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## Chapter 15: Capital Budgeting

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**Chapter 15:Capital Budgeting**Cost Accounting Principles, 9e Raiborn● Kinney**Learning Objectives**• Why do most capital budgeting methods focus on cash flows? • How is payback period computed, and what does it measure? • How are the net present value and profitability index of a project computed, and what do they measure? • How is the internal rate of return on a project computed, and what does that rate measure? • How do taxation and depreciation affect cash flows? • What are the underlying assumptions and limitations of each capital project evaluation method? • How do managers rank investment projects? • How is risk considered in capital budgeting analyses? • How and why should management conduct a postinvestment audit of a capital project? • (Appendix 1) How are present values calculated? • (Appendix 2) What are the advantages and disadvantages of the accounting rate of return method?**Capital Budgeting**• Capital budgeting involves evaluating and ranking alternative future investments to effectively and efficiently allocated limited capital • Plan and prepare the capital budget • Review past investments to assess success of past decisions and enhance the decision process in the future**Capital Budgeting**• Compare and evaluate alternative projects • financial and nonfinancial criteria • short- and long-term benefits • usually multiple criteria • Consider all significant stakeholders**Cash**Flow Focus Capital Budgeting Financial Analysis • Payback period • Discounted payback period • Net present value • Profitability index • Internal rate of return • Accounting rate of return**Investment Decision**Which assets to acquire Made by divisional managers and top management Financing Decision How to raise capital (debt/equity) to fund an investment Made by treasurer and top management Interest is a financing decision Investment vs. Financing First justify the acquisition Then justify how to finance it**Payback Period**• Time required for project’s cash inflows to equal the original investment • the longer it takes to recover the original investment, the greater the risk • the faster capital is returned, the more rapidly it can be invested in other projects • management sets a maximum payback period**Discounting Future Cash Flows**• Reduce the future value of cash flows by the portion that represents interest • Variables are • length of time until the cash flow is received or paid • required rate of return on capital—discount rate • Present value is stated in a common base of current dollars**Net Present Value**• Evaluates if project rate of return is greater than, equal to, or less than the desired rate of return • Present value equals the cash flows discounted using the desired rate of return • Net present value equals present value of cash inflows minus present value of cash outflows • Does not calculate the rate of return**Profitability Index**• Compares present value of net cash flows to net investment • Measures efficiency of the use of capital • Should be greater than or equal to 1 • Does not calculate the rate of return Profitability = PV of Net Cash Flows Index Net Investment**Internal Rate of Return**• Discount rate where PV of cash inflows = PV of cash outflows NPV = 0 • Hurdle rate is the lowest acceptable return on investment (at least equal to the cost of capital) • If Internal Rate of Return = Hurdle Rate; Accept • If Internal Rate of Return > Hurdle Rate; Accept • If Internal Rate of Return < Hurdle Rate; Reject**After-Tax Cash Flows**• Depreciation is not a cash flow item • Depreciation on capital assets affects cash flows by reducing the tax obligation • Depreciation is a tax shield that provides a tax benefit depreciation tax benefit = depreciation expense * tax rate**Uses time value money**Provides specific rate of return Uses cash flows Considers returns during life of project Uses discount rate Payback NPV PI IRR N Y Y Y N N N Y Y Y Y Y N Y Y Y N Y Y N* Comparing Techniques *often used as a hurdle rate**The Investment Decision**• Is the activity worthy of an investment? • Which assets can be used for the activity? • Of the available assets for each activity, which is the best investment? • Of the “best investments” for all worthwhile activities, in which ones should the company invest? Consider Quantitative and Qualitative Factors**Capital Budgeting Terms**• Screening decision • Preference decision • Mutually exclusive projects • Independent projects • Mutually inclusive projects**Compensating for Risk**• Judgmental method • Use logic and reasoning to decide if acceptable rate of return will be achieved • Risk-adjusted discount rate method • Higher discount/hurdle rate for riskier projects and/or cash flows • Shorter payback period for riskier projects • Higher IRR for riskier projects • Sensitivity analysis**Postinvestment Audit**• Complete after project has stabilized • Compare actual results to expected results • Use same analysis techniques • Identify areas where results differ from expectation • Evaluate capital budgeting process, particularly original projections, problems with implementation, sponsor credibility**Questions**• Why do most capital budgeting methods focus on cash flows? • What is the relationship between the net present value and the profitability index? • What are the assumptions and limitations of the various capital project evaluation methods?**Potential Ethical Issues**• Ignoring the enhanced safety or detrimental environmental impact for project decisions • Changing assumptions or estimates to meet criteria for approval • Using a discount rate that is inappropriately low • Not conducting a postinvestment audit to hold decision makers accountable • Choosing projects based on accounting earnings only rather than including discounted cash flow methods