Managerial accounting tool for business decision making chapter 12

Chapter
12-1


CHAPTER 12

PLANNING FOR
CAPITAL
INVESTMENTS
Managerial Accounting, Fifth Edition

Chapter
12-2


Study

Chapter
12-3

Study Objectives

1.

Discuss the capital budgeting evaluation process, and
explain inputs used in capital budgeting.

2.

Describe the cash payback technique.

3.

Explain the net present value method.

4.

Identify the challenges presented by intangible benefits
in capital budgeting.

5.

Describe the profitability index.

6.

Indicate the benefits of performing a post-audit.

7.

Explain the internal rate of return method.

8.

Describe the annual rate of return method.


Planning
Planning for
for Capital
Capital Investments

Investments

Capital
Capital
Budgeting
Budgeting
Evaluation
Process
Process
Cash flow
information
Illustrative
data

Chapter
12-4

Cash
Cash
Payback
Payback

Calculation
Evaluation

Net
Net Present
Present
Value
Value

Method
Method

Equal cash
flows
Unequal
cash flows
Choosing a
discount
Rate
Simplifying
Assumption
Comprehensive example

Other
Other
Capital
Capital
Budgeting
Techniques
Techniques
Intangible
benefits
Profitability
index
Risk analysis
Post-audit of
projects

Additional

Additional
Considerations
erations

Intangible
benefits
Internal rate
of return
method
Comparing
discounted
cash flow
methods
Annual rate
of return
method


Capital Budgeting Evaluation Process
Many companies follow a carefully prescribed
process in capital budgeting. At least once a
year:
1) Proposals for projects are requested from
each department.
2) The proposals are screened by a capital
budgeting committee, which submits its
finding to officers of the company.
3) Officers select projects and submit a list of
projects to the board of directors.
SO 1

Discuss the capital budgeting evaluation
process, and explain what inputs are used
in capital budgeting.


Capital Budgeting Authorization Process

Illustration 12-1

SO 1

Discuss the capital budgeting evaluation
process, and explain what inputs are used
in capital budgeting.


Capital Budgeting Evaluation Process







Chapter
12-7

Most methods to evaluate capital budgeting
decisions employ cash flow numbers rather

than accrual revenues and expenses.
For capital budgeting, estimated cash
inflows and outflows are the preferred
inputs.
WHY?
Ultimately the value of financial
investments is determined by the value of
the cash flows received or paid.
SO 1

Discuss the capital budgeting evaluation
process, and explain what inputs are used
in capital budgeting.


Typical Cash Flows Related to Capital
Budgeting Decisions

Illustration 12-2

Chapter
12-8

SO 1

Discuss the capital budgeting evaluation
process, and explain what inputs are used
in capital budgeting.

Capital Budgeting Evaluation Process
The capital budgeting decision depends on a
variety of considerations:
1)
2)
3)

The availability of funds.
Relationships among proposed projects.
The company’s basic decision-making
approach.
4) The risk associated with a
particular project.

Chapter
12-9

SO 1

Discuss the capital budgeting evaluation
process, and explain what inputs are used
in capital budgeting.


Facts for Stewart Soups Example

Illustration 12-3

SO 1
Chapter

12-10

Discuss the capital budgeting evaluation
process, and explain what inputs are used in
capital budgeting.


Cash Payback Formula

The cash payback technique identifies the
time period required to recover the cost of
the capital investment from the net annual
cash flow produced by the investment.
The formula for computing the cash payback
period is:

Illustration 12-4

Chapter
12-11

SO 2 Describe the cash payback technique.


Cash Payback Formula-Equal Cash Flows

Illustration 12-4

$130,000

÷

$24,000

=

5.42 years

The shorter the payback the more attractive the
investment.

Chapter
12-12

SO 2 Describe the cash payback technique.


Cash Payback Formula-Unequal Cash Flows

Illustration 12-5

Chapter
12-13

SO 2 Describe the cash payback technique.


Cash Payback
May be useful as an initial screening tool.
Easy to use and understand.

May be critical for company that wants
quick cash turnaround with weak cash
position.
Ignores profitability of the project!
Ignores the time value of money!

Chapter
12-14

SO 2 Describe the cash payback technique.


Review Question
A $100,000 investment with a zero scrap value has an 8-year life. Compute
the payback period if straight-line depreciation is used and net income is
determined to be $20,000.

a.
b.
c.
d.

Chapter
12-15

8.00 years.
3.08 years.
5.00 years.
13.33 years.

$20,000
+12,500 depreciation
32,500 =net annual cash flow
$100,000 = Cost of Capital
÷ 32,500 = Net annual cash flow
= 3.08 Years cash payback period
SO 2 Describe the cash payback technique.


Net Present Value Method


The discounted cash flow technique is
generally recognized as the best conceptual
approach to making capital budgeting decisions.



This technique considers both the estimated
total cash inflows and the time value of money.
Two methods are used with the
discounted cash flow technique:
1) Net present value, and
2) Internal rate of return.



Chapter
12-16

SO 3 Explain the net present value method.


Net Present Value Method
Under the net present value method, cash inflows are
discounted to their present value and then compared
with the capital outlay required by the investment.
The interest rate used in discounting the future cash
inflows is the required minimum rate of return.
A proposal is acceptable when NPV is zero or positive.
The higher the positive NPV, the more attractive the
investment.

Chapter
12-17

SO 3 Explain the net present value method.


Net Present Value Decision Criteria

Chapter
12-18

Illustration 12-6

SO 3 Explain the net present value method.


Present Value of Equal Annual Cash

Flows
Stewart Soup Company’s annual cash inflows are $24,000. If we
assume this amount is uniform over the asset’s useful life, the present
value of the annual cash inflows can be computed by using the present
value of an annuity of 1 for 10 periods. The computations at rates of
return of 12% and 15%, respectively are:

Illustration 12-7

Chapter
12-19

SO 3 Explain the net present value method.


Computation of Net Present Values
The analysis of the proposal by the net present
value method is as follows:

Illustration 12-8
The proposed capital expenditure is acceptable at a required rate of
return of 12% (not 15%) because the net present value is positive.
Chapter
12-20

SO 3 Explain the net present value method.


Present Value of Annual Cash Inflows-Unequal
Annual Cash Flows

When annual cash inflows are unequal, we cannot use annuity tables to
calculate their present value. Instead tables showing the present value of a
single future amount must be applied to each annual cash inflow.

Chapter
12-21

Illustration 12-9

SO 3 Explain the net present value method.


Analysis of Proposal Using Net Present
Value Method
Therefore, the analysis of the proposal by the net present
value method is as follows:

Illustration 12-10

In this example, the present values of the cash inflows are
greater than the $130,000 capital investment. Thus, the
project is acceptable at both a 12% and 15% required rate
of return.
Chapter
12-22

SO 3 Explain the net present value method.


Choosing a Discount Rate

In most cases the discount rate (required
rate of return) is equal to its cost of capital
– the amount it must pay to obtain funds
from creditors or stockholders.

Chapter
12-23

SO 2 Describe the cash payback technique.


Simplifying Assumptions
All cash flows come at the end of the
year.
All cash flows are immediately
reinvested in another project that has a
similar return.
All cash flows can be predicted with
certainty.

Chapter
12-24

SO 3 Explain the net present value


Review Question
Compute the net present value of a $260,000 investment with a 10-year
life, annual cash inflows of $50,000 and a discount rate of 12%.

a.
b.
c.
d.

Chapter
12-25

$(9,062).
$22,511.
$9,062.
$(22,511).

Present Value of Cash Flows:
$50,000 × 5.65022 =
$282,511
Minus capital investment 260,000
Net present value $ 22,511
SO 3 Explain the net present value method.