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Capital Budgeting and Cost Analysis Chapter 21

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Learning Objective 1 Recognize the multiyear focus of capital budgeting.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

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Two Dimensions of Cost Analysis


1. A project dimension

2. An accounting-period dimension The accounting system that corresponds to the project dimension is termed life-cycle costing.
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Two Dimensions of Cost Analysis


Project D

Project C
Project B Project A 2002 2003 2004 2005 2006
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Learning Objective 2 Understand the six stages of capital budgeting for a project.

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Capital Budgeting
Capital budgeting is the making of long-run planning decisions for investments in projects and programs. It is a decision-making and control tool that focuses primarily on projects or programs that span multiple years.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

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Capital Budgeting
Capital budgeting is a six-stage process: 1. Identification stage 4. Selection stage 2. Search stage 5. Financing stage

3. Information-acquisition stage
6. Implementation and control stage

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Capital Budgeting Example


One of the goals of Assisted Living is to improve the diagnostic capabilities of its facility.

Management identifies a need to consider the purchase of new equipment. The search stage yields several alternative models, but management focuses on one particular machine.
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Capital 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 Example


Working capital is expected to be recovered at the end of year 3 with an expected return of 10%. Operating cash flows are assumed to occur at the end of the year. In the selection stage, management must decide whether to purchase the new machine.
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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.
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

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Time Value of Money


Compound Growth, 5 periods at 6% Year 5: $1.338

Year 4: $1.262
Year 3: $1.91

Year 2: $1.124
Year 1: $1.06 Year 0: $1.00
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Discounted 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 Example

Only projects with a zero or positive net present value are acceptable. What is the the net present value of the diagnostic machine?

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Net Present Value Example


Year in the Life of the Project
0

$(250,000)
Net initial investment

$125,000 $130,000 $115,000


Annual cash inflows
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2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Net Present Value Example


Net Cash Year 10% Col. Inflows 1 0.909 $125,000 2 0.826 130,000 3 0.751 115,000 Total PV of net cash inflows Net initial investment Net present value of project NPV of Net Cash Inflows $113,625 107,380 86,365 $307,370 250,000 $ 57,370
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2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Net 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%.
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

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Net Present Value Example


Net Cash Years 10% Col. Inflows 1-3 2.487 $80,000 3 0.751 9,000 Total PV of net cash inflows Net initial investment Net present value of project NPV of Net Cash Inflows $198,960 6,759 $205,719 250,000 ($ 44,281)
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2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Internal 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 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 IRR


The NPV method has the advantage that the end result 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 required rate of return varies over the life of the project.
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

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Comparison of NPV and IRR


The IRR of individual projects cannot be added 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 Method
Payback measures the time it will take to recoup, in the form of expected future cash flows, the initial investment in a project.

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Payback 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 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 Example


Suppose that as an alternative to the $210,000 piece of equipment, there is another one (Machine 2) that also costs $210,000 but will save $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 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 Example


Year 1 brings in $160,000. Recovery of the amount invested occurs in Year 2.

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Payback 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 Accounting Rate-of-Return Method


The accrual accounting rate-of-return (AARR) method divides an accounting measure of income by an accounting measure of investment. Increase in expected Initial AARR = average annual required operating income investment
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

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Accrual Accounting Rate-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 Accounting Rate-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 Evaluation
A manager who uses DCF methods to make capital budgeting decisions can face goal congruence problems if AARR is used for performance evaluation. Suppose top management uses the AARR to judge 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 Evaluation
The conflict between using AARR and DCF methods to evaluate performance can be reduced by evaluating managers on a project-by-project basis.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

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

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Relevant Cash Flows


Relevant cash flows are expected future cash flows that differ among the alternatives.

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Relevant 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 Flow Analysis Example


G. T. is considering replacing old equipment.
Old equipment: Current book value Current disposal price Terminal disposal price (5 years) Annual depreciation Working capital Income tax rate $50,000 $ 3,000 0 $10,000 $ 5,000 40%
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Relevant Cash Flow Analysis Example


Current disposal price of old equipment $ 3,000 Deduct current book value of old equipment 50,000 Loss on disposal of equipment $47,000 How much are the tax savings? $47,000 0.40 = $18,800

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Relevant Cash Flow Analysis Example


What is the after-tax cash flow from current disposal of old equipment? Current disposal price $ 3,000 Tax savings on loss 18,800 Total $21,800

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Relevant Cash Flow Analysis Example


New equipment: Current book value Current disposal price is irrelevant Terminal disposal price (5 years) Annual depreciation Working capital

$225,000 0 $ 45,000 $ 15,000

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Relevant Cash Flow Analysis Example


How much is the net investment for the new equipment? Current cost $225,000 Add increase in working capital 10,000 Deduct after-tax cash flow from current disposal of old equipment 21,800 Net investment $213,200
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Relevant Cash Flow Analysis Example


Assume $90,000 pretax annual cash flow from operations (excluding depreciation effect). What is the after-tax flow from operations? Cash flow from operations Deduct income tax (40%) Annual after-tax flow from operations
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$90,000 36,000 $54,000


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Relevant Cash Flow Analysis Example


What is the difference in depreciation deduction? Annual depreciation of new equipment Deduct annual depreciation of old equipment Difference
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$45,000
10,000 $35,000
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Relevant Cash Flow Analysis Example


What is the annual increase in income tax savings from depreciation? Increase in depreciation $35,000 Multiply by tax rate .40 Income tax cash savings from additional depreciation $14,000

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Relevant Cash Flow Analysis Example


What is the cash flow from operations, net of income taxes? Annual after-tax flow from operations $54,000 Income tax cash savings from additional depreciation 14,000 Cash flow from operations, net of income taxes $68,000
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Relevant Cash Flow Analysis Example


G. T. requires a 14% rate of return on its investments. What is the net present value of the new equipment incorporating income taxes?

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Relevant Cash Flow Analysis Example


Net Cash NPV of Net Years 14% Col. Inflows Cash Inflows 1-5 3.433 $68,000 $233,444 5 0.519 10,000 5,190 Total PV of net cash inflows $238,636 Investment 213,200 Net present value of new equipment $ 25,436
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Postinvestment Audit
A postinvestment audit compares the actual results for a project to the costs and benefits expected at the time the project was selected. It provides management with feedback about performance.

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Strategic Considerations

Capital investment decisions that are strategic in nature require managers to consider a broad range of factors that may be difficult to estimate.
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End of Chapter 21

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