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11 - 1©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Chapter 11
Capital
Budgeting
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Learning Objective 1
Describe capital budgeting
decisions and use the net
present value (NPV)
method to make
such decisions.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Capital Budgeting
Capital budgeting describes the long-termplanning for making and financingmajor long-term projects.
Identify potential investments.
Choose an investment.
Follow-up or “post audit.”
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Discounted-Cash-Flow Models (DCF)
These models focus on a project’s cashinflows and outflows while taking intoaccount the time value of money.
DCF models compare the value of today’scash outflows with the value of the futurecash inflows.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Net Present Value
The net-present-value (NPV) method is adiscounted-cash-flow approach to capitalbudgeting that computes the present valueof all expected future cash flows using aminimum desired rate of return.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Net Present Value
The minimum desired rate of return dependson the risk of a proposed project; the higherthe risk, the higher the rate.
The required rate of return (also called hurdlerate or discount rate) is the minimum desiredrate of return based on the firm’s cost of capital.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Applying the NPV Method
Prepare a diagram of relevantexpected cash inflows and outflows.
Find the present value of each expected cash inflow or outflow.
Sum the individual present values.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
NPV Example
Original investment (cash outflow): $6,075 Useful life: four years Annual income generated from investment
(cash inflow): $2,000 Minimum desired rate of return: 10%
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
NPV Example
Years Amount PV Factor Present Value0 ($6,075) 1.0000 ($6,075)1 2,000 .9091 1,8182 2,000 .8264 1,6533 2,000 .7513 1,5034 2,000 .6830 1,366
Net present value $ 265
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
NPV Example
Years Amount PV Factor Present Value0 ($6,075) 1.0000 ($6,075)1-4 2,000 3.1699 6,340
Net present value $ 265
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
NPV Assumptions
There is a world ofcertainty.
There are perfectcapital markets.
Money can be borrowedor loaned at the sameinterest rate.
Predicted cash flowsoccur timely.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Capital Budgeting Decisions
If the sum of the present values is positive, theproject is desirable.
If the sum of the present values is negative, theproject is undesirable.
Managers determine the sum of the present valuesof all expected cash flows from the project.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Learning Objective 3
Calculate the NPV difference
between two projects using
both the total project and
differential approaches.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Comparison of Two Projects
Two common methods for comparingalternatives are:
Total project approach
Differential approach
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Total Project Approach
The total project approach computes the total impact on cash flows for each alternative and then converts these total cash flows to their present values.
The alternative with the largest NPV of total cash flows is best.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Differential Approach
The differential approach computes the differences in cash flows between alternatives and then converts these differences to their present values.
This method cannot be used to compare more than two alternatives.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Learning Objective 4
Identify relevant cash flows
for DCF analyses.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Relevant Cash Flows for NPV
Be sure to consider the four types of inflows and outflows:
1 Initial cash inflows and outflows at time zero2 Investments in receivables and inventories (w/c)3 Future disposal values4 Operating cash flows
(w/c) – working capital
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Operating Cash Flows
Using relevant-cost analysis, the only relevant cash flows are those that will differ among alternatives.
Depreciation and book values should be ignored.
A reduction in cash outflow is treated the same as a cash inflow.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Learning Objective 5
Compute the after-tax net
present values of projects.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Income Taxes and Capital Budgeting
What is an example of another type ofcash flow that must be consideredwhen making capital-budgeting decisions?
Income taxes
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Marginal Income Tax Rate
In capital budgeting, the relevant tax rate is the marginal income tax rate.
This is the tax rate paid on additional amounts of pretax income.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Tax Effect on Cash Inflows from Depreciation Deductions
Depreciation expense is a noncash expense andso is ignored for capital budgeting, except thatit is an expense for tax purposes and so willprovide a cash inflow from income tax savings.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Tax Effect on Cash Inflows from Operations
Assume the following:Cash inflow from operations $60,000Tax rate 40%
What is the after-tax inflow from operations?
$60,000 × (1 – tax rate) = $60,000 × .6 = $36,000
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Learning Objective 6
Explain the after-tax effect on
cash of disposing of assets.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Gains or Losses on Disposal
Suppose an equipment with a 5-year lifewas purchased for $125,000 and is nowsold at the end of year 3 after taking 3three years of straight-line depreciation.
What is the book value?
$125,000 – (3 × $25,000) = $50,000
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Gains or Losses on Disposal
1. If it is sold for book value, there is no gain or loss and so there is no tax effect.
2. If it is sold for more than $50,000, there is a gain and an additional tax payment.
3. If it is sold for less than $50,000, there is a loss and a tax savings.
TAX
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Example 1
Sales = $50,000
Book Value = $50,000
Profit = 0
Taxes @30% = 0
Cash Flow from Sale = $50,000
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Example 2
Sales = $70,000
Book Value = $50,000
Profit = $20,000
Taxes @30% = $6,000
Cash Flow from Sale = $64,000
(70,000-6,000)
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Example 3
Sales = $30,000
Book Value = $50,000
Profit = ($20,000)
Taxes @30% = ($6,000) (taxes saved)
Cash Flow from Sale = $36,000
(30,000 - -6,000)
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Comprehensive Example:
Machine Cost = $100,000 Required increase in inventory $10,000 Depreciation, straight-line for 5 years Sold after 3 years for $65,000 and inventory fully
recouped Annual cash revenue is $50,000 Annual cash expenses is $12,000 Tax rate 30%, desired rate of return 10%
Required - NPV ?
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Year 0
$$
Machine Cost 100,000
Increase in inventory 10,000
Initial Investment 110,000
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Year 1, 2 & 3
Cash Revenues $$50,000
Cash Expenses 12,000
Net Operating Cash before tax 38,000
x (1- 0.30)
Net Operating Cash after tax = 26,600Tax savings from depreciation:
20,000 x 0.30 = 6,000
Total net cash flow = 32,600
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Also in Year 3
Sales = $65,000
Book Value = $40,000
Profit = $25,000
Taxes @30% = $7,500
Cash Flow from Sale = $57,500 (65,000- 7,500)
Inventory recouped = $10,000
Terminal Cash Flow = $67,500
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
NPV
Year 0 1 2 3 _
Initial Investment (110,000)
Annual Cash Flow 32,600 32,600 32,600
Terminal Cash Flow 67,500
(110,000) 32,600 32,600 100,100
x (Pvif 10%,n) 1 0.9091 0.8264 0.7513
(110,000) 29,637 26,941 75,205 = 21, 783
NPV = $21,783 Go ahead and purchase machine
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Learning Objective 7
Compute the impact of inflation
on a capital-budgeting project.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Inflation
What is inflation?
It is the decline in generalpurchasing power of the monetary unit.
Simply put, one has to factor in inflation in estimating future cash flows
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Learning Objective 8
Use the payback model
and the accounting
rate-of-return model
and compare them
with the NPV model.
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Payback Model Payback time, or payback period, is the
time it will take to recoup, in the form of cash inflows from operations, the initial dollars invested in a project.
(If the cash flows represent an annuity)
The payback model has some deficiencies!
P= I ÷ O
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Payback Model Example
Assume that $12,000 is spent for a machine with an estimated useful life of 8 years.
Annual savings of $4,000 in cash outflows are expected from operations.
What is the payback period?
P = I ÷ O = $12,000 ÷ $4,000 = 3 years
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Accounting Rate-of-Return Model
The accounting rate-of-return (ARR) model expresses a project’s return as the increase in expected average annual operating income divided by the required initial investment.
We will NOT go any further in this because it is also has deficiencies!
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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Post Audit
A recent survey showed that most large companies conduct a follow-up evaluation of at least some capital-budgeting decisions, often called a post audit.
The post audit focuses on actual versus predicted cash flows.