Introduction to Capital Budgeting

Learning Objectives
• Overview
• Managerial Accountant’s Role in Capital Budgeting
• Effect Income taxes
• Depreciation for Tax Purposes
• Non-Discounted Cash Flow Analysis
 Definition of Capital Budgeting
• The decision making process by which a firm evaluates the
purchase of major fixed assets. It involves firm's decision to
invest its current funds for addition, disposition, modification
and replacement of fixed assets
 Importance of Capital Budgeting
• The success and failure of business mainly depends on how the
available resources are being utilized.
• Main tool of financial management
• Capital budgeting offers effective control on cost of capital
expenditure projects.
• It helps the management to avoid over investment and under
investment
 Screening Decision

• a decision taken to determine if a proposed investment meets

certain preset requirements, such as those in a cost/benefit
analysis.
 Preference Decisions
• the company compares several alternative projects that have
met their screening criteria -- whether a minimum rate of
return or some other measure of usefulness -- and ranks them
in order of desirability. The decision makers then choose the
investment or course of action that best meets company goals
 Role of Managerial Accountant in Capital Budgeting

• Assessing Needs and Resources

• Cost Accounting
• Marketing
• Profitability
 Effect Income Taxes
• Cash Revenue and Cash Expenses
• Non Cash Expenses
• Gain/Losses on Disposal
• Working Capital
Cash Revenue and Cash Expenses
Non Cash Expenses
Gain/Loss Capital
Working Capital
 Depreciation for Tax Purposes
• Depreciation is the process by which a company allocates an
asset's cost over the duration of its useful life.
 Non-Discounted Cash Flow Analysis
• Payback Period
• Accounting Rate-of-Return
 Pay Back Period 1
• Payback Period
• In case they are even, the formula to calculate
• payback period is:
• Payback Period =Initial Investment/Cash Inflow per Period
 Pay Back Period
• Example 1: Even Cash Flows
• Company C is planning to undertake a project requiring initial
investment of $105 million. The project is expected to generate
$25 million per year for 7 years. Calculate the payback period
of the project.
• Solution
Payback Period = Initial Investment ÷ Annual Cash Flow
= $105M ÷ $25M = 4.2 years
 Pay Back Period 2
• When cash inflows are uneven, we use the following formula
for payback period:
• Payback Period = A + (B/C)
In the above formula,
• A is the last period with a negative cumulative cash flow;
• B is the absolute value of cumulative cash flow at the end of
the period A;
• C is the total cash flow during the period after A
 Pay Back Period
• Traditional Method
Company C is planning to undertake another project requiring initial investment
of $50 million and is expected to generate $10 million in Year 1, $13 million in
Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in Year 5.
Calculate the payback value of the project. (cash flows in millions) Cumulative
• Solution:
Payback Period
• = 3 + ($11M ÷ $19M)
• ≈ 3 + 0.58
• ≈ 3.58 years
 Accounting rate of return method

• This method of ARR is not commonly accepted in assessing the

profitability of capital expenditure
Formula
• Accounting Rate of Return is calculated using the following
formula:
• ARR = Average Accounting Profit/Average Investment
 ARR Example
An initial investment of $130,000 is expected to generate annual cash inflow of
$32,000 for 6 years. Depreciation is allowed on the straight line basis. It is
estimated that the project will generate scrap value of $10,500 at end of the
6th year. Calculate its accounting rate of return assuming that there are no
other expenses on the project.
Solution
• Annual Depreciation = (Initial Investment − Scrap Value) ÷ Useful Life in Years
• Annual Depreciation = ($130,000 − $10,500) ÷ 6 ≈ $19,917
• Average Accounting Income = $32,000 − $19,917 = $12,083
• Accounting Rate of Return = $12,083 ÷ $130,000 ≈ 9.3%