CHAPTER 21

CAPITAL BUDGETING AND COST ANALYSIS

LEARNING OBJECTIVES
1. Recognize the multiyear focus of capital budgeting

2. Understand the six stages of capital budgeting for a project

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

4. Use and evaluate the payback method

5. Use and evaluate the accrual accounting rate-of-return (AARR) method

6. Identify and reduce conflicts from using DCF for capital budgeting decisions and accrual accounting
for performance evaluation

7. Identify relevant cash inflows and outflows for capital budgeting decisions

CHAPTER OVERVIEW
Chapter 21 looks at long-run decisions, those spanning multiple years. The focus moves from operations
of a year-by-year approach to that of an entire life span of a project. The accounting for capital budgeting
on a project-by-project approach is similar to life-cycle costing introduced in Chapter 12. The role of the
management accountant is highlighted in the six stages of capital budgeting.

Four quantitative methods used in making capital budgeting decisions are described and illustrated. The
two methods that focus on cash flows and the time value of money are net present value and internal rate-
of-return, discounted-cash flow models. Typically, the discounted cash-flow methods are superior for
providing information in the decision-making process because they are the most comprehensive in scope.
The concept of money having time value is a main feature of these models. The other methods presented
are the payback method and the accrual accounting rate-of-return. The payback method does use cash
flow as a basis but does not incorporate time value of money nor profitability. The accrual accounting
rate-of-return does not focus on cash flow but uses measures from the income statement. The role of
income taxes is incorporated within the chapter and the role of inflation is in the appendix to the chapter.

Though the methods presented provide a basis on which to make a quantitative financial decision, the
chapter examines the importance of nonfinancial quantitative and qualitative aspects for each decision.
The tension of evaluating a decision using a different model than the one used to make the initial decision
is discussed.

Capital Budgeting and Cost Analysis 31

Analysis of ways to increase capital (value) of business with projects that span multiple years II. To distinguish which types of capital expenditure projects are necessary to accomplish organization objectives and strategies b. All cash flows or cash savings over entire life considered B. A project dimension for capital budgeting over entire life of project (horizontal) [Exhibit 21-1] 1. Two dimensions of cost analysis Learning Objective 1: Recognize the multiyear focus of capital budgeting A. Life of a project is more than one year 2. An accounting-period dimension with focus on income determination and routine planning and control that cuts across all projects (vertical) 1. Accumulates revenues and costs on a project-by-project basis 2. An accounting system that corresponds to project dimension—life-cycle costing [See Chapter 12] 1. Six stages in capital budgeting 1. To use line management to identify projects linked to organization’s objectives and strategies 32 Chapter 21 . Accounting period of one year 2.CHAPTER OUTLINE I. Reported income for managers’ bonuses and for effect on company’s stock price C. Stages of capital budgeting A. Capital budgeting: a decision-making and control tool for making long-run planning decisions for investments in projects that span multiple years Learning Objective 2: Understand the six stages of capital budgeting for a project B. Accumulation extends accrual accounting system to a system that computes cash flow or income over entire project covering many accounting periods III. Capital budgeting overview A. Challenge to managers to balance long-run and short-run issues B. Stage 1: Identification stage a.

To use judgment of managers for considering nonfinancial considerations of conclusions based on formal analysis 5. Discounted cash-flow (DCF) methods 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 1. Stage 3: Information-acquisition stage a. Weights cash flows by time value of money and usually most comprehensive and best methods to use Capital Budgeting and Cost Analysis 33 . To use a postinvestment audit to evaluate if projections made at time of selection compare toactual results IV. Use time value of money: dollar received today is worth more than a dollar received in the future (opportunity cost from not having the money today) [Exercise 21-16 and Appendix C] a. Capital budgeting methods A. Stage 2: Search stage a. Stage 5: Financing stage a. To use organization’s treasury function for sources of financing. Stage 6: Implementation and control stage a. internally using generated cash flow and externally through capital markets 6. Stage 4: Selection stage a. To use cross-functional teams from all parts of the value chain to evaluate alternatives 3. To use financial and nonfinancial costs and benefits that can be quantitative or qualitative 4. Measure all expected future cash inflows and outflows of a project as if they occurred at a single point in time 2. To get projects underway and monitor their performance b. To obtain project funding b. To consider the expected costs and the expected benefits of alternative capital investments b. To explore alternatives of capital investments that will achieve organization objectives b. 2. To choose projects of implementation whose expected benefits exceed expected costs by the greatest amounts b.

using required rate of return (RRR) i. Step 3: Sum the present value figures to determine the net present value (net means some amounts are inflows and others are outflows—the difference)  If NPV is zero or positive. accept—cash flows are adequate to recover net initial investment and earn a return equal to or greater than RRR over useful life of project 34 Chapter 21 . Step 2: Choose the correct compound interest table from Appendix C  Use given discount factors of time periods (n) and interest rate (r or i)  Determine if annuity (series of payments of equal time and amount) or lump sum payment iii. hurdle rate. or (opportunity) cost of capital  Point of comparison when using internal rate of return (IRR) B. Net present value (NPV) method a. Required rate of return (RRR): minimum acceptable rate of return on an investment  Return the organization could expect to receive elsewhere for investment of comparable risk  Also called discount rate. Only projects with zero (return = RRR) or positive (return > RRR) net present value acceptable ii. NPV method i. Step 1: Draw a sketch of relevant cash inflows and outflows [Exhibit 21-2]  Organizes data in systematic way  Focuses only on cash flows  Indifferent as to where cash flows come from ii. the better when all other things equal b. Higher the NPV. Expects cash amount to be greater in the future than cash invested now (present) 4. Focuses on cash flows rather than operating income as determined by accrual accounting 3. b. Two DCF methods 1. NPV calculates expected monetary gain or loss from project by discounting all expected future cash inflows and outflows to the present point in time.

Table 4. do not accept—expected rate of return is below RRR c. IRR method  Use calculator or computer program to compute  Use trial-and-error approach  Step 1: Calculate NPV using a chosen discount rate  Step 2: Choose (and keep trying) a lower or higher discount rate to have NPV equal zero. IRR calculates the discount rate at which the present value of expected cash inflows from a project equals the present value of expected cash outflows b. Internal rate-of-return method [Exhibit 21-3] a. and Problems for Self-Study]  Accept project if internal rate of return (IRR) equals or exceeds required rate of return (RRR) 3. NPV needs managers to also judge nonfinancial factors 2. the point at which the chosen rate is the IRR (If NPV < 0. Helps managers focus on decisions that are most sensitive to different assumptions and worry less about decisions that are not so sensitive C. NPV assumes reinvestment at required rate of return in comparing projects with unequal economic lives whereas internal rate-of-return does not have such comparison available 4. Comparison of net present value and internal rate-of-return methods a. Sensitivity analysis used to examine how a result from use of NPV or IRR will change if predicted financial outcomes are not achieved or if an underlying assumption changes b. Sensitivity analysis [Exhibit 21-4] a. use lower rate. if NPV > 0. NPV uses dollars rather than percentages that aids in summing individual projects to see effect of accepting a combination of projects. use higher rate)  Use factor from present value of an annuity table if cash inflows are equal [Refer to Exhibit 21-3. IRR of individual projects cannot be added or averaged to represent IRR of a combination of projects b. Payback method Learning Objective 4: Use and evaluate the payback method Capital Budgeting and Cost Analysis 35 .  If NPV is negative.

Fails to incorporate the time value of money b. Payback measures time it will take to recoup. Used when preliminary screening of many proposals is necessary c. Without uniform cash flows: Each year’s cash flow accumulated until sum equals net initial investment c. if all other things are equal e. AARR calculations [Surveys of Company Practice] 36 Chapter 21 . Organization can choose a cutoff period as basis for accepting or rejecting payback of project 2. Simplest to calculate with project having uniform cash flows i. 1. Method easy to understand. as DCF methods not affected by accrual accounting conventions such as depreciation b. Highlights liquidity d. in form of expected future cash flows. Does not distinguish between origins of cash flows (like DCF models) b. Does not consider a project’s cash flows after the payback period c. Expected cash flows in later years of a project are highly uncertain 3. Ignores cash flows after the payback period d. Payback useful measure a. Projects with shorter paybacks preferred to those with longer paybacks. With uniform cash flows: Net initial investment ÷ Uniform increase in annual future cash flows ii. Payback weaknesses a. Accrual accounting rate-of-return method Learning Objective 5: Use and evaluate the accrual accounting rate-of-return (AARR) method 1. Accrual accounting rate-of-return (AARR) method: divides an accrual accounting measure of income by an accrual accounting measure of investment (also called accounting rate of return) 2. Method may promote only short-lived projects from choosing too short a cutoff period D. the net initial investment in a project a.

and Problems 21-27. Relevant after-tax flows [Exhibit 21-6] a. 21. Evaluating managers and goal-congruence issues 1. 22. Two methods based on income statement: one focuses on cash items only. Increase in expected average annual after-tax operating income ÷ Net initial investment b. Calculates return using operating income numbers after considering accruals and taxes whereas IRR calculates return on basis of after-tax cash flows and time value of money (IRR method regarded as better than AARR method) d. Relevant cash flows: differences in expected future cash flows as a result of making the investment 2. Assign Exercises 21-17. the other used with net income and depreciation adjustments ii. Relevant cash flows in discounted cash flow analysis [Exhibit 21-5] Learning Objective 7: Identify relevant cash inflows and outflows for capital budgeting decisions 1. a. 23. Computations easy to understand and they use numbers reported in the income statement e. Inconsistency between using the NPV method as best for capital budgeting decisions and then using a different method to evaluate performance over short time horizon (such as accrual accounting results) 2. Temptations for managers to use methods that would increase bonuses or personal goals or if transferred frequently B. 20. and 30. 29. Differential approach used i. 18. Other considerations Learning Objective 6: Identify and reduce conflicts from using DCF for capital budgeting decisions and accrual accounting for performance evaluation A. then income tax (t) aspect = t x S  If depreciation (D) in any aspect. the income tax aspect = t x D Capital Budgeting and Cost Analysis 37 . One method uses cash flow from operations—item-by-item method  If savings (S) in any aspect. V. Considers income earned throughout a project’s expected useful life (unlike payback which ignores cash flows after payback period) Do multiple choice 1–8. Quotient is rate (similar to IRR) or percentage c.

Some initial investments are more complex and take more time 2. take the deduction sooner rather than later Do multiple choice 9 and 10. 24. C. Assign Exercises 21-19. Net initial investment  Initial machine investment (cash outflow to purchase machine)  Initial working capital of investment (working-capital cash flow)  After-tax cash flow from current disposal of old machine (cash inflow) ii. and Problems 21-28. Operations (difference between each year’s cash flow under the alternatives)  Annual after-tax cash flow from operations (excluding depreciation effects)  Income tax cash savings from annual depreciation deduction iii. Problems in implementing the project 38 Chapter 21 . 25. the income tax aspect = t x G  If loss (L) in any aspect. Provides feedback about performance i. Compares actual results for a project to the costs and benefits expected at time project selected b. the income tax aspect = t x L b. Management control of the project—postinvestment audit a. Managing the project 1. Management control of the investment activity itself a. General rule in tax planning used—where there is a legal choice. Some initial investments are relatively easy to implement b. Terminal disposal of assets and recovery of working capital  After-tax cash flow from terminal disposal of machine  After-tax cash flow from recovery of working capital c. 31. Three categories of cash flows for capital investment projects i. and 32.  If gain (G) in any aspect. Original estimates overly optimistic iii.

d 9. customer base. Illustration using example of intangible asset of customer base a.c 6.a 7. By recognizing that not all customers will be retained over an extended time period (customer retention rate measures percentage of existing customers that will be retained next period) iii.b Capital Budgeting and Cost Analysis 39 . Intangible assets and capital budgeting 1. By recognizing that new customers will be attracted c. Strategic decisions about intangible assets such as brand names. Cash inflows (revenues minus expenses) for each customer compared over a period of years b. and intellectual capital of employees 2.d 8.d 2.a 4.c 3.c 10.b 5. By recognizing an even longer time horizon ii. Capital budgeting methods (NPV) useful for evaluating a company’s intangible assets 3. Success in maintaining long-run profitable relationships with customers highlighted V. Capital investment decisions that are strategic require consideration of broad range of factors that may be difficult to estimate or measure E. Company’s strategy is source of its strategic capital budgeting decisions 2. D. Strategic considerations in capital budgeting 1. Analysis refined in at least three ways i. Appendix: Capital budgeting and inflation CHAPTER QUIZ SOLUTIONS: 1.

The old machine is fully depreciated but can be used by the corporation through 2006. d.250).61 3. 5.57 .73 1.00 Received at the End of Period Present Value of an Annuity of $1. [CPA Adapted] If the algebraic sum of the present values of all cash flows related to a proposed capital expenditure discounted at the company’s required rate of return is positive.64 . 4.89 . 5.84 .04 2. 2002. c. c. Due to the increased efficiency of the new machine. $175. Hilltop uses the straight-line method of depreciation for all classes of machinery. the net present value for replacing the old machine with the new machine is a.CHAPTER QUIZ 1.86 .91 0. 3.68 . If Hilltop decides to replace the old machine. investment is the best alternative. [CMA Adapted] The internal rate of return. All operating cash receipts.49 2.83 .77 2 1.000 for the new machine would be paid in cash at the time of replacement. estimated annual cash savings of $125.32 4 .68 . 40 Chapter 21 . If the replacement occurs. return on the investment exceeds the company’s required rate of return.6 years. The disposal value of the old machine would be zero at the end of 2006. 0%. 5.43 2.68 3 2. $48. and applicable tax payments and credits are assumed to occur at the end of the year.89 0. Baker Company has offered to purchase it for $40. 28%.91 . is a. 2. b. 6%. it indicates that the a.000 would be generated through 2006.6%. to the nearest percent.91 5 .93 0. d.78 1.79 . 10%.75 . Present Value of $1. a new machine would be acquired from Busby Industries on January 2. c. The accrual accounting rate of return on the initial investment. b.94 .79 . Assume for questions 2–6 that Hilltop is not subject to income taxes.94 0. the end of its expected useful life.71 .80 . c. $(36.4 years. d. 8%.40 2.88 2 . The Hilltop Corporation is considering (as of 1/1/02) the replacement of an old machine that is currently being used. 3.99 3. c. The following data apply to questions 2–6.93 .69 1.0 years. to replace the old machine is a.67 2. resultant amount is the maximum that should be paid for the asset.000. operating cash expenditures. The new machine is expected to have a zero disposal price at the end of 2006.83 1.31 3. 4.62 . b. 12%. Hilltop employs the calendar year for reporting purposes.17 3. [CMA Adapted] If Hilltop requires investments to earn an 8% return. 4. [CMA Adapted] The payback period to replace the old machine with the new machine is a.89 .88 1 0.000.00 Received at the End of Each Period Period 6% 8% 10% 12% 14% Period 6% 8% 10% 12% 14% 1 .%.74 .47 3.5 years. discount rate used is not the proper required rate of return for this company.000 on the replacement date.59 4 3. Discount tables for several different interest (discount) rates that are to be used in any discounting calculations are given below.75 .750.21 3. The purchase price of $500. d.0. $50. b. d. b.65 3 .79 3. to the nearest percent.52 5 4.58 2.

825.500 d. $125. Yes No 8.500 10. Refer to data for questions 2–6. $18. Yes Yes d. No No 9.500 b.000 c.6. c. [CPA Adapted] The payback capital budgeting technique considers Time value of money Income over entire life of project a. the net present value for replacing the old machine with the new machine is a. lower direct labor cost and less scrap and rework. If Hilltop is subject to an income tax rate of 30% and a required rate of return of 8 %. $3. [CPA Adapted] The assumption that cash flows are reinvested at the rate earned by the investment belongs to which of the following capital budgeting methods? Internal rate of return Net present value a.425. $117. $87. what amount of annual cash savings would be used in a discounted cash flow method or in the payback method? a. d. d. improved competitive position and cost of retraining of personnel. c. $157. Among the nonfinancial quantitative and qualitative factors that Hilltop should consider in its analysis are a. Yes Yes b. $(100. lower product defect rate and faster response to market changes. No No b. Refer to data for questions 2–6. $163.875). If Hilltop is subject to an income tax rate of 30%. 7. No Yes c. b. Capital Budgeting and Cost Analysis 41 .825. Yes No c. lower hourly support labor cost and reduction in manufacturing cycle time. No Yes d. b.

WRITING/DISCUSSION EXERCISES 1. In Chapter 12. The importance of cash flow is noted by requiring the cash flow statement as one of the basic financial statements of a company.  Varying the required payback time (discussed in chapter in text). The decisions about projects involve the entire organization as noted in each of the stages. the higher the required rate of return and the faster management would want to recover the net initial investment. 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 What approaches might be used to recognize risk in capital budgeting? The required rate of return (RRR) is a critical variable in discounted cash flow analysis. 42 Chapter 21 . is separated from the operating events in the cash flow statement because of timing differences. Risk is used here to refer to the business risk of the project. 3. Can the emphasis on cash flows be reconciled with an accrual accounting approach? A basic tenet of accrual accounting is realization. Project-by-project approach to capital budgeting decision has these same characteristics. A safe generalization is that the higher the risk. not the specific manner in which the project is financed. (b) a high percentage of total life-cycle costs were incurred before production began and before any revenues received.  Adjusting the estimated future cash inflows (reduce the estimated cash inflows if higher risk). the emphasis is on the objectives and strategy of the organization. Recognize the multiyear focus of capital budgeting Compare the reasons for using life-cycle costing to the project-by-project orientation for capital budgeting. not because of basic differences in amounts. life-cycle costing was noted as being particularly important when (a) nonproduction costs were large.  Estimating the probability distribution of future cash inflows and outflows for each project. and (c) many of the life-cycle costs were locked in at the beginning stages of the process.  Sensitivity analysis (discussed in chapter in text). though recognizing revenue when earned and expense when incurred. 2. The accrual basis of accounting. Understand the six stages of capital budgeting for a project How do the six stages of capital budgeting support the concept that one can look at resource allocation in a budget and note what top management considers most important? Throughout the six stages. Organizations can use one or more of the following in dealing with risk factors of projects:  Adjusting the required rate of return (higher rate when higher risk). It is the rate of return that the organization forgoes by investing in a particular project rather than in an alternative project of comparable risk. A higher risk means a greater chance that the project may lose money. and what makes management willing to take added risk is a higher expected rate of return.

Identify relevant cash inflows and outflows for capital budgeting decisions What would be the effect of using a depreciation method other than straight-line when considering the role of income taxes on the net present value method? Accelerated depreciation methods such as double-declining balance and sum-of-years’ digits serve the purpose of taking the deduction sooner rather than later. It has been stated that the conceptual framework for financial accounting is primarily the definition of terms. For example. Chapter 9 – LO4. Use and evaluate the payback method The payback method of capital budgeting has been compared to a meat cleaver and the discounted cash flow methods to a scalpel. Only projects that would pay back within a prescribed number of years would be considered in more detail. 7. The cash flow in the earlier years is larger (tax savings). Some examples thus far have been from Chapter 6 – LO 8 (related one in Chapter 15 – LO2). “Return” has several different meanings. the value of common meanings for terms is critical. Chapter 11 – LO9. resulting in higher NPV. net income. 6. Because accounting serves as an information tool for organizations (“the language of business”). the evaluation of the results of that decision should be in terms of the fulfilling of that purpose—and not other purposes. Use and evaluate the accrual accounting rate-of-return (AARR) method Discuss the need to specifically define words used in describing the various methods. an initial threshold could be established by use of the payback method. 5. Similar situations are discussed in the last two chapters—22 and 23. income before interest and income taxes. the use of the term “return” elicits several definitions. and income from extraordinary items among other uses. and Chapter 20 – LO3. The text clearly illustrates the use of the term in this chapter. Identify and reduce conflicts from using DCF for capital budgeting decisions and accrual accounting for performance evaluation The tension between methods used to make the initial decision and then to evaluate the decision is an ongoing problem. Capital Budgeting and Cost Analysis 43 . Do note that the accrual accounting method has its own required rate of return that differs from the required rate of return used in net present value or internal rate of return. creating more present value inflows. Why might this be an appropriate analogy? If an organization must select a few projects from a large pool of projects. Income can mean operating income.4. Recall some other situations in which this has been noted. One common point to be noted: If the purpose is clearly stated and understood for original decision. Return can mean income.

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