Accounting principles, 13th edition ch27

Accounting Principles
Thirteenth Edition
Weygandt Kimmel Kieso

Chapter 27

Planning for Capital
Investments
Prepared by

Coby Harmon

University of California, Santa Barbara
Westmont College


Chapter Outline
Learning Objectives
LO 1 Describe capital budgeting inputs and apply the
cash payback technique.
LO 2 Use the net present value method.
LO 3 Identify capital budgeting challenges and
refinements.
LO 4 Use the internal rate of return method.
LO 5 Use the annual rate of return method.
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Capital Budgeting and Cash Payback

Corporate capital budget authorization process:
1. Proposals for projects are requested from each
department, plants, and authorized personnel.
2. Proposals are screened by a capital budget
committee.
3. Officers determine which projects are worthy of
funding.
4. Board of directors approves capital budget.

LO 1

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Cost Flow Information
For purposes of capital budgeting, estimated cash
inflows and outflows are the preferred inputs.
Why?
Ultimately, the value of all financial investments is
determined by the value of cash flows received and
paid.

LO 1

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Cost Flow Information
Cash Outflows
Initial investment
Repairs and maintenance
Increased operating costs
Overhaul of equipment

ILLUSTRATION 27.2
Typical cash flows relating to
capital budgeting decisions

Cash Inflows
Proceeds from sale of old equipment
Increased cash received from customers
Reduced cash outflows related to operating costs
Salvage value of equipment
LO 1

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Cost Flow Information
Capital budgeting decisions depend on:
a. Availability of funds
b. Relationships among proposed projects
c. Company’s basic decision-making approach
d. Risk associated with a particular project

LO 1

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Illustrative Data
Stewart Shipping Company is considering an
investment of $130,000 in new equipment.
Initial investment
Estimated useful life
Estimated salvage value
Estimated annual cash flows
Cash inflows from customers
Cash outflows for operating costs
Net annual cash flow

$130,000
10 years
-0$200,000
176,000
$ 24,000

ILLUSTRATION 27.3
Investment information for Stewart Shipping example
LO 1

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Cash Payback
Cash payback technique identifies time period
required to recover cost of capital investment from
net annual cash inflow produced by investment.
Cash payback period for Stewart is …
Cost of Capital
÷
Investment
$130,000

LO 1

÷

ILLUSTRATION 27.4
Cash payback formula

Net Annual
Cash Flow

=

Cash Payback
Period

$24,000

=

5.42 years

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Cash Payback
Shorter payback period = More attractive
investment
In case of uneven net annual cash flows, company
determines cash payback period when:
Cumulative net
cash flows from
investment

LO 1

=

Cost of
investment

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ILLUSTRATION 27.5
Computation of cash
payback period—
unequal cash flows

Cash Payback

Illustration: Chen Company proposes an investment
in a new website that is estimated to cost $300,000.
Year
0
1
2
3
4
5
LO 1

Investmen
t
$300,00
0

Net Annual
Cash Flows

$60,000
90,000
90,000

120,000
100,000
Cash payback period = 3.5 years
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Cumulative Net
Cash Flow

$60,000
150,000
240,000
360,000
460,000
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Cash Payback
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. 8.00 years.
b. 3.08 years.
c. 5.00 years.
d. 13.33 years.
LO 1

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DO IT! 1 Cash Payback Period
Watertown Paper Corporation is considering adding another
machine for the manufacture of corrugated cardboard. The
machine would cost $900,000. It would have an estimated life of
6 years and no salvage value. The company estimates that
annual cash inflows would increase by $400,000 and that annual
cash outflows would increase by $190,000. Compute the cash
payback period.
Estimated annual cash inflows
Estimated annual cash outflows
Net annual cash flow

$400,000
190,000
$210,000

Cash payback period = $900,000/$210,000 = 4.3 years
LO 1

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Net Present Value Method
Discounted cash flow technique:
a. Generally recognized as best approach
b. Considers both estimated total cash inflows and time

value of money
c. Two methods:

LO 2



Net present value (NPV)



Internal rate of return (IRR)

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Net Present Value Method
a. Cash inflows are discounted to their present value
and then compared with capital outlay required by
investment
b. Interest rate used in discounting is required minimum
rate of return
c. Proposal is acceptable when NPV is zero or positive
d. Higher positive NPV, more attractive investment

LO 2

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Net Present
Value
Method

Present Value of
Net Cash Flows
Less

Capital
Investment

Proposal is
acceptable when
net present value
is zero or positive.

Less

If zero or positive:

Accept
Proposal
LO 2

Net Present
Value

ILLUSTRATION 27.6
Net present value decision criteria

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If negative:

Reject
Proposal
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Equal Annual Cash Flows
Illustration: Stewart Shipping Company example, the
company’s net annual cash flows are $24,000. If we assume
this amount is uniform over the asset’s useful life, we can
compute the present value of the net annual cash flows.

Discounted factor for 10 periods

Present Value
at 12%
5.65022

Present value of net cash flows:
$24,000 × 5.65022

$135,605

ILLUSTRATION 27.7
Computation of present value of equal net annual cash flows

LO 2

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Equal Annual Cash Flows
Illustration: Calculate the net present value.
Present value of net cash flows
Less: Capital investment
Net present value

ILLUSTRATION 27.8
Computation of net
present value—equal net
annual cash flows

12%
$135,605
130,000
$ 5,605

Proposed capital expenditure is acceptable at a required
rate of return of 12% because the net present value is
positive.

LO 2

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Unequal Annual Cash Flows
Illustration: Stewart Shipping Company expects the same
total net cash flows of $240,000 over the life of the
investment. Because of a declining market demand for
the new product the net annual cash flows are higher in
the early years and lower in the later years.
The present value of the net annual cash flows is
calculated as follows.

LO 2

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Year
1
2
3
4
5
6

7
8
9
10

LO 2

Assumed Net Annual Discount Factor
Cash Flows
12%
(1)
(2)
$34,000
0.89286
30,000
0.79719
27,000
0.71178
25,000
0.63552
24,000
0.56743
22,000
0.50663
21,000
0.45235
20,000
0.40388
19,000
0.36061

18,000
0.32197
$240,000

ILLUSTRATION 27.9
Computation of present value—
unequal annual cash flows

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Present Value
12%
(1) x (2)
$30,357
23,916
19,218
15,888
13,618
11,146
9,499
8,078
6,852
5,795
$144,367
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Unequal Annual Cash Flows
Illustration: Calculate the net present value.
Present value of net cash flows

Less: Capital investment
Net present value

ILLUSTRATION 27.10
Computation of net
present value—unequal
annual cash flows

12%
$144,367
130,000
$ 14,367

Proposed capital expenditure is acceptable at a required
rate of return of 12% because the net present value is
positive.

LO 2

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Choosing a Discount Rate
In most instances a company uses a required rate of
return equal to its cost of capital — that is, the rate
that it must pay to obtain funds from creditors and
stockholders.
Discount rate has two elements:

• Cost of capital
• Risk

Rate also know as required rate of return, hurdle rate,
and cutoff rate.
LO 2

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Choosing a Discount Rate
Illustration: Stewart Shipping used a discount rate of 12%.
Suppose this rate does not take into account the risk of the
project. A more appropriate rate might be 15%.
ILLUSTRATION 27.11
Comparison of net present value at
different discount rates

Discounted factor for 10 periods
Present value of net cash flows:
$24,000 × 5.65022
$24,000 x 5.01877
Less: Capital investment
Positive (negative) net present value
LO 2

Present Values at
Different Discount Rates

12%
15%
5.65022
5.01877
$135,605
130,000
$ 5,605

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$120,450
130,000
$ (9,550)
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Simplifying Assumptions
• All cash flows come at end of each year
• All cash flows are immediately reinvested in another
project that has a similar return
• All cash flows can be predicted with certainty

LO 2

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Net Present Value (NPV) Method

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. $(9,062)
b. $22,511
c. $9,062
d. $(22,511)

LO 2

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Comprehensive Example (1 of 3)

ILLUSTRATION 27.12
Investment information for
Best Taste Foods example

Best Taste Foods is considering investing in new equipment to
produce fat-free snack foods.

LO 2

Initial investment
Cost of equipment overhaul in 5 years
Salvage value of equipment in 10 years
Cost of capital (discount rate)

$1,000,000
$200,000
$20,000
15%

Estimated annual cash flows
Cash inflows received from sales
Cash outflows for cost of goods sold
Maintenance costs
Other direct operating costs

$500,000
$200,000
$30,000
$40,000

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