Managerial accounting and introduction to concepts methods and user 11e by maher chapter 08

Present value analysis, also called discounted cash flow DCF, provides analysts with the appropriate technique... Strategic planning provides the context for capital expenditure deci

Capital Expenditure Decisions

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LuAnn Bean

Professor of Accounting

Florida Institute of Technology

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CHAPTER GOAL

This chapter explains how the differential

principle applies to long–term decisions where the focus is on changes in operating capacity

over several future time periods Present value analysis, also called discounted cash flow

(DCF), provides analysts with the appropriate

technique.

CAPITAL BUDGETING:

Definition

CAPITAL BUDGETING:

Definition

Involves deciding which

long-term investments to take involving capital (long-term)

assets.

STRATEGIC PLANNING

In strategic planning, an organization

decides on major programs and

the resources to devote to them

Strategic planning provides the

context for capital expenditure

decisions.

In strategic planning, an organization

decides on major programs and

the resources to devote to them

Strategic planning provides the

context for capital expenditure

decisions.

BENEFITS: Long-Term Investments

Reducing potential to make mistakes improves

product

Making goods, delivering services that competitors

cannot

Reducing cycle time to make product

Permanently reducing costs to provide such an

advantage that competitors cannot afford to enter

market

ELEMENTS OF DISCOUNT RATE

The choice of a discount rate should consider the following

A pure rate of interest that reflects the productive capability of capital assets

A risk factor reflecting the riskiness of the project

An increase reflecting inflation expected to occur

over the life of the project

RISK-FREE RATE: Definition

Is the pure interest rate plus

expected inflation.

What is the real

interest rate?

The real interest rate is the

pure interest rate plus a

premium for risk but no increase for inflation.

If the present value of future cash

inflows exceeds the present value of

future cash outflows for a proposal,

DECISION RULE

Estimate the amounts of future cash inflows

and future cash outflows in each period for

each alternative

Discount the future cash flows to the present

using the project’s discount rate

CASH FLOW VARIETIES

 Initial cash flows:

Occur at beginning of project

 Periodic cash flows

Occur during life of project

 Terminal cash flows

Occur at end of project

EXAMPLE: JEP Realty Syndicators

JEP Reality Syndicators, Inc (JEP) is considering

acquisition of computer hardware with a 5-year

life Disposal of current hardware occurs in Year 0

with no gain or loss and no tax consequences

Market value of present equipment $ 10,000

P

EXHIBIT 8.1 cash flows Projected

over life of project

Projected cash flows over life of project

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Depreciation is subtracted before

Depreciation is subtracted before

+ + + + +

=

Projected cash flows over life

Projected cash flows over life

Calculating NPV

The calculation of NPV for a proposed project

requires three types of projections

Amount of future cash flows

Timing of future cash flows

Note: errors in predicting amounts of future cash flows will

likely have the largest impact.

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EXHIBIT 8.3

+ + + + +

Amount of future cash flows

= $344,000

in revenues, less than projected

= $344,000

in revenues, less than projected

= $350,000

in revenues, not received

as expected.

= $350,000

in revenues, not received

as expected.

+

Timing of future cash flows

+ +

+

= $350,000

in revenues, but discount rate changed.

DECISION RULE

Net Present Value Method Internal Rate of Return Method

1 Compute the investment’s

net present value, using the

organization’s cost of capital

adjusted for project-specific

risk as the discount rate

(hurdle rate).

2 Undertake the investment

1 Compute the investment’s internal rate of return.

2 Undertake the investment if its internal rate of return is equal to or greater than the organization’s cost of capital

The decision to accept or reject an investment proposal can be made using

either the internal rate of return method or the net present value method under

most circumstances.

EXHIBIT 8.4

JEP’s hurdle rate

is 12% Should they accept this project?

JEP’s hurdle rate

is 12% Should they accept this project?

P

JUSTIFYING INVESTMENTS

Investments in computer-integrated manufacturing are

often difficult because of difficulties in applying

discounted cash flow methods

LONG-TERM INVESTMENTS

Three types of long term capital investments are:

Replacement and minor improvements

Expansion

Strategic moves

Auditing to compare estimates of capital

budgeting projects to actual results provides

advantages:

Audits identify which estimates were wrong to

correct in future

Managers can use audits to reward good planning

Audits create environment that removes the

BEHAVIORAL ISSUES

Planners have a desire to implement a project,

meet performance measures This can

influence their objectivity in making

estimates Additionally, conflicts may arise

between criteria used to evaluate individual

projects and criteria used to evaluate an

organization’s overall or unit performance.

Planners have a desire to implement a project,

meet performance measures This can

influence their objectivity in making

estimates Additionally, conflicts may arise

between criteria used to evaluate individual

organization’s overall or unit performance.