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Copyright © 2003 Pearson Education Canada Inc. Slide 21-1
Chapter 21
Capital Budgeting and Cost Analysis
Copyright © 2003 Pearson Education Canada Inc. Slide 21-2
Capital Budgeting
• Long-term planning for making and financing acquisitions
Six stages of Capital Budgeting
1. identify potential investments
2. explore alternative investments
3. consider costs and consequences of alternatives
4. choose projects for implementation
5. obtain necessary funding
6. put project in motion and monitor performance
Pages 778 - 779
Copyright © 2003 Pearson Education Canada Inc. Slide 21-3
Discounted Cash Flow Methods
• Discounted cash flow (DCF) measures cash inflows and outflows of a project as if they occurred at a single point in time
• Focuses on cash inflows and outflows rather than net income
• Common methods are net present value (NPV) and internal rate of return (IRR)
Net present value (NPV)
• Discount all expected futurecash flows to the present using a minimum desired rate of return
• Accept project if NPV > 0
Internal rate of return (IRR)
• Determine the rate of return which will result in a NPV of zero
• Accept project if IRR > minimum desired rate of return
Pages 780 - 783
Copyright © 2003 Pearson Education Canada Inc. Slide 21-4
Using theAnnuityTables
Net initial investment ($379,100)
Recurring cash flows ($100,000 x 3.993) 399,300
Net present value $20,200
Net Present Value
Cash flows:annual savings .926 $92,600 $100,000
.857 85,700 $100,000
.794 79,400 $100,000
.735 73,500 $100,000
.681 68,100 $100,000Present valueof future inflows $399,300
Initial outlay 1.000 (379,100) (379,100)
Net present value $20,200
Present Total End of Year Cash FlowsValue of Present$1 @ 8% Value 0 1 2 3 4 5
Page 781
Copyright © 2003 Pearson Education Canada Inc. Slide 21-5
Internal Rate of Return
Cash flows:annual savings .909 $90,900 $100,000
.826 82,600 $100,000
.751 75,100 $100,000
.683 68,300 $100,000
.621 62,100 $100,000Present valueof future inflows $379,100
Initial outlay 1.000 (379,100) (379,100)
Net present value $ 0
Present Total End of Year Cash FlowsValue of Present$1 @ 10% Value 0 1 2 3 4 5
Using theAnnuityTables
Net initial investment ($379,100)
Recurring cash flows ($100,000 x 3.791) 379,100
Net present value $ 0
Page 783
Copyright © 2003 Pearson Education Canada Inc. Slide 21-6
Comparing NPV and IRR Models
• NPV calculates an amount in dollars rather than a percentage• avoids problems inherent in comparing %s• various NPVs can be added together
• NPV can also incorporate different required rates of return over the life of a project • such as 8% for years 1-3 and 12% for years 4-5
Sensitivity Analysis• in all cases, sensitivity analysis is useful to compare
how the evaluation of the projects will change if the projected cash flows, timing of the cash flows, or required rates of return change
Pages 783 - 785
Copyright © 2003 Pearson Education Canada Inc. Slide 21-7
Relevant Cash Flows in DCF Analysis
1. Initial investment in capital assets and working capital
2. Current disposal price of existing capital assets
3. Recurring operating cash flows
4. Terminal disposal price of investment in capital assets and recovery of working capital
Initial investment in machinery & working capital
Current disposalvalues
Terminal disposal
values andrecovery of
working capital
Recurring Operating Cash Flows
Pages 785 - 787
Copyright © 2003 Pearson Education Canada Inc. Slide 21-8
Payback Method
• Length of time required to recoup, in the form of cash flows from operations, the initial outlay
Payback = Net initial investment time Uniform increase in annual cash flows
• Construct a table of cumulative cash inflows if the annual cash flows are nonuniform
• Problems with payback method• fails to consider the "profitability" of the project• ignores the time value of money • ignores cash flows after the payback period
Pages 787 - 789
Copyright © 2003 Pearson Education Canada Inc. Slide 21-9
Accounting Rate-of-Return Model
• Annual rate of return including depreciation expenses
• Also known as accrual accounting rate-of-return model or the unadjusted rate-of-return model
Increase in expectedAccounting = average annual operating income
rate of return Net initial investment
• Can also use average book value of fixed assets as the denominator
• Major drawback is that it ignores the time value of money
Pages 789 - 791
Copyright © 2003 Pearson Education Canada Inc. Slide 21-10
Complexities in Capital Budgeting
• Predicting the full set of benefits and costs is a challenge and often difficult to quantify• benefit of faster response time to market changes• benefit of increased worker knowledge of
automation
• Also, difficult to recognize the full time horizon of the project• when benefits will occur over a long period of time• when major benefits occur far in the future
• Use of accounting rate of return model may lead manager to reject profitable projects
Pages 791 - 793
Copyright © 2003 Pearson Education Canada Inc. Slide 21-11
Post-Investment Audits
• A post-investment audit compares the predictions of investment costs and outcomes made at the time a project was selected to the actual results achieved
• Point to areas requiring corrective action• underestimation of time to implement a new project• underestimation of capital investment requirements• overestimation of savings from new investment
• Conduct the post-investment audit after the project outcomes have stabilized
Capital BudgetingPromises
Actual ResultsAchieved
Pages 793 - 794
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