Week10 CapitalBudgeting

Capital Budgeting
Chapter 11
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 11 - 1
Capital Budgeting
Capital budgeting describes the long-term

planning for making and financing
major long-term projects.
1. Identify potential investments.
2. Choose an investment.
3. Follow-up or “postaudit.”
Payback Model
Payback time, or payback period, is the

time it will take to recoup, in the form
of cash inflows from operations, the
initial dollars invested in a project.
P = I ÷ Incremental inflow
Payback Model Example
Assume that $12,000 is spent for a machine

with an estimated useful life of 8 years.
Annual savings of $4,000 in cash outflows

are expected from operations.
What is the payback period
P = $12,000 ÷ $4,000 = 3 years
Accounting Rate-of-Return Model
The accounting rate-of-return (ARR) model

expresses a project’s return as the increase
in expected average annual operating income
divided by the required initial investment.
Increase in expected Initial

ARR = average annual ÷ required
operating income investment
Accounting Rate-of-Return
Example
Assume the following:
 Investment is $6,075.
 Useful life is 4 years.
 Estimated disposal value is zero.
 Expected annual cash inflow
from operations is $2,000.
What is the annual depreciation?
Accounting Rate-of-Return
Example
$6,075 ÷ 4 = $1,518.75 (rounded to $1,519)
What is the ARR?
ARR = ($2,000 – $1,519) ÷ $6,075 = 7.9%
Discounted-Cash-Flow
Models (DCF)
These models focus on a project’s cash

inflows and outflows while taking into
account the time value of money.
DCF models compare the value

of today’s cash outflows with the
value of the future cash inflows.
Net Present Value Model
The net-present-value (NPV) method

computes the present value of all
expected future cash flows using
a minimum desired rate of return.
The minimum desired rate of return depends

on the risk of a proposed project –
the higher the risk, the higher the rate.
The required rate of return (also called hurdle

rate or discount rate) is the minimum desired
rate of return based on the firm’s cost of capital.
Applying the NPV Method
Prepare a diagram of relevant

expected cash inflows and outflows.
Find the present value of each

expected cash inflow or outflow.
Sum the individual present values.
Discounting cash-flow
- Comparing future cash-flows in the present value
Year
0 1 2 3 4
NPV Example
Original investment (cash outflow): $6,075
Useful life: 4 years
Annual income generated from

investment (cash inflow): $2,000
Minimum desired rate of return: 10%
NPV Example (pg 475)
Years Amount PV Factor Present Value

0 ($6,075) 1.0000 ($6,075)
1 2,000 .9091 1,818
2 2,000 .8264 1,653
3 2,000 .7513 1,503
4 2,000 .6830 1,366
Net present value $ 265
NPV Example
Years Amount PV Factor Present Value

0 ($6,075) 1.0000 ($6,075)
1-4 2,000 3.1699 6,340
Net present value $ 265
Calculating the PV Factor
At a discount rate of 10%, the PV Factor for Year 1:
1
 0.9091
1  0.1
At a discount rate of 10%, the PV Factor for Year 2:
1
2
 0.8264
(1  0.1)
Calculating the Annuity Factor
At a discount rate of 10%, the Annuity PV Factor
for Years 1-4:
Years PV Factor
1 .9091
2 .8264
3 .7513
4 .6830
Annuity PV Factor 3.1698
Decision Rules
Managers determine the sum of

the present values of all expected
cash flows from the project.
If the sum of the present values is

positive, the project is desirable.
If the sum of the present values is

negative, the project is undesirable.
Sensitivity Analysis
Sensitivity analysis shows the financial

consequences that would occur if
actual cash inflows and outflows
differ from those expected.
Sensitivity Analysis Example
Suppose that a manager knows that the

actual cash inflows in the previous example
could fall below the predicted level of $2,000.
How far below $2,000 must the annual cash

inflow drop before the NPV becomes negative?
Sensitivity Analysis Example
(3.1699 × Cash flow) – $6,075 = 0
Cash flow = $6,075 ÷ 3.1698 = $1,916
If the annual cash flow is less than

$1,916, the NPV is negative, and
the project should be rejected.
Relevant Cash Flows for NPV
The 4 types of inflows and outflows

should be considered when the
relevant cash flows are arrayed:
1) Initial cash inflows and outflows at time zero

2) Investments in receivables and inventories
3) Future disposal values
4) Operating cash flows
Operating Cash Flows
The only relevant cash flows are

those that will differ among alternatives.
Depreciation and book

values should be ignored.
A reduction in cash outflow is

treated the same as a cash inflow.
Cash Flows for Investment
in Technology
Suppose a company has a $10,000
net cash inflow this year
using a traditional system.
Investing in an automated system will

increase the net cash inflow to $12,000.
Failure to invest will cause net

cash inflows to fall to $8,000.
Cash Flows for Investment
in Technology
What is the benefit from the investment?
Post Audit
Investment expenditures are

on time and within budget.
Comparing actual versus predicted cash flows.
Improving future predictions of cash flows.
Evaluating the continuation of the project.
Exercise 11-45 (Page 506)
Bob’s Big Burgers is considering a proposal to
invest in a speaker system that would allow its
employees to service drive-through customers.
The cost of the system (including the installation of
special windows and driveway modifications) is
RM30,000. Jenna, manager of Bob’s, expects the
drive-through operations to increase annual sales
by RM25,000, with a 40% contribution margin ratio.
Assume that the system has an economic life of 6
years, at which time it will have no disposal value.
The cost of capital (required rate of return) is 12%.
Ignore taxes.
What is the payback time?
Annual addition to profit = 40% x $25,000 = $10,000.
Payback period is $30,000 ÷ $10,000 = 3 years.
What are the advantages/disadvantages of this method?

Advantages  easy to use, can be used as a rough
estimate of the riskiness of a project, especially in rapid
technological changes & changes in product design, where
cash flows are uncertain
Disadvantages  does not measure profitability, ignores

time value of money
Compute rate of return on the initial investment, based
on the accounting rate-of-return model.
ARR = ($10,000 - $5,000) ÷ $30,000 = 16.7%

depreciation
Advantages  measures profitability, easy to use

Disadvantages  ignores time value of money
Compute the net present value.
Year Discount factor Cash inflow/ PV

(12%) (outflow)
0 1.0000 (30,000) (30,000)
1 0.8929 10,000 8,929
2 0.7972 10,000 7,972
3 0.7118 10,000 7,118
4 0.6355 10,000 6,355
5 0.5674 10,000 5,674
6 0.5066 10,000 5,066
NPV 11,114
Should Jenna accept the proposal? Why or why not?
Yes, accept the proposal because of positive NPV.
Advantages  considers time value of money, considers

relevant cash flows
Disadvantages  discount factor is subjective

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Week10 CapitalBudgeting

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Capital Budgeting

Capital budgeting describes the long-term

1. Identify potential investments.

Payback time, or payback period, is the

Assume that $12,000 is spent for a machine

Annual savings of $4,000 in cash outflows

What is the payback period

P = $12,000 ÷ $4,000 = 3 years

The accounting rate-of-return (ARR) model

Increase in expected Initial

What is the annual depreciation?

$6,075 ÷ 4 = $1,518.75 (rounded to $1,519)

What is the ARR?

ARR = ($2,000 – $1,519) ÷ $6,075 = 7.9%

These models focus on a project’s cash

DCF models compare the value

The net-present-value (NPV) method

The minimum desired rate of return depends

The required rate of return (also called hurdle

Prepare a diagram of relevant

Find the present value of each

Sum the individual present values.

Original investment (cash outflow): $6,075

Useful life: 4 years

Annual income generated from

Minimum desired rate of return: 10%

Years Amount PV Factor Present Value

Years Amount PV Factor Present Value

Managers determine the sum of

If the sum of the present values is

If the sum of the present values is

Sensitivity analysis shows the financial

Suppose that a manager knows that the

How far below $2,000 must the annual cash

(3.1699 × Cash flow) – $6,075 = 0

Cash flow = $6,075 ÷ 3.1698 = $1,916

If the annual cash flow is less than

The 4 types of inflows and outflows

1) Initial cash inflows and outflows at time zero

The only relevant cash flows are

Depreciation and book

A reduction in cash outflow is

Investing in an automated system will

Failure to invest will cause net

What is the benefit from the investment?

Investment expenditures are

Comparing actual versus predicted cash flows.

Improving future predictions of cash flows.

Evaluating the continuation of the project.

What are the advantages/disadvantages of this method?

Disadvantages  does not measure profitability, ignores

ARR = ($10,000 - $5,000) ÷ $30,000 = 16.7%

Advantages  measures profitability, easy to use

Year Discount factor Cash inflow/ PV

What are the advantages/disadvantages of this method?

Advantages  considers time value of money, considers

Disadvantages  discount factor is subjective

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