Qualitative
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Employee morale,
safety, and
responsibility
Corporate image
Social responsibility
Market share
Growth
Strategic planning
Sustainability
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accessible website, in whole or in part.
Capital Budgeting: Financial
Analysis
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Payback period
NPV
PI
IRR
Accounting rate of return
Cash
Flow
Focus
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accessible website, in whole or in part.
Cash Flow
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Cash Receipts
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Revenues earned and collected
Savings generated by reducing operating costs
Proceeds from sale of assets
Cash Disbursements
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Expenditures for asset acquisition
Working capital investments
Costs for direct material, direct labor, and
overhead
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accessible website, in whole or in part.
Investment vs. Financing
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Investment decision
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Which assets to acquire
Made by divisional
managers and top
management
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Financing decision
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First justify the acquisition.
Then justify how to finance it.
How to raise capital
(debt/equity) to fund an
investment
Made by treasurer and
top management
Interest is a financing
decision
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Interest cost
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Cash flow associated
with debt financing
Not part of the project
selection process
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accessible website, in whole or in part.
Payback Period
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Time required for project’s cash inflows to equal the
original investment
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The longer it takes to recover the original investment, the
greater the risk
The faster capital is returned, the more rapidly it can be
invested in other projects
Management sets a maximum payback period
Ignores
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Cash inflows that occur after payback has been reached
Desired rate of return
Time value of money
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accessible website, in whole or in part.
Payback Period Illustration
Original Investment
Annual Cash Inflows
=
Payback Period
(assuming equal cash flows)
Example:
Original Investment
Annual Cash Inflows
Payback Period
$25,000
$10,000
2.5 years
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accessible website, in whole or in part.
Discounting Future Cash Flows
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Reduce the future value (FV) of cash flows by
the portion that represents interest
Variables are
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Length of time until the cash flow is received or
paid
Required rate of return on capital—discount rate
PV is stated in a common base of current
dollars
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accessible website, in whole or in part.
Discount Rate and Returns
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Discount rate
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Discount rate should
equal or exceed the
cost of capital
Cost of Capital—
weighted average
cost for the debt and
equity that comprise
a firm’s financial
structure
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Return OF Capital
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Recovery of the initial
investment
Return ON Capital
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Represents income
Original investment
multiplied by the discount
rate
$100,000 * 12% =
$12,000 return on capital
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accessible website, in whole or in part.
Discounted Cash Flow Methods
Net Present Value (NPV)
 Profitability Index (PI)
 Internal Rate of Return (IRR)

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accessible website, in whole or in part.
Net Present Value
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Evaluates if project rate of return is greater than,
equal to, or less than the desired rate of return
PV equals the cash flows discounted using the
desired rate of return
NPV equals PV of cash inflows minus PV of cash
outflows
Does not calculate the rate of return
Minus
Plus
Minus
Equals
Investment made currently
PV of future cash inflows or cost savings
PV of future cash outflows
NPV
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accessible website, in whole or in part.
Interpreting NPV
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NPV = 0
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NPV > 0
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Actual rate of return equals desired rate of
return
Actual rate of return is greater than desired
rate of return
NPV < 0

Actual rate of return is less than desired
rate of return
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accessible website, in whole or in part.
Net Present Value
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Function of two factors
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Discount rate
Amount and timing of cash flows
Useful to select best project among
investments that can perform the same task
or achieve the same objective
When comparing independent projects
requiring different initial investments, use the
PI
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accessible website, in whole or in part.
Profitability Index
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Compares PV of net cash flows to net
investment
Measures efficiency of the use of capital
Should be greater than or equal to 1
Does not calculate the rate of return
Profitability =
Index
PV of Net Cash Flows
Net Investment
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accessible website, in whole or in part.
Profitability Index Illustration
Project
PV of net cash flows
Net investment
NPV
PI
$900,000/$720,000
$580,000/$425,000
1
$900,000
$720,000
$180,000
2
$580,000
$425,000
$155,000
1.25
1.36
Assuming limited funds, which project would you choose?
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accessible website, in whole or in part.
Internal Rate of Return
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Discount rate where
PV of cash inflows = PV of cash outflows
NPV = 0
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Hurdle rate is the lowest acceptable return on
investment (at least equal to the cost of capital)
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If IRR = Hurdle Rate; Accept
If IRR > Hurdle Rate; Accept
If IRR < Hurdle Rate; Reject
Computed using
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Financial calculators
Computers
Annuity tables (assuming equal cash flows)
Trial and error
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accessible website, in whole or in part.
Income Taxes
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An integral part of the business planning and
decision-making process
Operating income is taxed, which reduces the
cash inflows from projects
Depreciation reduces operating income,
which reduces the taxes paid
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accessible website, in whole or in part.
After-Tax Cash Flows
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Depreciation is not a cash flow item
Depreciation on capital assets affects cash
flows by reducing the tax obligation
Depreciation is a tax shield that provides a
tax benefit
Depreciation tax benefit = Depreciation expense * Tax rate
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accessible website, in whole or in part.
Tax Depreciation
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Deprecation tax shield is affected by
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Changes in tax laws
Different depreciation methods
Changes in tax rates
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accessible website, in whole or in part.
Capital Budgeting Methods
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Understand similarities and differences of
capital budgeting methods
Use several techniques
Limitations of all methods
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Management preferences regarding timing of
cash flows are not included
Single, deterministic measures of cash flow are
used rather than probabilities
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accessible website, in whole or in part.
Payback
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Assumptions
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Speedy recovery of
investment is key
Cash flows can be
accurately predicted
Risk is lower for the
shorter payback project
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Limitations
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Ignores cash flows after
payback
Cash flow and project life
are deterministic, not
subject to probabilities
Ignores time value of
money
Does not consider
recognized cash flow
pattern preferences
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accessible website, in whole or in part.
Net Present Value
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Assumptions
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Discount rate is valid
Timing and size of cash
flows can be predicted
Life of project can be
predicted
If shorter-lived project is
selected, proceeds of
shorter project will earn
the discount rate through
theoretical completion of
longer project
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Limitations
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Cash flow and project life
are deterministic, not
subject to probabilities
Alternative project rates
of return are not known
Does not consider
recognized cash flow
pattern preferences
IRR on project is not
reflected
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accessible website, in whole or in part.
Profitability Index

Assumptions (same as NPV)
 Measures efficient use of
capital
 Discount rate is valid
 Timing and size of cash
flows can be predicted
 Life of project can be
predicted
 If shorter project selected,
proceeds of shorter project
will earn the discount rate
through theoretical
completion of longer project
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Limitations (same as NPV)
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Cash flow and project life
are deterministic, not
subject to probabilities
Alternative project rates of
return are not known
Does not consider cash flow
pattern preferences
IRR on project is not
reflected
A relative answer is given
but dollars of NPV are not
reflected
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accessible website, in whole or in part.
Internal Rate of Return
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Assumptions
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Hurdle rate is valid
Timing and size of cash
flows can be predicted
Project life can be
predicted
If shorter project
selected, proceeds of
shorter project will
continue to earn the IRR
through theoretical
completion of longer
project
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Limitations
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Projects are ranked by
IRR and not dollar size
NPV dollars are not
reflected
Cash flow and project life
are deterministic, not
subject to probabilities
Does not consider cash
flow pattern preferences
Multiple rates of return
can be calculated on the
same project
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accessible website, in whole or in part.
Comparing Techniques
Payback
NPV
PI
IRR
Uses time value money
N
Y
Y
Y
Provides specific rate of return
N
N
N
Y
Uses cash flows
Y
Y
Y
Y
Considers returns during life of
project
N
Y
Y
Y
Uses discount rate
N
Y
Y
N*
*often used as a hurdle rate
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accessible website, in whole or in part.
The Investment Decision
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Is the activity worthy of an investment?
Which assets can be used for the activity?
Of the available assets for each activity,
which is the best investment?
Of the “best investments” for all worthwhile
activities, in which ones should the company
invest?
Consider Quantitative and Qualitative Factors
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accessible website, in whole or in part.
Capital Budgeting Terms
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Screening decision
Preference decision
Mutually exclusive projects
Independent projects
Mutually inclusive projects
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accessible website, in whole or in part.
Ranking Capital Projects
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For the projects under consideration
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NPV is nonnegative
PI of 1 or more
IRR equals or exceeds hurdle rate
Selection ranking of multiple projects

Results can vary depending on evaluation
techniques and whether dollars or percentages
are used
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accessible website, in whole or in part.
Reinvestment Assumptions
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NPV and PI assume that released cash flows
are reinvested at the discount rate

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At least the cost of capital
IRR assumes that released cash flows are
reinvested at the expected IRR

Could be substantially different than the cost of
capital
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accessible website, in whole or in part.
NPV Compared to IRR

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More realistic reinvestment assumption
Results measured in dollars not rates
?
Do you prefer
a 100% return on $1, or
a 10% return on $100?
?
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Compensating for Risk (slide 1 of 2)
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Judgmental method
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Risk-adjusted discount rate method
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Use logic and reasoning to decide if acceptable
rate of return will be achieved
Higher discount/hurdle rate for riskier projects
and/or cash flows
Shorter payback period for riskier projects
Higher IRR for riskier projects
Sensitivity analysis
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Compensating for Risk (slide 2 of 2)

Sensitivity Analysis—the amount of change
that must occur in a variable before a
different decision would be made
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Discount rate—What increases could occur in the
cost of capital and related discount rate before a
project becomes unacceptable?
Cash flows—How small can the net cash inflows
be before a project becomes undesirable?
Asset life—What is the minimum time the cash
flows must be received for the project to remain
acceptable?
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accessible website, in whole or in part.
Post-Investment Audit
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Complete after project has stabilized
Compare actual results to expected results
Use same analysis techniques
Identify areas where results differ from
expectation
Evaluate capital budgeting process,
particularly original projections, problems with
implementation, sponsor credibility
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accessible website, in whole or in part.
Time Value of Money (Appendix 1)

Future value (FV) and present value (PV)
depend on
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Amount of cash flow
Rate of interest
Timing of cash flow
Simple vs. compound interest
Single cash flow
Annuity

Ordinary annuity or annuity due
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accessible website, in whole or in part.
Accounting Rate of Return

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Measures rate of return on earnings for
average capital investment over project’s life
Consistent with accounting model
Uses profits shown on accrual-based
financial statements
Not based on cash flows
Accounting
Rate of Return
=
Average Annual Profits
Average Investment
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accessible website, in whole or in part.
Questions



Why do most capital budgeting methods
focus on cash flows?
What is the relationship between the NPV
and the PI?
What are the assumptions and limitations of
the various capital project evaluation
methods?
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accessible website, in whole or in part.
Potential Ethical Issues
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Ignoring enhanced safety or detrimental
environmental impact for project decisions
Changing assumptions or estimates to meet criteria
for approval
Using a discount rate that is inappropriately low
Not conducting a post-investment audit to hold
decision makers accountable
Choosing projects based on accounting earnings
only rather than including discounted cash flow
methods
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accessible website, in whole or in part.

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