ACCTG 505 – CHAPTER 21



ACCTG 505 – CHAPTER 21

DECISION ANALYSIS II

CAPITAL BUDGETING[1]

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I. Capital Budgeting Defined.

• Capital Expenditure – an outlay of funds for a project that is expected to generate positive net cash inflows over an extended period of time.

• Capital Budgeting – the process of identifying, analyzing, and selecting projects which will allow management to implement and realize the firm’s profit strategy.

• Can involve very large financial outlays and last for extended periods of time, so can have a significant financial impact on a firm.

II. Considerations

A. Quantitative – (financial)

• What is the predicted rate of return generated by the project (Internal Rate of Return or IRR)?

• How does this rate compare with a minimum required rate of return (RRR)?

• What is the basis for measuring this return? Cash flows or accrual numbers?

• How does the time value of money affect the decision?

• What is the minimum acceptable time period for investment cost recovery?

• How are risk and uncertainty dealt with?

B. Qualitative -- (anticipated desirable outcomes not measurable in dollars). Examples include

• Improved operating efficiency

• Adding value to product or service leading to improved customer satisfaction

• Improvement in environmental impact

III. Cash Flows -- Preferred evaluation models focus on after-tax cash flows.

Potential Cash Outflows:

• cost of initial investment

• estimated repairs and maintenance during project life

• incremental operating costs

• increase in working capital at beginning of project

Potential Cash Inflows:

• incremental revenues

• reduction in costs (i.e. cost savings)

• salvage (terminal) values

o salvage value of any asset being sold upon acquisition of a new/replacement asset. Reduces investment cost.

o salvage value of asset being acquired is cash flow in terminal year of project.

• release of working capital at end of project

(Note: Depreciation is non-cash expense. Annual operating cash flows will always exceed accrual income at least by amount of this expense.)[2]

IV. Project Evaluation Methods

A. Discounted Cash Flow Models[3] – Preferred.

These examine the relationship between the present value of the cash inflows and the present value of the cash outflows over the life of the project.

Issue: The discount rate involved in these time-value models.

• Should take into consideration the opportunity value of the next best use of available funds.

• Companies often use the WACC

1. Net Present Value (NPV) Model – uses a benchmark minimum required rate of return (RRR

Procedure: Determine the difference between the total present value of the cash inflows and the total present value of the cash outflows. (i.e. the net present value).

Where NPV = $0, the PVs of the cash flows are equal; minimum required rate of return is expected. Accept project.

Where NPV > $0, PV of inflows > PV of outflows. Expected return > minimum required rate of return. Accept project.

Where NPV < $0, PV of inflows < PV of outflows. Expected return < minimum required rate of return. Reject project.

Complete example analysis on next page.

Illustrative Project:

Erudite Bookstore wants to buy a new coding machine to help control book inventories. The machine has a list price of $32,500 and requires an increase in working capital of $4,000 at the beginning of its use. Its estimated useful life is five years, after which it is estimated to have a salvage value of $4,000. Recovery of working capital will be $4,000 at the end of its useful life. Annual operating cash savings from the use of the new machine will be $10,000.

If Erudite’s required rate of return is 12% on projects of this type and level of risk, what is the net present value of this proposed investment?

1. Determine the total present value of the cash inflows, using either your calculator (preferred) or tables (requires two computations).

2. Determine the present value of cash outflows. Since all occur at “time zero” (i.e. now), this requires no p.v. computation.

3. Determine NPV and interpret result.

2. Internal Rate of Return (IRR) Model – determines the actual rate of return expected to be generated by the project.

Procedure: Determine the interest rate at which the total PVs of the cash inflows and outflows are equal. In other words, at what interest rate is the net present value equal to zero? The IRR is compared with the required rate of return. Where it exceeds or is equal to the RRR, project is acceptable.

Difficult to do where periodic cash flows are unequal or where there are several different lump-sum cash flows occurring at different points in time.

Methods:

Trial-and-error approach. Tedious, time-consuming, and not fun!

Calculator. Much easier! Recommended!

Example: What is the IRR of the illustrative project? (see p. 4)

1. From NPV analysis, we know that IRR is greater than 12%.

2. Since this project has lump sum future cash inflows in addition to periodic equal cash inflows, either a trial-and-error approach must be used OR a financial calculator approach.[4]

3. Interpret result.

3. Comparison of NPV and IRR Methods

• NPV focuses on dollars; IRR on comparative rates of return.

• NPV is more conservative and, for longer projects, therefore, a less risky model.

• NPV can be used when annual project returns differ among the years of the project’s life. If IRR is used, there is not one overall RRR against which the IRR can be compared.

B. Non-Discounted Methods – Not Preferred

1. Payback Method – period of time to recover cost of investment in absolute dollars.

Net investment cost/annual cash flows where the latter are equal.

e.g. What is the payback period for the illustrative project? Interpret the result if Erudite requires a maximum payback period of 3 years.

What if cash flows are not equal? Use sequential subtraction and then interpolation.

e.g. Suppose Erudite’s annual cash savings were expected to be $8,000, $9,000, $10,000, $12,000, and $11,000 in Years 1 through 5 respectively. How would this affect the payback computation?

Concerns about the payback period approach:

1. Ignores time-value of money.

2. Ignores cash flows beyond payback time.

3. Primary reliance on it may result in suboptimal decisions.

Why used?

1. Easy to understand and compute.

2. For long projects, it provides a measure of reassurance about cost recovery where payback period is relatively short.

2. Accrual Accounting Rate of Return (AARR) – the only approach which is not based on cash flows.

Average Accrual Operating Income/Net Investment Cost

Assume that Erudite requires a minimum AARR of 7%. Is the project acceptable?

1. Determine average accrual operating income.

2. Divide by net investment cost

3. Interpret result.

Alternative assumption. How would you determine average accrual operating income if the annual cash flows were as reported on the bottom of Page 6?

Concerns about the accrual accounting rate of return approach:

1. Is not based on cash flows.

2. Does not take into account time value of money.

3. May lead to suboptimal decision-making because

• Accrual income negatively impacted by items not affecting cash flows, such as trading in an old asset for new at a loss, and/or

• AARR < ROI of an investment center. (More on this in Chapter 23.)

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[1] Since our time is limited, we shall study the basic analytical procedures in stand-alone investment decisions, not in comparative decisions as is demonstrated in the “Lifetime Care” example presented in the text. Additionally, we shall not consider tax effects.

[2] Since we shall not consider the effect of income taxes in this course, we shall not discuss the “tax shield” afforded by depreciation. Those of you interested in the impact of income taxes on capital budgeting cash flows are referred to text pp.734 – 740. For depreciation impact, see Item 2b, page 739.

[3] It is assumed that you are comfortable working with time value of money since you have just completed a sequence of modules in which certain topics (e.g. bonds, leases, asset impairment procedures, etc.) required that you use a time value of money approach. No separate instruction on present-value, therefore, will be included in this module If you are not comfortable with these procedures, you should see the TA or the instructor.

[4] It is possible to estimate IRR fairly easily using the tables if the only cash inflows are periodic equal flows. For an example of this, see your text, page 729, section beginning “the step-by-step computations of internal rate of return…” You will not be asked to work with the trial-and-error approach. It is not practical.

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