Accounting tools for business decision making 7 kieo ch25

Accounting: Tools for Business
Decision Making
Seventh Edition
Kimmel; Weygandt; Kieso

Chapter 25
Planning for Capital Investments
Prepared by
COBY HARMON
University of California, Santa Barbara
Westmont College
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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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Cost Flow Information

LEARNING OBJECTIVE 1

Describe capital budgeting inputs and apply the cash
payback technique.
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
Typical cash flows relating to capital budgeting

Cash Outflows
Initial investment
Repairs and maintenance
Increased operating costs
Overhaul of equipment
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
Considerations for capital budgeting decisions
• Availability of funds.
• Relationships among proposed projects.
• Company’s basic decision-making approach.
• 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

LO 1

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

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Cash Payback
Cash payback formula
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

Net Annual
�
Cash Flow

$130,000 �

LO 1

$24,000

Cash Payback
=
Period
=

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5.42 years

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Cash Payback
Evaluation of project

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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Cash Payback
Cash payback period-unequal cash flows

Illustration: Chen Company proposes an investment in a
new website that is estimated to cost $300,000.

LO 1

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Cash Payback
Question
A $100,000 investment with a zero scrap value has an 8year 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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Cash Payback
Answer
A $100,000 investment with a zero scrap value has an 8year 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. Answer: 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

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

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Net Present Value Method

LEARNING OBJECTIVE 2

Use the net present value method.
Discounted cash flow technique:
• Generally recognized as best approach
• Considers both estimated total cash inflows and time
value of money
• Two methods:

LO 2

o

Net present value (NPV)

o

Internal rate of return (IRR)
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Net Present Value Method
The primary capital budgeting technique
• Cash inflows are discounted to their present value and
then compared with capital outlay required by
investment
• Interest rate used in discounting is required minimum
rate of return
• Proposal is acceptable when NPV is zero or positive
ã Higher positive NPV, more attractive investment

LO 2

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Net Present Value Method
Net present value decision criteria

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

LO 2

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Equal Annual Cash Flows
Present value of equal net annual cash flows
Illustration: In the Stewart Shipping Company example
(Illustration 12.3), 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 of net cash flows:
$24,000 × 5.65022

LO 2

Present Value
at 12%
5.65022
$135,605

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

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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Unequal Annual Cash Flows
Present value of unequal annual cash flows
Assumed Net Annual
Cash Flows

Discount Factor
12%

Present Value
12%

(1)

(2)

(1) ì (2)

1

$34,000

0.89286

$30,357

2

30,000

0.79719

23,916

3

27,000

0.71178

19,218

4

25,000

0.63552

15,888

5

24,000

0.56743

13,618

6

22,000

0.50663

11,146

7

21,000

0.45235

9,499

8

20,000

0.40388

8,078

9

19,000

0.36061

6,852

10

18,000

0.32197

5,795

Year

$240,000

LO 2

$144,367

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Unequal Annual Cash Flows
Net present value-unequal annual cash flows
Illustration: Calculate the net present value.
Present value of net cash flows
Less: Capital investment
Net present value

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
Rate to obtain funds from creditors and stockholders

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
Comparison of NPV at different discount rates
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%.

LO 2

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

LO 2

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Net Present Value (NPV) Method
Answer

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. Answer: $22,511
c. $9,062
d. $(22,511)

LO 2

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