Managerial Accounting

Wild and Shaw

Third Edition
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 11

Capital Budgeting and

Investment Analysis
 Conceptual Learning
Objectives

C1: Describe the selection of a hurdle

rate for an investment.

11-3
Analytical Learning Objectives

A1: Analyze a capital investment project

using break-even time.

11-4
 Procedural Learning
Objectives
P1: Compute payback period and
describe its use.
P2: Compute accounting rate of return
and explain its use.
P3: Compute net present value and
explain its use.
P4: Compute internal rate of return and
explain its use.

11-5
C1

Capital Budgeting
 Outcome  Large amounts of
money are usually
is uncertain.
involved.

Capital budgeting:
Analyzing alternative long-
term investments and deciding
which assets to acquire or sell.

 Decision may be  Investment involves a

difficult or impossible
long-term commitment.
to reverse.
11-6
P1

Payback Period

The payback period of an investment

is the time expected to recover
the initial investment amount.

Payback Cost of Investment

=
period Annual Net Cash Flow

Managers prefer investing in projects

with shorter payback periods.
11-7
P1 Payback Period with Even
Cash Flows
FasTrac is considering buying a new machine that will be
used in its manufacturing operations. The machine costs
$16,000 and is expected to produce annual net cash flows
of $4,100. The machine is expected to have an 8-year
useful life with no salvage value.

Calculate the payback period.

Payback Cost of Investment
=
period Annual Net Cash Flow

Payback $16,000
= = 3.9 years
period $4,100
11-8
P1 Payback Period with
Uneven Cash Flows
In the previous example, we assumed that
the increase in cash flows would be the
same each year. Now, let’s look at an
example where the cash flows vary each
year.

$5,000

$4,100

11-9
P1 Payback Period with
Uneven Cash Flows
Cumulative
Annual Net Net Cash
FasTrac wants to Year Cash Flows Flows
install a machine 0 $ (16,000) $ (16,000)
that costs $16,000 1 3,000 (13,000)
and has an 8-year 2 4,000 (9,000)
useful life with 3 4,000 (5,000)
zero salvage 4 4,000 (1,000)
value. Annual net 5 5,000 4,000
cash flows are: 6 3,000 7,000
7 2,000 9,000
8 2,000 11,000
11-10
P1 Payback Period with
Uneven Cash Flows
Cumulative
We recover the $16,000 Annual Net Net Cash
purchase price between Year Cash Flows Flows
years 4 and 5, about 0 $ (16,000) $ (16,000)
4.2 years for the 1 3,000 (13,000)
payback period. 2 4,000 (9,000)
3 4,000 (5,000)
4 4,000 (1,000)
4.2
5 5,000 4,000
6 3,000 7,000
7 2,000 9,000
8 2,000 11,000
11-11
P1

Using the Payback Period

Ignores the
time value
Unacceptable for
of money.
projects with long
lives where time
value of
money effects
Ignores cash
are major.
flows after
the payback
period.

11-12
P1

Using the Payback Period

Consider two projects, each with a five-year life
and each costing $6,000.
Project One Project Two
Net Cash Net Cash
Year Inflows Inflows
1 $ 2,000 $ 1,000
2 2,000 1,000
3 2,000 1,000
4 2,000 1,000
5 2,000 1,000

Would you invest in Project One just because

it has a shorter payback period? 11-13
P2

Accounting Rate of Return

The accounting rate of return focuses on
annual income instead of cash flows.

Accounting = Annual after-tax net income

rate of return Annual average investment

Beginning book value + Ending book value

2
11-14
P2

Accounting Rate of Return

Reconsider the $16,000 investment being considered by FasTrac. The
annual after-tax net income is $2,100. Compute the
accounting rate of return.

Accounting = Annual after-tax net income

rate of return Annual average investment

Beginning book value + Ending book value

2
11-15
P2

Accounting Rate of Return

Reconsider the $16,000 investment being considered by FasTrac. The
annual after-tax net income is $2,100. Compute the
accounting rate of return.

Accounting = Annual after-tax net income

rate of return Annual average investment

Beginning book value + Ending book value

2
11-16
P2

Accounting Rate of Return

Reconsider the $16,000 investment being considered by FasTrac. The
annual after-tax net income is $2,100. Compute the
accounting rate of return.

Accounting $2,100
= = 26.25%
rate of return $8,000

$16,000 + $0
2
11-17
P2 Using Accounting Rate of
Return
So why
 Depreciation may be would I ever
calculated several ways. want to use
 Income may vary from this method
year to year. anyway?
 Time value of
money is ignored.

11-18
P3

Net Present Value

Now let’s look at a capital budgeting model
that considers the time value of cash
flows.

11-19
P3

Net Present Value

 Discount the future net cash flows from the
investment at the required rate of return.
 Subtract the initial amount invested from
sum of the discounted cash flows.
FasTrac is considering the purchase of a conveyor
costing $16,000 with an 8-year useful life with zero
salvage value that promises annual net cash flows of
$4,100. FasTrac requires a 12 percent compounded
annual return on its investments.

11-20
P3 Net Present Value
with Even Cash Flows
Present Present
Annual Net Value of $1 Value of
Year Cash Flows Factor Cash Flows
1 $ 4,100 0.8929 $ 3,661
2 4,100 0.7972 3,269
3 4,100 0.7118 2,918
4 4,100 0.6355 2,606
5 4,100 0.5674 2,326
6 4,100 0.5066 2,077
7 4,100 0.4523 1,854
8 4,100 0.4039 1,656
Total $ 32,800 $ 20,367
Amount to be invested (16,000)
Net present value of investment $ 4,367
11-21
P3 Net Present Value
with Even Cash Flows
Present value factors Present Present
Annual Net Value of $1
for 12 percent Value of
Year Cash Flows Factor Cash Flows
1 $ 4,100 0.8929 $ 3,661
2 4,100 0.7972 3,269
3 4,100 0.7118 2,918
4 4,100 0.6355 2,606
5 4,100 0.5674 2,326
6 4,100 0.5066 2,077
7 4,100 0.4523 1,854
8 4,100 0.4039 1,656
Total $ 32,800 $ 20,367
Amount to be invested (16,000)
Net present value of investment $ 4,367
11-22
P3 Net Present Value
with Even Cash Flows
Present Present
Annual Net Value of $1 Value of
Year Cash Flows Factor Cash Flows
1 $ 4,100 0.8929 $ 3,661
2 4,100 0.7972 3,269
3 4,100 0.7118 2,918
4 4,100 0.6355 2,606
5 4,100 0.5674 2,326
6 4,100 0.5066 2,077
A positive
7 net present
4,100 value indicates that
0.4523 1,854this
project earns
8 more than
4,10012 percent
0.4039on the investment.
1,656
Total $ 32,800 $ 20,367
Amount to be invested (16,000)
Net present value of investment $ 4,367
11-23
P3

Using Net Present Value

General decision rule . . .
If the Net Present
Value is . . . Then the Project is . . .
Acceptable, since it promises a
Positive . . . return greater than the required
rate of return.

Acceptable, since it promises a

Zero . . . return equal to the required rate
of return.

Not acceptable, since it

Negative . . . promises a return less than the
required rate of return.

11-24
P3 Net Present Value
with Uneven Cash Flows
Pre se nt
Va lue of
Ne t Ca sh Flow s $1 Fa ctor PV of Ne t Ca sh Flow s
Ye a r A B C a t 10% A B C
1 $ 5,000 $ 8,000 $ 1,000 0.9091 $ 4,546 $ 7,273 $ 909
2 5,000 5,000 5,000 0.8264 4,132 4,132 4,132
3 5,000 2,000 9,000 0.7513 3,757 1,503 6,762
Tota l $ 15,000 $ 15,000 $ 15,000 $ 12,435 $ 12,908 $ 11,803
Am ount inve ste d (12,000) (12,000) (12,000)
Ne t Pre se nt Va lue $ 435 $ 908 $ (197)

Although all projects require the same investment and have

the same total net cash flows, project B has a higher net present
value because of a larger net cash flow in year 1.
11-25
P4

Internal Rate of Return (IRR)

The interest rate that makes . . .

 Present Present
value of = value of
cash inflows cash outflows

 The net present value equal zero.

11-26
P4

Internal Rate of Return (IRR)

Projects with even annual cash flows
Project life = 3 years
Initial cost = $12,000
Annual net cash inflows = $5,000
Determine the IRR for this project.

1. Compute present value factor.

2. Using present value of annuity table . . .

11-27
P4

Internal Rate of Return (IRR)

Projects with even annual cash flows
Project life = 3 years
Initial cost = $12,000
Annual net cash inflows = $5,000
Determine the IRR for this project.

1. Compute present value factor.

$12,000 ÷ $5,000 per year = 2.4

2. Using present value of annuity table . . .

11-28
P4

Internal Rate of Return (IRR)

1. Determine the present value factor.

$12,000 ÷ $5,000 per year = 2.4000

2. Using present value of annuity table . . .

Periods 10% 12% 14%

Locate the row
1 0.90909 0.89286 0.87719
whose number
2 1.73554 1.69005 1.64666
equals the 3 2.48685 2.40183 2.32163
periods in the 4 3.16987 3.03735 2.91371
project’s life. 5 3.79079 3.60478 3.43308

11-29
P4

Internal Rate of Return (IRR)

1. Determine the present value factor.

$12,000 ÷ $5,000 per year = 2.4000

2. Using present value of annuity table . . .

In that row,
locate the Periods 10% 12% 14%
interest factor 1 0.90909 0.89286 0.87719
closest in 2 1.73554 1.69005 1.64666
3 2.48685 2.40183 2.32163
amount to the
4 3.16987 3.03735 2.91371
present value 5 3.79079 3.60478 3.43308
factor.
11-30
P4

Internal Rate of Return (IRR)

1. Determine the present value factor.
IRR is
approximately
$12,000 ÷ $5,000 per year = 2.4000
12%.

2. Using present value of annuity table . . .

IRR is the Periods 10% 12% 14%

interest rate 1 0.90909 0.89286 0.87719
of the column 2 1.73554 1.69005 1.64666
3 2.48685 2.40183 2.32163
in which the
4 3.16987 3.03735 2.91371
present value
5 3.79079 3.60478 3.43308
factor is found.
11-31
P4 Internal Rate of Return –
Uneven Cash Flows
If cash inflows are unequal, trial and error
solution will result if present value tables
are used.
Sophisticated business calculators and
electronic spreadsheets can be used to
easily solve these problems.

11-32
P4

Using Internal Rate of Return

Internal Rate of Return
 Compare the internal rate
of return on a project to a
predetermined hurdle rate (cost
of capital).
 To be acceptable, a project’s rate
of return cannot be less than the
cost of capital.

11-33
C1
Comparing Methods
Payback Accounting Net present Internal rate
period rate of return value of return
Basis of Cash Accrual Cash flow s Cash flows
measurement flows income Profitability Profitability
Measure Number Percent Dollar Percent
expressed as of years Amount
Easy to Easy to Considers time Considers time
Understand Understand value of money value of money

Strengths Allows Allows Accommodates Allow s

comparison comparison different risk comparisons
across projects across projects levels over of dissimilar
a project's life projects
Doesn't Doesn't Difficult to Doesn't reflect
consider time consider time compare varying risk
value of money value of money dissimilar levels over the
Limitations projects project's life

Doesn't Doesn't give

consider cash annual rates
flows after over the life
payback period of a project
11-34
A1

Break-Even Time

Break-even time incorporates time value

of money into the payback period method
of evaluating capital investments.

11-35
End of Chapter 11

11-36