powerpoint chapter 21
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21 - 1©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Capital Budgetingand Cost Analysis
Chapter 21
21 - 2©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 1
Recognize the multiyear focusof capital budgeting.
21 - 3©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Two Dimensions of Cost Analysis
1. A project dimension
2. An accounting-period dimension
The accounting system that corresponds to theproject dimension is termed life-cycle costing.
21 - 4©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
2002 2003 2004 2005 2006
Project A
Project B
Project C
Project D
Two Dimensions of Cost Analysis
21 - 5©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 2
Understand the six stages ofcapital budgeting for a project.
21 - 6©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Capital Budgeting
Capital budgeting is the making of long-runplanning decisions for investments in
projects and programs.It is a decision-making and control tool thatfocuses primarily on projects or programs
that span multiple years.
21 - 7©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Capital Budgeting
Capital budgeting is a six-stage process:1. Identification stage 2. Search stage
3. Information-acquisition stage4. Selection stage 5. Financing stage
6. Implementation and control stage
21 - 8©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Capital Budgeting Example
One of the goals of Assisted Living is to improvethe diagnostic capabilities of its facility.
Management identifies a need to consider thepurchase of new equipment.
The search stage yields several alternativemodels, but management focuses on
one particular machine.
21 - 9©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Capital Budgeting Example
The administration acquires information.Initial investment is $245,000.
Investment in working capital is $5,000.Useful life is three years.
Estimated residual value is zero.Net cash savings is $125,000,
$130,000, and $110,000 over its life.
21 - 10©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Capital Budgeting Example
Working capital is expected to be recovered atthe end of year 3 with an expected return of 10%.
In the selection stage, management must decidewhether to purchase the new machine.
Operating cash flows are assumed to occurat the end of the year.
21 - 11©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 3
Use and evaluate the two maindiscounted cash-flow (DCF)
methods: the net present value(NPV) method and the internalrate-of-return (IRR) method.
21 - 12©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Time Value of Money
Compound Growth,5 periods at 6%
Year 0: $1.00Year 1: $1.06
Year 2: $1.124Year 3: $1.91
Year 4: $1.262Year 5: $1.338
21 - 13©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Discounted Cash Flow
There are two main DCF methods:
Net present value (NPV) method
Internal rate-of-return (IRR) method
21 - 14©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Net Present Value Example
Only projects with a zero or positivenet present value are acceptable.
What is the the net present value ofthe diagnostic machine?
21 - 15©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Net Present Value Example
Year in the Life of the Project
$(250,000) $125,000 $130,000 $115,000
0 1 2 3
Net initialinvestment
Annual cashinflows
21 - 16©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Net Present Value Example
Net Cash NPV of Net Year 10% Col. Inflows Cash Inflows
1 0.909 $125,000 $113,6252 0.826 130,000 107,3803 0.751 115,000 86,365
Total PV of net cash inflows $307,370Net initial investment 250,000Net present value of project $ 57,370
21 - 17©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Net Present Value Example
The company is considering another investment.Initial investment is $245,000.
Investment in working capital is $5,000.Working capital will be recovered.
Useful life is three years.Estimated residual value is $4,000.
Net cash savings is $80,000 per year.Expected return is 10%.
21 - 18©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Net Present Value Example
Net Cash NPV of NetYears 10% Col. Inflows Cash Inflows1-3 2.487 $80,000 $198,960 3 0.751 9,000 6,759Total PV of net cash inflows $205,719Net initial investment 250,000Net present value of project ($ 44,281)
21 - 19©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Internal Rate of Return
Investment= Expected annual net cash inflow
× PV annuity factor
Investment÷ Expected annual net cash inflow
= PV annuity factor
21 - 20©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Internal Rate of Return Example
Initial investment is $303,280.Useful life is five years.
Net cash inflows is $80,000 per year.What is the IRR of this project?
$303,280 ÷ $80,000 = 3.791 (PV annuity factor)10% (from the table, five-period line)
21 - 21©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Comparison of NPV and IRR
The NPV method has the advantage that the endresult of the computations is expressed in
dollars and not in a percentage.Individual projects can be added.
It can be used in situations where the requiredrate of return varies over the life of the project.
21 - 22©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Comparison of NPV and IRR
The IRR of individual projects cannot beadded or averaged to derive the IRR
of a combination of projects.
21 - 23©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 4
Use and evaluate thepayback method.
21 - 24©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Payback Method
Payback measures the time it will take torecoup, in the form of expected future cash
flows, the initial investment in a project.
21 - 25©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Payback Method Example
Assisted Living is considering buying Machine 1.Initial investment is $210,000.
Useful life is eleven years.Estimated residual value is zero.
Net cash inflows is $35,000 per year.
21 - 26©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Payback Method Example
How long would it take to recover the investment?$210,000 ÷ $35,000 = 6 years
Six years is the payback period.
21 - 27©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Payback Method Example
Suppose that as an alternative to the $210,000piece of equipment, there is another one
(Machine 2) that also costs $210,000 but willsave $42,000 per year during its five-year life.
What is the payback period?$210,000 ÷ $42,000 = 5 years
Which piece of equipment is preferable?
21 - 28©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Payback Method Example
Assisted Living is considering buying Machine 3.Initial investment is $250,000.
Useful life is eleven years.Cash savings are $160,000, $180,000,
and $110,000 over its life.What is the payback period?
21 - 29©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Payback Method Example
Year 1 brings in $160,000.Recovery of the amount
invested occurs in Year 2.
21 - 30©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Payback Method Example
Payback = 1 year$ 90,000 needed to complete recovery
180,000 net cash inflow in Year 21 year + 0.5 year
1.5 years or 1 year and 6 months
+÷==
21 - 31©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 5
Use and evaluate the accrualaccounting rate-of-return
(AARR) method.
21 - 32©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Accrual AccountingRate-of-Return Method
The accrual accounting rate-of-return (AARR)method divides an accounting measure of
income by an accounting measure of investment.
AARR =Increase in expected
average annualoperating income
÷Initial
requiredinvestment
21 - 33©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Accrual AccountingRate-of-Return Method Example
Initial investment is $303,280.Useful life is five years.
Net cash inflows is $80,000 per year.IRR is 10%.
What is the average operating income?
21 - 34©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Accrual AccountingRate-of-Return Method Example
Straight-line depreciation is $60,656 per year.Average operating income is
$80,000 – $60,656 = $19,344.What is the AARR?
AARR= ($80,000 – $60,656) ÷ $303,280
= .638, or 6.4%
21 - 35©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 6
Identify and reduce conflictsfrom using DCF for capital
budgeting decisions andaccrual accounting for
performance evaluation.
21 - 36©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Performance Evaluation
A manager who uses DCF methods to make capitalbudgeting decisions can face goal congruence
problems if AARR is used forperformance evaluation.
Suppose top management uses the AARR tojudge performance if the minimum desired
rate of return is 10%.A machine with an AARR of 6.4% will be rejected.
21 - 37©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Performance Evaluation
The conflict between using AARR andDCF methods to evaluate performancecan be reduced by evaluating managers
on a project-by-project basis.
21 - 38©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 7
Identify relevant cashinflows and outflows for
capital budgeting decisions.
21 - 39©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash Flows
Relevant cash flows are expected future cashflows that differ among the alternatives.
21 - 40©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash Flows
Net initial investment components– cash outflow to purchase investment
– working-capital cash outflow – cash inflow from disposal of old asset
21 - 41©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash FlowAnalysis Example
Old equipment:Current book value $50,000Current disposal price $ 3,000Terminal disposal price (5 years) 0Annual depreciation $10,000Working capital $ 5,000Income tax rate 40%
G. T. is considering replacing old equipment.
21 - 42©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash FlowAnalysis Example
Current disposal price of old equipment $ 3,000Deduct current book value of old equipment 50,000Loss on disposal of equipment $47,000
How much are the tax savings?$47,000 × 0.40 = $18,800
21 - 43©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash FlowAnalysis Example
What is the after-tax cash flow fromcurrent disposal of old equipment?Current disposal price $ 3,000Tax savings on loss 18,800Total $21,800
21 - 44©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash FlowAnalysis Example
New equipment:Current book value $225,000Current disposal price is irrelevantTerminal disposal price (5 years) 0Annual depreciation $ 45,000Working capital $ 15,000
21 - 45©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash FlowAnalysis Example
How much is the net investmentfor the new equipment?
Current cost $225,000Add increase in working capital 10,000Deduct after-tax cash flow from current disposal of old equipment – 21,800Net investment $213,200
21 - 46©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash FlowAnalysis Example
Assume $90,000 pretax annual cash flow fromoperations (excluding depreciation effect).What is the after-tax flow from operations?
Cash flow from operations $90,000Deduct income tax (40%) 36,000Annual after-tax flow from operations $54,000
21 - 47©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash FlowAnalysis Example
What is the difference in depreciation deduction?Annual depreciation of new equipment $45,000Deduct annual depreciation of old equipment 10,000Difference $35,000
21 - 48©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash FlowAnalysis Example
What is the annual increase in income taxsavings from depreciation?
Increase in depreciation $35,000Multiply by tax rate .40Income tax cash savings from additional depreciation $14,000
21 - 49©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash FlowAnalysis Example
What is the cash flow from operations,net of income taxes?
Annual after-tax flow from operations $54,000Income tax cash savings from additional depreciation 14,000Cash flow from operations, net of income taxes $68,000
21 - 50©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash FlowAnalysis Example
G. T. requires a 14% rate of returnon its investments.
What is the net present value of the newequipment incorporating income taxes?
21 - 51©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Relevant Cash FlowAnalysis Example
Net Cash NPV of NetYears 14% Col. Inflows Cash Inflows1-5 3.433 $68,000 $233,444 5 0.519 10,000 5,190Total PV of net cash inflows $238,636Investment 213,200Net present value of new equipment $ 25,436
21 - 52©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Postinvestment Audit
A postinvestment audit compares the actualresults for a project to the costs and benefitsexpected at the time the project was selected.
It provides management with feedbackabout performance.
21 - 53©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Strategic Considerations
Capital investment decisionsthat are strategic in nature
require managers to considera broad range of factors thatmay be difficult to estimate.