MANACC Chapter19

CHAPTER 19- CAPITAL BUDGETING 2.
The operating cash flows or returns from the

investment
Capital budgeting- process of deciding whether or not 3. The minimum acceptable rate of return of
to commit resources to projects whose costs and investment
benefits are spread over several time periods.
- Used to describe actions relating to net investment- represents the initial cash outlay that is
the planning and financing capital required to obtain future returns or the net cash
outlays for such purposes as the outflow to support a capital investment project.
purchase of new machinery, the
modernization of plant facilities or Net cash returns- inflows of cash expected from a
introduction of new product lines. project reduced by the cash cost that can be directly
attributed to the project.
Capital budgeting involves:
1. Preparation of annual budget for capital “the minimum or lowest acceptable rate of return or
investment; opportunity cost may EQUAL the average rate of
2. Assessment of funding capacities; return that the company will earn from alternative
3. Allocation of resources to renewal and investment opportunities or the cost of capital which
expansion projects which most clearly conform is the average rate of return that the firm must pay to
with the company’s priorities. attract investment fund.”
Capital expenditure- long-term commitments of Process of capital budgeting:

resources to realize future benefits and budgeting for 1. Finding investment opportunities
them is one of the most important areas of managerial 2. Collect relevant information about
decision. Opportunities
3. Select discount rate
“one of the most difficult steps involved in the 4. Financial analysis of cash flows
decision-making process relates to the identification of 5. Decision
costs relevant to the problem.” 6. Project implementation
7. Project evaluation and appraisal
“the only relevant costs are future costs.”
Major categories of cash flows:
“historical costs are sunk costs.” 1. Cash inflows:
a. Periodic cash inflows from operations,
General types of capital investment decisions: net of taxes
1. Independent capital investment b. Investment tax credit
project/screening decisions c. Proceeds from sale of old asset being
2. Mutually exclusive capital investment replaced, net of taxes
projects/preference decisions d. Avoidable costs, net of taxes
e. Return of some working capital
Independent capital investment project/screening invested in the project
decisions- projects which are evaluated individually and f. Cash inflow from salvage of the new
reviewed against predetermined corporate standards of long-term asset at the end of its useful
acceptability resulting in an “accept” or “reject” life. This will be net of tax
decision. consequence.
2. Cash outflows:
Mutually exclusive capital investment g. acquisition cost of purchasing and
projects/preference decisions- projects which require installing assets
the company to choose from among specific h. additional working capital
alternatives. i. other cash flows such as severance
payments, relocation costs, restoration
Elements of capital budgeting: costs and similar costs.
1. The net amount of the investment
Disinvestment flows- cash flows resulted from the end 2. Ignores the impact of cash inflows after the
of a project’s life. PBperiod
3. Does not distinguish between alternatives
“to generate positive periodic operating cash flows is having different economic llives
usually the primary reason for acquiring long-term 4. Conventional payback computation fails to
assets.” consider salvage value, if any
5. Does not measure profitability
Investment tax credit- allows a credit against a 6. No necessary relationship bbetween a given
company’s income tax liability based on the cost of an payback and investor wealth maximization so
acquired asset. an investor would not know what an
acceptable payback is.
“If an old equipment is to be sold, the proceeds from
such sale is treated as a REDUCTION from cost of Bail-out period-approach which incorporates the
initial investment.” salvage value in payback computaions.
“the avoidable repairs cost, net of incremental tax will Simple rate of return or accounting rate of return-
be treated as a DEDUCTION in computing the cost of measures profitability from the conventional accounting
initial investment.” standpoint by relating the required investment to the
future annual net income
Most commonly used methods of evaluating capital
investment project: Decision rule:
1. non-discounted cash flow (unadjusted) If: ARR > or = Required rate of return; Accept
approach If: ARR < Required rate of return; Reject
a. payback period
b. accounting rate of return Advantages of ARR:
c. payback reciprocal 1. easily understood by investors acquainted
2. discounted cash flow(time-adjusted) approach with FS
a. net present value 2. used as a rough preliminary screening device
b. discounted rate of return (IRR) of investment proposals
c. profitability index
d. discounted payback period Disadvantages of ARR:
1. ignores the time value of money by failing to
payback period- (pay-off and payout period) measures discount the future cash inflows and outflows.
length time required to recover the amount of initial 2. Does not consider the timing component of
investment. cash inflows
- Time interval between time of 3. Different averaging techniques may yield
initial outlay and the full recovery of the investment. inaccurate answers
4. Utilizes the concepts of capital and income
Decision rule: primarily designed for the purposes of FS
If: PBperiod > or = Maximum allowed PBperiod; Accept preparation and which may not be relevant to
If: PBperiod < Maximum allowed PBperiod; Reject the evaluation of investment proposals
Advantages of payback period method: Discounted cash flow techniques- cash outlays and
1. Easy to compute and understand cash inflows are both discounted back to the present
2. Used to measure the degree of risk associated period using an appropriate discount rate.
with a project
3. The longer the payback period, the higher the Variations of discounted cash flow:
risk 1. Net present value or excess present method
4. Used to select projects which provide a quick 2. Discount rate of return or IRR
return of investment funds. 3. Profitability index
4. Discounted payback period
Disadvantages of PBperiod method:
1. Does not recognize the time value of money
Net present value- excess of the present value of cash “the higher the IRR, the more desirable the project.”
inflows generated by the project over the amount of
the initial investment. Net present value method- can be used to rank
competing investment projects if the projects are of
Discounted rate of return- (IRR) rate which equates the equal size, that is, investment funds required are the
present value of the future cash inflows with the cost of same.
the investment which produces them
Economic life- period within which returns are expected
Steps in the computation of the discounted rate of Direct costing- assignment of direct material, DL,
return: variable FOH costs to products
A. Cash inflows are evenly received: Incremental analysis- comparison of cost and revenue
a. Compute the present value factor by data that differ among alternatives
dividing net investment annual cash Average cost of capital- cost of financing the company’s
return activities
b. Trace the pv factor in the table for pv Sales mix analysis- determining the most profitable
of p1 received annually using the life of combination of product sales.
the project as point of reference
c. The column that gives the closest
amount to the PV factor is the
“discounted rate of return”
d. To get the exact discount rate of
return, interpolation applied.
B. Cash inflows are not evenly received:
a. Compute the average annual cash
returns
b. Divided net investment by the average
annual cash returns to get the present
value factor
c. Determine rate
d. Compute present value of annual cash
returns
e. Add the present value of the annual
returns and compare with net
investment
f. Try another rate
g. Interpolate to get exact disc rate of
return
Payback reciprocal-rate of recovery of investment

during payback period
Profitability index- ratio of the total present value of

future cash inflows to the initial investment.
Discounted payback period- method that recognizes

the time value of money in a payback context
Preference decisions- come after screening decisions

and attempt to resove the question of “how the
investment proposals, all of which have been screened
and provide an acceptable rate of return, rank in terms
of predference?”

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MANACC Chapter19

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CHAPTER 19- CAPITAL BUDGETING 2.

The operating cash flows or returns from the

Capital expenditure- long-term commitments of Process of capital budgeting:

Payback reciprocal-rate of recovery of investment

Profitability index- ratio of the total present value of

Discounted payback period- method that recognizes

Preference decisions- come after screening decisions

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