Horngren Ima16 Inppt11

Copyright
©2005 Prentice Hall Business Publishing, © 2014 Pearson

Introduction Education, Inc.
to Management publishing
Accounting as Prentice
13/e, Hall
Horngren/Sundem/Stratton 11 - 1
11
Chapter 11
Capital
Budgeting
Copyright
13/e, Hall
11
Chapter 11 Learning Objectives
1. Describe capital-budgeting decisions and use the net-

present-value (NPV) method to make such decisions.
2. Use sensitivity analysis to evaluate the effect of changes

in predictions on investment decisions.
3. Calculate the NPV difference between two projects using

both the total project and differential approaches.
4. Identify relevant cash flows for NPV analyses.
5. Compute the after-tax net present values of projects.
Copyright
13/e, Hall
11
Chapter 11 Learning Objectives
6. Explain the after-tax effect on cash received from the

disposal of assets.
7. Use the payback model and the accounting rate-of-return

model and compare them with the NPV model.
8. Reconcile the conflict between using an NPV model for

making decisions and using accounting income for
evaluating the related performance.
9. Compute the impact of inflation on a capital-budgeting

project (Appendix 11).
Copyright
13/e, Hall
11
Learning
Objective 1 Capital Budgeting
Capital budgeting describes the

long-term planning for making and
financing major long-term projects.
1. Identify potential investments.
2. Choose an investment.
3. Follow-up or “post audit.”

Copyright
13/e, Hall
11
The long-term planning for long-term
investment decisions such as :
(1)investment in new equipment,
(2) replacement of assets
(3) expansion of facilities
(4) Investment in employee training
programs,
(5) expenditures to improve process
efficiency and reduce future costs
Copyright
13/e, Hall
11
Capital Budgeting Models :
Discounted-Cash-Flow Models
(DCF)
These models focus on a project’s cash

inflows and outflows while taking into
account the time value of money
“The value of a dollar today is greater than the value
of a dollar to be received in the future”
DCF models compare the value

of today’s cash outflows with the
value of the future cash inflows.
Copyright
13/e, Hall
11
Net Present Value Model
The net-present-value (NPV) method computes

the present value of all expected future cash
flows using a minimum desired rate of return.
The minimum desired rate of return depends on

the risk-the higher the risk, the higher the rate.
The required rate of return (also called hurdle

rate or discount rate) is the minimum desired
rate of return based on the firm’s cost of capital.
Copyright
13/e, Hall
11
Applying the NPV Method
Copyright
13/e, Hall
11
NPV Example
Original investment (cash outflow): $5,827
Useful life: four years
Annual income generated from

investment (cash inflow): $2,000
Minimum desired rate of return: 10%
Copyright
13/e, Hall
11
NPV Example
Present
Value
of $1 Total Sketch of Cash
Discounted Present Flows at End of Year
At 10% Value 0 1 2 3 4
Approach 1: Discounting Cash Flows
Cash flows
Annual savings .9091 $1,818 2,000
.8264 1,653 2,000
.7513 1,503 2,000
.6830 1,366 2,000
Present value of
Future inflows $6,340
Initial Outlay 1.0000 (5,827) $(5,827)
Net present value $ 513
Copyright
13/e, Hall
11
NPV Example
Because the four annual cash flows in the

example are all equal, this table can be used to
make one PV computation instead of four
individual computations.
Approach 2: Using an Annuity Table

Sketch of Cash Flows at End of Year
0 1 2 3 4
Annual Savings 3.1699 $6,340 $2,000 $2,000 $2,000 $2,000
Initial Outlay 1.0000 (5,827) $(5,827)
Net present value $ 513
Copyright
13/e, Hall
11
Assumptions of the NPV Model
Two Major Assumptions
World of certainty.
There are perfect

capital markets.
Copyright
13/e, Hall
11
Decision Rules
Managers determine the sum of

the present values of all expected
cash flows from the project.
If the sum of the present values is

positive, the project is desirable.
If the sum of the present values is

negative, the project is unattractive.
Copyright
13/e, Hall
11
Internal Rate of Return Model
The IRR determines the interest rate

at which the NPV equals zero.
If IRR > minimum desired rate of return,

then NPV > 0 and accept the project.
If IRR < minimum desired rate of return,

then NPV < 0 and reject the project.
Copyright
13/e, Hall
11
Real Option Model
This model recognizes the value

of contingent investments.
Contingent investments are

investments that a company
can adjust as it learns more
about their potential for success.
Copyright
13/e, Hall
11
Learning
Objective 2 Sensitivity Analysis
Sensitivity analysis shows the financial

consequences that would occur if
actual cash inflows and outflows
differ from those expected.
Managers often use sensitivity

analysis to deal with uncertainty, to
answer the what-if questions.
Copyright
13/e, Hall
11
Sensitivity Analysis Example
Suppose that a manager knows that the

actual cash inflows in the previous example
could fall below the predicted level of $2,000.
How far below $2,000 must the annual cash

inflow drop before the NPV becomes negative?
Copyright
13/e, Hall
11
Sensitivity Analysis Example
(Discounted Cash inflow) –cash outflow = 0

NPV = 0
(3.1699 × Cash flow) – $5,827 = 0
Cash flow = $5,827 ÷ 3.1699 = $1,838
If the annual cash flow is less than $1,838, the NPV

is negative, and the project should be rejected.
Annual cash inflows can drop only

$2,000 – $1,838 = $162 or 8.1% (=162/2000 x100%)
Copyright
13/e, Hall
11
Learning
Objective 3 Comparison of Two Projects
Two common methods for

comparing alternatives are:
Total project
approach
Differential
approach
Copyright
13/e, Hall
11
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.
Copyright
13/e, Hall
11
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.
Copyright
13/e, Hall
11
Learning
Objective 4 Relevant Cash Flows for NPV
Three types of inflows and outflows

should be considered when the
relevant cash flows are arrayed:
1) Initial cash inflows and outflows at time zero

2) Future disposal values
3) Operating cash flows
Copyright
13/e, Hall
11
Operating Cash Flows
The only relevant cash flows are those

that will differ among alternatives.
Fixed overhead can be ignored.
A reduction in cash outflow is

treated the same as a cash inflow.
Copyright
13/e, Hall
11
Cash Flows for Investments in Technology
Decision:
Invest in a highly automated production
system to replace a traditional system.
Cash flows predicted for the automated system

should be compared to cash flows predicted
for continuation of present system.
A changing competitive environment can

cause failure to invest in an automated system
which causes a decline in sales and an
uncompetitive cost structure.
Copyright
13/e, Hall
11
Learning
Objective 5 Income Taxes and Capital Budgeting
Another type of cash flow

that must be considered when
making capital-budgeting decisions is
after-tax cash flows.
In capital budgeting,
This is the tax rate paid
the relevant tax
on incremental
rate is the marginal
taxable income.
income tax rate.
Copyright
13/e, Hall
11
Effects of Depreciation Deductions
Depreciation expense is a noncash expense and

is ignored for capital budgeting, except that
it is an expense for tax purposes and will
provide a cash inflow from income tax savings.
Organizations that pay income taxes usually

keep two sets of books one set that follows the
rules for financial reporting and one that
follows the tax rules, a practice that is not
illegal or immoral – it is necessary.
Copyright
13/e, Hall
11
U.S. tax authorities allow

accelerated depreciation.
The focus is on the tax reporting rules,

not those for public financial reporting.
The recovery period is the number

of years over which an asset is
depreciated for tax purposes.
Copyright
13/e, Hall
11
Assume the following:

Cash inflow from operations: $60,000
Tax rate: 40%
What is the after-tax inflow from operations?
$60,000 × (1 – tax rate)

= $60,000 × .6 = $36,000
Copyright
13/e, Hall
11
What is the after-tax effect

of $25,000 depreciation?
$25,000 × 40% = $10,000 tax savings
The depreciation deduction reduces

taxes, and thereby increases cash
flows, by $10,000 annually.
Copyright
13/e, Hall
11
Modified Accelerated Cost Recovery System
Under U.S. income tax laws, companies

depreciate most assets using the Modified
Accelerated Cost Recovery System (MACRS).
MACRS specifies a recovery period and

an accelerated depreciation schedule
for all types of assets in eight classes.
Copyright
13/e, Hall
11
Present Value of MACRS
Depreciation Tax
Deduction
Depreciation Tax Shield is the tax savings

due to depreciation deductions, generally the
present value of the product of the tax rate
and the depreciation deduction. The value of
a depreciation deduction depends on timing.
MACRS specifies the timing of deductions for

each recovery period. The present value of the
depreciation tax shield for any recovery period
can be easily computed.
Copyright
13/e, Hall
11
Learning
Objective 6 Gains or Losses on Disposal
The disposal of equipment for cash

can also affect income taxes.
Suppose a 5-year piece of equipment purchased

for $125,000 is sold at the end of year 3 after
taking three years of straight-line depreciation.
What is the book value?
$125,000 – (3 × $25,000) = $50,000

Copyright
13/e, Hall
11
Gains or Losses on Disposal
If the equipment is sold for $50,000

(book value), there is no gain or loss
and there is no tax effect.
If it is sold for more than $50,000, there

is a gain and an additional tax payment.
If it is sold for less than $50,000,

there is a loss and a tax savings.
Copyright
13/e, Hall
11
Gains or Losses on Disposal
Assume that the equipment is sold for

$70,000 and the tax rate is 40%.
What is the tax savings on the sale?
($70,000 – $50,000) = 20,000 × 40% = $8,000
What is the net cash inflow from the sale?
$70,000 – $8,000 = $62,000

Copyright
13/e, Hall
11
Cash Flow Effects of
Disposal of Equipment
Copyright
13/e, Hall
11
Learning Other Models for Analyzing
Objective 7
Long-Range Decisions
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.
P=I÷O
Assume that $12,000 is spent for a commercial

stove with an estimated useful life of 4 years.
Copyright
13/e, Hall
11
Payback Model Example
Annual savings of $4,000 in cash outflows

are expected from operations.
What is the payback period?
P = $12,000 ÷ $4,000 = 3 years
Copyright
13/e, Hall
11
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.
ARR
*Average annual incremental cash inflow from operations

minus incremental average annual depreciation.
Copyright
13/e, Hall
11
Accounting Rate-of-Return Example
Assume the following:

Investment is $5,827.
Useful life is four years.
Estimated disposal value is zero.
Expected annual cash inflow
from operations is $2,000.
Annual depreciation = (cost – disposal value)/useful life
Annual depreciation = ($5,827 – 0)/4 = $1,456.75
Copyright
13/e, Hall
11
ARR =
Average annual incremental

cash inflow –
Incremental annual depreciation
ARR = ($2,000 – $1457) ÷ $5,827 = 9.3%
Copyright
13/e, Hall
11
Some companies use the “average” investment

(often assumed to be the average book value
over the useful life) instead of original
investment in the denominator
Average annual incremental

cash inflow –
Incremental annual depreciation
ARR = ($2,000 – $1457) ÷ $2,913.50 = 18.6%
Copyright
13/e, Hall
11
Learning
Objective 8 Performance Evaluation
Many managers are reluctant to accept

DFC models as the best way to make
capital-budgeting decisions.
Their superiors evaluate them

using a non-DCF model.
Copyright
13/e, Hall
11
Reconciliation of Conflict
Use DCF for both capital-budgeting

decisions and performance evaluation.
Use Economic Value Added (EVA)
Follow-up evaluation
of capital decisions
Copyright
13/e, Hall
11
Post Audit
Most large companies conduct a

follow-up evaluation of selected
capital-budgeting decisions.
One follow-up evaluation of

capital-budgeting decisions often
used is a post-audit.
Copyright
13/e, Hall
11
Post Audit
Investment expenditures are

on time and within budget.
Comparing actual versus predicted cash flows.
Improving future predictions of cash flows.
Evaluating the continuation of the project.
Copyright
13/e, Hall
11
Learning
Objective 9 Capital Budgeting and Inflation
What is inflation?
It is the decline in general purchasing

power of the monetary unit.
The key in capital budgeting is consistent

treatment of the minimum desired rate
of return and the predicted cash
inflows and outflows.
Copyright
13/e, Hall
11
Watch for Consistency
Consistency can be achieved by

including an element for inflation in
both the minimum desired rate of
return and in the cash-flow predictions.
Many firms base their minimum desired rate

of return on market interest rates (nominal
rates) that include an inflation element.
Copyright
13/e, Hall
11
All rights reserved. No part of this publication
may be reproduced, stored in a retrieval system,
or transmitted, in any form or by any means,
electronic, mechanical, photocopying, recording,
or otherwise, without the prior written permission
of the publisher. Printed in the United States of
America.
Copyright
13/e, Hall
11

Horngren Ima16 Inppt11

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Horngren Ima16 Inppt11

Uploaded by

Copyright:

Available Formats

Copyright

©2005 Prentice Hall Business Publishing, © 2014 Pearson

1. Describe capital-budgeting decisions and use the net-

2. Use sensitivity analysis to evaluate the effect of changes

3. Calculate the NPV difference between two projects using

4. Identify relevant cash flows for NPV analyses.

5. Compute the after-tax net present values of projects.

6. Explain the after-tax effect on cash received from the

7. Use the payback model and the accounting rate-of-return

8. Reconcile the conflict between using an NPV model for

9. Compute the impact of inflation on a capital-budgeting

Capital budgeting describes the

1. Identify potential investments.

3. Follow-up or “post audit.”

These models focus on a project’s cash

DCF models compare the value

The net-present-value (NPV) method computes

The minimum desired rate of return depends on

The required rate of return (also called hurdle

Original investment (cash outflow): $5,827

Useful life: four years

Annual income generated from

Minimum desired rate of return: 10%

Because the four annual cash flows in the

Approach 2: Using an Annuity Table

Two Major Assumptions

There are perfect

Managers determine the sum of

If the sum of the present values is

If the sum of the present values is

The IRR determines the interest rate

If IRR > minimum desired rate of return,

If IRR < minimum desired rate of return,

This model recognizes the value

Contingent investments are

Sensitivity analysis shows the financial

Managers often use sensitivity

Suppose that a manager knows that the

How far below $2,000 must the annual cash

(Discounted Cash inflow) –cash outflow = 0

(3.1699 × Cash flow) – $5,827 = 0

Cash flow = $5,827 ÷ 3.1699 = $1,838

If the annual cash flow is less than $1,838, the NPV

Annual cash inflows can drop only

Two common methods for

The total project approach computes the

The alternative with the largest

The differential approach computes

This method cannot be used to

Three types of inflows and outflows

1) Initial cash inflows and outflows at time zero

The only relevant cash flows are those

Fixed overhead can be ignored.

A reduction in cash outflow is

Cash flows predicted for the automated system

A changing competitive environment can

Another type of cash flow

Depreciation expense is a noncash expense and

Organizations that pay income taxes usually

U.S. tax authorities allow

The focus is on the tax reporting rules,

The recovery period is the number

Assume the following: