Test bank accounting management 11e chapter 21 CAPITAL BUDGETING AND COST ANALYSIS

CHAPTER 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 rateof-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.

Capital Budgeting and Cost Analysis

31


CHAPTER 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
strategies

32 Chapter 21


2. 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
Capital Budgeting and Cost Analysis

33


b. 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)
•

34 Chapter 21

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


•

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

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35


a. 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

36 Chapter 21


b. 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

Capital Budgeting and Cost Analysis

37


•

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

38 Chapter 21


1. 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

Capital Budgeting and Cost Analysis

39


CHAPTER 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.
b.
c.
d.

resultant amount is the maximum that should be paid for the asset.
discount rate used is not the proper required rate of return for this company.
investment is the best alternative.
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
Period 6%
8%
10%
12%
14%
1
2
3
4
5

.94
.89
.84
.79

.75

.93
.86
.79
.74
.68

.91
.83
.75
.68
.62

.89
.80
.71
.64
.57

.88
.77
.68
.59
.52

Present Value of an Annuity of $1.00 Received at the End of Each Period
Period
6%
8%

10%
12%
14%
1
2
3
4
5

0.94
1.83
2.67
3.47
4.21

0.93
1.78
2.58
3.31
3.99

0.91
1.73
2.49
3.17
3.79

0.89
1.69
2.40

3.04
3.61

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
a. 12%.

b. 10%.

c. 8%.

d. 6%.

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
a. 0%.

40 Chapter 21

b. 5.0.%.

c. 5.6%.

d. 28%.

0.88
1.65
2.32
2.91
3.43


6. Among the nonfinancial quantitative and qualitative factors that Hilltop should consider in its analysis
are
a.
b.
c.
d.

lower direct labor cost and less scrap and rework.
lower hourly support labor cost and reduction in manufacturing cycle time.
lower product defect rate and faster response to market changes.
improved competitive position and cost of retraining of personnel.

7. [CPA Adapted] The assumption that cash flows are reinvested at the rate earned by the investment
belongs to which of the following capital budgeting methods?
a.
b.
c.
d.

Internal rate of return
No
No
Yes
Yes

Net present value
No
Yes
Yes
No

8. [CPA Adapted] The payback capital budgeting technique considers
a.
b.
c.
d.

Time value of money
Yes
Yes
No

No

Income over entire life of project
Yes
No
Yes
No

9. Refer to data for questions 2–6. If Hilltop is subject to an income tax rate of 30%, what amount of
annual cash savings would be used in a discounted cash flow method or in the payback method?
a. $157,500

b. $125,000

c. $117,500

d. $87,500

10. Refer to data for questions 2–6. If Hilltop is subject to an income tax rate of 30% and a required rate
of return of 8 %, the net present value for replacing the old machine with the new machine is
a. $(100,875).

b. $3,825.

c. $18,825.

d. $163,425.

Capital Budgeting and Cost Analysis

41


WRITING/DISCUSSION EXERCISES
1. Recognize the multiyear focus of capital budgeting

Compare the reasons for using life-cycle costing to the project-by-project orientation for
capital budgeting. In Chapter 12, life-cycle costing was noted as being particularly important when
(a) nonproduction costs were large, (b) a high percentage of total life-cycle costs were incurred before
production began and before any revenues received, and (c) many of the life-cycle costs were locked in at
the beginning stages of the process.
Project-by-project approach to capital budgeting decision has these same characteristics.
2. Understand the six stages of capital budgeting for a project
How do the six stages of capital budgeting support the concept that one can look at
resource allocation in a budget and note what top management considers most
important? Throughout the six stages, the emphasis is on the objectives and strategy of the
organization. The decisions about projects involve the entire organization as noted in each of the stages.
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

What approaches might be used to recognize risk in capital budgeting?
The required rate of return (RRR) is a critical variable in discounted cash flow analysis. It is the rate of
return that the organization forgoes by investing in a particular project rather than in an alternative project
of comparable risk. Risk is used here to refer to the business risk of the project, not the specific manner
in which the project is financed. A safe generalization is that the higher the risk, the higher the required
rate of return and the faster management would want to recover the net initial investment. A higher risk
means a greater chance that the project may lose money, and what makes management willing to take
added risk is a higher expected rate of return.
Organizations can use one or more of the following in dealing with risk factors of projects:







Adjusting the required rate of return (higher rate when higher risk).
Adjusting the estimated future cash inflows (reduce the estimated cash inflows if higher risk).
Estimating the probability distribution of future cash inflows and outflows for each project.
Sensitivity analysis (discussed in chapter in text).
Varying the required payback time (discussed in chapter in text).

Can the emphasis on cash flows be reconciled with an accrual accounting approach?
A basic tenet of accrual accounting is realization. The accrual basis of accounting, though recognizing
revenue when earned and expense when incurred, is separated from the operating events in the cash flow
statement because of timing differences, not because of basic differences in amounts. The importance of
cash flow is noted by requiring the cash flow statement as one of the basic financial statements of a
company.

42 Chapter 21


4. Use and evaluate the payback method
The payback method of capital budgeting has been compared to a meat cleaver and the
discounted cash flow methods to a scalpel. Why might this be an appropriate analogy?
If an organization must select a few projects from a large pool of projects, an initial threshold could be
established by use of the payback method. Only projects that would pay back within a prescribed number
of years would be considered in more detail.
5. Use and evaluate the accrual accounting rate-of-return (AARR) method
Discuss the need to specifically define words used in describing the various methods. It
has been stated that the conceptual framework for financial accounting is primarily the

definition of terms. Because accounting serves as an information tool for organizations
(“the language of business”), the value of common meanings for terms is critical. For
example, the use of the term “return” elicits several definitions.
“Return” has several different meanings. Return can mean income. Income can mean operating income,
net income, income before interest and income taxes, and income from extraordinary items among other
uses. The text clearly illustrates the use of the term in this chapter. Do note that the accrual accounting
method has its own required rate of return that differs from the required rate of return used in net present
value or internal rate of return.
6. Identify and reduce conflicts from using DCF for capital budgeting decisions and accrual
accounting for performance evaluation

The tension between methods used to make the initial decision and then to evaluate the
decision is an ongoing problem. Recall some other situations in which this has been
noted. Some examples thus far have been from Chapter 6 – LO 8 (related one in Chapter 15 – LO2),
Chapter 9 – LO4, Chapter 11 – LO9, and Chapter 20 – LO3. Similar situations are discussed in the last
two chapters—22 and 23. One common point to be noted: If the purpose is clearly stated and understood
for original decision, the evaluation of the results of that decision should be in terms of the fulfilling of
that purpose—and not other purposes.
7. Identify relevant cash inflows and outflows for capital budgeting decisions
What would be the effect of using a depreciation method other than straight-line when
considering the role of income taxes on the net present value method? Accelerated
depreciation methods such as double-declining balance and sum-of-years’ digits serve the purpose of
taking the deduction sooner rather than later. The cash flow in the earlier years is larger (tax savings),
creating more present value inflows, resulting in higher NPV.

Capital Budgeting and Cost Analysis

43

SUGGESTED READINGS
Arya, A., Fellingham, J. and Glover, J., “Capital Budgeting: Some Exceptions to the Net Present Value
Rule,” Issues in Accounting Education (August 1998) p.499 [10p].
Ashton, A., Ashton, R. and Maines, l., “Instructional Case: General Medical Center—Evaluation of
Diagnostic Imaging Equipment,” Issues in Accounting Education (November 1998) p.985 [19p].
Bailes, J., Nielsen, J. and Lawton, S., “How Forest Product Companies Analyze Capital Budgets,”
Management Accounting (October 1998) p.24 [7p].
Balakrishnan, R. and Bhattacharya, U., “Ace Company (B): The Option Value of Waiting and Capital
Budgeting,” Issues in Accounting Education (Fall 1997) p.399 [13p].
Coburn, S., Grove, H. and Cook, T. “How ABC Was Used in Capital Budgeting,” Management
Accounting (May 1997) p.38 [9p].
Copeland, T., “The Real-Options Approach to Capital Allocation,” Strategic Finance (October 2001)
p.33 [6p].
Gordon, L. and Myers, M., “Postauditing Capital Projects,” Management Accounting (January 1991) p.39
[4p].
Hendricks, J., Bastian, R. and Sexton, T., “Bundle Monitoring of Strategic Projects,” Management
Accounting (February 1992) p.31 [6p].
Migliore, R. and McCracken, D., “Tie Your Capital Budget to Your Strategic Plan,” Strategic Finance
(June 2001) p.38 [5p].
Truitt, J. F., “Capital Rationing: An Annualized Approach,” Journal of Cost Analysis (Summer 1988)
p.63 [13p].
Wolk, H. I., Porter, G. A. and Vetter, D. E., “Net Working Capital Investment and Capital Budgeting
Analysis: Some Pedagogical Insights,” Journal of Accounting Education (Fall 1989) p.253 [10p].

44 Chapter 21