CH 27

Accounting Principles
Thirteenth Edition
Weygandt ● Kimmel ● Kieso
Chapter 27
Planning for Capital Investments

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Chapter Outline
Learning Objectives
LO 1 Describe capital budgeting inputs and apply the cash
payback technique.
LO 2 Use the net present value method.
LO 3 Identify capital budgeting challenges and refinements.
LO 4 Use the internal rate of return method.
LO 5 Use the annual rate of return method.
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Capital Budgeting and Cash Payback
Corporate capital budget authorization process:
1. Proposals for projects are requested from each
department, plants, and authorized personnel.
2. Proposals are screened by a capital budget committee.
3. Officers determine which projects are worthy of
funding.
4. Board of directors approves capital budget.

Cost Flow Information (1 of 3)
For purposes of capital budgeting, estimated cash inflows
and outflows are the preferred inputs.
Why?
Ultimately, the value of all financial investments is
determined by the value of cash flows received and paid.

Cash Outflows
Initial investment
Repairs and maintenance
Increased operating costs
Overhaul of equipment
Cash Inflows
Proceeds from sale of old equipment
Increased cash received from customers
Reduced cash outflows related to operating costs
Salvage value of equipment
Capital budgeting decisions depend on:
• Availability of funds
• Relationships among proposed projects
• Company’s basic decision-making approach
• Risk associated with a particular project

Illustrative Data
Stewart Shipping Company is considering an investment
of $130,000 in new equipment.
Initial investment $130,000
Estimated useful life 10 years
Estimated salvage value -0-
Estimated annual cash flows
Cash inflows from customers $200,000
Cash outflows for operating costs 176,000
Net annual cash flow $ 24,000

Cash Payback (1 of 5)
Cash payback technique identifies time period required to recover
cost of capital investment from net annual cash inflow produced by
investment.
Cash payback period for Stewart is …
Cost of Capital Net Annual Cash Payback

÷ =
Investment Cash Flow Period
$130, 000 ÷ $24, 000 = 5.42 years

Shorter payback period = More attractive investment
In case of uneven net annual cash flows, company
determines cash payback period when:
Cumulative net cash flows from investment = Cost of

investment

Illustration: Chen Company proposes an investment in a
new website that is estimated to cost $300,000.

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.
c. 5.00 years.
d. 13.33 years.

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. Answer: 3.08 years.
c. 5.00 years.
d. 13.33 years.

DO IT! 1: Cash Payback Period
Watertown Paper Corporation is considering adding another
machine for the manufacture of corrugated cardboard. The machine
would cost $900,000. It would have an estimated life of 6 years and
no salvage value. The company estimates that annual cash inflows
would increase by $400,000 and that annual cash outflows would
increase by $190,000. Compute the cash payback period.
Estimated annual cash inflows $400,000

Estimated annual cash outflows 190,000
Net annual cash flow $210,000
$900,000
Cash payback period =  4.3 years
$210,000
Net Present Value Method (1 of 3)
Discounted cash flow technique:
• Generally recognized as best approach
• Considers both estimated total cash inflows and time
value of money
• Two methods:
o Net present value (NPV)
o Internal rate of return (IRR)

• Cash inflows are discounted to their present value and
then compared with capital outlay required by
investment
• Interest rate used in discounting is required minimum
rate of return
• Proposal is acceptable when NPV is zero or positive
• Higher positive NPV, more attractive investment

Proposal is acceptable when net present value is zero or
positive.

Equal Annual Cash Flows (1 of 2)
Illustration: Stewart Shipping Company example, the
company’s net annual cash flows are $24,000. If we
assume this amount is uniform over the asset’s useful
life, we can compute the present value of the net annual
cash flows.
Present Value at 12%
Discounted factor for 10 periods 5.65022
Present value of net cash flows:
$24,000 × 5.65022 $135,605

Equal Annual Cash Flows (2 of 2)
Illustration: Calculate the net present value.
12%
Present value of net cash flows $135,605
Less: Capital investment 130,000
Net present value $ 5,605
Proposed capital expenditure is acceptable at a required

rate of return of 12% because the net present value is
positive.

Unequal Annual Cash Flows (1 of 3)
Illustration: Stewart Shipping Company expects the same
total net cash flows of $240,000 over the life of the
investment. Because of a declining market demand for
the new product the net annual cash flows are higher in
the early years and lower in the later years.
The present value of the net annual cash flows is
calculated as follows.

Assumed Net Annual
Year Cash Flows Discount Factor 12% Present Value 12%
(1) (2) (1) × (2)
1 $34,000 0.89286 $30,357
2 30,000 0.79719 23,916
3 27,000 0.71178 19,218
4 25,000 0.63552 15,888
5 24,000 0.56743 13,618
6 22,000 0.50663 11,146
7 21,000 0.45235 9,499
8 20,000 0.40388 8,078
9 19,000 0.36061 6,852
10 18,000 0.32197 5,795
$240,000 $144,367

Illustration: Calculate the net present value.
12%
Present value of net cash flows $144,367
Proposed capital expenditure is acceptable at a required

rate of return of 12% because the net present value is
positive.

Choosing a Discount Rate (1 of 2)
In most instances a company uses a required rate of
return equal to its cost of capital — that is, the rate that it
must pay to obtain funds from creditors and stockholders.
Discount rate has two elements:
• Cost of capital
• Risk
Rate also known as required rate of return, hurdle rate,

and cutoff rate.

Choosing a Discount Rate (2 of 2)
Illustration: Stewart Shipping used a discount rate of 12%. Suppose
this rate does not take into account the risk of the project. A more
appropriate rate might be 15%.

Simplifying Assumptions
• All cash flows come at end of each year
• All cash flows are immediately reinvested in another
project that has a similar return
• All cash flows can be predicted with certainty

Net Present Value (NPV) Method (1 of 2)
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
d. $9,062

Net Present Value (NPV) Method (2 of 2)
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. Answer: $22,511
c. $9,062
d. $9,062

Comprehensive Example (1 of 3)
Best Taste Foods is considering investing in new
equipment to produce fat-free snack foods.
Initial investment $1,000,000
Cost of equipment overhaul in 5 years $200,000
Salvage value of equipment in 10 years $20,000
Cost of capital (discount rate) 15%
Estimated annual cash flows
Cash inflows received from sales $500,000
Cash outflows for cost of goods sold $200,000
Maintenance costs $30,000
Other direct operating costs $40,000
Compute the net annual cash flows for this project.
Cash inflows received from sales $ 500,000

Cash outflows for cost of goods sold (200,000)
Maintenance costs (30,000)
Other direct operating costs (40,000)

Compute the net present value for this proposed
investment.
15%
Time Cash Discount Present
Event Period Flow × Factor = Value
Net annual cash flow 1 to 10 $ 230,000 5.01877 $1,154,317

Salvage value 10 20,000 .24719 4,944
Less: Equipment purchase 0 1,000,000 1.00000 1,000,000
Less: Equipment overhaul 5 200,000 .49718 99,436

DO IT! 2: Net Present Value (1 of 2)
Watertown Paper Corporation is considering adding
another machine for the manufacture of corrugated
cardboard. The machine would cost $900,000. It would
have an estimated life of 6 years and no salvage value.
The company estimates that annual cash inflows would
increase by $400,000 and that annual cash outflows
would increase by $190,000. Management has a required
rate of return of 9%.
Calculate the net present value on this project and
discuss whether it should be accepted.

DO IT! 2: Net Present Value (2 of 2)
Calculate the net present value on this project and discuss whether it
should be accepted.
9%
Discount Present
Cash Flow Factor Value
Present value of net annual cash flows $210,000 4.48592 $942,043
NPV is greater than zero, Waterton should accept the project.

Capital Budgeting Challenges and Refinements
Intangible Benefits
Might include increased quality, improved safety, or
enhanced employee loyalty.
To avoid rejecting projects with intangible benefits:
1. Calculate NPV ignoring intangible benefits
2. Project conservative estimates of value of intangible
benefits, and incorporate these values into NPV
calculation

Intangible Benefits
Example: Berg Company is considering the purchase of a new
mechanical robot.
Annual cash inflows $ 50,000
Annual cash outflows 20,000
Estimated life of equipment 10 years
Discount rate 12%
Cash Flows × 12% Discount Factor = Present Value

Present value of net
annual cash flows $ 30,000 × 5.65022 = $169,507
Initial investment 200,000
Net present value $ (30,493)

Intangible Benefits Example (1 of 2)
Berg estimates that improved sales will increase cash
inflows by $10,000 annually as a result of an increase in
perceived quality. Berg also estimates that annual cost
outflows would be reduced by $5,000 as a result of lower
warranty claims, reduced injury claims, and fewer missed
work days.
Using these conservative estimates of the value of the
additional benefits, should Berg accept the project?

Intangible Benefits Example (2 of 2)
Annual cash inflows (revised) $ 60,000 ($50,000 + $10,000)
Annual cash outflows (revised) 15,000 ($20,000 − $5,000)
Estimated life of equipment 10 years
Discount rate 12%
Cash Flows × 12% Discount Factor = Present Value

Present value of net
annual cash flows $ 45,000 × 5.65022 = $254,260
Initial investment 200,000
Berg would accept the project.

Profitability Index for Mutually Exclusive
Projects (1 of 2)
• Proposals are often mutually exclusive
• Managers choose between various positive-NPV
projects because of limited resources
• Tempting to choose project with higher NPV

Profitability Index for Mutually Exclusive
Projects (2 of 2)
Illustration: Two mutually exclusive projects, each assumed to have
a 10-year life and a 12% discount rate.
Project A Project B
Initial investment $40,000 $90,000
Net annual cash flow 10,000 19,000
Salvage value 5,000 10,000
Present value of net cash flows
($10,000 × 5.65022) + ($5,000 × .32197) 58,112
($19,000 × 5.65022) + ($10,000 × .32197) 110,574

Profitability Index (1 of 3)
Illustration: One method of comparing alternative projects is the
profitability index.
Project A Project B
Present value of net cash flows $58,112 $110,574
Less: Initial investment 40,000 90,000
Net present value $18,112 $ 20,574
Present Value of Net Cash Flows
Profitability Index =
Initial Investment
Project A Project B
$58,112 $110,574
 1.45  1.23
$40,000 $90,000
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 A
b. Project B
c. Project A or B
d. There is not enough data to answer the 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. Answer: Project A
b. Project B
c. Project A or B
d. There is not enough data to answer the question
Risk Analysis
A simplifying assumption made by many financial analysts
is that projected results are known with certainty.
• Projected results are only estimates
• Sensitivity analysis is used to deal with uncertainty
o Uses a number of outcome estimates to get a sense of
variability among potential returns

Post-Audit of Investment Projects
Performing a post-audit is important.
• If managers know their estimates will be compared to
actual results they will be more likely to submit
reasonable and accurate data when making investment
proposals
• Provides a formal mechanism to determine whether
existing projects should be supported or terminated
• Improve future investment proposals

DO IT! 3: Profitability Index (1 of 2)
Taz Corporation has decided to invest in renewable energy
sources to meet part of its energy needs for production. It is
considering solar power versus wind power. After considering
cost savings as well as incremental revenues from selling
excess electricity into the power grid, it has determined the
following.
Solar Wind
Present value of annual cash flows $78,580 $168,450
Initial investment $45,500 $125,300
Determine the net present value and profitability index of

each project. Which energy source should it choose?
DO IT! 3: Profitability Index (2 of 2)
Solar Wind
Present value of annual cash flows $78,580 $168,450
Initial investment 45,500 125,300
Net present value $33,080 $ 43,150
Profitability index 1.73* 1.34**
*$78,580 ÷ $45,500 **$168,450 ÷ $125,300

The investment in wind power generates higher net present value
and requires a substantially higher initial investment. The
profitability index favors solar power, which suggests that the
additional net present value of wind is outweighed by the cost of
the initial investment. The company should choose solar power.
Internal Rate of Return (1 of 4)
• Differs from net present value method in that it finds
interest yield of potential investment
• Internal rate of return (IRR) - interest rate that will
cause present value of proposed capital expenditure to
equal present value of expected net annual cash flows
(NPV equal to zero)
• How does one determine internal rate of return?

Stewart Shipping Company is considering the purchase of a new front-end
loader at a cost of $244,371. Net annual cash flows from this loader are
estimated to be $100,000 a year for three years. To determine the internal
rate of return on this front-end loader, the company finds the discount rate
that results in a net present value of zero.
Discount Discount Discount

Net Annual Factor Present Factor Present Factor Present
Year Cash Flows 10% Value 10% 11% Value 11% 12% Value 12%
1 $100,000 .90909 $ 90,909 .90090 $ 90,090 .89286 $ 89,286
2 $100,000 .82645 82,645 .81162 81,162 .79719 79,719
3 $100,000 .75132 75,132 .73119 73,119 .71178 71,178
248,686 244,371 240,183
Less: Initial
investment 244,371 244,371 244,371
Net present
value $ 4,315 $ 0 $ (4,188)

An easier approach to solving for internal rate of return when net
annual cash flows are equal.


Comparing Discounted Cash Flow Methods
Net Present Value Internal Rate of Return
1. Objective Compute net present Compute internal rate of
value (a dollar amount). return (a percentage)
2. Decision Rule If net present value is If internal rate of return is
zero or positive, accept equal to or greater than
the proposal. the required rate of return,
If net present value is accept the proposal.
negative, reject the If internal rate of return is
proposal. less than the required rate
of return, reject the
proposal.

DO IT! 4: Internal Rate of Return (1 of 3)
The company estimates that annual cash inflows would
increase by $400,000 and that annual cash outflows
would increase by $190,000. Management has a required
rate of return of 9%.
Calculate the internal rate of return on this project and
discuss whether it should be accepted.

Calculate the internal rate of return on this project.
Machine cost $900,000
Net annual cash flow ÷ $210,000
Present value factor 4.28571
Now, find the rate that corresponds to the present value factor.

Find the rate that corresponds to the present value factor of
4.28571 for 6 periods.
Required rate of return is only 9%, project should be accepted.

Annual Rate of Return (1 of 3)
Indicates profitability of a capital expenditure by dividing
expected annual net income by average investment.
Expected Average Annual

Annual Net ÷ = Rate
Income Investment of Return

Illustration: Reno Company is considering an investment of
$130,000 in new equipment. The equipment is expected to last five
years and have zero salvage value at the end of its useful life. Reno
uses straight-line depreciation.
Sales $200,000
Less: Costs and expenses
Manufacturing costs (exclusive of depreciation) $132,000
Depreciation expense ($130,000 ÷ 5) 26,000
Selling and administrative expenses 22,000 180,000
Income before income taxes 20,000
Income tax expense 7,000
Net income $ 13,000

Original Investment  Value at End of Useful Life
 Average Investment
2
$13,000  $0
 $65,000
2
$13,000
Expected annualrateofreturn   20%
$65,000
A project is acceptable if its rate of return is greater than

management’s required rate of return.

DO IT! 5: Annual Rate of Return (1 of 2)
The company estimates that annual revenues would
increase by $400,000 and that annual expenses excluding
depreciation would increase by $190,000. It uses the
straight-line method to compute depreciation expense.
Management has a required rate of return of 9%.
Compute the annual rate of return.

DO IT! 5: Annual Rate of Return (2 of 2)
Compute the annual rate of return.
Revenues $400,000
Less:
Expenses (excluding depreciation) $190,000
Depreciation expense ($900,000 ÷ 6 years) 150,000 340,000
Annual net income $ 60,000
$900,000 + $0 
Average investment = = $450,000.
2
$60,000
Annual rate of return = = $13.3%.
$450,000
Since the annual rate of return (13.3%) is greater than Watertown’s required
rate of return (9%), the proposed project is acceptable.

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Accounting Principles

Planning for Capital Investments

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Cost of Capital Net Annual Cash Payback

$130, 000 ÷ $24, 000 = 5.42 years

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Cumulative net cash flows from investment = Cost of

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Estimated annual cash inflows $400,000

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Proposed capital expenditure is acceptable at a required

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Proposed capital expenditure is acceptable at a required

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Rate also known as required rate of return, hurdle rate,

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Cash inflows received from sales $ 500,000

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Net annual cash flow 1 to 10 $ 230,000 5.01877 $1,154,317

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NPV is greater than zero, Waterton should accept the project.

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Cash Flows × 12% Discount Factor = Present Value

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Cash Flows × 12% Discount Factor = Present Value

Berg would accept the project.

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Determine the net present value and profitability index of

*$78,580 ÷ $45,500 **$168,450 ÷ $125,300

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Discount Discount Discount

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Required rate of return is only 9%, project should be accepted.

Expected Average Annual

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A project is acceptable if its rate of return is greater than