Chapter

12-1
 CHAPTER 12

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Managerial Accounting, Fifth Edition

Chapter
12-2
 Study Study Objectives
1. Discuss the capital budgeting evaluation
process, and explain inputs used in capital
budgeting.
2. Describe the cash payback technique.
3. Explain the net present value method.
4. Identify the challenges presented by
intangible benefits in capital budgeting.
5. Describe the profitability index.
6. Indicate the benefits of performing a post-
audit.
7. Explain the internal rate of return method.
8. Describe the annual rate of return method.
Chapter
12-3
 Planning for Capital Investments

Capital Other
Net Present Additional
Budgeting Cash Capital
Value Consid-
Evaluation Payback Budgeting
Method erations
Process Techniques

Cash flow Equal cash Intangible Intangible

Calculation flows benefits benefits
infor-
Evaluation Unequal Profitability Internal rate
mation
Illustrative cash flows index of return
data Choosing a Risk analysis method
discount Post-audit of Comparing
Rate projects discounted
Simplifying cash flow
Assumption methods
Comprehen- Annual rate
Chapter sive example of return
12-4 method
 Capital Budgeting Evaluation Process

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 a list
of projects to the board of directors.

SO 1 Discuss the capital budgeting evaluation

process, and explain what inputs are used
in capital budgeting.
Capital Budgeting Authorization Process

Illustration 12-1

SO 1 Discuss the capital budgeting evaluation

process, and explain what inputs are used
in capital budgeting.
 Capital Budgeting Evaluation Process

v Most methods to evaluate capital budgeting

decisions employ cash flow numbers rather
than accrual revenues and expenses.
v For capital budgeting, estimated cash
inflows and outflows are the preferred D
inputs.
v WHY?
D
D D

Ultimately the value of financial

D
v
investments is determined by the value of
the cash flows received or paid.

SO 1 Discuss the capital budgeting evaluation

Chapter process, and explain what inputs are used
12-7
in capital budgeting.
 Typical Cash Flows Related to Capital
Budgeting Decisions

Illustration 12-2

SO 1 Discuss the capital budgeting evaluation

Chapter process, and explain what inputs are used
12-8
in capital budgeting.
 Capital Budgeting Evaluation Process

The capital budgeting decision depends on a

variety of considerations:

1) The availability of funds.

2) Relationships among proposed projects.
3) The company’s basic decision-making
approach.
4) The risk associated with a
particular project.

SO 1 Discuss the capital budgeting evaluation

Chapter process, and explain what inputs are used
12-9
in capital budgeting.
 Facts for Stewart Soups Example

Illustration 12-3

SO 1 Discuss the capital budgeting evaluation

process, and explain what inputs are used in
Chapter
12-10 capital budgeting.
 Cash Payback Formula

The cash payback technique identifies the

time period required to recover the cost of
the capital investment from the net annual
cash flow produced by the investment.
The formula for computing the cash
payback period is:

Illustration 12-4

Chapter
12-11
SO 2 Describe the cash payback technique.
 Cash Payback Formula-Equal Cash Flows

Illustration 12-4

$130,000 ÷ $24,000 = 5.42 years

The shorter the payback the more attractive the

investment.

Chapter
12-12
SO 2 Describe the cash payback technique.
 Cash Payback Formula-Unequal Cash Flows

Illustration 12-5

Chapter
12-13
SO 2 Describe the cash payback technique.
 Cash Payback

May be useful as an initial screening tool.

Easy to use and understand.
May be critical for company that wants
quick cash turnaround with weak cash
position.

Ignores profitability of the project!

Ignores the time value of money!

Chapter
12-14
SO 2 Describe the cash payback technique.
 Review Question
A $100,000 investment with a zero scrap value has an 8-year life. Compute
the payback period if straight-line depreciation is used and net income is
determined to be $20,000.

a. 8.00 years.
b. 3.08 years. $20,000
+12,500 depreciation
c. 5.00 years. 32,500 =net annual cash flow
d. 13.33 years. $100,000 = Cost of Capital
÷ 32,500 = Net annual cash flow
= 3.08 Years cash payback period
Chapter
12-15
SO 2 Describe the cash payback technique.
 Net Present Value Method

l The discounted cash flow technique is

generally recognized as the best conceptual
approach to making capital budgeting decisions.
l This technique considers both the estimated
total cash inflows and the time value of money.
l Two methods are used with the
discounted cash flow technique:
1) Net present value, and
2) Internal rate of return.

Chapter
12-16
SO 3 Explain the net present value method.
 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.
Chapter
12-17
SO 3 Explain the net present value method.
 Net Present Value Decision Criteria

Chapter Illustration 12-6

12-18
SO 3 Explain the net present value method.
 Present Value of Equal Annual Cash
Flows
Stewart Soup Company’s annual cash inflows are $24,000. If we
assume this amount is uniform over the asset’s useful life, the present
value of the annual cash inflows can be computed by using the present
value of an annuity of 1 for 10 periods. The computations at rates of
return of 12% and 15%, respectively are:

Illustration 12-7

Chapter
12-19
SO 3 Explain the net present value method.
 Computation of Net Present Values

The analysis of the proposal by the net present

value method is as follows:

Illustration 12-8

The proposed capital expenditure is acceptable at a required rate of

return of 12% (not 15%) because the net present value is positive.

Chapter
12-20
SO 3 Explain the net present value method.
 Present Value of Annual Cash Inflows-Unequal
Annual Cash Flows
When annual cash inflows are unequal, we cannot use annuity tables to
calculate their present value. Instead tables showing the present value of a
single future amount must be applied to each annual cash inflow.

Illustration 12-9
Chapter
12-21
SO 3 Explain the net present value method.
 Analysis of Proposal Using Net Present
Value Method
Therefore, the analysis of the proposal by the net present
value method is as follows:

Illustration 12-10

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.

Chapter
12-22
SO 3 Explain the net present value method.
 Choosing a Discount Rate

In most cases the discount rate (required

rate of return) is equal to its cost of capital
– the amount it must pay to obtain funds
from creditors or stockholders.

Chapter
12-23
SO 2 Describe the cash payback technique.
 Simplifying Assumptions

All cash flows come at the end of the

year.
All cash flows are immediately
reinvested in another project that has a
similar return.
All cash flows can be predicted with
certainty.

Chapter SO 3 Explain the net present value

12-24
 Review Question
Compute the net present value of a $260,000 investment with a 10-year
life, annual cash inflows of $50,000 and a discount rate of 12%.

a. $(9,062).
b. $22,511.
c. $9,062.
Present Value of Cash Flows:
d. $(22,511). $50,000 × 5.65022 = $282,511
Minus capital investment 260,000
Net present value $ 22,511
Chapter
12-25
SO 3 Explain the net present value method.
 Additional Considerations – NPV

The previous NPV example relied on

tangible costs and benefits that can be
relatively easily quantified.
By ignoring intangible benefits, capital
budgeting techniques might incorrectly
eliminate projects that could be
financially beneficial.
A few intangible benefits:
Increased quality, and
Improved safety.

Chapter SO 4 Explain the net present value method.

12-26
 Additional Considerations - NPV

To avoid rejecting projects that actually should be

accepted, two possible approaches are suggested:

1. 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.

2. Project rough, conservative estimates of the value

of the intangible benefits, and incorporate these
values into the NPV calculation.

Chapter SO 4 Identify the challenges presented by

12-27
intangible benefits in capital budgeting.
 Additional Considerations – Intangibles

Illustration 12-14

Based on negative NPV the projected is

unacceptable.
Chapter SO 4 Identify the challenges presented by
12-28
intangible benefits in capital budgeting.
 Additional Considerations – Intangibles

Illustration 12-15

However, engineers believe buying the machine will

improve electrical connections (an intangible benefit )
that may reduce future warranty costs.

Chapter SO 4 Identify the challenges presented by

12-29
intangible benefits in capital budgeting.
 Additional Considerations - Intangibles

Illustration 12-16

Chapter SO 4 Identify the challenges presented by

12-30
intangible benefits in capital budgeting.
 The Profitability Index

Illustration 12-20

Chapter
12-31
SO 5 Describe the profitability index.
 The Profitability Index

All projects with NPV should be

accepted – in theory.
Why aren’t they?
Projects are mutually exclusive – only
need one new packaging
machine.
Limited resources.

Chapter
12-32
SO 5 Describe the profitability index.
 The Profitability Index

Illustration 12-17

Illustration 12-18

Chapter
12-33
SO 5 Describe the profitability index.
 The Profitability Index

Profitability index allows comparison of the relative

desirability of projects that require initial investments

Illustration 12-20

Chapter
12-34
SO 5 Describe the profitability index.
 Review Question
Assume Project A has a present value of net cash inflows of $79,600
and an initial investment of $60,000. Project B has a present value of
net cash inflows of $82,500 and an initial investment of $75,000.
Assuming the projects are mutually exclusive, which project should
management select?

a. Project B. Present Value of Net Cash Flows

Initial Investment
b. Project A or B. Project A Project B
PV of Net Cash Flows 79,600 82,500
c. Project A. Initial Investment 60,000 75,000
d. I give up. Profitability Index 1.33 1.10

Chapter
12-35
SO 5 Describe the profitability index.
 Post-Audit of Investment Projects

Performing a post-audit is important for a variety of

reasons.
1. If managers know that their estimates will be
compared to actual results they will be more likely
to submit reasonable and accurate data when
making investment proposals.
2. A post-audit provides a formal mechanism by
which the company can determine whether
existing projects should be supported or
terminated.
3. Post-audits improve future investment proposals
because by evaluating past successes and failures,
managers improve their estimation techniques.

Chapter SO 6 Indicate the benefits of performing

12-36
a post-audit.
 Internal Rate of Return Method
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:

Illustration 12-22

Chapter
12-37
SO 7 Explain the internal rate of return method.
 Internal Rate of Return Method

The computation for the Stewart Soup

Company, assuming equal annual cash inflows is:

$244,371 ÷ $1000,000 = 2.44371

Chapter
12-38
SO 7 Explain the internal rate of return method.
 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%.

Chapter
12-39
SO 7 Explain the internal rate of return method.
 Internal Rate of Return Decision Criteria

Illustration 12-23

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.
Chapter
12-40
SO 7 Explain the internal rate of return method.
 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:
Item Net Present Value Internal Rate of Return
1. Objective Compute net Compute internal rate of
present value. return.
2. Decision rule If net present If internal rate of return
value is zero or is equal to or greater
positive, accept than the minimum
the proposal; if required rate of return,
net present value accept the proposal; if
is negative, reject internal rate of return is
the proposal. less than the minimum
rate, reject the proposal.
Illustration 12-24
Chapter
12-41
SO 7 Explain the internal rate of return method.
 Review Question
A $60,000 project has net cash inflows for 10 years of $9,349.
Compute the internal rate of return from this investment.

Capital Investment = 60,000 = 6.4177

a. 8%. Net Annual Cash Flows 9,349

b. 10%.
c. 9%.
d. 11.

Chapter
12-42
SO 7 Explain the internal rate of return method.
 Annual Rate of Return Formula

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 company’s cost of capital,
which is the rate of return that management expects to pay on
all borrowed and equity funds.

Chapter
12-43
SO 8 Describe the annual rate of return method.
 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]

Chapter
12-44
SO 8 Describe the annual rate of return method.
 Solution to Annual Rate of Return Problem

The expected annual rate of return for Reno Company’s

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 management’s
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.

Chapter
12-45
SO 8 Describe the annual rate of return method.
 Review Question
Bear Company computes an expected annual net income of $30,000 from
an investment . The investment has an initial cost of $200,000 and a
terminal value of $20,000. Compute the annual rate of return.

Expected Annual Net Income = 30,000 = 27.3%

a. 15%. Average Investment 110,000

b. 30%.
c. 25%.
d. 27.3%.
Chapter
12-46
SO 8 Describe the annual rate of return method.
 All About You: The Risks of Adjustable
Rates

Chapter
12-47
 All About You: The Risks of Adjustable
Rates

Chapter
12-48
 All About You: The Risks of Adjustable
Rates

Chapter
12-49