21 - 1 capital budgeting and cost analysis chapter 21
TRANSCRIPT
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Capital Budgetingand Cost AnalysisCapital Budgetingand Cost Analysis
Chapter 21
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Learning Objective 1
Recognize the multiyear focus
of capital budgeting.
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Two Dimensions of Cost AnalysisTwo Dimensions of Cost Analysis
1. A project dimension
2. An accounting-period dimension
The accounting system that corresponds to theproject dimension is termed life-cycle costing.
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2002 2003 2004 2005 2006
Project A
Project B
Project C
Project D
Two Dimensions of Cost AnalysisTwo Dimensions of Cost Analysis
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Learning Objective 2
Understand the six stages of
capital budgeting for a project.
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Capital BudgetingCapital Budgeting
Capital budgeting is the making of long-runplanning decisions for investments in
projects and programs.
It is a decision-making and control tool thatfocuses primarily on projects or programs
that span multiple years.
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Capital BudgetingCapital Budgeting
Capital budgeting is a six-stage process:
1. Identification stage 2. Search stage
3. Information-acquisition stage
4. Selection stage 5. Financing stage
6. Implementation and control stage
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Capital Budgeting ExampleCapital Budgeting Example
One of the goals of Assisted Living is to improvethe diagnostic capabilities of its facility.
Management identifies a need to consider thepurchase of new equipment.
The search stage yields several alternativemodels, but management focuses on
one particular machine.
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Capital Budgeting ExampleCapital Budgeting Example
The administration acquires information.
Initial investment is $245,000.
Investment in working capital is $5,000.
Useful life is three years.
Estimated residual value is zero.
Net cash savings is $125,000, $130,000, and $110,000 over its life.
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Capital Budgeting ExampleCapital Budgeting Example
Working capital is expected to be recovered atthe end of year 3 with an expected return of 10%.
In the selection stage, management must decidewhether to purchase the new machine.
Operating cash flows are assumed to occurat the end of the year.
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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.
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Time Value of MoneyTime Value of Money
Compound Growth,5 periods at 6%
Year 0: $1.00
Year 1: $1.06
Year 2: $1.124
Year 3: $1.91
Year 4: $1.262
Year 5: $1.338
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Discounted Cash FlowDiscounted Cash Flow
There are two main DCF methods:
Net present value (NPV) method
Internal rate-of-return (IRR) method
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Net Present Value ExampleNet Present Value Example
Only projects with a zero or positivenet present value are acceptable.
What is the the net present value ofthe diagnostic machine?
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Net Present Value ExampleNet Present Value Example
Year in the Life of the Project
$(250,000) $125,000 $130,000 $115,000
0 1 2 3
Net initialinvestment
Annual cashinflows
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Net Present Value ExampleNet Present Value Example
Net Cash NPV of Net Year 10% Col. Inflows Cash Inflows
1 0.909 $125,000 $113,6252 0.826 130,000 107,3803 0.751 115,000 86,365
Total PV of net cash inflows $307,370Net initial investment 250,000Net present value of project $ 57,370
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Net Present Value ExampleNet Present Value Example
The company is considering another investment.
Initial investment is $245,000.Investment in working capital is $5,000.
Working capital will be recovered.Useful life is three years.
Estimated residual value is $4,000.Net cash savings is $80,000 per year.
Expected return is 10%.
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Net Present Value ExampleNet Present Value Example
Net Cash NPV of NetYears 10% Col. Inflows Cash Inflows1-3 2.487 $80,000 $198,960 3 0.751 9,000 6,759Total PV of net cash inflows $205,719Net initial investment 250,000Net present value of project ($ 44,281)
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Internal Rate of ReturnInternal Rate of Return
Investment= Expected annual net cash inflow
× PV annuity factor
Investment÷ Expected annual net cash inflow
= PV annuity factor
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Internal Rate of Return ExampleInternal Rate of Return Example
Initial investment is $303,280.Useful life is five years.
Net cash inflows is $80,000 per year.
What is the IRR of this project?
$303,280 ÷ $80,000 = 3.791 (PV annuity factor)
10% (from the table, five-period line)
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Comparison of NPV and IRRComparison of NPV and IRR
The NPV method has the advantage that the endresult of the computations is expressed in
dollars and not in a percentage.
Individual projects can be added.
It can be used in situations where the requiredrate of return varies over the life of the project.
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Comparison of NPV and IRRComparison of NPV and IRR
The IRR of individual projects cannot beadded or averaged to derive the IRR
of a combination of projects.
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Learning Objective 4
Use and evaluate the
payback method.
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Payback MethodPayback Method
Payback measures the time it will take torecoup, in the form of expected future cash
flows, the initial investment in a project.
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Payback Method ExamplePayback Method Example
Assisted Living is considering buying Machine 1.
Initial investment is $210,000.
Useful life is eleven years.
Estimated residual value is zero.
Net cash inflows is $35,000 per year.
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Payback Method ExamplePayback Method Example
How long would it take to recover the investment?
$210,000 ÷ $35,000 = 6 years
Six years is the payback period.
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Payback Method ExamplePayback Method Example
Suppose that as an alternative to the $210,000piece of equipment, there is another one
(Machine 2) that also costs $210,000 but willsave $42,000 per year during its five-year life.
What is the payback period?
$210,000 ÷ $42,000 = 5 years
Which piece of equipment is preferable?
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Payback Method ExamplePayback Method Example
Assisted Living is considering buying Machine 3.
Initial investment is $250,000.
Useful life is eleven years.
Cash savings are $160,000, $180,000, and $110,000 over its life.
What is the payback period?
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Payback Method ExamplePayback Method Example
Year 1 brings in $160,000.
Recovery of the amountinvested occurs in Year 2.
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Payback Method ExamplePayback Method Example
Payback = 1 year
$ 90,000 needed to complete recovery
180,000 net cash inflow in Year 2
1 year + 0.5 year
1.5 years or 1 year and 6 months
+÷==
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Learning Objective 5
Use and evaluate the accrual
accounting rate-of-return
(AARR) method.
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Accrual AccountingRate-of-Return Method
Accrual AccountingRate-of-Return Method
The accrual accounting rate-of-return (AARR)method divides an accounting measure of
income by an accounting measure of investment.
AARR =Increase in expected
average annualoperating income
÷Initial
requiredinvestment
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Accrual AccountingRate-of-Return Method Example
Accrual AccountingRate-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?
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Accrual AccountingRate-of-Return Method Example
Accrual AccountingRate-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%
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Learning Objective 6
Identify and reduce conflicts
from using DCF for capital
budgeting decisions and
accrual accounting for
performance evaluation.
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Performance EvaluationPerformance Evaluation
A manager who uses DCF methods to make capitalbudgeting decisions can face goal congruence
problems if AARR is used forperformance evaluation.
Suppose top management uses the AARR tojudge performance if the minimum desired
rate of return is 10%.
A machine with an AARR of 6.4% will be rejected.
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Performance EvaluationPerformance Evaluation
The conflict between using AARR andDCF methods to evaluate performancecan 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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Relevant Cash FlowsRelevant Cash Flows
Relevant cash flows are expected future cashflows that differ among the alternatives.
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Relevant Cash FlowsRelevant Cash Flows
Net initial investment components
– cash outflow to purchase investment
– working-capital cash outflow
– cash inflow from disposal of old asset
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Relevant Cash FlowAnalysis Example
Relevant Cash FlowAnalysis Example
Old equipment:Current book value $50,000Current disposal price $ 3,000Terminal disposal price (5 years) 0Annual depreciation $10,000Working capital $ 5,000Income tax rate 40%
G. T. is considering replacing old equipment.
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Relevant Cash FlowAnalysis Example
Relevant Cash FlowAnalysis Example
Current disposal price of old equipment $ 3,000Deduct current book value of old equipment 50,000Loss on disposal of equipment $47,000
How much are the tax savings?
$47,000 × 0.40 = $18,800
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Relevant Cash FlowAnalysis Example
Relevant Cash FlowAnalysis Example
What is the after-tax cash flow fromcurrent disposal of old equipment?
Current disposal price $ 3,000Tax savings on loss 18,800Total $21,800
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Relevant Cash FlowAnalysis Example
Relevant Cash FlowAnalysis Example
New equipment:Current book value $225,000Current disposal price is irrelevantTerminal disposal price (5 years) 0Annual depreciation $ 45,000Working capital $ 15,000
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Relevant Cash FlowAnalysis Example
Relevant Cash FlowAnalysis Example
How much is the net investmentfor the new equipment?
Current cost $225,000Add increase in working capital 10,000Deduct after-tax cash flow from current disposal of old equipment – 21,800Net investment $213,200
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Relevant Cash FlowAnalysis Example
Relevant Cash FlowAnalysis Example
Assume $90,000 pretax annual cash flow fromoperations (excluding depreciation effect).
What is the after-tax flow from operations?
Cash flow from operations $90,000Deduct income tax (40%) 36,000Annual after-tax flow from operations $54,000
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Relevant Cash FlowAnalysis Example
Relevant Cash FlowAnalysis Example
What is the difference in depreciation deduction?
Annual depreciation of new equipment $45,000Deduct annual depreciation of old equipment 10,000Difference $35,000
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Relevant Cash FlowAnalysis Example
Relevant Cash FlowAnalysis Example
What is the annual increase in income taxsavings from depreciation?
Increase in depreciation $35,000Multiply by tax rate .40Income tax cash savings from additional depreciation $14,000
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Relevant Cash FlowAnalysis Example
Relevant Cash FlowAnalysis Example
What is the cash flow from operations,net of income taxes?
Annual after-tax flow from operations $54,000Income tax cash savings from additional depreciation 14,000Cash flow from operations, net of income taxes $68,000
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Relevant Cash FlowAnalysis Example
Relevant Cash FlowAnalysis Example
G. T. requires a 14% rate of returnon its investments.
What is the net present value of the newequipment incorporating income taxes?
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Relevant Cash FlowAnalysis Example
Relevant Cash FlowAnalysis Example
Net Cash NPV of NetYears 14% Col. Inflows Cash Inflows1-5 3.433 $68,000 $233,444 5 0.519 10,000 5,190Total PV of net cash inflows $238,636Investment 213,200Net present value of new equipment $ 25,436
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Postinvestment AuditPostinvestment Audit
A postinvestment audit compares the actualresults for a project to the costs and benefitsexpected at the time the project was selected.
It provides management with feedbackabout performance.
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Strategic ConsiderationsStrategic Considerations
Capital investment decisionsthat are strategic in nature
require managers to considera broad range of factors thatmay be difficult to estimate.
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End of Chapter 21End of Chapter 21