CHAPTER 21

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Capital Budgetingand

Cost Analysis


Two Dimension of Cost AnalysisProject-by-project dimension—one project

spans multiple accounting periodsPeriod-by-period dimension—one period

contains multiple projects


Project and Time Dimensions of Capital Budgeting Illustrated


Capital BudgetingCapital budgeting is making long-run

planning decisions for investing in projects.Capital budgeting is a decision-making and

control tool that spans multiple years.


Five Stages in Capital Budgeting1. Identify projects—determine which types

of capital investments are necessary to accomplish organizational objectives and strategies.

2. Obtain information—gather information from parts of the value chain to evaluate projects.

3. Make predictions—forecast all potential cash flows attributable to the alternative projects.


Five Stages in Capital Budgeting4. Decision stage—determine which

investment yields the greatest benefit and least cost to the organization.

5. Implementation and evaluate performance:

1. Obtain funding.2. Track realized cash flows.3. Compare results to project predictions.4. Revise plans if necessary.


Four Capital Budgeting Methods1. Net present value (NPV)2. Internal rate of return (IRR)3. Payback period4. Accrual accounting rate of return (AARR)


Discounted Cash FlowsDiscounted cash flow (DCF) methods

measure all expected future cash inflows and outflows of a project as if they occurred at a single point in time.

The key feature of DCF methods is the time value of money (interest), meaning that a dollar received today is worth more than a dollar received in the future.


Discounted Cash FlowsDCF methods use the required rate of

return (RRR), which is the minimum acceptable annual rate of return on an investment.

RRR is the return that an organization could expect to receive elsewhere for an investment of comparable risk.

RRR is also called the discount rate, hurdle rate, cost of capital, or opportunity cost of capital.


Net Present Value (NPV) MethodNPV method calculates the expected

monetary gain or loss from a project by discounting all expected future cash inflows and outflows to the present point in time, using the RRR.

Based on financial factors alone, only projects with a zero or positive NPV are acceptable.


Three-Step NPV Method1. Draw a sketch of the relevant cash

inflows and outflows.2. Convert the inflows and outflows into

present value figures using tables or a calculator.

3. Sum the present value figures to determine the NPV. Positive or zero NPV signals acceptance, negative NPV signals rejection.


NPV Method Illustrated


Internal Rate of Return (IRR) MethodThe IRR Method calculates the discount rate

at which the present value of expected cash inflows from a project equals the present value of its expected cash outflows.

A project is accepted only if the IRR equals or exceeds the RRR.


IRR Method Analysts use a calculator or computer

program to provide the IRR. Trial and error approach:

Use a discount rate and calculate the project’s NPV. Goal: find the discount rate for which NPV = 01. If the calculated NPV is greater than zero, use a

higher discount rate.2. If the calculated NPV is less than zero, use a lower

discount rate.3. Continue until NPV = 0.


IRR Method Illustrated


Comparison NPV and IRR MethodsNPV analysis is generally regarded as the

preferred method.NPV expresses the computations in dollars,

not in percentages.The NPV value can always be computed for a

project.NPV method can be used when the RRR

varies over the life of the project.


Sensitivity Analysis Illustration


Payback MethodPayback measures the time it will take to recoup,

in the form of expected future cash flows, the net initial investment in a project.

Shorter payback period are preferable.Organizations choose a project payback period.

The greater the risk, the shorter the payback period.

Easy to understand.The two weaknesses of the payback method are:

Fails to recognize the time value of moneyDoesn’t consider the cash flow beyond the payback

point


Payback Method

Payback Net Initial InvestmentPeriod Uniform Increase in Annual Future Cash Flows=

With uniform cash flows:

With non-uniform cash flows: add cash flows period-by-period until the initial investment is recovered; count the number of periods included for payback period.


Accrual Accounting Rate of Return Method (AARR)AARR method divides an accrual accounting

measure of average annual income of a project by an accrual accounting measure of its investment.

Also called the accounting rate of return.


AARR Method Formula

Increase in Expected AverageAccrual Accounting Annual After-Tax Operating Income

Rate of Return Net Initial Investment=


AARR MethodFirms vary in how they calculate AARREasy to understand, and use numbers

reported in financial statementsDoes not track cash flowsIgnores time value of money


Evaluating Managers and Goal-Congruence IssuesSome firms use NPV for capital budgeting

decisions and a different method for evaluating performance.

Managers may be tempted to make capital budgeting decisions on the basis of short-run accrual accounting results, even though that would not be in the best interest of the firm.


Relevant Cash Flows in DCF Analysis Relevant cash flows are the differences in

expected future cash flows as a result of making an investment.

Categories of cash flows:1. Net initial investment2. After-tax cash flow from operations3. After-tax cash flow from terminal disposal of

an asset and recovery of working capital


Net Initial Investment Three components:1. Initial machine investment2. Initial working capital investment3. After-tax cash flow from current disposal of

old machine


Cash Flow from Operations Two components:1. Inflows (after-tax) from producing and

selling additional goods or services, or from savings in operating costs—excludes depreciation, handled below:

2. Income tax cash savings from annual depreciation deductions


Terminal Disposal of Investment Two components:1. After-tax cash flow from terminal disposal

of asset (investment)2. After-tax cash flow from recovery of

working capital (liquidating receivables and inventory once needed to support the project)


Cash Flow Effects from Investment Decisions, Illustrated


Managing the ProjectImplementation and control:

Management of the investment activity itselfManagement control of the project as a whole

A post-investment audit may be done to provide management with feedback about the performance of a project, so that management can compare actual results to the costs and benefits expected at the time the project was selected.


Strategic Considerations in Capital BudgetingA company’s strategy is the source of its

strategic capital budgeting decisions.Some firms regard R&D projects as

important strategic investments.Outcomes very uncertainFar in the future

CHAPTER 21

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