Capital Budgeting and Cost

Analysis

Chapter 21
 Introduction

Capital budgeting methods deal with how to

select projects (or programs) that increase
rather than decrease the “capital” (value) of a
business.
These methods assist managers in analyzing
projects that span multiple years.
 Learning Objectives
Adopt the project-by-project orientation of capital
budgeting when evaluating projects spanning
multiple years
Follow the six stages of capital budgeting for a
project
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
Learning Objectives
4 Identify relevant cash inflows and
outflows for capital-budgeting decisions
that use DCF methods
5 Use and evaluate the payback method
6 Use and evaluate the accrual
accounting rate-of-return (AARR)
method
Learning Objectives
7 Identify and reduce conflicts from using
DCF for capital budgeting and accrual
accounting for performance evaluation
8 Incorporate depreciation deductions
into the computation of after-tax cash
flows in capital budgeting
Learning Objective 1
Adopt the project-by-
project orientation of
capital budgeting when
evaluating projects
spanning multiple years
Cost Analysis
 There are two different dimensions of
cost analysis:
1 A project dimension
2 An accounting period dimension
 The accounting system that
corresponds to the project dimension is
termed life-cycle costing.
Cost Analysis
 Life-cycle costing accumulates revenues
and costs on a project-by-project basis.
 This accumulation extends the accrual
accounting system that measures income
on a period-by-period basis to a
system that computes cash flow or
income over the entire project covering
many accounting periods.
 Cost Analysis

Project D
Project C
Project B
Project A
2000 2001 2002 2003 2004
Cost Analysis
 The life of the project is usually longer
than one year, so capital budgeting
decisions consider revenues and costs
over relatively long periods.
 Capital Budgeting

Capital budgeting is the making of long-run

planning decisions for investments in projects and
programs.
It is a decision-making and control tool that
focuses primarily on projects or programs that
span multiple years.
 Capital Budgeting

Capital budgeting is a six-stage process:

Identification stage. To distinguish which types of

capital expenditure projects are necessary to

accomplish organization objectives.
Search stage. To explore alternative capital

investments that will achieve organization

objectives.
 Capital Budgeting

 Information-acquisition stage. To consider the

expected costs and the expected benefits of
alternative capital investments.
 Selection stage. To choose projects for
implementation.
 Financing stage. To obtain project funding.
 Implementation and control stage. To get
projects underway and monitor their
performance.
Capital Budgeting
 Healthy Living is a non-profit organization.
 One of its goals is to improve the diagnostic
capabilities of its Miami facility.
 Management identifies a need to consider the
purchase of new, state-of-the-art equipment.
 The search stage yields several alternative
models, but management focuses on one
machine as being particularly suitable.
Capital Budgeting
 The administration next begins to acquire
information to do more detailed evaluation.
 The required net initial investment consists
of the cost of the new machine ($245,000)
plus an additional cash investment in working
capital (supplies and spare parts) of $5,000.
 Management expects the new machine to
have a three-year useful life and a $0
terminal disposal price at the end of the three
years.
Capital Budgeting
 This proposed investment will yield net
cash savings of $125,000, $130,000,
and $110,000 over its life.
 The working capital investment of
$5,000 is expected to be recovered at
the end of year 3.
 Operating cash flows are assumed to
occur at the end of the year.
Capital Budgeting
 Management also identifies the
following nonfinancial quantitative and
qualitative benefits of investing in the
new diagnostic machine.
– Improved diagnoses and patient care
– Reduced inconvenience of transporting
patients to other facilities for diagnoses
Capital Budgeting
 Nonfinancial benefits are not
incorporated into the analysis.
 In the selection stage, management
must decide whether Healthy Living
should purchase the new machine.
 Assume that the required rate of return
for Healthy Living is 10%.
 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
Discounted Cash Flow
 Discounted cash-flow (DCF) methods
measure all expected future cash
inflows and outflows of a project as if
they occurred at a single point in time.
 The discounted cash-flow methods
incorporate the time value of money.
Discounted Cash Flow
 The time value of money means that a
dollar received today is worth more
than a dollar received at any
future time.
 Why?
 Because it can earn income and
become greater in the future.
Discounted Cash Flow
 There are two main DCF methods:
1 Net present value (NPV) method
2 Internal rate-of-return (IRR) method
Net Present Value
 The NPV method computes the expected net
monetary gain or loss from a project by
discounting all expected cash flows to the
present point in time, using the required rate
of return.
 Management’s minimum desired rate of
return is also called the discount rate, hurdle
rate, required rate of return, or cost of
capital.
Net Present Value
 Only projects with a zero or positive net
present value are acceptable.
 What is the the net present value of the
diagnostic machine?
 Net Present Value
Sketch of Relevant Cash Flows
0 1 2 3
Net initial
investment ($250,000)

Annual cash inflow $125,000 $130,000 $115,000

 Net Present Value
Net Cash NPV of Net
Year 10% Col. Inflows Cash Inflows
1 0.909 $125,000 $113,625
2 0.826 130,000 107,380
3 0.751 115,000 86,365
Total PV of net cash
inflows $307,370 Investment
250,000 Net present value of
project $ 57,370
Net Present Value
 This project is acceptable because its
net present value is $57,370.
 Assume that Healthy Living is
considering another investment that will
generate $80,000 per year for three
years, and have a residual value of
$4,000 at the end of the third year.
Net Present Value
 The cost of this investment is $250,000
including working capital.
 The working capital investment of
$5,000 is expected to be recovered
at the end of year 3.
 Healthy Living expects a return of 10%.
 Should the investment be made?
 Net Present Value
 No, the net present value is negative.
 Net Cash NPV of
Net Years 10% Col. Inflows Cash
Inflows 1-3 2.487 $80,000
$198,960 3 0.751
9,000 6,759 Total PV of net cash
inflows $205,719 Investment
250,000 Net present value
of project ($44,281)
Internal Rate of Return...
– is another model using discounted cash
flows.
 The internal rate-of-return (IRR)
method calculates the discount rate at
which the present value of expected
cash inflows from a project equals the
present value of expected cash
outflows.
Internal Rate of Return
 Investment = Expected annual net cash
inflow × PV annuity factor
 Investment ÷ Expected annual net cash
inflow = PV annuity factor
 Internal Rate of Return
 Assume that Healthy Living is considering
investing $303,280 in a scanning machine
that will yield net cash savings of $80,000
per year over its five-year life.
 What is the IRR of this project?
 $303,280 ÷ $80,000 = 3.791 (PV annuity
factor)
Internal Rate of Return
 The annuity table shows that 3.791 is in
the 10% column for a 5 period row
in this example.
 Therefore, 10% is the internal rate of
return of this project.
 If the minimum desired rate of return is
10% or less, Healthy Living should
undertake this project.
Comparison of NPV and IRR
 The NPV method has the important
advantage that the end result of the
computations is expressed in dollars and not
in a percentage.
 Individual projects can be added to see the
effect of accepting a combination of projects.
 It can be used in situations where the
required rate of return varies over the life of
the project.
Comparison of NPV and IRR
 The IRR of individual projects cannot be
added or averaged to derive the IRR of
a combination of projects.
Learning Objective 4
Identify relevant cash
inflows and outflows for
capital-budgeting
decisions that use DCF
methods
Relevant Cash Flows
 Relevant cash flows are expected future cash
flows that differ among the alternatives.
 Capital investment projects typically have
three major categories of cash flows:
1 Net initial investment
2 Cash flow from operations
3 Cash flow from terminal disposal of assets
and recovery of working capital
Relevant Cash Flows
 Typically, net initial investment
components are:
1 Initial asset investment
2 Initial working capital investment
3 Current disposal value of old asset
Net Initial Investment
 The original Healthy Living example
included the following:
 Initial machine investment
$245,000 Initial working
capital investment $ 5,000
Current disposal value of old machine
0
Cash Flow From Operations
 Cash inflows may result from producing and
selling additional goods or services, or, as in
the Healthy Living example, from savings in
cash operating costs.
 Depreciation is irrelevant in DCF analysis
because it is a noncash allocation of costs.
 DCF is based on inflows and outflows of cash.
Terminal Disposal Price
 At the end of the machine’s useful life
the terminal disposal price may be zero
or an amount considerably less than the
initial machine investment.
 The original Healthy Living example
assumed zero disposal value of the
new diagnostic machine.
Working Capital Recovery
 The initial investment in working capital
is usually fully recouped when the
project is terminated.
 The relevant working capital cash inflow
is the $5,000 that Healthy Living will
recover in year 3.
Learning Objective 5
Use and evaluate the
payback method
Payback Method
 Payback measures the time it will take
to recoup, in the form of expected
future cash flows, the initial investment
in a project.
Payback Method
 Assume that Healthy Living is
considering buying some equipment
(Machine 1) for $210,000, with an
estimated useful life of 11 years, and
zero predicted residual value.
 Managers expect use of the equipment
to generate $35,000 of net cash inflows
from operations per year.
Payback Method
 How long would it take to recover the
investment?
 $210,000 ÷ $35,000 = 7 years
 7 years is the payback period.
Payback Method
 Suppose that an alternative to the
$210,000 piece of equipment, there is
another one (Machine 2) that also costs
$210,000 but will save $42,000 per year
during its five-year life.
 What is the payback period?
 $210,000 ÷ $42,000 = 5 years
 Which piece of equipment is preferable?
Payback Method
 Machine 1 is preferable because it will
continue to generate net cash inflows
for four years after its payback
period.
 This will give the company an additional
net cash inflow of $140,000.
Payback Method
 When cash flows are uneven, calculations
must take a cumulative form.
 Assume that Healthy Living’s diagnostic
machine investment is going to yield net
cash savings of $160,000, $180,000, and
$110,000 over its life.
 The initial investment is $250,000.
 What is the payback period?
Payback Method
 Year 1 brings in $160,000.
 Recovery of the amount invested occurs
in Year 2.
Payback Method
 Payback
= 1 year
+ $90,000 needed to complete recovery
$180,000 net cash inflow in Year 2
 1 year + 0.5 year = 1.5 years or,
 1 year and 6 months
 Learning Objective 6
Use and evaluate the
accrual accounting rate-
of-return (AARR) method
Accrual Accounting
Rate-of-Return Method
 The accrual accounting rate-of-return
(AARR) method divides an accounting
measure of income by an accounting
measure of investment.
 This method is also called the
accounting rate of return.
Accrual Accounting
Rate-of-Return Method
 Recall the scanning machine with a cost
$303,280, no residual value, expected
annual net cash savings of $80,000,
and a useful life of 5 years.
 The IRR of this machine is 10%.
 What is the average operating income?
 Accrual Accounting
Rate-of-Return Method
 Straight-line depreciation is $60,656 per
year.
 Average operating income is $19,344.
 $80,000 – $60,656 = $19,344
 What is the AARR?
 AARR = $80,000 – $60,656 = 6.38%
$303,280
Accrual Accounting
Rate-of-Return Method
 An AARR of 6.38% indicates the rate at
which a dollar of investment generates
operating income.
 Projects whose AARR exceeds an
accrual accounting required rate of
return for the project are considered
desirable.
Accrual Accounting
Rate-of-Return Method
 The AARR method is similar to the IRR
method in that both methods calculate
a rate-of-return percentage.
 While the AARR calculates return using
operating income numbers after
considering accruals, the IRR method
calculates return on the basis of cash
flows and the time value of money.
 Learning Objective 7
Identify and reduce
conflicts from using DCF
for capital budgeting and
accrual accounting for
performance evaluation
Performance Evaluation
 A manager who uses DCF methods to make
capital budgeting decisions can face goal
congruence problems if AARR is used for
performance evaluation.
 Suppose top management uses the AARR to
judge performance if the minimum desired
rate of return is 10%.
 A machine with an AARR of 6.38% will be
rejected.
Performance Evaluation
 The AARR is low because the investment
increases the denominator and, as a result of
depreciation, also reduces the numerator
(operating income) in the AARR computation.
 Frequently, the optimal decision made using a
DCF method will not report good “operating
income” results in the project’s early years on
the basis of the AARR.
Performance Evaluation
 The conflict between using AARR and
DCF methods to evaluate performance
can be reduced by evaluating
managers on a project-by-project basis.
 Income-Tax Considerations

 Although depreciation is a noncash expense, it

is a deductible cost for calculating tax outflow.
 Taxes saved as a result of depreciation
deductions increase cash flows in discounted
cash-flow (DCF) computations.
 Income-Tax Considerations
 Assume Miami Transit is considering the
replacement of an old piece of equipment with
new, more modern equipment.
 The income tax rate is 40%.
 The company uses straight-line depreciation.
 The tax effects of cash inflows and outflows
occur at the same time that the inflows and
outflows occur.
 Income-Tax Considerations
Old equipment:
Current book value $50,000
Current disposal price $ 3,000
Terminal disposal price
(5 years)
0 Annual depreciation
$10,000 Working capital $
5,000
Income-Tax Considerations
 Current disposal price of
old equipment $
3,000 Deduct current book value
of old equipment
50,000 Loss on disposal
of equipment $47,000
 How much is the tax savings?
 $47,000 × 0.40 = $18,800
Income-Tax Considerations
 What is the after-tax cash flow from
current disposal of old equipment?
 Current disposal price $ 3,000
Tax savings on loss
18,800 Total
$21,800
Income-Tax Considerations
New equipment
Current book value
$225,000 Current
disposal price is irrelevant
Terminal disposal price (5 years)
0 Annual depreciation $
45,000 Working capital
$ 15,000
Income-Tax Considerations
 How much is the net investment for the new
equipment?
 Current cost
$225,000 Add increase in working
capital 10,000 Deduct after-tax cash
flow from current disposal of old
equipment – 21,800 Net investment
$213,200
Income-Tax Considerations
 Assume $90,000 pretax annual cash flow
from operations (excluding depreciation
effect).
 What is the after-tax flow from operations?
 Cash flow from operations $90,000
Deduct income tax (40%)
36,000 Annual after-tax flow from
operations
$54,000
Income-Tax Considerations
 What is the difference in depreciation
deduction?
 Annual depreciation of new
equipment
$45,000 Deduct annual depreciation
of old equipment
10,000 Difference
$35,000
Income-Tax Considerations
 What is the annual increase in income
tax savings from depreciation?
 Increase in depreciation
$35,000
Multiply by tax rate
× .40 Income tax cash savings
from additional
depreciation $14,000
Income-Tax Considerations
 What is the cash flow from operations, net
of income taxes?
 Annual after-tax flow from
operations
$54,000 Income tax cash savings from
additional depreciation
14,000 Cash flow from operations, net
of income taxes
$68,000
Income-Tax Considerations
 Miami Transit requires 14% rate of
return on its investments.
 What is the net present value of the
new equipment incorporating income
taxes?
 Income-Tax Considerations
Net Cash NPV of Net
Years 14% Col. Inflows Cash Inflows
1-5 3.433 $68,000 $233,444
5 0.519 10,000 5,190
Total PV of net cash inflows $238,636
Investment 213,200
Net present value of new equipment $ 25,436
 Intangible Assets

Intangible assets are critical to most organizations.

 These assets have the potential to yield net cash

inflows many years into the future.

 Top management can use a capital budgeting

tool, such as NPV, to summarize the difference

in the future net cash inflows from an intangible
asset at two different points in time.