Chapter 3- Process Cost Accounting

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Capital Budgeting
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Capital Budgeting
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Capital Budgeting Is...

• The process of making capital expenditure
  decisions in business.
• Choosing among many capital projects to find the
  one(s) that will MAXIMIZE a companys return on
  its financial investment.

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Capital Budgeting Authorization
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Capital Budgeting

• Uses estimated Cash Inflows and Outflows- not
  accrual-based income statement numbers.

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Capital Budgeting
Illustration 10-2

• Cash Outflows
• Initial investment
• Repairs and investment
• Increased operating cost
• Overhaul of equipment
• Cash Inflows
• Sale of old equipment
• Increased cash received from customers
• Reduced cash outflows related to operating costs
• Salvage value of equipment when project is
  completed.

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Data To Be Used In Following Examples
Illustration 10-3
Initial investment 130,000 Estimated useful
life 10 years Estimated salvage value - 0 -
Estimated annual cash flows Cash inflow from
customers 200,000 Cash outflows for
operating costs 176,000 Net annual cash
inflow 24,000
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Cash Payback Technique

• A capital budgeting technique that identifies the
  time period required to recover the cost of a
  capital investment from the annual cash inflow
  produced by the investment.

The shorter the payback period, the better.
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Cash Payback Technique
Illustration 10-4
130,000 ? 24,000 5.42 years
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Cash Payback

• Advantages
• May be critical factor if company needs a fast
  turnaround of money.
• Easy to compute and understand.
• Disadvantages
• Ignores profitability of project.
• Ignore time value of money.

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Net Present Value

• The difference that results when the original
  capital outlay is subtracted from the discounted
  cash inflows.

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Net Present Value Method

• A method used in capital budgeting in which cash
  inflows are discounted to their present value and
  then compared to the capital outlay required by
  the investment.

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Discounted Cash Flow Technique

• A capital budgeting technique that considers both
  the estimated total cash inflows from the
  investment and the time value of money.

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Net Present Value Criteria
Illustration 10-5
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Net Present Value

• Annual cash inflows are 24,000 for all ten
  years.

The analysis of the proposal by the Net Present
Value method is
The proposed capital expenditure is acceptable
at the 12 required rate of return because the
NPV is positive.
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Choosing A Discount Rate

• A company uses a discount rate that is equal to
  its cost of capital.
• The cost of capital is a weighted average of the
  rates paid on borrowed funds and funds from
  investors in the companys stock.
• A discount rate has two elements
• a cost of capital element
• a risk element.
• Companies often assume the risk element is zero.

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Cost of Capital

• The average rate of return that the firm must pay
  to obtain borrowed and equity funds.

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Net Present Value Assumptions

• All cash flows come at the end of each year.
• All cash flows are immediately reinvested in
  another project that has a similar return.
• All cash flows can be predicted with certainty.

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Intangible Benefits

• Increased quality
• Safety
• Employee loyalty
• To avoid rejecting projects that should be
  accepted, two possible approaches are suggested
• Calculate NPV ignoring intangible benefits and if
  NPV is negative, ask if intangible benefits are
  worth at least the negative NPV.
• Project rough, conservative estimates of the
  value of the intangible benefits and include
  those in NPV calculation.

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Mutually Exclusive Projects
10 year life 12 discount rate
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Mutually Exclusive Projects

• Revised investment information for the two
  projects is

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Profitability Index

• A method of comparing alternative projects that
  takes into account
• the size of the investment
• its discounted future cash flows.

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Profitability Index

• Revised investment information for the two
  projects is

Project A is better because it has the higher
profitability index.
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Post-audit

• A thorough evaluation of how well a projects
  actual performance matches the projections made
  when the project was proposed.

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Illustration 10-21
Internal Rate of Return
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Internal Rate of Return

• The rate that will cause the present value of the
  proposed capital expenditure to equal the present
  value of the expected annual cash inflows.

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Internal Rate of Return Method

• A method used in capital budgeting that results
  in finding the interest yield of the potential
  investment.

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Annual Rate of Return Method

• The determination of the profitability of a
  capital expenditure by dividing expected annual
  net income by the average investment

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Annual Rate of Return Method
Illustration 10-23
Illustration 10-24
Sales 200,000 Less Cost and expenses
Manufacturing costs 132,000 Depreciation
expense (130,000 ? 5) 26,000 Selling and
administrative expenses 22,000
180,000 Income before income taxes 20,000 Income
tax expense 7,000 Net income 13,000
Illustration 10-25
13,000 ? 65,000 20
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