Managerial Accounting

by James Jiambalvo
Chapter 9:
Capital Budgeting
Decisions

Slides Prepared by:

Scott Peterson
Northern State
University
 Objectives
1. Define capital expenditure decisions and
capital budgets.
2. Evaluate investment opportunities using
the net present value approach.
3. Evaluate investment opportunities using
the internal rate of return approach.
4. Calculate the depreciation tax shield, and
explain why depreciation is important in
investment analysis only because of
income taxes.
Objectives (continued)

5. Use the payback period and the

accounting rate of return methods to
evaluate investment opportunities.
6. Explain why managers may
concentrate erroneously on the short-
run profitability of investments rather
than their net present values.
Capital Budgeting Decisions
1. Capital Budgeting Decisions include
the acquisition of long-lived assets.
2. Require that capital (company funds)
be expended to acquire additional
resources.
3. Also known as Capital Expenditure
Decisions.
Capital Budgeting Decisions:
Examples
1. New retail store outlets.
2. Robotic manufacturing equipment.
3. Digital imaging systems for healthcare
facilities.
4. New chairlift for a ski resort.
5. New fleets:
 Ships
 Planes
 Cars
6. New equipment for food preparation.
Evaluating Investment
Opportunities: Time Value of
Money Approaches
1. The Time Value of Money says: a
dollar today is worth more than a dollar
tomorrow.
2. It is necessary to convert future dollars
into their equivalent present value
dollars.
3. Two methods:
a. Net Present Value.
b. Internal Rate of Return.
Basic Time Value of Money
Calculations
1. To convert future value to present
value:

P = F
(1 + i)n
Where:
P = present value
F = future value
i = (interest) rate of return
n = number of units of time
Basic Time Value of Money
Calculations: Example
Calculate the present value of $1.00 to be
paid (or collected) 5-years from now
assuming an interest rate of 8%. Set it up
as follows:

P = 1.00
(1 + .08)5
Basic Time Value of Money
Calculations: Example Solution
P = 1.00
(1 + .08)5

P = 1.00
1.46933…

Thus: $0.68
The Net Present Value Method
1. Based on the time-value of money.
2. Recall that only incremental cash flows
are relevant.
3. Three-step process.
The Net Present Value Method:
Step 1
 Identify the amount and time period
of each cash flow associated with a
potential investment.
 Note: Investment projects have both
cash inflows and cash outflows.
The Net Present Value Method:
Step 2
 Discount the cash flows to their
present values using a required rate
of return (a.k.a. hurdle rate).
 Note: This is the minimum return that
management will accept.
The Net Present Value Method:
Step 3
 Evaluate the net present value--the
sum of all of the cash inflows less
cash outflows.
 Note: if the net present value (NPV) is
greater than or equal to zero, the
investment should be made. If less than
zero, it should not be made.
The Net Present Value Method:
Example, Step 1
 Identify the amount and time period
of each cash flow associated with a
potential investment.
1. Initial cash outlay: $70,000
2. Year 1 – 4 net cash savings: $21,000
per year.
3. Year 5 net cash savings: $26,000.
4. Required rate of return: 12%.
The Net Present Value Method:
Example Step 2
 Discount the cash flows to their
present values using a required rate
of return (a.k.a. hurdle rate).
 Initial outlay: $70,000 x 1.00
 Year 1: $21,000 x .8929
 Year 2: $21,000 x .7972
 Year 3: $21,000 x .7118
 Year 4: $21,000 x .6355
 Year 5: $26,000 x ..5674
The Net Present Value Method:
Example Step 3
 Evaluate the net present value--the
sum of all of the cash inflows less
cash outflows.
 Year 0: ($70,000)
 Year 1: $18,751
 Year 2: $16,741
 Year 3: $14,948
 Year 4: $13,346
 Year 5: $14,752
 NPV: $ 8,538
The Net Present Value Method:
Example
 Do it! $8,538 > $0
The Net Present Value Method:
Summary
The Internal Rate of Return
Method
1. Internal Rate of Return (IRR) is an
alternative to the Net Present Value
(NPV) method.
2. IRR uses the time value of money.
3. IRR is the rate of return that equates the
present value of future cash flows to the
investment outlay.
The Internal Rate of Return
Method
1. Internal Rate of Return (IRR) is an
alternative to the Net Present Value
(NPV) method.
2. IRR uses the time value of money.
3. IRR is the rate of return that equates the
present value of future cash flows to the
investment outlay.
4. IRR analysis yields a yes or no, < or >
result.
The Internal Rate of Return
Method: Setup
Present value factor = Initial Outlay
Annuity Amount
The Internal Rate of Return
Method: Example
Investment: $100
Expected 2-year return: $60 per year

Present value factor = 100

60
The Internal Rate of Return
Method: Example
1. Present value factor = 1.667
2. Approximately equal to the PV factor of
1.6681 or 13%.
The Internal Rate of Return
Method: Summary
The Internal Rate of Return
With Unequal Cash Flows
1. For cases with unequal yearly cash
flows.
2. Thus one cannot use a single present
value factor.
3. Must estimate the IRR.
Summary of Net Present Value
and Internal Rate of Return
Methods
1. Both the Net Present Value method and
the Internal Rate of Return method take
into account the time value of money.
2. They differ in their approach to
evaluating investment alternatives.
Considering “Soft” Benefits In
Investment Decisions
1. “Soft” Benefits not directly related to
NPV or IRR.
2. Hard to quantify.
3. Includes indirect benefits to:
a. Future sales.
b. Firm reputation.
c. Derivative products.
Calculating the Value of Soft
Benefits Required To Make an
Investment Acceptable
Needed present value = Discount factor x
Value of benefits

Value of Benefits: Needed Present Value

Discount Factor
Estimating the Required Rate
of Return

1. In the textbook examples, required rate of

return was “invented.”
2. In practice, required rate of return must be
estimated by management.
3. Under certain conditions, the required rate
of return should be equal to the cost of
capital for the firm.
Additional Cash Flow
Considerations

1. Both the NPV and IRR require proper

specification of cash flows.
2. Only cash inflows and cash outflows are
discounted back to the present, not
revenues and expenses.
Cash Flows, Taxes, and The
Depreciation Tax Shield

1. Previously the effect of income taxes on

cash flows was ignored.
2. Tax considerations play a major role in
capital budgeting decisions.
3. Though depreciation does not directly affect
cash flows, it indirectly affects cash flows.
4. Depreciation reduces the amount of tax
(which is paid in cash) a company must pay.
5. Thus it is called a Depreciation Tax Shield.
Depreciation Tax Shield at
Amazon.com

1. Amazon.com has yet to generate a profit.

2. When companies have net losses, they can
carry the losses forward and offset future
income for federal tax purposes.
3. This reduces cash outflows paid for taxes in
future years.
Adjusting Cash Flows For
Inflation

1. Inflation should not be ignored in net

present value analysis.
2. Many worthwhile investment opportunities
may be rejected.
3. The reason:current rates of return for debt
and equity financing already include
estimates of future inflation.
Simplified Approaches To
Capital Budgeting

1. Payback Period Method.

2. Accounting Rate of Return.
Payback Period Method

1. The length of time it takes to recover the

initial cost of an investment.
2. Example: an investment costs $1,000 and
returns $500 per year, it has a payback
period of 2-years.
3. Two serious limitations:
a. Does not consider cash inflows in years
beyond the payback year.
b. Does not consider the time value of
money.
Accounting Rate of Return

1. Accounting Rate of Return (ARR) is the

average after-tax income from a project
divided by the average investment in the
project.
2. Example: ARR = Average Net Income
Average Investment
3. Ignores the time value of money.
Conflict Between Performance
Evaluation and Capital
Budgeting
1. Managers should use Net Present Value
and Internal Rate of Return analyses to
maximize shareholder wealth.
2. Manager’s performance (and bonus) is
often measured in the short-term on
accounting income.
3. Inherent conflict between what is good for
the firm and what is good for the manager.
Wilson Air Example Revisited:
An Example of “Conflict”
1. Typical example of short-run performance
evaluation vs. long-run wealth maximization
for firm.
2. Accounting income (short-run) as a basis
for manager performance evaluation may
cause managers to NOT undertake new
investments.
3. Manager performance measurement and
shareholder wealth maximization should be
congruous.
Quick Review Question #1

1. If the net present value (NPV) of a

project is zero, the project is earning a
return equal to:
a. Zero.
b. The rate of inflation.
c. The accounting rate of return.
d. The required rate of return.
Quick Review Answer #1

1. If the present value of a project is zero,

the project is earning a return equal to:
a. Zero.
b. The rate of inflation.
c. The accounting rate of return.
d. The required rate of return.
Quick Review Question #2

2. A project costs $200,000 and yields

cash inflows of $50,000 per year for 5-
yrars. In this case, the payback period
is:
a. Four years.
b. Five years.
c. $50,000.
d. None of these.
Quick Review Answer #2

2. A project costs $200,000 and yields

cash inflows of $50,000 per year for 5-
yrars. In this case, the payback period
is:
a. Four years.
b. Five years.
c. $50,000.
d. None of these.
Quick Review Question #3

3. The present value of $2,000 to be

collected in three years using a rate of
11% is:
a. $1,462
b. $2,735
c. $1,333
d. $1,278
Quick Review Answer #3

3. The present value of $2,000 to be

collected in three years using a rate of
11% is:
a. $1,462
b. $2,735
c. $1,333
d. $1,278
Quick Review Question #4

4. New equipment costing $5,000 is

expected to yield net cash inflows of
$1,350 each year for the next five
years. Assuming a required rate of
return of 14%, should the equipment
be purchased (use IRR)?
a. Yes (accept).
b. No (reject).
Quick Review Answer #4

4. New equipment costing $5,000 is

expected to yield net cash inflows of
$1,350 each year for the next five
years. Assuming a required rate of
return of 14%, should the equipment
be purchased (use IRR)?
a. Yes (accept).
b. No (reject).
Note: $1,350 * 3.4331 = $4,635
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