chapter 15: capital budgeting

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Chapter 15:Capital Budgeting

Cost Accounting Principles, 9eRaiborn ● 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


Capital Budgeting Financial Analysis Payback period Discounted payback period Net present value Profitability index Internal rate of return Accounting rate of return

Cash FlowFocus


Investment vs. FinancingInvestment 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

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 outflowsNPV = 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


Comparing Techniques

Uses time value money Provides specific rate of

return Uses cash flows Considers returns during

life of project Uses discount rate

Payback NPV PIIRRN Y Y Y

N N N YY Y Y Y

N Y Y YN Y YN**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

chapter 15: capital budgeting

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