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 4.. The two methods that focus on cash flows a
Trang 1CHAPTER 21 CAPITAL BUDGETING AND COST ANALYSIS
LEARNING OBJECTIVES
1 Recognize the multiyear focus of capital budgeting
2 Understand the six stages of capital budgeting for a project
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
4 Use and evaluate the payback method
5 Use and evaluate the accrual accounting rate-of-return (AARR) method
6 Identify and reduce conflicts from using DCF for capital budgeting decisions and accrual accounting for performance evaluation
7 Identify relevant cash inflows and outflows for capital budgeting decisions
CHAPTER OVERVIEW
Chapter 21 looks at long-run decisions, those spanning multiple years The focus moves from operations
of a year-by-year approach to that of an entire life span of a project The accounting for capital budgeting
on a project-by-project approach is similar to life-cycle costing introduced in Chapter 12 The role of the management accountant is highlighted in the six stages of capital budgeting
Four quantitative methods used in making capital budgeting decisions are described and illustrated The two methods that focus on cash flows and the time value of money are net present value and internal rate-of-return, discounted-cash flow models Typically, the discounted cash-flow methods are superior for providing information in the decision-making process because they are the most comprehensive in scope The concept of money having time value is a main feature of these models The other methods presented are the payback method and the accrual accounting rate-of-return The payback method does use cash flow as a basis but does not incorporate time value of money nor profitability The accrual accounting rate-of-return does not focus on cash flow but uses measures from the income statement The role of income taxes is incorporated within the chapter and the role of inflation is in the appendix to the chapter Though the methods presented provide a basis on which to make a quantitative financial decision, the chapter examines the importance of nonfinancial quantitative and qualitative aspects for each decision The tension of evaluating a decision using a different model than the one used to make the initial decision
is discussed
Trang 2CHAPTER OUTLINE
I Capital budgeting overview
A Challenge to managers to balance long-run and short-run issues
B Analysis of ways to increase capital (value) of business with projects that span multiple years
II Two dimensions of cost analysis
Learning Objective 1:
Recognize the multiyear focus of capital budgeting
A A project dimension for capital budgeting over entire life of project (horizontal) [Exhibit 21-1]
1 Life of a project is more than one year
2 All cash flows or cash savings over entire life considered
B An accounting-period dimension with focus on income determination and routine planning and
control that cuts across all projects (vertical)
1 Accounting period of one year
2 Reported income for managers’ bonuses and for effect on company’s stock price
C An accounting system that corresponds to project dimension—life-cycle costing [See Chapter 12]
1 Accumulates revenues and costs on a project-by-project basis
2 Accumulation extends accrual accounting system to a system that computes cash flow or income over entire project covering many accounting periods
III Stages of capital budgeting
A Capital budgeting: a decision-making and control tool for making long-run planning decisions
for investments in projects that span multiple years
Learning Objective 2:
Understand the six stages of capital budgeting for a project
B Six stages in capital budgeting
1 Stage 1: Identification stage
a To distinguish which types of capital expenditure projects are necessary to accomplish organization objectives and strategies
b To use line management to identify projects linked to organization’s objectives and
Trang 32 Stage 2: Search stage
a To explore alternatives of capital investments that will achieve organization objectives
b To use cross-functional teams from all parts of the value chain to evaluate alternatives
3 Stage 3: Information-acquisition stage
a To consider the expected costs and the expected benefits of alternative capital
investments
b To use financial and nonfinancial costs and benefits that can be quantitative or qualitative
4 Stage 4: Selection stage
a To choose projects of implementation whose expected benefits exceed expected costs by the greatest amounts
b To use judgment of managers for considering nonfinancial considerations of conclusions based on formal analysis
5 Stage 5: Financing stage
a To obtain project funding
b To use organization’s treasury function for sources of financing, internally using
generated cash flow and externally through capital markets
6 Stage 6: Implementation and control stage
a To get projects underway and monitor their performance
b To use a postinvestment audit to evaluate if projections made at time of selection
compare toactual results
IV Capital budgeting methods
A Discounted cash-flow (DCF) methods
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
1 Measure all expected future cash inflows and outflows of a project as if they occurred at a single point in time
2 Use time value of money: dollar received today is worth more than a dollar received in the
future (opportunity cost from not having the money today) [Exercise 21-16 and Appendix C]
a Weights cash flows by time value of money and usually most comprehensive and best methods to use
Trang 4b Focuses on cash flows rather than operating income as determined by accrual accounting
3 Expects cash amount to be greater in the future than cash invested now (present)
4 Required rate of return (RRR): minimum acceptable rate of return on an investment
• Return the organization could expect to receive elsewhere for investment of comparable risk
• Also called discount rate, hurdle rate, or (opportunity) cost of capital
• Point of comparison when using internal rate of return (IRR)
B Two DCF methods
1 Net present value (NPV) method
a NPV calculates expected monetary gain or loss from project by discounting all expected future cash inflows and outflows to the present point in time, using required rate of return (RRR)
i Only projects with zero (return = RRR) or positive (return > RRR) net present value acceptable
ii Higher the NPV, the better when all other things equal
b NPV method
i Step 1: Draw a sketch of relevant cash inflows and outflows [Exhibit 21-2]
• Organizes data in systematic way
• Focuses only on cash flows
• Indifferent as to where cash flows come from
ii Step 2: Choose the correct compound interest table from Appendix C
• Use given discount factors of time periods (n) and interest rate (r or i)
• Determine if annuity (series of payments of equal time and amount) or lump sum payment
iii Step 3: Sum the present value figures to determine the net present value (net means
some amounts are inflows and others are outflows—the difference)
• If NPV is zero or positive, accept—cash flows are adequate to recover net initial investment and earn a return equal to or greater than RRR over useful life of project
Trang 5• If NPV is negative, do not accept—expected rate of return is below RRR
c NPV needs managers to also judge nonfinancial factors
2 Internal rate-of-return method [Exhibit 21-3]
a IRR calculates the discount rate at which the present value of expected cash inflows from
a project equals the present value of expected cash outflows
b IRR method
• Use calculator or computer program to compute
• Use trial-and-error approach
Step 1: Calculate NPV using a chosen discount rate
Step 2: Choose (and keep trying) a lower or higher discount rate to have NPV equal zero, the point at which the chosen rate is the IRR (If NPV < 0, use lower rate; if NPV > 0, use higher rate)
• Use factor from present value of an annuity table if cash inflows are equal [Refer to
Exhibit 21-3, Table 4, and Problems for Self-Study]
• Accept project if internal rate of return (IRR) equals or exceeds required rate of return (RRR)
3 Comparison of net present value and internal rate-of-return methods
a NPV uses dollars rather than percentages that aids in summing individual projects to see effect of accepting a combination of projects; IRR of individual projects cannot be added
or averaged to represent IRR of a combination of projects
b NPV assumes reinvestment at required rate of return in comparing projects with unequal economic lives whereas internal rate-of-return does not have such comparison available
4 Sensitivity analysis [Exhibit 21-4]
a Sensitivity analysis used to examine how a result from use of NPV or IRR will change if predicted financial outcomes are not achieved or if an underlying assumption changes
b Helps managers focus on decisions that are most sensitive to different assumptions and worry less about decisions that are not so sensitive
C Payback method
Learning Objective 4:
Use and evaluate the payback method
1 Payback measures time it will take to recoup, in form of expected future cash flows, the net
initial investment in a project
Trang 6a Does not distinguish between origins of cash flows (like DCF models)
b Simplest to calculate with project having uniform cash flows
i With uniform cash flows: Net initial investment ÷ Uniform increase in annual future cash flows
ii Without uniform cash flows: Each year’s cash flow accumulated until sum equals net initial investment
c Highlights liquidity
d Projects with shorter paybacks preferred to those with longer paybacks, if all other things are equal
e Organization can choose a cutoff period as basis for accepting or rejecting payback of project
2 Payback useful measure
a Method easy to understand, as DCF methods not affected by accrual accounting
conventions such as depreciation
b Used when preliminary screening of many proposals is necessary
c Expected cash flows in later years of a project are highly uncertain
3 Payback weaknesses
a Fails to incorporate the time value of money
b Does not consider a project’s cash flows after the payback period
c Ignores cash flows after the payback period
d Method may promote only short-lived projects from choosing too short a cutoff period
D Accrual accounting rate-of-return method
Learning Objective 5:
Use and evaluate the accrual accounting rate-of-return (AARR) method
1 Accrual accounting rate-of-return (AARR) method: divides an accrual accounting measure
of income by an accrual accounting measure of investment (also called accounting rate of return)
2 AARR calculations [Surveys of Company Practice]
a Increase in expected average annual after-tax operating income ÷ Net initial investment
Trang 7b Quotient is rate (similar to IRR) or percentage
c Calculates return using operating income numbers after considering accruals and taxes whereas IRR calculates return on basis of after-tax cash flows and time value of money (IRR method regarded as better than AARR method)
d Computations easy to understand and they use numbers reported in the income statement
e Considers income earned throughout a project’s expected useful life (unlike payback which ignores cash flows after payback period)
Do multiple choice 1–8 Assign Exercises 21-17, 18, 20, 21, 22, 23, and
Problems 21-27, 29, and 30.
V Other considerations
Learning Objective 6:
Identify and reduce conflicts from using DCF for capital budgeting decisions and accrual accounting for performance evaluation
A Evaluating managers and goal-congruence issues
1 Inconsistency between using the NPV method as best for capital budgeting decisions and then using a different method to evaluate performance over short time horizon (such as accrual accounting results)
2 Temptations for managers to use methods that would increase bonuses or personal goals or if transferred frequently
B Relevant cash flows in discounted cash flow analysis [Exhibit 21-5]
Learning Objective 7:
Identify relevant cash inflows and outflows for capital budgeting decisions
1 Relevant cash flows: differences in expected future cash flows as a result of making the investment
2 Relevant after-tax flows [Exhibit 21-6]
a Differential approach used
i Two methods based on income statement: one focuses on cash items only; the other used with net income and depreciation adjustments
ii One method uses cash flow from operations—item-by-item method
• If savings (S) in any aspect, then income tax (t) aspect = t x S
• If depreciation (D) in any aspect, the income tax aspect = t x D
• If gain (G) in any aspect, the income tax aspect = t x G
Trang 8• If loss (L) in any aspect, the income tax aspect = t x L
b Three categories of cash flows for capital investment projects
i Net initial investment
• Initial machine investment (cash outflow to purchase machine)
• Initial working capital of investment (working-capital cash flow)
• After-tax cash flow from current disposal of old machine (cash inflow)
ii Operations (difference between each year’s cash flow under the alternatives)
• Annual after-tax cash flow from operations (excluding depreciation effects)
• Income tax cash savings from annual depreciation deduction iii Terminal disposal of assets and recovery of working capital
• After-tax cash flow from terminal disposal of machine
• After-tax cash flow from recovery of working capital
c General rule in tax planning used—where there is a legal choice, take the deduction sooner rather than later
Do multiple choice 9 and 10 Assign Exercises 21-19, 24, 25, and Problems 21-28, 31, and 32.
C Managing the project
1 Management control of the investment activity itself
a Some initial investments are relatively easy to implement
b Some initial investments are more complex and take more time
2 Management control of the project—postinvestment audit
a Compares actual results for a project to the costs and benefits expected at time project selected
b Provides feedback about performance
i Original estimates overly optimistic iii Problems in implementing the project
D Strategic considerations in capital budgeting
Trang 91 Company’s strategy is source of its strategic capital budgeting decisions
2 Capital investment decisions that are strategic require consideration of broad range of factors that may be difficult to estimate or measure
E Intangible assets and capital budgeting
1 Strategic decisions about intangible assets such as brand names, customer base, and
intellectual capital of employees
2 Capital budgeting methods (NPV) useful for evaluating a company’s intangible assets
3 Illustration using example of intangible asset of customer base
a Cash inflows (revenues minus expenses) for each customer compared over a period of years
b Analysis refined in at least three ways
i By recognizing an even longer time horizon
ii By recognizing that not all customers will be retained over an extended time period
(customer retention rate measures percentage of existing customers that will be
retained next period) iii By recognizing that new customers will be attracted
c Success in maintaining long-run profitable relationships with customers highlighted
V Appendix: Capital budgeting and inflation
CHAPTER QUIZ SOLUTIONS: 1.d 2.c 3.a 4.b 5.c 6.a 7.d 8.d 9.c 10.b
Trang 10CHAPTER QUIZ
1 [CPA Adapted] If the algebraic sum of the present values of all cash flows related to a proposed capital expenditure discounted at the company’s required rate of return is positive, it indicates that the
a resultant amount is the maximum that should be paid for the asset
b discount rate used is not the proper required rate of return for this company
c investment is the best alternative
d return on the investment exceeds the company’s required rate of return
The following data apply to questions 2–6.
The Hilltop Corporation is considering (as of 1/1/02) the replacement of an old machine that is currently being used The old machine is fully depreciated but can be used by the corporation through 2006 If Hilltop decides to replace the old machine, Baker Company has offered to purchase it for $40,000 on the replacement date The disposal value of the old machine would be zero at the end of 2006 Hilltop uses the straight-line method of depreciation for all classes of machinery
If the replacement occurs, a new machine would be acquired from Busby Industries on January 2, 2002 The purchase price of $500,000 for the new machine would be paid in cash at the time of replacement Due to the increased efficiency of the new machine, estimated annual cash savings of $125,000 would be generated through 2006, the end of its expected useful life The new machine is expected to have a zero disposal price at the end of 2006
All operating cash receipts, operating cash expenditures, and applicable tax payments and credits are assumed to occur at the end of the year Hilltop employs the calendar year for reporting purposes
Discount tables for several different interest (discount) rates that are to be used in any discounting calculations are given below Assume for questions 2–6 that Hilltop is not subject to income taxes
Present Value of $1.00 Received at the End of Period Present Value of an Annuity of $1.00 Received at the End of Each Period Period 6% 8% 10% 12% 14% Period 6% 8% 10% 12% 14%
1 94 93 91 89 88 1 0.94 0.93 0.91 0.89 0.88
2 89 86 83 80 77 2 1.83 1.78 1.73 1.69 1.65
3 84 79 75 71 68 3 2.67 2.58 2.49 2.40 2.32
4 79 74 68 64 59 4 3.47 3.31 3.17 3.04 2.91
5 75 68 62 57 52 5 4.21 3.99 3.79 3.61 3.43
2 [CMA Adapted] If Hilltop requires investments to earn an 8% return, the net present value for
replacing the old machine with the new machine is
a $175,000 b $50,000 c $48,750 d $(36,250)
3 [CMA Adapted] The internal rate of return, to the nearest percent, to replace the old machine is
4 [CMA Adapted] The payback period to replace the old machine with the new machine is
a 2.5 years b 3.6 years c 4.0 years d 4.4 years
5 The accrual accounting rate of return on the initial investment, to the nearest percent, is