Principles of Accounting, Volume 2: Managerial

Accounting
Chapter 11 CAPITAL BUDGETING DECISIONS
PowerPoint Image Slideshow
Chapter Outline

• 11.1 Describe Capital Investment Decisions and How They Are Applied
• 11.2 Evaluate the Payback and Accounting Rate of Return in Capital
Investment Decisions
• 11.3 Explain the Time Value of Money and Calculate Present and
Future Values of Lump Sums and Annuities
• 11.4 Use Discounted Cash Flow Models to Make Capital Investment
Decisions
• 11.5 Compare and Contrast Non-Time Value-Based Methods and Time
Value-Based Methods in Capital Investment Decisions
Module 11.1 Describe Capital Investment Decisions and How They
Are Applied

• Capital investment (sometimes also referred to as capital budgeting)

is a company’s contribution of funds toward the acquisition of long-
lived (long-term or capital) assets for further growth.
• Long-term assets can include investments such as the purchase of new
equipment, the replacement of old machinery, the expansion of operations
into new facilities, or even the expansion into new products or markets. These
capital expenditures are different from operating expenses.
• An operating expense is a regularly-occurring expense used to maintain the
current operations of the company, but a capital expenditure is one used to
grow the business and produce a future economic benefit.
Figure 11.2

Select Between Alternatives. Screening and preference decisions can narrow alternatives in making a selection. (attribution:
Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Module 11.2 Evaluate the Payback and Accounting Rate of Return in
Capital Investment Decisions

The process to select the best investment option requires budgeting

and analysis. A company may use various evaluation methods with
differing inputs and analysis features:
1. Those that consider the time value of money
2. Those that do not consider the time value of money
• Payback method
• Accounting rate of return method
Payback Period

Payback period: the length of time it takes a company to recover their

initial investment
When the net annual cash flows are even, then

where
Payback with Even Net Annual Cash Flows Example

A printing company is considering a printer with an initial investment

cost of $150,000. They expect an annual net cash flow of $20,000. The
company expects a payback period of 6 years on these type of
investments. The payback period for the printer is
$150,000
Payback Period = = 7.5 years
$20,000

The company would not consider this a good investment since 7.5 years
> 6 years required payback period.
Case of Uneven Net Annual Cash Flows

When the net annual cash flows are uneven, or not the same amount
each year, the payback method will require the calculation of a partial
year payback.
Figure 11.3: Uneven Net Annual Cash Flow Example
A company is considering making an initial investment of $40,000 and from
this investment receiving net cash flows of $10,000 in years one and two,
$5,000 in years three and four, and $7,500 for years five and beyond.

The investment would be

recouped between years
5 and 6. We know the
payback is 5 years + part
of the 6th year. Using the
partial year payback =
$5,000/$7,500. The
partial year is 0.33 of a
year, so the payback
become 5.33 years.

Cash Flow. Modified for PPT. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Would the company accept this investment based on payback?

Sample Exercise

EA5. If a garden center is considering the purchase of a new tractor

with an initial investment cost of $120,000, and the center expects a
return of $30,000 in year one, $20,000 in years two and three, $15,000
in years four and five, and $10,000 in year six and beyond, what is the
payback period?
Think It Through: Capital Investment

You are the accountant at a large firm looking to make a capital

investment in a future project. Your company is considering two project
investments. Project A’s payback period is 3 years, and Project B’s
payback period is 5.5 years.
Your company requires a payback period of no more than 5 years on
such projects. Which project should they further consider? Why? Is
there an argument that can be made to advance either project or
neither project? Why? What other factors might be necessary to make
that decision?
Accounting Rate of Return

• Accounting rate of return (ARR): the return on investment

considering changes to net income
• Shows how much extra income the company can expect if it
undertakes the proposed project
Sample Exercise

EA7. A mini-mart needs a new freezer and the initial investment will
cost $300,000. Incremental revenues, including cost savings, are
$200,000, and incremental expenses, including depreciation, are
$125,000. There is no salvage value. What is the accounting rate of
return (ARR)?
Your Turn: Analyzing Hurdle Rate

Turner Printing is looking to invest in a printer, which costs $60,000.

Turner expects a 15% rate of return on this printer investment. The
company expects incremental revenues of $30,000 and incremental
expenses of $15,000. There is no salvage value for the printer. What is
the accounting rate of return (ARR) for this printer? Did it meet the
hurdle rate of 15%?
Your Turn: Analyzing Investments

Your company is considering making an investment in equipment that

will cost $240,000. The equipment is expected to generate annual cash
flows of $60,000, provide incremental cash revenues of $200,000, and
provide incremental cash expenses of $140,000 annually. Depreciation
expense is included in the $140,000 incremental expense.
Calculate the payback period and the accounting rate of return.
Module 11.3 Explain the Time Value of Money and Calculate Present
and Future Values of Lump Sums and Annuities

• The concept of the time value of money asserts that the value of a dollar

today is worth more than the value of a dollar in the future.
• This is because a dollar today can be used now to earn more money in the future.
• Also the possibility of future inflation decreases the value of a dollar over time and
could potentially lead to a reduction in economic buying power.
• A dollar today is also more valuable because there is less risk than if the
dollar is in a long-term investment, which may or may not yield the
expected results.
• Businesses consider the time value of money before making an investment
decision. They need to know what the future value of their investment is
compared to today’s present value and what potential earnings they could
see because of delayed payment. These considerations include present and
future values.
Two Types of Cash Flows: Lump Sums and Annuities

• Lump sum: one-time payment or repayment of funds at a particular

point in time
• Can be either a present value or future value
• $100 is deposited in the bank today, earns interest, and in 5 years is worth
$125
• Present value = $100
• Future value = $125
Two Types of Cash Flows: Lump Sums and Annuities

• Annuity: cash flows that occur each time period are the same amount;
in other words, the cash flows are even each period
• Can be either a present value or future value
• $100 is deposited in the bank on the last day of the year for each of 5 years,
and at the end of the 5 years is worth $780
• Present value = $460
• Future value = $780
Future Value

Future value requires an understanding of compounding, or the process

of earning interest on previous interest earned, along with the interest
earned on the original investment.
$10,000 is invested for 4 years and earns 10% per year. What is the
value of the $10,000 (present value) at the end of the 4 years (future
value)?
Future Value of a Lump Sum
Applying compounding each year to an investment can be tedious. Future value tables, formulas,
financial calculators, or spreadsheet programs such as Excel simplify the process.

You are saving for a vacation:

Time period: 6 years Initial Investment: $4,500 Annual Interest Rate: 8%
What is your investment worth at the end of 6 years? In other words, what is the future value?

For n = 6 years and i = 8%, we

get a future value factor of
1.587.

$4,500 × 1.587 = $7,141.50

This means your initial savings

of $4,500 will be worth
approximately $7,141.50 in 6
years.
Future Value of an Ordinary Annuity
You are saving for retirement:
Time period: 15 years Annual Contribution: $10,000 Annual Interest Rate: 12%
What are your annual contributions worth at the end of 15 years? In other words, what is the future
value of this stream of contributions?

For n = 15 years and i = 8%, we get

a future value of an ordinary
annuity factor of 37.280.

$10,000 × 37.280 = $372,800

This means your annual

contributions of $10,000 for each
of 15 years, will grow to
approximately $372,800.
Your Turn: Determining Future Value

Determine the future value for each of the following situations. Use the
future value tables provided in Appendix B when needed, and round
answers to the nearest cent where required.
A. You are saving for a car and you put away $5,000 in a savings
account. You want to know how much your initial savings will be
worth in 7 years if you have an anticipated annual interest rate of
5%.
B. You are saving for retirement and make contributions of $11,500
per year for the next 14 years to your 403(b) retirement plan. The
interest rate yield is 8%.
Relationship between Future Value and Present Value

• Present value (PV) considers the future value of an investment

expressed in today’s value. This concept is very important in business
decision-making.
• Present value techniques bring future dollars back to today’s dollars
through a procedure known as discounting.
• Discounting is the procedure used to calculate the present value of an
individual payment or a series of payments that will be received in the
future based on an assumed interest rate or return on investment.
Present Value of a Lump Sum
You are saving for college:
Time period: 10 years Future Value: $40,000 Annual Interest Rate: 3%
How much would you need to invest now if you can earn 3% annually in order to have $40,000 10
years from now? In other words, what is the present value?

For n = 10 years and i = 3%, we get

a present value factor of 0.744.

$40,000 × 0.7447 = $29,760

This means to have $40,000 10

years from now, you would need
to invest $29,760 today at a 3%
annual interest rate.
Present Value of an Ordinary Annuity
Borrowing a student loan:
Time period: 5 years Annual Payment: $1,200 Annual Interest Rate: 5%
If the student can make payments of $1,200 annually over five years, and the lending rate is 5%, how
much will the bank loan the student today? In other words, what is the present value of this stream of
payments?

For n = 5 years and i = 5%, we get a

present value of an ordinary
annuity factor of 4.329.

$1,200 × 4.329 = $5,294.80

This means if the current lending

rate is 5% and the student can
make annual payments of $1,200,
the bank will loan the student
$5,294.80 today.
Your Turn: Determining Present Value

Determine the present value for each of the following situations. Use
the present value tables provided in Appendix B when needed, and
round answers to the nearest cent where required.
A. You are saving for college and you want to return a sum of $100,000
in 12 years. The bank returns an interest rate of 5% after these 12
years.
B. You need to borrow money for college and can afford a yearly
payment to the lending institution of $1,000 per year for the next 8
years. The interest rate charged by the lending institution is 3% per
year.
Module 11.4 Use Discounted Cash Flow Models to Make Capital
Investment Decisions

• Discount cash flow model assigns a value to a business opportunity

using time-value measurement tools.
• The model considers future cash flows of the project, discounts them back to
present time, and compares the outcome to an expected rate of return.
• If the outcome exceeds the expected rate of return and initial investment cost,
the company would consider the investment.
• If the outcome does not exceed the expected rate of return or the initial
investment, the company may not consider investment.
• When considering the discounted cash flow process, the time value of money
plays a major role.
Time Value Based Methods

• Net present value (NPV): measures (discounts) future cash flows to

their present value at the expected rate of return and compares that
to the initial investment
• Stated in dollars, if positive, then project is acceptable.
• Internal rate of return (IRR): shows the profitability or growth
potential of an investment at the point where NPV equals zero, so it
determines the actual rate of return a project earns.
• Stated as an interest rate, if the rate is above the company’s required rate of
return, then the project is acceptable.
 NPV for Even Cash Flows
Rudolph Incorporated is determining the NPV for a new X-ray machine.
Initial investment to buy the machine: $200,000
Expected annual cash flows (cost savings, efficiencies): $40,000
Expected life of machine: 10 years
Required rate of return on such an investment: 8%

For n = 10 years and i = 8%, we get a present value of an ordinary

annuity factor of 6.710.

Cash Item Timing Amount PV Factor PV

Initial Investment now ($200,000) 1.000 ($200,000)
Annual Cash Flows 1–10 40,000 6.710 268,400
Net Present Value $ 68,400

Based on NPV, the project is acceptable since the NPV is greater

than zero.
What happens when more than one project is being evaluated using
NPV and either (1) the NPV’s are similar or (2) the projects are vastly
different in size?

The profitability index can be used to measure the profitability of each

of the projects.

Profitability index shows the profit generated for each dollar invested.
Profitability Index Example
Rudolph Incorporated is considering the X-ray machine that had present value cash
flows of $268,400 and an initial investment cost of $200,000. Another X-ray
equipment option, Option B, produces present value cash flows of $290,000 and an
initial investment cost of $240,000. The profitability index is computed as follows.

$268,400
Option A: = 1.342
$200,000
$290,000
Option B: = 1.208
$240,000

Rudolph would choose Option A as it has a higher profitability index. Option A is

expected to return $1.32 for each dollar invested, while Option B is expected to
return $1.21 for each dollar invested.
Present Value with Uneven Cash Flows

Instead of having annual even cash flow, Randolph predicts that the X-
ray machine under Option B will have the following cash flows. What is
the present value of these cash flows?
Each cash flow is treated like an individual lump sum, and the present
value is calculated for each individual cash flow item. Then the
individual present values are added.
Sample Exercise

EA13. Julio Company is considering the purchase of a new bubble

packaging machine. If the machine will provide $20,000 annual savings
for 10 years and can be sold for $50,000 at the end of the period, what
is the present value of the machine investment at a 9% interest rate
with savings realized at year end?
Your Turn: Analyzing a Postage Meter Investment

Yellow Industries is considering investment in a new postage meter

system. The postage meter system would have an initial investment
cost of $135,000. Annual net cash flows are $40,000 for the next 5
years, and the expected interest rate return is 10%. Calculate net
present value and decide whether or not Yellow Industries should
invest in the new postage meter system.
Sample Exercise

EA16. Project B cost $5,000 and will generate after-tax net cash inflows
of $500 in year one, $1,200 in year two, $2,000 in year three, $2,500 in
year four, and $2,000 in year five. What is the NPV using 8% as the
discount rate?
Sample Problem

PA4. Ralston Consulting, Inc., has a $25,000 overdue debt with Supplier
No. 1. The company is low on cash, with only $7,000 in the checking
account and does not want to borrow any more cash. Supplier No. 1
agrees to settle the account in one of two ways:
Option 1: Pay $7,000 now and $23,750 when some large projects are
finished, two years from today.
Option 2: Pay $35,000 three years from today, when even larger
projects are finished.
Assuming that the only factor in the decision is the cost of money (8%),
which option should Ralston choose?
Internal Rate of Return

Internal rate of return (IRR) is found using a two step process:

• Step 1: Determine the present value factor.

• Step 2: Find the interest rate in the Present Value of an Ordinary

Annuity table that corresponds to the present value factor from Step
1 and the time period (n) for the investment.
Internal Rate of Return Example
An initial investment cost is $312,000 and each annual net cash flow is $49,944 for the
next 9 years. The expected rate of return for such a purchase is 6%. What is the internal
rate of return for this investment?
$312,000
•Step 1: = 6.247 (rounded)
present value factor
$49,944
•Step 2: Find 6.247 in the Present Value of an Ordinary Annuity Table by scanning across
the row where n = 9, so IRR = 8%.

IRR = 8%
Company’s expected rate = 6%

8% > 6%, so this project is

acceptable
Think It Through: Choosing Investments

Companies are presented with viable alternatives that sometimes produce

nearly identical results and profitability goals. If they have the ability to
invest in both alternatives, they may do so. But what about when
resources are constrained? How do they choose which investment is best
for their company?
Consider this: you have two projects that met the payback period and
accounting rate of return screenings identically. Project 1 produced an NPV
of $45,000 and had an IRR between 5% and 8%. Project 2 produced a NPV
of $35,000 and had an IRR of 10%. This leaves you with a difficult choice,
since each alternative has a measurement that exceeds the other and the
other variables are the same. Which project would you invest in and why?
Module 11.5 Compare and Contrast Non-Time Value-Based Methods
and Time Value-Based Methods in Capital Investment Decisions

• Each method has pros and cons. Understanding these will help you
understand when one method is more appropriate than another
method.
 Payback Method
Strengths Weaknesses

• Simple calculation • Does not consider time value of money

• Screens out many unviable alternatives quickly • Profitability of an investment is ignored
• Removes high-risk investments from consideration • Cash flows beyond investment return are not
considered

Table 11.4
 Accounting Rate of Return
Strengths Weaknesses

• Simple calculation • Does not consider time value of money

• Screens out many unviable alternatives quickly
• Considers the impact on income rather than cash
flows only (profitability)
Table 11.5
• Return rates for the entire lifespan of the
investment is not considered
• External factors, such as inflation, are ignored
• Return rates override the risk of invest

Strengths
• Considers the time value of money
• Acknowledges higher risk investments
• Comparable future earnings with
today’s value
• Allows for a selection of investment
Table 11.6
Net Present Value
Weaknesses
• Requires a more difficult calculation than non-time value
methods
• Required return rate is an estimate, thus any changes to this
condition and the impact that has on earnings are unknown
• Difficult to compare alternatives that have varying investment
amounts
 Internal Rate of Return
Strengths
• Considers the time value of money
• Easy to compare different-sized
investments, removes dollar bias
• A predetermined rate of return is not
required
• Allows for a selection of investment
Table 11.7
Weaknesses
• Does not acknowledge higher risk investments because the
focus is on return rates
• More difficult calculation than non-time value methods, and
outcome may be uncertain if not using a financial calculator
or spreadsheet program
• If the time for return on investment is important, IRR will not
place more importance on shorter-term investments
Summary
• Capital investment decisions select a project for future business development. These projects typically
require a large outlay of cash, provide an uncertain return, and tie up resources for an extended period of
time.
• Screening decisions help eliminate undesirable alternatives that may waste time and money. Preference
decisions rank alternatives emerging from the screening process to help make the final decision.
• The payback method determines how long it will take a company to recoup their investment. Annual cash
flows are compared to the initial investment but the time value of money is not considered and cashflows
beyond the payback period are ignored.
• The accounting rate of return considers incremental net income as it compares to the initial investment.
Time value of money is not considered with this method.
• A dollar is worth more today than it will be in the future. This is due to many reasons including the power of
investment in today’s economy, market inflation, and the ability to use the money in the present to make
more money in the future, with interest.
• The discounted cash flow model assigns values to a project’s alternatives using time value of money and
discounts future rates back to present value. Two measurement tools are used in discounted cash flows: net
present value and internal rate of return.
• Net present value considers an expected rate of return, converts future cash flows into present value, and
compares that to the initial investment cost. If the outcome is positive, the company would look to invest in
the project.
• Internal rate of return shows the profitability of an investment, where NPV equals zero. If the corresponding
interest rate exceeds the expected rate of return, the company would invest in the project.
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