Capital budgeting and cost analysis
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Capital Budgeting and Cost Analysis. Chapter 21. Introduction. Capital budgeting methods deal with how to select projects (or programs) that increase rather than decrease the “capital” (value) of a business. These methods assist managers in analyzing projects that span multiple years.

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Introduction

Capital budgeting methods deal with how to select projects (or programs) that increase rather than decrease the “capital” (value) of a business.

These methods assist managers in analyzing projects that span multiple years.


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Learning Objectives

Adopt the project-by-project orientation of capital budgeting when evaluating projects spanning multiple years

Follow the six stages of capital budgeting for a project

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


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Learning Objectives

  • Identify relevant cash inflows and outflows for capital-budgeting decisions that use DCF methods

  • Use and evaluate the payback method

  • Use and evaluate the accrual accounting rate-of-return (AARR) method


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Learning Objectives

  • Identify and reduce conflicts from using DCF for capital budgeting and accrual accounting for performance evaluation

  • Incorporate depreciation deductions into the computation of after-tax cash flows in capital budgeting


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Learning Objective 1

Adopt the project-by-project orientation of capital budgeting when evaluating projects spanning multiple years


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Cost Analysis

  • There are two different dimensions of cost analysis:

  • A project dimension

  • An accounting period dimension

  • The accounting system that corresponds to the project dimension is termed life-cycle costing.


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Cost Analysis

  • Life-cycle costing accumulates revenues and costs on a project-by-project basis.

  • This accumulation extends the accrual accounting system that measures income on a period-by-period basis to a system that computes cash flow or income over the entire project covering many accounting periods.


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Cost Analysis

Project D

Project C

Project B

Project A

2000

2001

2002

2003

2004


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Cost Analysis

  • The life of the project is usually longer than one year, so capital budgeting decisions consider revenues and costs over relatively long periods.


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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.


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Capital Budgeting

Capital budgeting is a six-stage process:

  • Identification stage. To distinguish which types of capital expenditure projects are necessary to accomplish organization objectives.

  • Search stage. To explore alternative capital investments that will achieve organization objectives.


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Capital Budgeting

  • Information-acquisition stage. To consider the expected costs and the expected benefits of alternative capital investments.

  • Selection stage. To choose projects for implementation.

  • Financing stage. To obtain project funding.

  • Implementation and control stage. To get projects underway and monitor their performance.


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Capital Budgeting

  • Healthy Living is a non-profit organization.

  • One of its goals is to improve the diagnostic capabilities of its Miami facility.

  • Management identifies a need to consider the purchase of new, state-of-the-art equipment.

  • Thesearch stage yields several alternative models, but management focuses on one machine as being particularly suitable.


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Capital Budgeting

  • The administration next begins to acquire informationto do more detailed evaluation.

  • The required net initial investment consists of the cost of the new machine ($245,000) plus an additional cash investment in working capital (supplies and spare parts) of $5,000.

  • Management expects the new machine to have a three-year useful life and a $0 terminal disposal price at the end of the three years.


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Capital Budgeting

  • This proposed investment will yield net cash savings of $125,000, $130,000, and $110,000 over its life.

  • The working capital investment of $5,000 is expected to be recovered at the end of year 3.

  • Operating cash flows are assumed to occur at the end of the year.


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Capital Budgeting

  • Management also identifies the following nonfinancial quantitative and qualitative benefits of investing in the new diagnostic machine.

  • Improved diagnoses and patient care

  • Reduced inconvenience of transporting patients to other facilities for diagnoses


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Capital Budgeting

  • Nonfinancial benefits are not incorporated into the analysis.

  • In the selection stage, management must decide whether Healthy Living should purchase the new machine.

  • Assume that the required rate of return for Healthy Living is 10%.


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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


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Discounted Cash Flow

  • Discounted cash-flow (DCF) methods measure all expected future cash inflows and outflows of a project as if they occurred at a single point in time.

  • The discounted cash-flow methods incorporate the time value of money.


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Discounted Cash Flow

  • The time value of money means that a dollar received today is worth more than a dollar received at any future time.

  • Why?

  • Because it can earn income and become greater in the future.


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Discounted Cash Flow

  • There are two main DCF methods:

  • Net present value (NPV) method

  • Internal rate-of-return (IRR) method


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Net Present Value

  • The NPV method computes the expected net monetary gain or loss from a project by discounting all expected cash flows to the present point in time, using the required rate of return.

  • Management’s minimum desired rate of return is also called the discount rate, hurdle rate, required rate of return, or cost of capital.


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Net Present Value

  • Only projects with a zero or positive net present value are acceptable.

  • What is the the net present value of the diagnostic machine?


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Net Present Value

Sketch of Relevant Cash Flows

0

1

2

3

Net initial investment

($250,000)

$125,000

$130,000

$115,000

Annual cash inflow


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Net Present Value

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 Investment 250,000 Net present value of project $ 57,370


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Net Present Value

  • This project is acceptable because its net present value is $57,370.

  • Assume that Healthy Living is considering another investment that will generate $80,000 per year for three years, and have a residual value of $4,000 at the end of the third year.


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Net Present Value

  • The cost of this investment is $250,000 including working capital.

  • The working capital investment of $5,000 is expected to be recovered at the end of year 3.

  • Healthy Living expects a return of 10%.

  • Should the investment be made?


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Net Present Value

  • No, the net present value is negative.

  • 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 Investment 250,000 Net present value of project ($44,281)


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Internal Rate of Return...

  • is another model using discounted cash flows.

  • The internal rate-of-return (IRR) method calculates the discount rate at which the present value of expected cash inflows from a project equals the present value of expected cash outflows.


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Internal Rate of Return

  • Investment = Expected annual net cash inflow × PV annuity factor

  • Investment ÷ Expected annual net cash inflow = PV annuity factor


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Internal Rate of Return

  • Assume that Healthy Living is considering investing $303,280 in a scanning machine that will yield net cash savings of $80,000 per year over its five-year life.

  • What is the IRR of this project?

  • $303,280 ÷ $80,000 = 3.791 (PV annuity factor)


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Internal Rate of Return

  • The annuity table shows that 3.791 is in the 10% column for a 5 period row in this example.

  • Therefore, 10% is the internal rate of return of this project.

  • If the minimum desired rate of returnis 10% or less, Healthy Living should undertake this project.


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Comparison of NPV and IRR

  • The NPV method has the important advantage that the end result of the computations is expressed in dollars and not in a percentage.

  • Individual projects can be added to see the effect of accepting a combination of projects.

  • It can be used in situations where the required rate of return varies over the life of the project.


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Comparison of NPV and IRR

  • The IRR of individual projects cannot be added or averaged to derive the IRR of a combination of projects.


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Learning Objective 4

Identify relevant cash inflows and outflows for capital-budgeting decisions that use DCF methods


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Relevant Cash Flows

  • Relevant cash flows are expected future cash flows that differ among the alternatives.

  • Capital investment projects typically have three major categories of cash flows:

  • Net initial investment

  • Cash flow from operations

  • Cash flow from terminal disposal of assets and recovery of working capital


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Relevant Cash Flows

  • Typically, net initial investment components are:

  • Initial asset investment

  • Initial working capital investment

  • Current disposal value of old asset


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Net Initial Investment

  • The original Healthy Living example included the following:

  • Initial machine investment $245,000 Initial working capital investment $ 5,000 Current disposal value of old machine 0


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Cash Flow From Operations

  • Cash inflows may result from producing and selling additional goods or services, or, as in the Healthy Living example, from savings in cash operating costs.

  • Depreciation is irrelevant in DCF analysis because it is a noncash allocation of costs.

  • DCF is based on inflows and outflows of cash.


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Terminal Disposal Price

  • At the end of the machine’s useful life the terminal disposal price may be zero or an amount considerably less than the initial machine investment.

  • The original Healthy Living example assumed zero disposal value of the new diagnostic machine.


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Working Capital Recovery

  • The initial investment in working capital is usually fully recouped when the project is terminated.

  • The relevant working capital cash inflow is the $5,000 that Healthy Living will recover in year 3.


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Learning Objective 5

Use and evaluate the payback method


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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.


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Payback Method

  • Assume that Healthy Living is considering buying some equipment (Machine 1) for $210,000, with an estimated useful life of 11 years, and zero predicted residual value.

  • Managers expect use of the equipment to generate $35,000 of net cash inflows from operations per year.


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Payback Method

  • How long would it take to recover the investment?

  • $210,000 ÷ $35,000 = 7 years

  • 7 years is the payback period.


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Payback Method

  • Suppose that 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?


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Payback Method

  • Machine 1 is preferable because it will continue to generate net cash inflows for four years after its payback period.

  • This will give the company an additional net cash inflow of $140,000.


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Payback Method

  • When cash flows are uneven, calculations must take a cumulative form.

  • Assume that Healthy Living’s diagnostic machine investment is going to yield net cash savings of $160,000, $180,000, and $110,000 over its life.

  • The initial investment is $250,000.

  • What is the payback period?


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Payback Method

  • Year 1 brings in $160,000.

  • Recovery of the amount invested occurs in Year 2.


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Payback Method

  • 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


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Learning Objective 6

Use and evaluate the accrual accounting rate-of-return (AARR) method


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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.

  • This method is also called the accounting rate of return.


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Accrual Accounting Rate-of-Return Method

  • Recall the scanning machine with a cost $303,280, no residual value, expected annual net cash savings of $80,000, and a useful life of 5 years.

  • The IRR of this machine is 10%.

  • What is the average operating income?


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Accrual Accounting Rate-of-Return Method

  • Straight-line depreciation is $60,656 per year.

  • Average operating income is $19,344.

  • $80,000 – $60,656 = $19,344

  • What is the AARR?

  • AARR = $80,000 – $60,656 = 6.38% $303,280


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Accrual Accounting Rate-of-Return Method

  • An AARR of 6.38% indicates the rate at which a dollar of investment generates operating income.

  • Projects whose AARR exceeds an accrual accounting required rate of return for the project are considered desirable.


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Accrual Accounting Rate-of-Return Method

  • The AARR method is similar to the IRR method in that both methods calculate a rate-of-return percentage.

  • While the AARR calculates return using operating income numbers after considering accruals, the IRR method calculates return on the basis of cash flows and the time value of money.


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Learning Objective 7

Identify and reduce conflicts from using DCF for capital budgeting and accrual accounting for performance evaluation


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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 6.38% will be rejected.


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Performance Evaluation

  • The AARR is low because the investment increases the denominator and, as a result of depreciation, also reduces the numerator (operating income) in the AARR computation.

  • Frequently, the optimal decision made using a DCF method will not report good “operating income” results in the project’s early years on the basis of the AARR.


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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.


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Income-Tax Considerations

  • Although depreciation is a noncash expense, it is a deductible cost for calculating tax outflow.

  • Taxes saved as a result of depreciation deductions increase cash flows in discounted cash-flow (DCF) computations.


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Income-Tax Considerations

  • Assume Miami Transit is considering the replacement of an old piece of equipment with new, more modern equipment.

  • The income tax rate is 40%.

  • The company uses straight-line depreciation.

  • The tax effects of cash inflows and outflows occur at the same time that the inflows and outflows occur.


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Income-Tax Considerations

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


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Income-Tax Considerations

  • 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 is the tax savings?

  • $47,000 × 0.40 = $18,800


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Income-Tax Considerations

  • 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


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Income-Tax Considerations

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


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Income-Tax Considerations

  • 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


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Income-Tax Considerations

  • 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


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Income-Tax Considerations

  • 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


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Income-Tax Considerations

  • 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


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Income-Tax Considerations

  • 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


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Income-Tax Considerations

  • Miami Transit requires 14% rate of return on its investments.

  • What is the net present value of the new equipment incorporating income taxes?


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Income-Tax Considerations

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


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Intangible Assets

Intangible assets are critical to most organizations.

  • These assets have the potential to yield net cash inflows many years into the future.

  • Top management can use a capital budgeting tool, such as NPV, to summarize the difference in the future net cash inflows from an intangible asset at two different points in time.


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