Accounting for Managers

Module 15: Capital Budgeting Decisions

Capital Budgeting
Steps of Capital Budgeting

• Screening decision: look at projects and determine whether they meet company’s basic
guidelines for consideration
• Preference decision: takes all of the projects that meet the screening process and then decide
which to choose
When to Make Capital Budgeting Decisions

• When might we need to make a decision?

• Cost reduction
• Expansion
• Picking the equipment
• Leasing or buying
• Replacement
Time Value of Money

• Interest rate is an important component of the time value of money

• PV: present value

• FV: future value
• r: rate of return (%)
• n: number of periods
Budget Methods for Making Decisions
The Payback Method

• First, we need the initial purchase price and net cash flow per year
• Will also need to know what net cash flow per year will be to figure out how many years it
will take to get our initial investment back
• Typical cash outflows include initial investment in equipment or project including
installation costs
• Cash inflows may include salvage value of equipment
Internal Rate of Return

• By looking at rate of return we expect on an investment over life of investment, we can

figure out internal rate of return
• Method uses discount rate that equals present value of cash outflows with cash inflows,
resulting in value of zero
Net Present Value

• Difference between the present value of cash inflows and outflows over a period of time
• Used in capital budgeting to determine profitability of potential investment or project
• Denotes project that will exceed anticipated cost
• If investment shows negative present value, company would lose money
• Many ways to determine value of cash flows, although the net present value includes pitfalls
Simple Rate of Return

• Calculated by taking annual incremental net operating income and dividing by initial
investment
• When calculating annual incremental net operating income, we must reduce by depreciation
expense
Risk and Capital Budgeting
Risk and Return

• Investment example:
• high level of risk aversion means putting money into bank and collecting small return
• low level or risk aversion means going with investment and hoping for the best
• Many questions surrounding capital budgeting and investment choices
• managers need to evaluate decisions but there will be room for error
Finalizing Capital Budgeting Decisions
Analyzing a Project

• Assume a manager is presented with two options for projects and has been tasked with
analyzing them
• make sure they meet company’s minimum requirements and then rank by preference (when funds are
limited)
• If funds are limited and only one option is needed, either internal rate of return or net present
value methods will yield best results
• IRR: option with higher internal rate of return makes most sense
• NPV: need to adjust for differences in initial investment of project
• Project profitability index = net present value of project/initial investment required
Postaudit

• In capital budgeting process, postaudit holds managers accountable and helps keep them
honest
• Without postaudit process, it might be too easy to inflate benefits or minimize pitfalls
• Postaudit process will analyze actual results using real data from the project
• begin with side-by-side analysis
• By comparing actual data to estimated data, it will help insure that submitted proposals in
future are carefully prepared
Quick Review

When company is faced with large capital budgeting decision, they have multiple ways to
evaluate options

By first vetting projects based on company’s guidelines and then using methods to analyze
decision, hopefully company can make most profitable decision long term

Payback method, net present value method, internal rate of return method, and simple rate of
return method are all potential ways to work through decisions

Learning the steps involved can help manager make good decisions or provide good insight