Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting.

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CHAPTER 12 MANAGERIAL ACCOUNTING
Study Objectives

• Discuss the capital budgeting evaluation process,
  and explain what inputs are used in capital
  budgeting.
• Describe the cash payback technique.
• Explain the net present value method.
• Identify the challenges presented by intangible
  benefits in capital budgeting.

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• Study Objectives Continued
• Explain the internal rate of return method.
• Describe the annual rate of return method.

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Capital Budgeting Evaluation ProcessStudy
Objective 1

• Many companies follow a carefully prescribed
  process in capital budgeting. At least once a
  year
• 1) Proposals for projects are requested from each
  department.
• 2) The proposals are screened by a capital
  budgeting committee, which submits its finding to
  officers of the company.
• 3) Officers select projects and submit list of
  projects to the board of directors.

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Capital Budgeting Evaluation Process

• The capital budgeting decision depends
• depends on a variety of considerations
• 1) The availability of funds.
• 2) Relationships among proposed
• projects.
• 3) The companys basic decision-making
• approach.
• 4) The risk associated with a particular
• project.

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Cash Payback FormulaStudy Objective 2
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Estimated Annual Net Income from Capital
Expenditure
Assume that Reno Co. is considering an investment
of 130,000 in new equipment. The new equipment
is expected to last 5 years. It will have zero
salvage value at the end of its useful life. The
straight-line method of depreciation is used for
accounting purposes. The expected annual
revenues and costs of the new product that will
be produced from the investment are (Text
Illustration 12-25)
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Computation of Annual Cash Inflow

• Cash income per year equals net income plus
  depreciation expense.

Net income 13,000
Add Depreciation expense 26,000
Cash income 39,000
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Cash Payback Period
The cash payback period in this example is
therefore 3.33 years, computed as follows

• 3.33 years

130,000
39,000
When the payback technique is used to decide
among acceptable alternative projects, the
shorter the payback period, the more attractive
the investment. This is true for two reasons 1)
the earlier the investment is recovered, the
sooner the cash funds can be used for other
purposes, and 2) the risk of loss from
obsolescence and changed economic conditions is
less in a shorter payback period.
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Net Present Value MethodStudy Objective 3

• The present value method technique is generally
  recognized as the best conceptual approach to
  making capital budgeting decisions.
• This technique considers both the estimated total
  cash inflows and the time value of money.
• Two methods are used with the discounted
  cash flow technique
• 1) net present value and
• 2) internal rate of return

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Net Present Value Method

• Under the net present value method, cash inflows
  are discounted to their present value and then
  compared with the capital outlay required by the
  investment.
• The interest rate used in discounting the future
  cash inflows is the required minimum rate of
  return.
• A proposal is acceptable when NPV is zero or
  positive.
• The higher the positive NPV, the more attractive
  the investment.

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Net Present Value Decision Criteria
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Present Value of Annual Cash Inflows-Equal
Annual Cash Flows
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Computation of Net Present Values
The analysis of the proposal by the net present
value method is as follows
The proposed capital expenditure is acceptable at
a required rate of return of 12 but NOT AT 15.
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Present Value of Annual Cash Inflows-Unequal
Annual Cash Flows

• 260,000
  155,667 140,061

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Analysis of Proposal Using Net Present Value
Method
Therefore, the analysis of the proposal by the
net present value method is as follows

• Positive (negative) net present value
  25,667 10,061

In this example, the present values of the cash
inflows are greater than the 130,000 capital
investment. Thus the project is acceptable at
both a 12 and 15 required rate of return.
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Additional ConsiderationsStudy Objective 4

• The previous NPV example relied on tangible costs
  and benefits that can be relatively easily
  quantified.
• By ignoring intangible benefits, such as
  increased quality, improved safety, etc. capital
  budgeting techniques might incorrectly eliminate
  projects that could be financially beneficial to
  the company.

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Additional Considerations

• To avoid rejecting projecting that
• actually should be accepted, two
• possible approaches are suggested
• Calculate net present value ignoring intangible
  benefits. Then, if the NPV is negative, ask
  whether the intangible benefits are worth at
  least the amount of the negative NPV.
• Project rough, conservative estimates of the
  value of the intangible benefits, and incorporate
  these values into the NPV calculation.

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Formula for Internal Rate of Return Factor
Internal Rate of Return MethodStudy Objective 5

• The internal rate of return method finds the
  interest yield of the potential investment.
• This is the interest rate that will cause the
  present value of the proposed capital expenditure
  to equal the present value of the expected annual
  cash inflows.
• Determining the true interest rate involves two
  steps
• STEP 1.Compute the internal rate of return
  factor using this formula

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Internal Rate of Return Method
The computation for the Stewart Soup
Company, assuming equal annual cash inflows is

• 244,371 1000,000 2.44371

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Internal Rate of Return Method

• STEP 2. Use the factor and the present value of
  an annuity of 1 table to find the internal rate
  of return.
• The internal rate of return is found by locating
  the discount factor that is closest to the
  internal rate of return factor for the time
  period covered by the annual cash flows.
• For Stewart Soup, the annual cash flows are
  expected to continue for 3 years. In the table
  below, the discount factor of 2.44371 represents
  an interest rate of 11.

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Internal Rate of Return Decision Criteria

• The decision rule is Accept the project when
  the internal rate of return is equal to or
  greater than the required rate of return. Reject
  the project when the internal rate of return is
  less than the required rate.

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Comparison of Discounted Cash Flow Methods

• In practice, the internal rate of return and cash
  payback methods are most widely used.
• A comparative summary of the two discounted cash
  flow methods-net present value and internal rate
  of return- is presented below

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Annual Rate of Return FormulaStudy Objective 6

• The annual rate of return technique is based on
  accounting data. It indicates the profitability
  of a capital expenditure. The formula is

The annual rate of return is compared with its
required minimum rate of return for investments
of similar risk. This minimum return is based on
the companys cost of capital, which is the rate
of return that management expects to pay on all
borrowed and equity funds.
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Formula for Computing Average Investment
Expected annual net income (13,000) is obtained
from the projected income statement. Average
investment is derived from the following formula

• For Reno, average investment is 65,000
  (130,000 0)/ 2

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Solution to Annual Rate of Return Problem
The expected annual rate of return for Reno
Companys investment in new equipment is
therefore 20, computed as follows

• 13,000 65,000 20

The decision rule is A project is acceptable if
its rate of return is greater than managements
minimum rate of return. It is unacceptable when
the reverse is true. When choosing among several
acceptable projects, the higher the rate of
return for a given risk, the more attractive the
investment.