Ch12 - Planning For Capital Investment

4/23/2020
Managerial Accounting
Eighth Edition
Weygandt Kimmel Kieso
Chapter 12
Planning for Capital Investments
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Chapter Outline
Learning Objectives
LO 1 Describe capital budgeting inputs and apply the
cash payback technique.
LO 2 Use the net present value method.
LO 3 Identify capital budgeting challenges and
refinements.
LO 4 Use the internal rate of return method.
LO 5 Use the annual rate of return method.
Copyright ©2018 John Wiley & Sons, Inc. 2
Cost Flow Information
LEARNING OBJECTIVE 1
Describe capital budgeting inputs and apply the cash
payback technique.
For purposes of capital budgeting, estimated cash

inflows and outflows are the preferred inputs.
Why?
Ultimately, the value of all financial investments is

determined by the value of cash flows received and paid.
LO 1 Copyright ©2018 John Wiley & Sons, Inc. 3
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Typical cash flows relating to capital budgeting
Cash Outflows
Initial investment
Repairs and maintenance
Increased operating costs
Overhaul of equipment
Cash Inflows
Proceeds from sale of old equipment
Increased cash received from customers
Reduced cash outflows related to operating costs
Salvage value of equipment

Considerations for capital budgeting decisions
• Availability of funds.
• Relationships among proposed projects.
• Company’s basic decision-making approach.
• Risk associated with a particular project.
Illustrative Data
Stewart Shipping Company is considering an investment
of $130,000 in new equipment.
Initial investment $130,000

Estimated useful life 10 years
Estimated salvage value -0-
Estimated annual cash flows
Cash inflows from customers $200,000
Cash outflows for operating costs 176,000
Net annual cash flow $ 24,000
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Cash Payback
Cash payback formula
Cash payback technique identifies time period required to
recover cost of capital investment from net annual cash
inflow produced by investment.
Cash payback period for Stewart is …
Cost of Capital Net Annual Cash Payback

 =
Investment Cash Flow Period
$130,000  $24,000 = 5.42 years
Cash Payback
Evaluation of project
Shorter payback period = More attractive investment
In case of uneven net annual cash flows, company
determines cash payback period when:
Cumulative net
Cost of
cash flows from =
investment
investment
Cash Payback
Cash payback period-unequal cash flows
Illustration: Chen Company proposes an investment in a
new website that is estimated to cost $300,000.
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Cash Payback
Question
A $100,000 investment with a zero scrap value has an 8-
year life. Compute the payback period if straight-line
depreciation is used and net income is determined to be
$20,000.
a. 8.00 years.
b. 3.08 years.
c. 5.00 years.
d. 13.33 years.
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DO IT! 1 Cash Payback Period

Watertown Paper Corporation is considering adding another
machine for the manufacture of corrugated cardboard. The machine
would cost $900,000. It would have an estimated life of 6 years and
no salvage value. The company estimates that annual cash inflows
would increase by $400,000 and that annual cash outflows would
increase by $190,000. Compute the cash payback period.
Estimated annual cash inflows $400,000

Estimated annual cash outflows 190,000
Net annual cash flow $210,000
$900,000
Cash payback period = = 4.3 years
$210,000
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Net Present Value Method
Use the net present value method.
Discounted cash flow technique:

• Generally recognized as best approach
• Considers both estimated total cash inflows and time value
of money
• Two methods:
o Net present value (NPV)
o Internal rate of return (IRR)
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The primary capital budgeting technique
• Cash inflows are discounted to their present value and

then compared with capital outlay required by investment
• Interest rate used in discounting is required minimum rate
of return
• Proposal is acceptable when NPV is zero or positive
• Higher positive NPV, more attractive investment
13

Net present value decision criteria
Proposal is acceptable
when net present value
is zero or positive.
14
Equal Annual Cash Flows

Present value of equal net annual cash flows
Illustration: In the Stewart Shipping Company example
(Illustration 12.3), the company’s net annual cash flows are
$24,000. If we assume this amount is uniform over the
asset’s useful life, we can compute the present value of the
net annual cash flows.
Present Value
at 12%
Discounted factor for 10 periods 5.65022
Present value of net cash flows:
$24,000 × 5.65022 $135,605
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Equal Annual Cash Flows

Net present value-equal net annual cash flows
Illustration: Calculate the net present value.
12%
Present value of net cash flows $135,605
Less: Capital investment 130,000
Net present value $ 5,605
Proposed capital expenditure is acceptable at a required

rate of return of 12% because the net present value is
positive.
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Unequal Annual Cash Flows

Illustration
Stewart Shipping Company expects the same total net cash
flows of $240,000 over the life of the investment. Because of
a declining market demand for the new product the net
annual cash flows are higher in the early years and lower in
the later years.
The present value of the net annual cash flows is calculated
as follows.
17

Present value of unequal annual cash flows
Assumed Net Discount Factor Present Value
Year
Annual Cash Flows 12% 12%
(1) (2) (1) × (2)
1 $34,000 0.89286 $30,357
2 30,000 0.79719 23,916
3 27,000 0.71178 19,218
4 25,000 0.63552 15,888
5 24,000 0.56743 13,618
6 22,000 0.50663 11,146
7 21,000 0.45235 9,499
8 20,000 0.40388 8,078
9 19,000 0.36061 6,852
10 18,000 0.32197 5,795
LO 2 $240,000 $144,367 18
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Net present value-unequal annual cash flows
Illustration: Calculate the net present value.
12%
Present value of net cash flows $144,367
Proposed capital expenditure is acceptable at a required rate

of return of 12% because the net present value is positive.
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Choosing a Discount Rate

Rate to obtain funds from creditors and stockholders
In most instances a company uses a required rate of return
equal to its cost of capital — that is, the rate that it must pay
to obtain funds from creditors and stockholders.
Discount rate has two elements:
• Cost of capital
• Risk
Rate also know as required rate of return, hurdle rate,

and cutoff rate.
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Choosing a Discount Rate

Comparison of NPV at different discount rates
Illustration: Stewart Shipping used a discount rate of 12%.
Suppose this rate does not take into account the risk of the
project. A more appropriate rate might be 15%.
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Simplifying Assumptions
• All cash flows come at end of each year
• All cash flows are immediately reinvested in another
project that has a similar return
• All cash flows can be predicted with certainty
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Net Present Value (NPV) Method

Question
Compute the net present value of a $260,000 investment
with a 10-year life, annual cash inflows of $50,000 and a
discount rate of 12%.
a. $(9,062)
b. $22,511
c. $9,062
d. $(22,511)
23
Comprehensive Example
Investment information for Best Taste Foods
Best Taste Foods is considering investing in new equipment to
produce fat-free snack foods.
Initial investment $1,000,000
Cost of equipment overhaul in 5 years $200,000
Salvage value of equipment in 10 years $20,000
Cost of capital (discount rate) 15%
Estimated annual cash flows
Cash inflows received from sales $500,000
Cash outflows for cost of goods sold $200,000
Maintenance costs $30,000
Other direct operating costs $40,000
LO 2 24
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Computation of net annual cash flow
Compute the net annual cash flows for this project.
Cash inflows received from sales $ 500,000

Cash outflows for cost of goods sold (200,000)
Maintenance costs (30,000)
Other direct operating costs (40,000)
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NPV of Best Taste Foods investment
Compute the net present value for this proposed investment.
15%
Time Cash Discount Present
Event Period Flow × Factor = Value
Net annual cash flow 1-10 $ 230,000 5.01877 $1,154,317
Salvage value 10 20,000 .24719 4,944
Less: Equipment
purchase 0 1,000,000 1.00000 1,000,000
Less: Equipment
overhaul 5 200,000 .49718 99,436

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DO IT! 2: Net Present Value

Problem data
machine for the manufacture of corrugated cardboard. The
machine would cost $900,000. It would have an estimated
life of 6 years and no salvage value. The company estimates
that annual cash inflows would increase by $400,000 and
that annual cash outflows would increase by $190,000.
Management has a required rate of return of 9%.
Calculate the net present value on this project and
discuss whether it should be accepted.
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DO IT! 2: Net Present Value

Solution
Calculate the net present value on this project and discuss whether it
should be accepted.

9% Discount Present
Cash Flow Factor Value
Present value of net annual cash flows $210,000 4.48592 $942,043
Net present value $42,043
NPV is greater than zero, Waterton should accept the project.
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Capital Budgeting Challenges and Refinements
Identify capital budgeting challenges and refinements.
Intangible Benefits
Might include increased quality, improved safety, or enhanced
employee loyalty.
To avoid rejecting projects with intangible benefits:
1. Calculate NPV ignoring intangible benefits
2. Project conservative estimates of value of intangible benefits,
and incorporate these values into NPV calculation
29
Intangible Benefits
Example: Berg Company is considering the purchase of a new
mechanical robot.
Annual cash inflows $ 50,000
Annual cash outflows 20,000
Estimated life of equipment 10 years
12% Discount Present

Cash Flows × Factor = Value
Present value of net annual
cash flows $ 30,000 × 5.65022 = $169,507
Initial investment 200,000
Net present value Project is not acceptable $ (30,493)
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Intangible Benefits Example

Problem data
Berg estimates that improved sales will increase cash inflows
by $10,000 annually as a result of an increase in perceived
quality. Berg also estimates that annual cost outflows would
be reduced by $5,000 as a result of lower warranty claims,
reduced injury claims, and fewer missed work days.
Using these conservative estimates of the value of the
additional benefits, should Berg accept the project?
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Intangible Benefits Example

Solution
Berg would accept the project.
Annual cash inflows (revised) $ 60,000 ($50,000 + $10,000)
Annual cash outflows (revised) 15,000 ($20,000 − $5,000)
Estimated life of equipment 10 years
12% Discount Present
Cash Flows × Factor = Value
Present value of net
annual cash flows $ 45,000 × 5.65022 = $254,260
Initial investment 200,000
Net present value Project is acceptable $ 54,260
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Profitability Index for Mutually

Exclusive Projects
• Proposals are often mutually exclusive
• Managers choose between various positive NPV projects
because of limited resources
• Tempting to choose project with higher NPV
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Profitability Index for Mutually

Exclusive Projects - NPVcomputation
Illustration: Two mutually exclusive projects, each
assumed to have a 10-year life and a 12% discount rate.
Project A Project B
Net annual cash flow $10,000 $19,000
Salvage value 5,000 10,000
Present value of net cash flows
($10,000 × 5.65022) + ($5,000 × .32197) 58,112
($19,000 × 5.65022) + ($10,000 × .32197) 110,574
Less: Initial investment 40,000 90,000
Net present value $18,112 $20,574
34
Profitability Index
Calculation of profitability index
Illustration: One method of comparing alternative projects is the
profitability index.
Project A Project B
Present value of net cash flows $58,112 $110,574
Less: Initial investment 40,000 90,000
Net present value $18,112 $20,574
Present Value of Net Cash Flows

Profitability Index =
Initial Investment
..
Project A Project B
$58,112 $110,574
= 1.45 = 1.23
$40,000 $90,000
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Profitability Index
Question
Assume Project A has a present value of net cash inflows of
$79,600 and an initial investment of $60,000. Project B has a
present value of net cash inflows of $82,500 and an initial
investment of $75,000. Assuming the projects are mutually
exclusive, which project should management select?
a. Project A
b. Project B
c. Project A or B
d. There is not enough data to answer the question
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Risk Analysis
A simplifying assumption made by many financial analysts
is that projected results are known with certainty.
• Projected results are only estimates
• Sensitivity analysis is used to deal with uncertainty
• Uses a number of outcome estimates to get a sense of
variability among potential returns
37
Post-Audit of Investment Projects

Performing a post-audit is important.
• If managers know their estimates will be compared to actual
results they will be more likely to submit reasonable and
accurate data when making investment proposals
• Provides a formal mechanism to determine whether existing
projects should be supported or terminated
• Improve future investment proposals
38
DO IT! 3: Profitability Index

Problem data
Taz Corporation has decided to invest in renewable energy sources
to meet part of its energy needs for production. It is considering
solar power versus wind power. After considering cost savings as
well as incremental revenues from selling excess electricity into the
power grid, it has determined the following.
Solar Wind
Present value of annual cash flows $78,580 $168,450
Initial investment $45,500 $125,300
Determine the net present value and profitability index of each

project. Which energy source should it choose?
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DO IT! 3: Profitability Index

Solution
Solar Wind
Present value of annual cash flows $78,580 $168,450
Initial investment 45,500 125,300
Net present value $33,080 $ 43,150
Profitability index 1.73* 1.34**
* $78,580 ÷ $45,500 ** 168,450 ÷ 125,300

The investment in wind power generates higher net present value
and requires a substantially higher initial investment. The
profitability index favors solar power, which suggests that the
additional net present value of wind is outweighed by the cost of the
initial investment. The company should choose solar power.
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Internal Rate of Return
Use the internal rate of return method.
• Differs from net present value method in that it finds interest

yield of potential investment
• Internal rate of return (IRR) - interest rate that will cause
present value of proposed capital expenditure to equal
present value of expected net annual cash flows (NPV equal
to zero)
• How does one determine internal rate of return?
41

Estimation of internal rate of return
Stewart Shipping Company is considering the purchase of a new front-end
loader at a cost of $244,371. Net annual cash flows from this loader are
estimated to be $100,000 a year for three years. To determine the internal rate
of return on this front-end loader, the company finds the discount rate that
results in a net present value of zero.
Net Discount Present Discount Present Discount Present
Annual Factor Value Factor Value Factor Value
Year CFs 10% 10% 11% 11% 12% 12%
1 $100,000 .90909 $ 90,909 .90090 $ 90,090 .89286 $ 89,286
2 $100,000 .82645 82,645 .81162 81,162 .79719 79,719
3 $100,000 .75132 75,132 .73119 73,119 .71178 71,178
248,686 244,371 240,183
Less: Initial
investment 244,371 244,371 244,371
NPV $ 4,315 $ 0 $ (4,188)
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Formula for internal rate of return-even cash flows
An easier approach to solving for internal rate of return when
net annual cash flows are equal.
43

Internal rate of return decision criteria
44
Comparing Discounted Cash Flow

Methods
Net Present Value Internal Rate of Return
1. Objective Compute NPV (a Compute IRR (a percentage)
dollar amount).
2. Decision If NPV is zero or If IRR is equal to or greater
Rule positive, accept the than the required rate of
proposal. return, accept the proposal.
If NPVis negative, If IRR is less than the
reject the proposal. required rate of return, reject
the proposal.
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DO IT! 4: Internal Rate of Return

Problem data
that annual cash inflows would increase by $400,000 and
that annual cash outflows would increase by $190,000.
Management has a required rate of return of 9%.
Calculate the IRR on this project and discuss whether it
should be accepted.
46

Calculation of the internal rate of return
Machine cost $900,000
Net annual cash flow ÷ $210,000
Present value factor 4.28571
Now, find the rate that corresponds to the present value

factor.
47

Rate for pv factor of 4.28571 for 6 periods
Required rate of return is only 9%, project should be accepted.
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Annual Rate of Return
Use the annual rate of return method.
Indicates profitability of a capital expenditure by dividing

expected annual net income by average investment.
Expected Annual Average Annual Rate

 =
Net Income Investment of Return
49

Problem data
Illustration: Reno Company is considering an investment of
$130,000 in new equipment. The equipment is expected to last
five years and have zero salvage value at the end of its useful life.
Reno uses straight-line depreciation.
Sales $200,000
Less: Costs and expenses
Manufacturing costs (exclusive of
depreciation) $132,000
Depreciation expense ($130,000 ÷ 5) 26,000
Selling and administrative expenses 22,000 180,000
Income before income taxes 20,000
Income tax expense 7,000
Net income $ 13,000
50

Solution
Original Investment +
Value at End of Useful Life
= Average Investment
2
$130,000
= $65,000
2
Expected annual $13,000
= 20%
rate of return 65,000
A project is acceptable if its rate of return is greater than

management’s required rate of return.
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DO IT! 5: Annual Rate of Return

Problem data
that annual revenues would increase by $400,000 and that
annual expenses excluding depreciation would increase by
$190,000. It uses the straight-line method to compute
depreciation expense. Management has a required rate of
return of 9%.
Compute the annual rate of return.
52
DO IT! 5: Annual Rate of Return

Solution
Compute the annual rate of return.
Revenues $400,000
Less:
Expenses (excluding depreciation) $190,000
Depreciation expense ($900,000 ÷ 6 years) 150,000 340,000
Annual net income $ 60,000
( $900,000 + $0 )
Average investment = = $450,000.
2
$60,000
Annual rate of return = = $13.3%.
$450,000
The proposed project is acceptable.
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Copyright
Copyright © 2018 John Wiley & Sons, Inc.
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Weygandt Kimmel Kieso

Copyright ©2018 John Wiley & Sons, Inc. 2

Cost Flow Information

For purposes of capital budgeting, estimated cash

Ultimately, the value of all financial investments is

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 3

Cost Flow Information

Cost Flow Information

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 5

Initial investment $130,000

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 6

Cost of Capital Net Annual Cash Payback

$130,000  $24,000 = 5.42 years

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 7

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 8

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 9

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 10

DO IT! 1 Cash Payback Period

Estimated annual cash inflows $400,000

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 11

Net Present Value Method

Discounted cash flow technique:

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 12

Net Present Value Method

• Cash inflows are discounted to their present value and

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 13

Net Present Value Method

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 14

Equal Annual Cash Flows

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 15

Equal Annual Cash Flows

Proposed capital expenditure is acceptable at a required

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 16

Unequal Annual Cash Flows

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 17

Unequal Annual Cash Flows

Unequal Annual Cash Flows

Proposed capital expenditure is acceptable at a required rate

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 19

Choosing a Discount Rate

Rate also know as required rate of return, hurdle rate,

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 20

Choosing a Discount Rate

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 21

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 22

Net Present Value (NPV) Method

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 23

Cash inflows received from sales $ 500,000

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 25

Net present value $ 59,825

DO IT! 2: Net Present Value

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 27

DO IT! 2: Net Present Value

Estimated annual cash inflows $400,000

NPV is greater than zero, Waterton should accept the project.

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 28

Capital Budgeting Challenges and Refinements

Identify capital budgeting challenges and refinements.

LO 3 Copyright ©2018 John Wiley & Sons, Inc. 29

12% Discount Present

LO 3 Copyright ©2018 John Wiley & Sons, Inc. 30

Intangible Benefits Example