Managerial Accounting: An Introduction To Concepts, Methods, And Uses

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Managerial Accounting An Introduction To
Concepts, Methods, And Uses

• Chapter 9
• Capital Expenditure Decisions

Maher, Stickney and Weil
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Learning Objectives (Slide 1 of 2)

• Explain the reasoning behind the separation of
  the investing and financing aspects of making
  long-term decisions.
• Explain the role of capital expenditure decisions
  in the strategic planning process.
• Describe the steps of the net present value
  method for making long-term decisions using
  discounted cash flows, and explain the effect of
  income taxes on cash flows.

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Learning Objectives (Slide 2 of 2)

• Explain how spreadsheets help the analyst to
  conduct sensitivity analyses of capital
  budgeting.
• Describe the internal rate of return method of
  assessing investment alternatives.
• Explain why analysts will need more than cash
  flow analysis to justify or reject an investment.
• Explain why the capital investment process
  requires audits.
• Identify the behavioral issues involved in
  capital budgeting.

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Capital Budgeting

• Involves decisions regarding which long-term
  investments to undertake and how to finance them
• Involves estimating future cash flows, selecting
  an appropriate discount rate to discount those
  cash flows, and deciding how to finance the
  project

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Discounted Cash Flow

• Discounted cash flow (DCF) methods aid in
  evaluating investments involving cash flows over
  time
• Two DCF methods used
• Net present value method
• Internal rate of return method

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Discount Rate

• Discount rate is the interest rate used to
  compute the present value of future cash flows
• Appropriate discount rate has three elements
• Pure rate of interest (riskless rate)
• Risk factor reflecting the projects riskiness
• An increase reflecting future inflation

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Net Present Value Method (Slide 1 of 2)

• Involves the following steps
• Estimate future cash inflows and outflows in each
  period under consideration
• Discount the future cash flows to the present
• Accept or reject the project

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Net Present Value Method (Slide 2 of 2)

• Decision rule If the present value (PV) of cash
  inflows exceeds the PV of future cash outflows,
  the project should be accepted
• Reject projects that have a negative net present
  value
• If one project is to be chosen from a set of
  alternatives, select the project with the highest
  net present value

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Estimating Cash Flows (Slide 1 of 4)

• When using the net present value (NPV) method,
  the following cash flows must be considered
• Initial cash flows occurring at the beginning of
  the project
• Periodic cash flows during the life of the
  project
• Terminal cash flows at the end of the project

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Estimating Cash Flows (Slide 2 of 4)

• Initial cash flows - include cost of purchasing
  the asset as well as freight and installation
• May include cash flows from disposal of existing
  assets, including tax effect of gain or loss on
  disposal

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Estimating Cash Flows (Slide 3 of 4)

• Periodic cash flows during the life of the
  project include
• Cash from sales and for fixed and variable
  production, selling, general, and administrative
  costs
• Should factor in savings in these items arising
  from the project under consideration
• Tax savings from the depreciation deduction
  should be factored in to the analysis
• Do not include noncash items such as depreciation
  expense

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Estimating Cash Flows (Slide 4 of 4)

• Terminal cash flows at the end of the project
  often include
• Cash from the salvage value of the asset
• Tax arising on the gain (loss) on disposal of the
  project

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Tax Effects

• Depreciation expense is not a cash flow, however
  it is a tax deductible expense
• Reduces the amount of taxes that must be paid, so
  should be considered in NPV analysis
• Simplifying assumptions (such as use of straight
  line method of depreciation) can be used in NPV
  analysis but may have a significant impact on
  discounted cash flows

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Sensitivity of NPV Estimates

• NPV analysis is based on three types of
  estimates
• The amount of future cash flows
• The timing of the cash flows
• The discount rate
• Spreadsheet programs, such as Microsoft Excel,
  can be used to determine how sensitive the NPV
  analysis is to changes in estimates

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Internal Rate of Return

• The internal rate of return (IRR) is the discount
  rate that yields a net present value of 0
• Essentially, discounts the future cash flows of a
  project to a present value equal to the initial
  investment
• When used to evaluate investment options, a
  cutoff rate (or hurdle rate) is specified
• Generally, a project is accepted if the IRR
  exceeds the hurdle rate

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Investments in Advanced Production Systems

• Difficult to justify these types of investments
  using DCF methods because
• Hurdle rate is too high
• Bias toward incremental projects
• Uncertainty about operating cash flows
• Benefits of project may be excluded from analysis
  because they are difficult to quantify

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Audits and Capital Budgeting

• Capital budgeting relies heavily on estimates
• Comparing budgeting estimates with actual results
  (called auditing) provides several advantages
• Identifies estimates that were wrong so planners
  can avoid similar mistakes in future budgeting
• Identifies and rewards those who are good at
  making capital budgeting decisions
• Reduces temptation to inflate estimates
  associated with a project

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• If you have any comments or suggestions
  concerning this PowerPoint Presentation for
  Managerial Accounting, An Introduction To
  Concepts, Methods, And Uses, please contact
• Dr. Donald R. Trippeer, CPA
• donald.trippeer_at_colostate-pueblo.edu
• Colorado State University-Pueblo