CH 13 Capital Budgeting Decisions

Managerial Accounting (Ch 13 Capital Budgeting Decisions)
CH 13 CAPITLA BUDGETING DECISIONS
Capital Budgeting-Planning Investments
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Typical capital budgeting decisions
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The term capital budgeting is used to describe how managers plan significant investments in projects
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that have long-term implications such as the purchase of new equipment or the introduction of new
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products. Typical capital budgeting decisions include:
i. Cost reduction decisions. Should new equipment be purchased to reduce costs?

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ii. Expansion decisions. Should a new plant, warehouse, or other facility be acquired to increase
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capacity and sales?

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iii. Equipment selection decisions. Which of several available machines should be purchased?
iv. Lease or buy decisions. Should new equipment be leased or purchased?
v. Equipment replacement decisions. Should old equipment be replaced now or later?
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The time value of money
Capital investments usually earn returns that extend over fairly long periods of time. Therefore, it is
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important to recognize the time value of money when evaluating investment proposals. Capital budgeting
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techniques that recognize the time value of money involve discounting cash flows.
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Discounted Cash Flows – The Net Present Value Method (NPV Method)
Under the NPV method, the present value of a project’s cash inflows is compared to the present value of
the project’s cash outflows. The difference between the present value of these cash flows, called the net
present value, determines whether or not the project is an acceptable investment.
Net Present Value (NPV)
NPV = PV (Cash-in) – PV (Cash-out)
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Cash outflows Cash inflows
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 Initial investment (including  Incremental revenues
installation costs)  Reduction in costs
 Increased working capital needs  Salvage value
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 Repairs and maintenance  Release of working capital

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 Incremental operating costs

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This is done by discounting back the life of the investment to determine whether they equal or exceed
the required investment. The basic discount rate is a company’s minimum required rate of return, which
usually is referred to as the cost of capital to the firm. The cost of capital is the average rate of return
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the company must pay to its long-term creditors and its shareholders for the use of their funds. If a
project’s rate of return is less than the cost of capital, the company does not earn enough to compensate its
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creditors and shareholders. Therefore, any project with a rate of return less than the cost of capital should
be rejected.
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Ex1) Elgin Restaurant Supplies is analyzing the purchase of manufacturing equipment that will cost
$20,000. The annual cash inflows for the next three years will be:
Year Cash Flow

1 $10,000
2 9,000
3 6,500
With a cost of capital of 12 %, should the machine be purchased?
PV of cash OUT: 20,000
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PV of cash IN: 20,730
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NPV: 20,730-20,000 = $730
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Therefore, the machine should be purchased.
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Ex2) harper Company is contemplating the purchase of a machine capable of performing some operations
that are now performed manually. The machine will cost $50,000, and it will last for five years. At the end
of the five-year period, the machine will have a zero scrap value. Use of the machine will reduce labor
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costs by $18,000 per year. Harper Company requires a minimum pretax return of 20% on all investment
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projects. Determine on the purchase of the machine.
PV of cost savings: 18,000 * PVIFA (20%, 5) = 18,000 * 2.991 = 53,838

PV of cash outflow: 50,000
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NPV: 53,838 – 50,000 = $3,838

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Therefore, it is more profitable to purchase the machine.

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Ex3) Aerospace Dynamics will invest $110,000 in a project that will produce the following cash flows.
The cost of capital is 11 percent. Should the project be undertaken? (Note: The fourth year’s cash flow is
negative.)
Year Cash flow

1 $36,000
2 44,000
3 38,000
4 (44,000)
5 81,000
PV of Cash IN: 32,432 + 35,711 + 27,785 + 48,070 = 143,998
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PV of Cash OUT: 110,000 + 28,984 = 138,984
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NPV: 143,998-138,984 = $5,014
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Discounted Cash Flows – The Internal Rate of Return Method (IRR Method)
The internal rate of return (IRR) is the rate of return promised by an investment project over its useful
life.
I. The internal rate of return is computed by finding the discount rate that equates the present value
of a project’s cash outflows with the present value of its cash inflows.
II. In other words, the internal rate of return is the discount rate that results in a net present value of
zero.
III. To evaluate a project, the internal rate of return is compared to the company’s minimum
required rate of return, which is usually the company’s cost of capital. If the internal rate of
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return is equal to or greater than the required rate of return, then the project is acceptable. If the
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internal rate of return is less than the required rate of return, then the project is rejected.
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Computing the IRR
Find a rate such that PV (Cash-in) = PV (Cash-out).

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Common Pattern)
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Initial Cost = PVIFA (R, n) * periodic cash receipt

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Evaluation of a project using the IRR
I. IRR > Cost of Capital: the project is acceptable.

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II. IRR < Cost of Capital: the project is rejected.

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Ex1) You buy a new piece of equipment for $19,477, and you receive a cash inflow of $3,000 per year for
12 years. What is the internal rate of return?
11%
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Ex2) Glendale School District is considering the purchase of a large tractor-pulled lawn mower. At
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present, the lawn is mowed using a small hand-pushed gas mower. The large, tractor-pulled mower will
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cost $16,950 and will have a useful life of 10 years. It will have a negligible scrap value, which can be
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ignored. The tractor-pulled mower would do the job faster than the old mower, resulting in labor savings
of $3,000 per year. If the cost of capital to Glendale School District is 10%, is it worthwhile to purchase
the lawn mower?
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16,950 = 3,000 * PVIFA (IRR, 10)

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PVIFA (IRR, 10): 5.650

IRR: 12% > 10%, Therefore, it is worthwhile to purchase the lawn mower.
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Other Approaches to Capital Budgeting Decisions
THE PAYBACK METHOD
Under the payback method, we compute the time required to recoup the initial investment. The basic
premise of the payback method is that the more quickly the cost of an investment can be recovered, the
more desirable is the investment.
I. It focuses on the payback period
II. The payback period is the length of time that it takes for a project to recover its initial cost from
the net cash inflows that it generates.
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III. “The time that it takes for an investment to pay for itself.”
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IV. The payback period is expressed in years.
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Computing the PP (Payback Period)

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Investment Required
PP =
Annual net cash inflow
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Ex1) York Company needs a new milling machine. The company is considering two machines: machine A
and machine B. Machine A costs $15,000, has a useful life of ten years, and will reduce operating costs by
$5,000 per year. Machine B costs only $12,000, will also reduce operating costs by $5,000 per year, but
has a useful life of only five years. What is the payback period to each machine?
A) 15,000/ 5,000 = 3 years

B) 12,000/ 5,000 = 2.4 years
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Ex2) Assume a $100,000 investment and the following cash flows for two alternatives.
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Cash inflows
Year Investment A Investment B
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1 $40,000 $30,000
2 30,000 50,000
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3 15,000 10,000
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4 15,000 50,000
5 50,000 -
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Which of the two alternatives would you select under the payback method?
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Payback period
A) 4 years
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B) 3.2 years (Selected)

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THE SIMPLE RATE OF RETURN METHOD (ARR)

The simple rate of return method is another capital budgeting technique that does not involve discounting
cash flows. The simple rate of return is also known as the accounting rate of return or the unadjusted rate
of return. Unlike the other capital budgeting methods, the simple rate of return method focuses on
accounting net operating income rather than cash flows.
Computing the ARR (Accounting Rate of Return, or Simple Rate of Return)
Annual incremental net operating income

ARR =
Inital Investment
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I. Depreciation charges that result from making the investment should be deducted when
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determining the annual incremental net operating income.
II.
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The initial investment should be reduced by any salvage value realized from the sale of old
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equipment.
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Ex) Brigham Tea, Inc., is a processor of low-acid tea. The company is contemplating purchasing
equipment for an additional processing line that would increase revenues by $90,000 per year.
Incremental cash operating expenses would be $40,000 per year. The equipment would cost $180,000 and
have a nine-year life with no salvage value Calculate the simple rate of return.
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30,000
= 16.7%
180,000
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Managerial Accounting (Ch 13 Capital Budgeting Decisions)

CH 13 CAPITLA BUDGETING DECISIONS

Capital Budgeting-Planning Investments

i. Cost reduction decisions. Should new equipment be purchased to reduce costs?

capacity and sales?

The time value of money

Bunker Hill Community College Page 1

Net Present Value (NPV)

NPV = PV (Cash-in) – PV (Cash-out)

 Repairs and maintenance  Release of working capital

 Incremental operating costs

Bunker Hill Community College Page 2

Year Cash Flow

With a cost of capital of 12 %, should the machine be purchased?

PV of cash OUT: 20,000

projects. Determine on the purchase of the machine.

PV of cost savings: 18,000 * PVIFA (20%, 5) = 18,000 * 2.991 = 53,838

NPV: 53,838 – 50,000 = $3,838

Therefore, it is more profitable to purchase the machine.

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Year Cash flow

PV of Cash IN: 32,432 + 35,711 + 27,785 + 48,070 = 143,998

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Find a rate such that PV (Cash-in) = PV (Cash-out).

Initial Cost = PVIFA (R, n) * periodic cash receipt

Evaluation of a project using the IRR

I. IRR > Cost of Capital: the project is acceptable.

II. IRR < Cost of Capital: the project is rejected.

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16,950 = 3,000 * PVIFA (IRR, 10)

PVIFA (IRR, 10): 5.650

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Other Approaches to Capital Budgeting Decisions

THE PAYBACK METHOD

I. It focuses on the payback period

Computing the PP (Payback Period)

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A) 15,000/ 5,000 = 3 years

B) 3.2 years (Selected)

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THE SIMPLE RATE OF RETURN METHOD (ARR)

Computing the ARR (Accounting Rate of Return, or Simple Rate of Return)

Annual incremental net operating income

Bunker Hill Community College Page 9

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