SlideShare a Scribd company logo
21 - 1
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Capital Budgeting
and Cost Analysis
Chapter 21
21 - 2
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 1
Recognize the multiyear focus
of capital budgeting.
21 - 3
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Two Dimensions of Cost Analysis
1. A project dimension
2. An accounting-period dimension
The accounting system that corresponds to the
project dimension is termed life-cycle costing.
21 - 4
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
2002 2003 2004 2005 2006
Project A
Project B
Project C
Project D
Two Dimensions of Cost Analysis
21 - 5
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 2
Understand the six stages of
capital budgeting for a project.
21 - 6
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Capital Budgeting
Capital budgeting is the making of long-run
planning decisions for investments in
projects and programs.
It is a decision-making and control tool that
focuses primarily on projects or programs
that span multiple years.
21 - 7
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Capital Budgeting
Capital budgeting is a six-stage process:
1. Identification stage 2. Search stage
3. Information-acquisition stage
4. Selection stage 5. Financing stage
6. Implementation and control stage
21 - 8
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Capital Budgeting Example
One of the goals of Assisted Living is to improve
the diagnostic capabilities of its facility.
Management identifies a need to consider the
purchase of new equipment.
The search stage yields several alternative
models, but management focuses on
one particular machine.
21 - 9
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Capital Budgeting Example
The administration acquires information.
Initial investment is $245,000.
Investment in working capital is $5,000.
Useful life is three years.
Estimated residual value is zero.
Net cash savings is $125,000,
$130,000, and $110,000 over its life.
21 - 10
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Capital Budgeting Example
Working capital is expected to be recovered at
the end of year 3 with an expected return of 10%.
In the selection stage, management must decide
whether to purchase the new machine.
Operating cash flows are assumed to occur
at the end of the year.
21 - 11
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
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.
21 - 12
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Time Value of Money
Compound Growth,
5 periods at 6%
Year 0: $1.00
Year 1: $1.06
Year 2: $1.124
Year 3: $1.91
Year 4: $1.262
Year 5: $1.338
21 - 13
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Discounted Cash Flow
There are two main DCF methods:
Net present value (NPV) method
Internal rate-of-return (IRR) method
21 - 14
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Net Present Value Example
Only projects with a zero or positive
net present value are acceptable.
What is the the net present value of
the diagnostic machine?
21 - 15
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Net Present Value Example
Year in the Life of the Project
$(250,000) $125,000 $130,000 $115,000
0 1 2 3
Net initial
investment
Annual cash
inflows
21 - 16
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Net Present Value Example
Net Cash NPV of Net
Year 10% Col. Inflows Cash Inflows
1 0.909 $125,000 $113,625
2 0.826 130,000 107,380
3 0.751 115,000 86,365
Total PV of net cash inflows $307,370
Net initial investment 250,000
Net present value of project $ 57,370
21 - 17
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Net Present Value Example
The company is considering another investment.
Initial investment is $245,000.
Investment in working capital is $5,000.
Working capital will be recovered.
Useful life is three years.
Estimated residual value is $4,000.
Net cash savings is $80,000 per year.
Expected return is 10%.
21 - 18
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Net Present Value Example
Net Cash NPV of Net
Years 10% Col. Inflows Cash Inflows
1-3 2.487 $80,000 $198,960
3 0.751 9,000 6,759
Total PV of net cash inflows $205,719
Net initial investment 250,000
Net present value of project ($ 44,281)
21 - 19
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Internal Rate of Return
Investment
= Expected annual net cash inflow
× PV annuity factor
Investment
÷ Expected annual net cash inflow
= PV annuity factor
21 - 20
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Internal Rate of Return Example
Initial investment is $303,280.
Useful life is five years.
Net cash inflows is $80,000 per year.
What is the IRR of this project?
$303,280 ÷ $80,000 = 3.791 (PV annuity factor)
10% (from the table, five-period line)
21 - 21
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Comparison of NPV and IRR
The NPV method has the advantage that the end
result of the computations is expressed in
dollars and not in a percentage.
Individual projects can be added.
It can be used in situations where the required
rate of return varies over the life of the project.
21 - 22
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Comparison of NPV and IRR
The IRR of individual projects cannot be
added or averaged to derive the IRR
of a combination of projects.
21 - 23
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 4
Use and evaluate the
payback method.
21 - 24
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Payback Method
Payback measures the time it will take to
recoup, in the form of expected future cash
flows, the initial investment in a project.
21 - 25
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Payback Method Example
Assisted Living is considering buying Machine 1.
Initial investment is $210,000.
Useful life is eleven years.
Estimated residual value is zero.
Net cash inflows is $35,000 per year.
21 - 26
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Payback Method Example
How long would it take to recover the investment?
$210,000 ÷ $35,000 = 6 years
Six years is the payback period.
21 - 27
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Payback Method Example
Suppose that as an alternative to the $210,000
piece of equipment, there is another one
(Machine 2) that also costs $210,000 but will
save $42,000 per year during its five-year life.
What is the payback period?
$210,000 ÷ $42,000 = 5 years
Which piece of equipment is preferable?
21 - 28
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Payback Method Example
Assisted Living is considering buying Machine 3.
Initial investment is $250,000.
Useful life is eleven years.
Cash savings are $160,000, $180,000,
and $110,000 over its life.
What is the payback period?
21 - 29
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Payback Method Example
Year 1 brings in $160,000.
Recovery of the amount
invested occurs in Year 2.
21 - 30
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Payback Method Example
Payback = 1 year
$ 90,000 needed to complete recovery
180,000 net cash inflow in Year 2
1 year + 0.5 year
1.5 years or 1 year and 6 months
+
÷
=
=
21 - 31
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 5
Use and evaluate the accrual
accounting rate-of-return
(AARR) method.
21 - 32
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Accrual Accounting
Rate-of-Return Method
The accrual accounting rate-of-return (AARR)
method divides an accounting measure of
income by an accounting measure of investment.
AARR =
Increase in expected
average annual
operating income
÷
Initial
required
investment
21 - 33
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Accrual Accounting
Rate-of-Return Method Example
Initial investment is $303,280.
Useful life is five years.
Net cash inflows is $80,000 per year.
IRR is 10%.
What is the average operating income?
21 - 34
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Accrual Accounting
Rate-of-Return Method Example
Straight-line depreciation is $60,656 per year.
Average operating income is
$80,000 – $60,656 = $19,344.
What is the AARR?
AARR
= ($80,000 – $60,656) ÷ $303,280
= .638, or 6.4%
21 - 35
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 6
Identify and reduce conflicts
from using DCF for capital
budgeting decisions and
accrual accounting for
performance evaluation.
21 - 36
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Performance Evaluation
A manager who uses DCF methods to make capital
budgeting decisions can face goal congruence
problems if AARR is used for
performance evaluation.
Suppose top management uses the AARR to
judge performance if the minimum desired
rate of return is 10%.
A machine with an AARR of 6.4% will be rejected.
21 - 37
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Performance Evaluation
The conflict between using AARR and
DCF methods to evaluate performance
can be reduced by evaluating managers
on a project-by-project basis.
21 - 38
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 7
Identify relevant cash
inflows and outflows for
capital budgeting decisions.
21 - 39
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash Flows
Relevant cash flows are expected future cash
flows that differ among the alternatives.
21 - 40
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash Flows
Net initial investment components
– cash outflow to purchase investment
– working-capital cash outflow
– cash inflow from disposal of old asset
21 - 41
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash Flow
Analysis Example
Old equipment:
Current book value $50,000
Current disposal price $ 3,000
Terminal disposal price (5 years) 0
Annual depreciation $10,000
Working capital $ 5,000
Income tax rate 40%
G. T. is considering replacing old equipment.
21 - 42
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash Flow
Analysis Example
Current disposal price of old equipment $ 3,000
Deduct current book value of old equipment 50,000
Loss on disposal of equipment $47,000
How much are the tax savings?
$47,000 × 0.40 = $18,800
21 - 43
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash Flow
Analysis Example
What is the after-tax cash flow from
current disposal of old equipment?
Current disposal price $ 3,000
Tax savings on loss 18,800
Total $21,800
21 - 44
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash Flow
Analysis Example
New equipment:
Current book value $225,000
Current disposal price is irrelevant
Terminal disposal price (5 years) 0
Annual depreciation $ 45,000
Working capital $ 15,000
21 - 45
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash Flow
Analysis Example
How much is the net investment
for the new equipment?
Current cost $225,000
Add increase in working capital 10,000
Deduct after-tax cash flow from
current disposal of old equipment – 21,800
Net investment $213,200
21 - 46
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash Flow
Analysis Example
Assume $90,000 pretax annual cash flow from
operations (excluding depreciation effect).
What is the after-tax flow from operations?
Cash flow from operations $90,000
Deduct income tax (40%) 36,000
Annual after-tax flow from operations $54,000
21 - 47
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash Flow
Analysis Example
What is the difference in depreciation deduction?
Annual depreciation
of new equipment $45,000
Deduct annual depreciation
of old equipment 10,000
Difference $35,000
21 - 48
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash Flow
Analysis Example
What is the annual increase in income tax
savings from depreciation?
Increase in depreciation $35,000
Multiply by tax rate .40
Income tax cash savings
from additional depreciation $14,000
21 - 49
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash Flow
Analysis Example
What is the cash flow from operations,
net of income taxes?
Annual after-tax flow from operations $54,000
Income tax cash savings from
additional depreciation 14,000
Cash flow from operations,
net of income taxes $68,000
21 - 50
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash Flow
Analysis Example
G. T. requires a 14% rate of return
on its investments.
What is the net present value of the new
equipment incorporating income taxes?
21 - 51
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash Flow
Analysis Example
Net Cash NPV of Net
Years 14% Col. Inflows Cash Inflows
1-5 3.433 $68,000 $233,444
5 0.519 10,000 5,190
Total PV of net cash inflows $238,636
Investment 213,200
Net present value of new equipment $ 25,436
21 - 52
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Postinvestment Audit
A postinvestment audit compares the actual
results for a project to the costs and benefits
expected at the time the project was selected.
It provides management with feedback
about performance.
21 - 53
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Strategic Considerations
Capital investment decisions
that are strategic in nature
require managers to consider
a broad range of factors that
may be difficult to estimate.
21 - 54
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
End of Chapter 21

More Related Content

PPT
11ch20.ppt
PPT
4 a. capital budgeting and cost analysis
PPT
Pengambilan keputusan investasi modal
PPTX
Rekonsiliasi bank
PPT
Akuntansi Manajemen Edisi 8 oleh Hansen & Mowen Bab 1
PDF
PELAPORAN SEGMEN, EVALUASI PUSAT INVESTASI, DAN PENETAPAN HARGA TRANSFER
PPTX
Basis akuntansi
PDF
PELAPORAN DAN ANALISIS LAPORAN KEUANGAN
11ch20.ppt
4 a. capital budgeting and cost analysis
Pengambilan keputusan investasi modal
Rekonsiliasi bank
Akuntansi Manajemen Edisi 8 oleh Hansen & Mowen Bab 1
PELAPORAN SEGMEN, EVALUASI PUSAT INVESTASI, DAN PENETAPAN HARGA TRANSFER
Basis akuntansi
PELAPORAN DAN ANALISIS LAPORAN KEUANGAN

What's hot (20)

PPTX
Sistem Pengendalian Manajemen - Perencanaan Strategi
DOCX
manajemen keuangan pengelolaan piutang
PPT
Chapter 19 Intermediate Accounting Kieso
PPT
PDF
Akuntansi Firma
PPTX
Audit akuntansi biaya
PPT
Akuntansi Manajemen - Ch.15 Segmented Reporting and Performance Evaluation
PPTX
Penyusutan aktiva tetap
PPTX
Hubungan Biaya, Volume dan Laba
PPTX
Analisis laporan-kinerja-keuangan
PPTX
Hubungan antara kantor pusat, kantor agen,
PPT
Akuntansi Piutang
PDF
Bab 7 - Analisa Rasio Profitabilitas
PPTX
Ringkasan materi-sak-etap
PDF
makalah Time value of money
PPT
Ch08 - accounting intermediate - IND
PPT
Ch 2 analisis transaksi, pengantar akuntansi, edisi ke21 warren reeve fess
PPT
Akuntansi keuangan pengakuan pendapatan
PPT
Ch16 dilutive sucurities kieso ifrs
PPT
Analisis-Laporan-Keuangan.ppt
Sistem Pengendalian Manajemen - Perencanaan Strategi
manajemen keuangan pengelolaan piutang
Chapter 19 Intermediate Accounting Kieso
Akuntansi Firma
Audit akuntansi biaya
Akuntansi Manajemen - Ch.15 Segmented Reporting and Performance Evaluation
Penyusutan aktiva tetap
Hubungan Biaya, Volume dan Laba
Analisis laporan-kinerja-keuangan
Hubungan antara kantor pusat, kantor agen,
Akuntansi Piutang
Bab 7 - Analisa Rasio Profitabilitas
Ringkasan materi-sak-etap
makalah Time value of money
Ch08 - accounting intermediate - IND
Ch 2 analisis transaksi, pengantar akuntansi, edisi ke21 warren reeve fess
Akuntansi keuangan pengakuan pendapatan
Ch16 dilutive sucurities kieso ifrs
Analisis-Laporan-Keuangan.ppt
Ad

Similar to 11ch21.ppt (20)

PPT
Capital Budgeting and Cost Analysis.ppt
PPTX
Capital budegeting-p pt
PPTX
PPT_12.pptx project identification for plan
PPT
Ch.3 Capital Budget (2) (4).ppt
PPT
capital budgeting ppt for MBA/BBA Students
PPTX
Chapter 4 Capital Budgeting and this is best topic
PPTX
Chapter of corporate finance of capital budegting
PPT
Iii. principles of_capital_budgeting
PPTX
Capital Budgeting
PPT
Capital Budgeting
PPT
Capital Budgeting
PDF
5) capital_budgeting_(1)_-(2)[1].ppt.pdf
PPTX
Net Present Value - NPV
PPTX
Capital budgeting decisions
PPT
Capital Budgeting.ppt
PPTX
Lecture 5. Investment Criteria (NPV, IRR)
PPTX
Capital budgeting
PPTX
Capital Budgeting financial management.pptx
PPTX
Chapter 5 FM.pptx
PPT
Finance -Ch09 - Capital Budgeting Final .ppt
Capital Budgeting and Cost Analysis.ppt
Capital budegeting-p pt
PPT_12.pptx project identification for plan
Ch.3 Capital Budget (2) (4).ppt
capital budgeting ppt for MBA/BBA Students
Chapter 4 Capital Budgeting and this is best topic
Chapter of corporate finance of capital budegting
Iii. principles of_capital_budgeting
Capital Budgeting
Capital Budgeting
Capital Budgeting
5) capital_budgeting_(1)_-(2)[1].ppt.pdf
Net Present Value - NPV
Capital budgeting decisions
Capital Budgeting.ppt
Lecture 5. Investment Criteria (NPV, IRR)
Capital budgeting
Capital Budgeting financial management.pptx
Chapter 5 FM.pptx
Finance -Ch09 - Capital Budgeting Final .ppt
Ad

Recently uploaded (20)

PPTX
GPAT Presentation PPT and details about imp topics.pptx
PPTX
ChandigarhUniversityinformationcareer.pptx
PPTX
Principles of Inheritance and variation class 12.pptx
PPT
ALLIED MATHEMATICS -I UNIT III MATRICES.ppt
PDF
APNCET2025RESULT Result Result 2025 2025
PPTX
Core Characteristics and Abilities of an Effective Teacher_0.pptx
PDF
Beginner’s Guide to Digital Marketing.pdf
PPTX
PE3-WEEK-3sdsadsadasdadadwadwdsdddddd.pptx
PDF
iTop VPN Crack Latest Version 2025 Free Download With Keygen
PPTX
Your Guide to a Winning Interview Aug 2025.
PPTX
Condensed_Food_Science_Lecture1_Precised.pptx
PPT
2- CELL INJURY L1 Medical (2) gggggggggg
PPT
NO000387 (1).pptsbsnsnsnsnsnsnsmsnnsnsnsjsnnsnsnsnnsnnansnwjwnshshshs
PDF
Sheri Ann Lowe Compliance Strategist Resume
PPTX
CYBER SECURITY PPT.pptx CYBER SECURITY APPLICATION AND USAGE
PPTX
Overview Planner of Soft Skills in a single ppt
PDF
LSR CASEBOOK 2024-25.pdf. very nice casbook
PDF
Shopify Store Management_ Complete Guide to E-commerce Success.pdf
PPTX
Slideham presentation for the students a
PDF
servsafecomprehensive-ppt-full-140617222538-phpapp01.pdf
GPAT Presentation PPT and details about imp topics.pptx
ChandigarhUniversityinformationcareer.pptx
Principles of Inheritance and variation class 12.pptx
ALLIED MATHEMATICS -I UNIT III MATRICES.ppt
APNCET2025RESULT Result Result 2025 2025
Core Characteristics and Abilities of an Effective Teacher_0.pptx
Beginner’s Guide to Digital Marketing.pdf
PE3-WEEK-3sdsadsadasdadadwadwdsdddddd.pptx
iTop VPN Crack Latest Version 2025 Free Download With Keygen
Your Guide to a Winning Interview Aug 2025.
Condensed_Food_Science_Lecture1_Precised.pptx
2- CELL INJURY L1 Medical (2) gggggggggg
NO000387 (1).pptsbsnsnsnsnsnsnsmsnnsnsnsjsnnsnsnsnnsnnansnwjwnshshshs
Sheri Ann Lowe Compliance Strategist Resume
CYBER SECURITY PPT.pptx CYBER SECURITY APPLICATION AND USAGE
Overview Planner of Soft Skills in a single ppt
LSR CASEBOOK 2024-25.pdf. very nice casbook
Shopify Store Management_ Complete Guide to E-commerce Success.pdf
Slideham presentation for the students a
servsafecomprehensive-ppt-full-140617222538-phpapp01.pdf

11ch21.ppt

  • 1. 21 - 1 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Capital Budgeting and Cost Analysis Chapter 21
  • 2. 21 - 2 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 1 Recognize the multiyear focus of capital budgeting.
  • 3. 21 - 3 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Two Dimensions of Cost Analysis 1. A project dimension 2. An accounting-period dimension The accounting system that corresponds to the project dimension is termed life-cycle costing.
  • 4. 21 - 4 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 2002 2003 2004 2005 2006 Project A Project B Project C Project D Two Dimensions of Cost Analysis
  • 5. 21 - 5 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 2 Understand the six stages of capital budgeting for a project.
  • 6. 21 - 6 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Capital Budgeting Capital budgeting is the making of long-run planning decisions for investments in projects and programs. It is a decision-making and control tool that focuses primarily on projects or programs that span multiple years.
  • 7. 21 - 7 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Capital Budgeting Capital budgeting is a six-stage process: 1. Identification stage 2. Search stage 3. Information-acquisition stage 4. Selection stage 5. Financing stage 6. Implementation and control stage
  • 8. 21 - 8 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Capital Budgeting Example One of the goals of Assisted Living is to improve the diagnostic capabilities of its facility. Management identifies a need to consider the purchase of new equipment. The search stage yields several alternative models, but management focuses on one particular machine.
  • 9. 21 - 9 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Capital Budgeting Example The administration acquires information. Initial investment is $245,000. Investment in working capital is $5,000. Useful life is three years. Estimated residual value is zero. Net cash savings is $125,000, $130,000, and $110,000 over its life.
  • 10. 21 - 10 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Capital Budgeting Example Working capital is expected to be recovered at the end of year 3 with an expected return of 10%. In the selection stage, management must decide whether to purchase the new machine. Operating cash flows are assumed to occur at the end of the year.
  • 11. 21 - 11 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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.
  • 12. 21 - 12 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Time Value of Money Compound Growth, 5 periods at 6% Year 0: $1.00 Year 1: $1.06 Year 2: $1.124 Year 3: $1.91 Year 4: $1.262 Year 5: $1.338
  • 13. 21 - 13 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Discounted Cash Flow There are two main DCF methods: Net present value (NPV) method Internal rate-of-return (IRR) method
  • 14. 21 - 14 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Net Present Value Example Only projects with a zero or positive net present value are acceptable. What is the the net present value of the diagnostic machine?
  • 15. 21 - 15 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Net Present Value Example Year in the Life of the Project $(250,000) $125,000 $130,000 $115,000 0 1 2 3 Net initial investment Annual cash inflows
  • 16. 21 - 16 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Net Present Value Example Net Cash NPV of Net Year 10% Col. Inflows Cash Inflows 1 0.909 $125,000 $113,625 2 0.826 130,000 107,380 3 0.751 115,000 86,365 Total PV of net cash inflows $307,370 Net initial investment 250,000 Net present value of project $ 57,370
  • 17. 21 - 17 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Net Present Value Example The company is considering another investment. Initial investment is $245,000. Investment in working capital is $5,000. Working capital will be recovered. Useful life is three years. Estimated residual value is $4,000. Net cash savings is $80,000 per year. Expected return is 10%.
  • 18. 21 - 18 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Net Present Value Example Net Cash NPV of Net Years 10% Col. Inflows Cash Inflows 1-3 2.487 $80,000 $198,960 3 0.751 9,000 6,759 Total PV of net cash inflows $205,719 Net initial investment 250,000 Net present value of project ($ 44,281)
  • 19. 21 - 19 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Internal Rate of Return Investment = Expected annual net cash inflow × PV annuity factor Investment ÷ Expected annual net cash inflow = PV annuity factor
  • 20. 21 - 20 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Internal Rate of Return Example Initial investment is $303,280. Useful life is five years. Net cash inflows is $80,000 per year. What is the IRR of this project? $303,280 ÷ $80,000 = 3.791 (PV annuity factor) 10% (from the table, five-period line)
  • 21. 21 - 21 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Comparison of NPV and IRR The NPV method has the advantage that the end result of the computations is expressed in dollars and not in a percentage. Individual projects can be added. It can be used in situations where the required rate of return varies over the life of the project.
  • 22. 21 - 22 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Comparison of NPV and IRR The IRR of individual projects cannot be added or averaged to derive the IRR of a combination of projects.
  • 23. 21 - 23 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 4 Use and evaluate the payback method.
  • 24. 21 - 24 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Payback Method Payback measures the time it will take to recoup, in the form of expected future cash flows, the initial investment in a project.
  • 25. 21 - 25 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Payback Method Example Assisted Living is considering buying Machine 1. Initial investment is $210,000. Useful life is eleven years. Estimated residual value is zero. Net cash inflows is $35,000 per year.
  • 26. 21 - 26 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Payback Method Example How long would it take to recover the investment? $210,000 ÷ $35,000 = 6 years Six years is the payback period.
  • 27. 21 - 27 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Payback Method Example Suppose that as an alternative to the $210,000 piece of equipment, there is another one (Machine 2) that also costs $210,000 but will save $42,000 per year during its five-year life. What is the payback period? $210,000 ÷ $42,000 = 5 years Which piece of equipment is preferable?
  • 28. 21 - 28 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Payback Method Example Assisted Living is considering buying Machine 3. Initial investment is $250,000. Useful life is eleven years. Cash savings are $160,000, $180,000, and $110,000 over its life. What is the payback period?
  • 29. 21 - 29 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Payback Method Example Year 1 brings in $160,000. Recovery of the amount invested occurs in Year 2.
  • 30. 21 - 30 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Payback Method Example Payback = 1 year $ 90,000 needed to complete recovery 180,000 net cash inflow in Year 2 1 year + 0.5 year 1.5 years or 1 year and 6 months + ÷ = =
  • 31. 21 - 31 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 5 Use and evaluate the accrual accounting rate-of-return (AARR) method.
  • 32. 21 - 32 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Accrual Accounting Rate-of-Return Method The accrual accounting rate-of-return (AARR) method divides an accounting measure of income by an accounting measure of investment. AARR = Increase in expected average annual operating income ÷ Initial required investment
  • 33. 21 - 33 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Accrual Accounting Rate-of-Return Method Example Initial investment is $303,280. Useful life is five years. Net cash inflows is $80,000 per year. IRR is 10%. What is the average operating income?
  • 34. 21 - 34 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Accrual Accounting Rate-of-Return Method Example Straight-line depreciation is $60,656 per year. Average operating income is $80,000 – $60,656 = $19,344. What is the AARR? AARR = ($80,000 – $60,656) ÷ $303,280 = .638, or 6.4%
  • 35. 21 - 35 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 6 Identify and reduce conflicts from using DCF for capital budgeting decisions and accrual accounting for performance evaluation.
  • 36. 21 - 36 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Performance Evaluation A manager who uses DCF methods to make capital budgeting decisions can face goal congruence problems if AARR is used for performance evaluation. Suppose top management uses the AARR to judge performance if the minimum desired rate of return is 10%. A machine with an AARR of 6.4% will be rejected.
  • 37. 21 - 37 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Performance Evaluation The conflict between using AARR and DCF methods to evaluate performance can be reduced by evaluating managers on a project-by-project basis.
  • 38. 21 - 38 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 7 Identify relevant cash inflows and outflows for capital budgeting decisions.
  • 39. 21 - 39 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Cash Flows Relevant cash flows are expected future cash flows that differ among the alternatives.
  • 40. 21 - 40 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Cash Flows Net initial investment components – cash outflow to purchase investment – working-capital cash outflow – cash inflow from disposal of old asset
  • 41. 21 - 41 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Cash Flow Analysis Example Old equipment: Current book value $50,000 Current disposal price $ 3,000 Terminal disposal price (5 years) 0 Annual depreciation $10,000 Working capital $ 5,000 Income tax rate 40% G. T. is considering replacing old equipment.
  • 42. 21 - 42 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Cash Flow Analysis Example Current disposal price of old equipment $ 3,000 Deduct current book value of old equipment 50,000 Loss on disposal of equipment $47,000 How much are the tax savings? $47,000 × 0.40 = $18,800
  • 43. 21 - 43 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Cash Flow Analysis Example What is the after-tax cash flow from current disposal of old equipment? Current disposal price $ 3,000 Tax savings on loss 18,800 Total $21,800
  • 44. 21 - 44 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Cash Flow Analysis Example New equipment: Current book value $225,000 Current disposal price is irrelevant Terminal disposal price (5 years) 0 Annual depreciation $ 45,000 Working capital $ 15,000
  • 45. 21 - 45 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Cash Flow Analysis Example How much is the net investment for the new equipment? Current cost $225,000 Add increase in working capital 10,000 Deduct after-tax cash flow from current disposal of old equipment – 21,800 Net investment $213,200
  • 46. 21 - 46 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Cash Flow Analysis Example Assume $90,000 pretax annual cash flow from operations (excluding depreciation effect). What is the after-tax flow from operations? Cash flow from operations $90,000 Deduct income tax (40%) 36,000 Annual after-tax flow from operations $54,000
  • 47. 21 - 47 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Cash Flow Analysis Example What is the difference in depreciation deduction? Annual depreciation of new equipment $45,000 Deduct annual depreciation of old equipment 10,000 Difference $35,000
  • 48. 21 - 48 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Cash Flow Analysis Example What is the annual increase in income tax savings from depreciation? Increase in depreciation $35,000 Multiply by tax rate .40 Income tax cash savings from additional depreciation $14,000
  • 49. 21 - 49 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Cash Flow Analysis Example What is the cash flow from operations, net of income taxes? Annual after-tax flow from operations $54,000 Income tax cash savings from additional depreciation 14,000 Cash flow from operations, net of income taxes $68,000
  • 50. 21 - 50 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Cash Flow Analysis Example G. T. requires a 14% rate of return on its investments. What is the net present value of the new equipment incorporating income taxes?
  • 51. 21 - 51 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Cash Flow Analysis Example Net Cash NPV of Net Years 14% Col. Inflows Cash Inflows 1-5 3.433 $68,000 $233,444 5 0.519 10,000 5,190 Total PV of net cash inflows $238,636 Investment 213,200 Net present value of new equipment $ 25,436
  • 52. 21 - 52 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Postinvestment Audit A postinvestment audit compares the actual results for a project to the costs and benefits expected at the time the project was selected. It provides management with feedback about performance.
  • 53. 21 - 53 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Strategic Considerations Capital investment decisions that are strategic in nature require managers to consider a broad range of factors that may be difficult to estimate.
  • 54. 21 - 54 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster End of Chapter 21