P A RT S I X

Capital budgeting for projects such as the Confed-

eration Bridge linking Prince Edward Island to New

Brunswick reflects a company’s long-term strategic

plans. Construction took almost four years at a cost

of $1 billion. Throughout construction over 5,000

people were employed, but at its peak almost 2,100

construction and 415 staff workers were employed.

The project was a joint venture of Stantec

and Jean Muller International (a member of Groupe

Egis). Stantec, founded in 1954, is a world-class

Canadian engineering company that provides

professional design and consulting services in

planning, engineering, architecture, interior design,

landscape architecture, surveying, and project

management. Multi-year projects of this type

require careful planning and control.

21CapitalBudgeting andCost Analysis

C h a p t e r

Organizations are often required to make decisions whoseconsequences are felt over many future years. Such

decisions frequently involve large investments of money andhave uncertain actual outcomes that have long-lasting effectson the organization. For example, Placer Dome must decideif it will spend $800 million to develop a new gold-miningproperty. Air Canada must decide whether it should investbillions of dollars in new Boeing 777 and 787 airplanesto renew its fleet. The investments and the financial out-comes from those investments (realized over a number ofyears) are collectively referred to as investment projects orinvestment programs. Poor long-term investment decisionscan affect the future stability of an organization, because it israre that organizations recover money tied up in badinvestments. Managers need a long-range planning tool orprocess to analyze and control investments with long-termconsequences.

Capital budgeting is the process of making thoselong-term planning decisions for investments. Income

L e a r n i n g O b j e c t i v e s

After studying this chapter, you should be able to1. Differentiate between project-by-project orientation

of capital budgeting and period-by-period orienta-tion of accrual accounting

2. Explain the time value of money and opportunity costs3. Identify the six stages of capital budgeting for a

project and its predicted outcomes4. Use and evaluate the two main discounted cash

flow (DCF) methods, the net present value (NPV)method, and the internal rate-of-return (IRR) method

5. Use and evaluate how the two main discountedcash flow methods (NPV and IRR) differ

6. Identify relevant cash inflows and outflows forcapital budgeting decisions that use DCF methods

7. Use and evaluate the payback method8. Use and evaluate the accrual accounting

rate-of-return (AARR) method9. Identify investment projects affecting different func-

tions in the value chain and reduce conflict betweenproject approval and performance evaluation measures.

determination and the planning and control of routine operations focus prima-rily on the current time period. Capital budgeting is a decision-making and con-trol tool that focuses primarily on projects or programs whose effects spanmultiple time periods.

813CAPITAL BUDGETING ANDCOST ANALYSIS

Investment projects (investmentprograms). Investments and financialoutcomes from those investments(realized over a number of years).

Capital budgeting. The process ofmaking long-term planning decisionsfor investments.

Two Focuses Of Cost AnalysisRecall a central theme of this book: different costs for different purposes. Capitalbudgeting decisions focus on the project, which spans multiple time periods. Thereis a great danger in basing capital budgeting decisions on the current accountingperiod’s income statement, ignoring the future implications of investing in a project.Investment in a project might depress the current period’s reported income, but itmay still be a worthwhile investment because of the high future cash inflows that it isexpected to generate.

Exhibit 21-1 illustrates two different dimensions of cost analysis: (1) the projectdimension and (2) the time dimension. Each project is represented in Exhibit 21-1 as adistinct horizontal rectangle. The life of each project is longer than one accountingperiod. Capital budgeting focusses on the entire life of the project in order to considerall cash inflows or cash savings from the investment. The white area in Exhibit 21-1illustrates the accounting-period focus on income determination and routine planningand control. This cross-section emphasizes the company’s performance for the 2010accounting period. Accounting income is of particular interest to the manager becausebonuses are frequently based on reported income. Income reported in an accountingperiod is also important to a company because of its impact on the company’s shareprice. Excessive focus on short-run accounting income, however, can cause a companyto forgo long-term profitability. Successful managers balance short-term accounting-period considerations and longer-term project considerations in their decision process.

The accounting system that corresponds to the project dimension in Exhibit 21-1is termed life cycle costing. This system, described in Chapter 12, accumulates revenuesand costs on a project-by-project basis. For example, a life cycle costing statement for anew car project at the Ford Motor Company could encompass a four-year period andwould accumulate costs for all business functions in the value chain, from R&D tocustomer service. This accumulation expands the accrual accounting system, whichmeasures income on a period-by-period basis, to a system that computes income overthe entire project covering many accounting periods.

Any system that focuses on the life span of a project must cover several yearsand thus must consider the time value of money. The time value of money takes into

O B J E C T I V E 1

Differentiate between project-by-project orientation of capital budgeting and period-by-period orientation ofaccrual accounting

Project P

Project O

Project N

Project M

Project L

2007 2008 2009 2010

Accounting Period

2011 2012

EXHIBIT 21-1The Project and Time Dimensions of Capital Budgeting

O B J E C T I V E 2

Explain the time value ofmoney and opportunitycosts

account the fact that a dollar (or any other monetary unit) received today is worthmore than a dollar received tomorrow. The reason is that $1 received today can beinvested to start earning a return of 10% per year (say) so that it grows to $1.10 atthe end of the year. The time value of money is the opportunity cost (the return of$0.10 forgone) from not having the money today.

Capital budgeting focuses on projects that can be accounted for using life cyclecosting and that must be evaluated taking into consideration the time value of money.

814 CHAPTER 21

When the interest forgone isimmaterial, as is the case for

short-term projects, the time value ofmoney is ignored.

Stages Of Capital BudgetingWe describe six stages in capital budgeting.

◆ Stage 1—Identification stage. Distinguish which types of capital expenditureprojects are necessary to accomplish organization objectives and strategies. Capitalexpenditure initiatives are closely tied to the strategies of an organization or anorganizational subunit. For example, an organization’s strategy could be eitherto increase revenues by targeting new products, customers, markets, or toreduce costs by improving design, productivity, and efficiency. Identifying whichtypes of capital investment projects to invest in is largely the responsibility ofline management.

◆ Stage 2—Search stage. Explore several alternative capital expenditure investmentsthat will achieve organization objectives and strategies. Employee teams from allparts of the value chain evaluate alternative technologies, machines, and projectspecifications. Some alternatives are rejected early. Others are evaluated morethoroughly in the information-acquisition stage.

◆ Stage 3—Information-acquisition stage. Analyze the predicted costs and predictedconsequences of alternative capital investments. These consequences can be quantita-tive and qualitative. Capital budgeting emphasizes financial quantitative factors,but nonfinancial quantitative and qualitative factors are also very important.Management accountants help identify these factors.

◆ Stage 4—Selection stage. Choose projects for implementation. Organizations choosethose projects whose predicted outcomes (benefits) exceed predicted costs by thegreatest amount. The formal analysis includes only predicted outcomes quantifiedin financial terms. Managers reevaluate the conclusions reached using formalanalysis, by applying managerial judgment to take into account nonfinancial andqualitative considerations. Evaluating costs and benefits is often the responsibilityof the management accountant.

◆ Stage 5—Financing stage. Obtain project funding. Sources of financinginclude internally (within the organization) generated cash flow from opera-tions and externally generated cash flow from capital markets (equity and debtinstruments). Financing is often the responsibility of the treasury function ofan organization.

◆ Stage 6—Implementation and control stage. Initiate selected projects and moni-tor performance. As the project is implemented, the company must evaluatewhether capital investments are being made as scheduled and within the budget.As the project generates cash inflows, monitoring and control may include apostinvestment audit, in which the predictions made at the time the project wasselected are compared with the actual results.

This chapter emphasizes the information-acquisition, selection, and imple-mentation and control stages of capital budgeting because these are the stages inwhich the management accountant is most involved. Beyond the numbers, however,the ability of individual managers to “sell” their own projects to senior managementis often pivotal in the acceptance or rejection of projects.

We use information from Lifetime Care Hospital to illustrate capital budgeting.Lifetime Care is a not-for-profit organization that is not subject to taxes. Chapter 22introduces tax considerations in capital budgeting.

One of Lifetime Care’s goals is to improve the productivity of its X-rayDepartment. To achieve this goal, the manager of Lifetime Care identifies a need to

O B J E C T I V E 3

Identify the six stages ofcapital budgeting for aproject and its predictedoutcomes

purchase a new state-of-the-art X-ray machine to replace an existing machine. Thesearch stage yields several alternative models, but the hospital’s technical staff focuseson one machine, XCAM8, as being particularly suitable. They next begin to acquireinformation for a more detailed evaluation. Quantitative financial information for theformal analysis follows:

Revenue will remain unchanged regardless of whether the new X-ray machineis acquired or not. Lifetime Care charges a fixed rate for a particular diagnosis,regardless of the number of X-rays taken. The only relevant financial benefit inevaluating Lifetime’s decision to purchase the X-ray machine is the cash savings inoperating costs. The existing X-ray machine can operate for another five years andwill have a disposal price of zero at the end of five years. The initial investment willbe $379,100, which is calculated as follows:

Cost of new machine $372,890Investment in working capital (supplies and spare parts

for the new machine) $ 10,000Cash flow from disposal of the old machine (after tax) $ (3,790)Net initial investment for the new machine $379,100

The manager expects the new machine to have a five-year useful life and adisposal price of zero at the end of five years. The new machine is faster and easier tooperate and has the ability to X-ray a larger area and will reduce the average number ofX-rays taken per patient. This will decrease labour, power, and utilities costs. Themanager expects the investment to result in annual cash inflows of $100,000. Thesecash flows will generally occur throughout the year; however, to simplify computa-tions, we assume that operating cash flows occur at the end of each year. The cashinflows are expected to come from cash savings in operating costs of $100,000 for eachof the first four years and $90,000 in year five plus recovery of working capital invest-ment of $10,000 in year five.

Managers at Lifetime Care also identify the following nonfinancial quantitativeand qualitative benefits of investing in the new X-ray equipment:

1. Quality: Higher-quality X-rays will lead to improved diagnoses and betterpatient treatment.

2. Safety: The greater efficiency of the new machine would mean that X-raytechnicians and patients are exposed to fewer of the possibly harmful effects ofX-ray radiation.

These nonfinancial benefits are not considered in the formal financial analysis.In the selection stage, managers must decide whether Lifetime Care should

purchase the new X-ray machine. They start with financial information. Thischapter discusses the following methods that they can use:

◆ Discounted cash flow methods: net present value (NPV) and internal rate-of-return (IRR)

◆ Payback method◆ Accrual accounting rate-of-return method

Most investment projects orprograms require an increase in

working capital—a cash outlay (usuallyat the beginning of the project) that willbe recovered at the end of the project.

O B J E C T I V E 4

Use and evaluate the twomain discounted cash flow(DCF) methods, the netpresent value (NPV)method, and the internalrate-of-return (IRR) method

Discounted Cash Flow MethodsDiscounted cash flow (DCF) measures the cash inflows and outflows of a projectas if they occurred at a single point in time so that they can be compared in anappropriate way. The discounted cash flow methods recognize that the use of moneyhas an opportunity cost—return forgone. Because the DCF methods explicitly androutinely weight cash flows by the time value of money, they are usually the best(most comprehensive) methods to use for long-run decisions.

DCF focuses on cash inflows and outflows rather than on operating income asused in conventional accrual accounting. Cash is invested now with the expectationof receiving a greater amount of cash in the future. Try to avoid injecting accrual

concepts of accounting into DCF analysis. For example, amortization is deducted asan accrual expense when calculating operating income under accrual accounting. Itis not deducted in DCF analysis because such expense entails no cash outflow.

The compound interest tables and formulas used in DCF analysis are includedin Appendix A. (Appendix A will be used frequently in Chapters 21 and 22.)

There are two main DCF methods:

1. Net present value (NPV)

2. Internal rate of return (IRR)

NPV is calculated using the required rate of return (RRR), which is theminimum acceptable rate of return on an investment. It is the return that theorganization could expect to receive elsewhere for an investment of comparable risk.This rate is also called the discount rate, hurdle rate, or (opportunity) cost ofcapital. When working with IRR, the RRR is used as a point of comparison.Chapter 22 discusses issues encountered in estimating this rate.

Assume that the required rate of return, or discount rate, for the Lifetime CareX-ray machine project is 8%.

Net Present Value MethodThe net present value (NPV) method calculates the expected net monetary gain orloss from a project by discounting all expected future cash inflows and outflows to thepresent point in time, using the required rate of return. Only projects with a positivenet present value are acceptable. Why? Because the return from these projectsexceeds the cost of capital (the return available by investing the capital elsewhere).Managers prefer projects with higher NPVs to projects with lower NPVs, if all otherthings are equal. Using the NPV method entails the following steps:

◆ Step 1: Sketch the relevant cash inflows and outflows. The right side of Exhibit 21-2shows how these cash flows are portrayed. Outflows appear in parentheses. Thesketch helps the decision maker organize the data in a systematic way. Notethat Exhibit 21-2 includes the outflow for the new machine at year 0, the time ofthe acquisition. The NPV method focuses only on cash flows. NPV analysis isindifferent to where the cash flows come from (operations, purchase or sale ofequipment, or investment or recovery of working capital) and to the accrualaccounting treatments of individual cash flow items (for example, amortizationcosts on equipment purchases).

◆ Step 2: Choose the correct compound interest table from Appendix A. In ourexample, we can discount each year’s cash flow separately using Table 2(Appendix A), or we can compute the present value of an annuity using Table 4(Appendix A). If we use Table 2, we find the discount factors for periods 1–5under the 8% column. Approach 1 in Exhibit 21-2 presents the five discountfactors. Because the investment produces an annuity, a series of equal cashflows at equal intervals, we may use Table 4. We find the discount factor forfive periods under the 8% column. Approach 2 in Exhibit 21-2 shows that thisdiscount factor is 3.993 (3.993 is the sum of the five discount factors used inapproach 1). To obtain the present value figures, multiply the discount factorsby the appropriate cash amounts in the sketch in Exhibit 21-2.

◆ Step 3: Sum the present value figures to determine the net present value. If thesum is zero or positive, the NPV model indicates that the project should beaccepted. That is, its expected rate of return equals or exceeds the required rateof return. If the total is negative, the project is undesirable. Its expected rate ofreturn is below the required rate of return.

Exhibit 21-2 indicates an NPV of $20,200 at the required rate of return of 8%;the expected return from the project exceeds the 8% required rate of return. Therefore,the project is desirable. The cash flows from the project are adequate to (1) recover thenet initial investment in the project and (2) earn a return greater than 8% on theinvestment tied up in the project from period to period. Had the NPV been negative,the project would have been undesirable on the basis of financial considerations.816 CHAPTER 21

Discounted cash flow (DCF).Capital budgeting method thatmeasures the cash inflows andoutflows of a project as if theyoccurred at a single point in timeso that they can be compared in anappropriate way.

Required rate of return (RRR)(discount rate, hurdle rate,opportunity cost of capital). Theminimum acceptable rate of returnon an investment; the return that theorganization could expect to receiveelsewhere for an investment ofcomparable risk.

Net present value (NPV) method.Discounted cash flow method thatcalculates the expected net monetarygain or loss from a project bydiscounting all expected future cashinflows and outflows to the presentpoint in time, using the required rateof return.

Of course, the manager of the hospital must also weigh nonfinancial factors.Consider the reduction in the average number of individual X-rays taken per patientwith the new machine. This reduction is a qualitative benefit of the new machinegiven the health risks to patients and technicians. Other qualitative benefits of thenew machine are the better diagnoses and treatments that patients receive. Had theNPV been negative, the manager would need to judge whether the nonfinancialbenefits outweigh the negative NPV.

It is important that you not proceed until you thoroughly understand Exhibit21-2. Compare approach 1 with approach 2 in Exhibit 21-2 to see how Table 4 inAppendix A merely aggregates the present value factors of Table 2. That is, the fun-damental table is Table 2; Table 4 reduces calculations when there is an annuity—aseries of equal cash flows at equal intervals. The DCF approach answers the questionof whether or not a project will break even or generate positive cash flow over itslifetime but does not answer the question of what the return on the investment willbe. This question is answered by using the internal rate-of-return method.

Internal Rate-of-Return MethodThe internal rate of return (IRR) is the discount rate at which the present value ofexpected cash inflows from a project equals the present value of expected cash outflowsof the project. That is, the IRR is the discount rate that makes NPV � $0. IRR issometimes called the time-adjusted rate of return. As in the NPV method, the sources ofcash flows and the accrual accounting treatment of individual cash flows are irrelevantto the IRR calculations. We illustrate the computation of the IRR using the X-raymachine project of Lifetime Care. Exhibit 21-3 on page 818 presents the cash flows 817CAPITAL BUDGETING AND

COST ANALYSIS

EXHIBIT 21-2Net Present Value Method: Lifetime Care Hospital’s New X-Ray Machine

Internal rate of return (IRR) (time-adjusted rate of return).Discount rate at which the presentvalue of expected cash inflows froma project equals the present value ofexpected cash outflows of the project.The IRR is the discount rate thatmakes NPV = $0.

If you use a calculator or computerto calculate the NPV, you will

often obtain a slightly different answerfor two reasons. The first is that thetables in Appendix A assume cash inflowoccurs at the end of each year, whereasmany programs for calculators and com-puters assume the inflow occurs at thebeginning of each year. The secondreason is rounding—the tables use only3 decimal places in contrast to 8 or moreused in calculators and computers.

A B C D E F G H I1 Net initial investment $379,1002 Useful life 5 years3 Annual cash inflow $100,0004 Required rate of return 8%56 Present Value Present Value of Sketch of Relevant Cash Flows at End of Each Year7 of Cash Flow $1 Discounted at 8% 0 1 2 3 4 58 Approach 1: Discounting Each Year’s Cash Flow Separatelya

9 Net initial investment $(379,100) 1.000 $(379,100)10 92,600 0.926 $100,00011 85,700 0.857 $100,00012 Annual cash inflow 79,400 0.794 $100,00013 73,500 0.735 $100,00014 68,100 0.681 $100,000

15 NPV if new machinepurchased $ 20,200

1617 Approach 2: Using Annuity Tableb

18 Net initial investment $(379,100) 1.000 $(379,100)19 $100,000 $100,000 $100,000 $100,000 $100,0002021 Annual cash inflow 399,300 3.993

22 NPV if new machinepurchased $ 20,200

2324 Note: Parentheses denote relevant cash outflows throughout all exhibits in Chapter 21.25 aPresent values from Table 2, Appendix A at the end of the book. For example, 0.857 � 1 � (1.08)2.

26bAnnuity present value from Table 4, Appendix A. The annuity table value of 3.993 is the sum of the individual discount rates 0.926 � 0.857 � 0.794 � 0.735 � 0.681, subject to rounding.

⎫⎪⎪⎬⎪⎪⎭

and shows the calculation of the NPV using a 10% discount rate. At a 10% discountrate, the NPV of the project is zero. Therefore, the IRR for the project is 10%. Allqualitative and nonfinancial considerations being equal, managers will choose projectswith the IRR exceeding the required rate of return by the greatest amount.

How do we determine the 10% discount rate that yields NPV � $0? In mostcases, analysts solving capital budgeting problems have a calculator or computerprogrammed to provide the internal rate of return. Without a calculator or com-puter program, a trial-and-error approach can provide the answer.

◆ Step 1: Try a discount rate and calculate the NPV of the project using thatdiscount rate.

◆ Step 2: If the NPV is less than zero, try a lower discount rate. (A lowerdiscount rate will increase the NPV; remember, we are trying to find a discountrate for which NPV � $0.) If the NPV is greater than zero, try a higher dis-count rate to lower the NPV. Keep adjusting the discount rate until NPV � $0.In the Lifetime Care example, a discount rate of 8% yields NPV of � $20,200(see Exhibit 21-2). A discount rate of 12% yields NPV of �$18,600 (3.605, thepresent value annuity factor from Table 4, � $100,000 � $379,100). Therefore,the discount rate that makes NPV � $0 must lie between 8% and 12%. Wehappen to try 10% and get NPV � $0. Hence, the IRR is 10%.818 CHAPTER 21

EXHIBIT 21-3Internal Rate-of-Return Method: Lifetime Care Hospital’s New X-Ray Machinea

A B C D E F G H I1 Net initial investment $379,1002 Useful life 5 years3 Annual cash inflow $100,0004 Annual Discount rate 10%56 Present Value Present Value of Sketch of Relevant Cash Flows at End of Each Year7 of Cash Flow $1 Discounted at 10% 0 1 2 3 4 58 Approach 1: Discounting Each Year’s Cash Flow Separatelyb

9 Net initial investment $(379,100) 1.000 $(379,100)10 90,900 0.909 $100,00011 82,600 0.826 $100,00012 Annual cash inflow 75,100 0.751 $100,00013 68,300 0.683 $100,00014 62,100 0.621 $100,000

15

NPV if new machinepurchasedc (the zerodifference provesthat the internal rate of return is 10%) $ 0

1617 Approach 2: Using Annuity Table18 Net initial investment $(379,100) 1.000 $(379,100)19 $100,000 $100,000 $100,000 $100,000 $100,0002021 Annual cash inflow 379,100 3.791d

22 NPV if new machinepurchased $ 0

2324 Note: Parentheses denote relevant cash outflows throughout all exhibits in Chapter 21.25 aThe internal rate of return is computed by methods explained on pp. 818–819.26 bPresent values from Table 2, Appendix A at the end of the book.27 cSum is $(100) due to rounding. We round to $0.

28dAnnuity present value from Table 4, Appendix A. The annuity table value of 3.791 is the sum of the individual discount rates 0.909 � 0.826 � 0.751 � 0.683 � 0.621, subject to rounding.

⎫⎪⎪⎬⎪⎪⎭

The step-by-step computations of an internal rate of return are easier when thecash inflows are equal, as in our example. Information from Exhibit 21-3 can beexpressed in the following equation:

$379,100 = Present value of annuity of $100,000 at x% for 5 years

Or, using Table 4 (Appendix A), what factor F will satisfy the following equation?

$379,100 � $100,000FF � 3.791

On the five-period line of Table 4, find the percentage column that is closest to3.791. It is exactly 10%. If the factor F falls between the factors in two columns,straight-line interpolation is used to approximate the IRR. (For an illustration ofinterpolation, see requirement 1 of the Problem for Self-Study on page 833.)

A project is accepted only if the internal rate of return exceeds the required rateof return (the opportunity cost of capital). In the Lifetime Care example, the X-raymachine has an IRR of 10%, which is greater than the required rate of return of 8%.On the basis of financial factors, Lifetime Care should invest in the new machine. Ifthe IRR exceeds the RRR, then the project has a positive NPV when project cashflows are discounted at the RRR. If the IRR equals the RRR, NPV � $0. If the IRRis less than the RRR, NPV is negative. Obviously, managers prefer projects withhigher IRRs to projects with lower IRRs, if all other things are equal. The IRR of10% means that the cash inflows from the project are adequate to (1) recover the netinitial investment in the project and (2) earn a return of exactly 10% on investmenttied up in the project over its useful life.

Despite the limitations of the IRR method, surveys report its widespread use,probably not only because managers find the IRR method easier to understand, butalso because in most instances their decisions would be unaffected by using IRR orNPV. In some cases, however, as when comparing two projects with unequal lives orunequal investments, the two methods will not indicate the same decision.

Comparison of Net Present Value and Internal Rate-of-Return MethodThis text emphasizes the NPV method, which has the important advantage that theend result of the computations is dollars, not a percentage. We can therefore add theNPVs of individual independent projects to estimate the effect of accepting a combi-nation of projects. In contrast, the IRRs of individual projects cannot be added oraveraged to derive the IRR of the combination of projects.

A second advantage of the NPV method is that we can use it in situationswhere the required rate of return varies over the life of the project. For example,suppose in the X-ray machine example Lifetime Care has a required rate of returnof 8% in years 1, 2, and 3 and 12% in years 4 and 5. The total present value of thecash inflows is as follows:

819CAPITAL BUDGETING ANDCOST ANALYSIS

O B J E C T I V E 5

Use and evaluate how thetwo main discounted cashflow methods (NPV andIRR) differ

Year(1)

12345

RequiredRate ofReturn

(3)

8%88

1212

Present Value of$1 Discounted

at Required Rate(4)

0.9260.8570.7940.6360.567

CashInflows

(2)

$100,000100,000100,000100,000100,000

Total PresentValue of

Cash Inflows(5) � (4) � (2)

92,60085,70079,40063,60056,700

$378,000

$

Given the net initial investment of $379,100, NPV calculations indicate thatthe project is unattractive: it has a negative NPV of �$1,100 ($378,000 � $379,100).However, it is not possible to use the IRR method to infer that the project should be

820 CHAPTER 21

Sensitivity AnalysisTo highlight the basic differences between the NPV and IRR methods, we haveassumed that the expected values of cash flows will occur for certain. Obviously,managers know that their predictions are imperfect and thus uncertain. To examinehow a result will change if the predicted financial outcomes are not achieved or if anunderlying assumption changes, managers can use sensitivity analysis, a what-iftechnique first introduced in Chapter 3.

Sensitivity analysis can take various forms. For example, suppose Lifetime Caremanagement believes forecasted savings are uncertain and difficult to predict.Management could then ask: What is the minimum annual cash savings that willcause us to invest in the new X-ray machine (that is, for NPV � $0)? For the data inExhibit 21-2, let ACI � annual cash inflows and let NPV � $0. The net initialinvestment is $379,100, and the present-value factor at the 8% required rate ofreturn for a five-year annuity of $1 is 3.993. Then:

NPV � $03.993A � $379,100 � $0

3.993A � $379,100A � $94,941

Thus, at the discount rate of 8%, annual cash inflows can decrease to $94,941(a decline of $100,000 � $94,941 � $5,059) before NPV falls below zero. If man-agement believes it can attain annual cash savings of at least $94,941, it could justifyinvesting in the new X-ray machine on financial grounds alone.

Computer spreadsheets enable managers to conduct systematic, efficientsensitivity analysis. Exhibit 21-4 shows how the net present value of the X-raymachine project is affected by variations in (1) the annual cash inflows and (2) therequired rate of return. NPVs can also vary with the useful life of a project.Sensitivity analysis helps a manager focus on those decisions that are most sensitive,and it eases the manager’s mind about those decisions that are not so sensitive. Forthe X-ray machine project, Exhibit 21-4 shows that variations in either the annualcash inflows or the required rate of return have sizable effects on NPV.

EXHIBIT 21-4Net Present Value Calculations for Lifetime Care Hospital Under Different Assumptions ofAnnual Cash Flows and Required Rates of Returna

The rapid changes in technologymake estimating the useful life of

a project one of the most challengingaspects of analyzing investment projects.

Relevant Cash Flows In Discounted Cash Flow AnalysisThe key point of discounted cash flow methods is to focus exclusively on differences inexpected future cash flows that result from implementing a project. All cash flows aretreated the same, whether they arise from operations, purchase or sale of equipment,

O B J E C T I V E 6

Identify relevant cash inflowsand outflows for capitalbudgeting decisions that useDCF methods

rejected. The existence of different required rates of return in different years (8% foryears 1, 2, and 3 versus 12% for years 4 and 5) means there is not a single RRR thatthe IRR (a single figure) must exceed for the project to be acceptable.

A B C D E F

1 Required Annual Cash Flow

2 Rate of Return $80,000 $90,000 $100,000 $110,000 $120,000

3 6% $(42,140) $ (20) $42,100 $84,220 $126,340

4 8% $(59,660) $(19,730) $20,200 $60,130 $100,060

5 10% $(75,820) $(37,910) $ 0 $37,910 $ 75,820

6

7 aAll calculated amounts assume the project’s useful life is five years.

or investment in or recovery of working capital. The opportunity cost and the timevalue of money are tied to the cash flowing in or out of the organization, not to thesource of the cash.

One of the biggest challenges in DCF analysis is determining those cash flowsthat are relevant to making the decision. Relevant cash flows are expected future cashflows that differ between the alternatives. At Lifetime Care, the alternatives are eitherto continue to use the old X-ray machine or to replace it with the new machine. Therelevant cash flows are the differences in cash flows between continuing to use the oldmachine and purchasing the new one. When reading this section, focus on identifyingfuture expected cash flows of each alternative and differences in cash flows between alternatives.

Capital investment projects (for example, purchasing a new machine) typicallyhave five major categories of cash flows: (1) initial investment in machine and work-ing capital, (2) cash flow from current disposal of the old machine, (3) recurringoperating cash flows, (4) cash flow from terminal disposal of machine and recoveryof working capital, and (5) income tax impacts on cash flows. We discuss the firstfour categories here, using Lifetime Care’s purchase decision of the X-ray machineas an illustration. Income tax effects are described in Chapter 22.

1. Initial investment. Two components of investment cash flows are (a) the cashoutflow to purchase the machine and (b) the working capital cash outflows.a. Initial machine investment. These outflows, made for purchasing plant, equip-

ment, and machines, occur in the early periods of the project’s life andinclude cash outflows for transporting and installing the item. In theLifetime Care example, the $372,890 cost (including transportation andinstallation costs) of the X-ray machine is an outflow in year 0. These cashflows are relevant to the capital budgeting decision because they will beincurred only if Lifetime decides to purchase the new machine.

b. Initial working capital investment. Investments in plant, equipment, andmachines and in the sales promotions for product lines are invariably accom-panied by incremental investments in working capital. These investmentstake the form of current assets, such as receivables and inventories (suppliesand spare parts for the new machine in the Lifetime Care example), minuscurrent liabilities, such as accounts payable. Working capital investments aresimilar to machine investments. In each case, available cash is tied up.

The Lifetime Care example assumes a $10,000 incremental investmentin working capital (supplies and spare parts inventory) if the new machine isacquired. The incremental working capital investment is the differencebetween the working capital required to operate the new machine (say$15,000) and the working capital required to operate the old machine (say$5,000). The $10,000 additional investment in working capital is a cash out-flow in year 0.

2. Current disposal price of old machine. Any cash received from disposal ofthe old machine is a relevant cash inflow (in year 0) because it is an expectedfuture cash flow that differs between the alternatives of investing and notinvesting in the new project. If Lifetime Care invests in the new X-raymachine, it will be able to dispose of its old machine for $3,790. These pro-ceeds are included as cash inflow in year 0.

Recall from Chapter 11 that the book value (original cost minus accumu-lated amortization) of the old equipment is irrelevant. It is a past cost. Nothingcan change what has already been spent or what has already happened.

The net initial investment for the new X-ray machine, $379,100, is the ini-tial machine investment plus the initial working capital investment minus currentdisposal price of the old machine: $372,890 � $10,000 � $3,790 � $379,100.

3. Recurring operating cash flows. This category includes all recurring operat-ing cash flows that differ among the alternatives. Organizations make capitalinvestments to generate cash inflows in the future. These inflows may resultfrom producing and selling additional goods or services, or, as in the LifetimeCare example, from savings in operating cash costs. Recurring operating cash 821CAPITAL BUDGETING AND

COST ANALYSIS

flows can be net outflows in some periods. For example, oil production mayrequire large expenditures every five years (say) to improve oil extraction rates.Focus on operating cash flows, not on accrued revenues and costs.

To underscore this point, consider the following additional facts aboutthe Lifetime Care X-ray machine example:

◆ Total X-Ray Department overhead costs will not change whether the newmachine is purchased or the old machine is kept. The X-Ray Department over-head costs are allocated to individual X-ray machines—Lifetime has several—on the basis of the labour costs for operating each machine. Because the newX-ray machine will have lower labour costs, overhead allocated to it will be$30,000 less than the amount allocated to the machine it is replacing.

◆ Amortization on the new X-ray machine using the straight-line method is$74,578 [(original cost, $372,890—expected terminal disposal price, $0) �useful life, 5 years].

The savings in operating cash flows (labour and materials) of $100,000in each of the first four years and $90,000 in the fifth year are clearly rele-vant because they are expected future cash flows that will differ between thealternatives of investing and not investing in the new machine. But whatabout the decrease in allocated overhead costs of $30,000? What aboutamortization of $74,578?a. Overhead costs. The key question is do total overhead cash flows decrease as a

result of acquiring the new machine? In our example, they do not. TotalX-Ray Department overhead costs remain the same whether or not the newmachine is acquired. They are fixed costs such as insurance. What changes isthe overhead allocated to individual machines. The overhead costs allocatedto the new machine are $30,000 less but this additional $30,000 will simplybe assigned to other machines in the department. No cash flow savings intotal overhead occur. Therefore, the $30,000 should not be included as partof recurring operating cash inflows.

b. Amortization. Amortization is irrelevant because it is a noncash allocationof costs, whereas DCF is based on inflows and outflows of cash. In DCFmethods, the initial cost of equipment is regarded as a lump sum outflowof cash at year 0. Deducting amortization from operating cash inflowswould be counting the lump sum amount twice. What we will examine inthe following chapter is the cash flow effect of tax regulations on capitalbudgeting.

4. Terminal disposal price of investment. The disposal of the investment at thedate of termination of a project generally increases cash inflow in the year ofdisposal. Errors in forecasting the terminal disposal price are seldom critical onlong-duration projects, because the present value of amounts to be received inthe distant future is usually small. Two components of the terminal disposalprice of an investment are (a) the terminal disposal price of the machine and(b) the recovery of working capital.a. Terminal disposal price of machine. At the end of the useful life of the project,

the initial machine investment may not be recovered at all, or it may be onlypartially recovered in the amount of the terminal disposal price.

The relevant cash inflow is the difference in expected terminal disposalprices at the end of five years under the two alternatives—the terminaldisposal price of the new machine (zero in the case of Lifetime Care) minusthe terminal disposal price of the old machine (also zero in the LifetimeCare example).1

822 CHAPTER 21

1The Lifetime Care example assumes that both the new and the old machine have a future useful lifeof five years. If instead the old machine had a useful life of only four years, management couldchoose to evaluate the investment decision over a four-year horizon. In this case, Lifetime’s manage-ment would need to predict the terminal disposal price of the new machine at the end of four years.

b. Recovery of working capital. The initial investment in working capital isusually fully recouped when the project is terminated. At that time, invento-ries and receivables necessary to support the project are no longer needed.The relevant cash inflow is the difference in the expected working capitalrecovered under the two alternatives. If the new X-ray machine ispurchased, Lifetime Care will recover $15,000 of working capital in year 5.If the new machine is not acquired, Lifetime will recover $5,000 of workingcapital in year 5, at the end of the useful life of the old machine. Therelevant cash inflow in year 5 if Lifetime invests in the new machine is$10,000 ($15,000 – $5,000).

Some capital investments reduce working capital. Assume that a computer-integrated manufacturing (CIM) project with a seven-year life will reduce inventoriesand hence working capital by $20 million from, say, $50 million to $30 million. Thisreduction will be represented as a $20-million cash inflow for the project at year 0.At the end of seven years, the recovery of working capital will show a relevant cashoutflow of $20 million. Why? Because the company recovers only $30 million ofworking capital under CIM rather than the $50 million of working capital it wouldhave recovered had it not implemented CIM.

Exhibit 21-5 above presents the relevant cash inflows and outflows for LifetimeCare’s decision to purchase the new machine as described in items 1–4 in the preced-ing list. The total relevant cash flows for each year are the same as the relevant cashflows used in Exhibits 21-2 and 21-3 to illustrate the NPV and IRR methods.

823CAPITAL BUDGETING ANDCOST ANALYSIS

EXHIBIT 21-5Relevant Cash Inflows and Outflows for Lifetime Care Hospital

A B C D E F G H1 Sketch of Relevant Cash Flows2

3 End of Year: 0 1 2 3 4 54 1a Initial machine investment $(372,890)5 b Initial working capital investment (10,000)6 2 Current disposal price of old machine 3,790 7 Net initial investment $(379,100)8 3 Recurring operating cash flows $100,000 $100,000 $100,000 $100,000 $ 90,000 9 4a Terminal disposal price of new machine – 10 b Recovery of working capital 10,000 11 Total relevant cash inflows and outflows12 as shown in Exhibits 21-2 and 21-3 $(379,100) $100,000 $100,000 $100,000 $100,000 $100,000

Payback Method

Uniform Cash FlowsWe now consider a third method for analyzing the financial aspects of projects.The payback method measures the time it will take to recoup, in the form of netcash inflows, the net initial investment in a project. Like NPV and IRR, thepayback method does not distinguish the sources of cash inflows (operations,disposal of equipment, or recovery of working capital). In the Lifetime Careexample, the X-ray machine costs $379,100, has a five-year expected useful

O B J E C T I V E 7

Use and evaluate thepayback method

life, and generates a $100,000 uniform cash inflow each year. The paybackcalculations2 are as follows:

Payback �

� � 3.791 years

Under the payback method, organizations often choose a cutoff period for aproject. The greater the risks of a project, the smaller the cutoff period. Why?Because faced with higher risks, managers would like to more quickly recover theinvestments they have made. For example, a software development company mayuse a payback period of one to two years for investment decisions. Projects with apayback period less than the cutoff period are acceptable. Those with a paybackperiod greater than the cutoff period are rejected. If Lifetime’s cutoff period underthe payback method is three years, Lifetime will reject the new machine. If Lifetimeuses a cutoff period of four years, Lifetime will consider the new machine to beacceptable.

The payback method highlights liquidity, which is often an important factor incapital budgeting decisions. Managers prefer projects with shorter paybacks (moreliquid) to projects with longer paybacks, if all other things are equal. Projects withshorter payback periods give the organization more flexibility because funds forother projects become available sooner. Also, managers are less confident about cashflow predictions that stretch far into the future. The shorter the payback, the moreconfident managers can feel that their forecasts are on target.

The major strength of the payback method is that it is easy to understand. Likethe DCF methods described previously, the payback method is not affected byaccrual accounting conventions such as amortization. Advocates of the paybackmethod argue that it is a handy measure when (1) estimates of profitability are notcrucial and preliminary screening of many proposals is necessary and (2) thepredicted cash flows in later years of the project are highly uncertain.

Two major weaknesses of the payback method are (1) it neglects the time valueof money and (2) it neglects to consider project cash flows after the net initialinvestment is recovered. Consider an alternative to the $379,100 X-ray machinementioned earlier. Assume that another X-ray machine, with a three-year useful lifeand zero terminal disposal price, requires only a $300,000 net initial investment andwill also result in cash inflows of $100,000 per year. First, compare the two paybackperiods:

Payback period for machine 1: � � 3.791 years

Payback period for machine 2: � � 3.000 years

The payback criterion would favour buying the $300,000 machine, because it has ashorter payback. In fact, if the cutoff period is three years, then Lifetime Carewould not acquire machine 1, because it fails to meet the payback criterion.Consider next the NPV of the two investment options using Lifetime Care’s 8%required rate of return for the X-ray machine investment. At a discount rate of8%, the NPV of machine 2 is �$42,300 (2.577, the present value annuity factorfor three years at 8% from Table 4 � $100,000 � $257,700 � the net initialinvestment of $300,000). Machine 1, as we know, has a positive NPV of $20,200(from Exhibit 21-2). The NPV criterion suggests that Lifetime Care should

$300,000100,000

$379,100100,000

$379,100100,000

Net initial investmentUniform increase in annual cash flows

824 CHAPTER 21

2Cash savings from the new X-ray machine occur throughout the year, but for simplicity in calculatingNPV and IRR, we assume they occur at the end of each year. A literal interpretation of this assumptionwould imply a payback of four years because Lifetime Care will only recover its investment whencash inflows occur at the end of the fourth year. The calculations shown in this chapter, however,better approximate Lifetime Care’s payback on the basis of uniform cash flows throughout the year.

Payback method. Capital budgetingmethod that measures the time it willtake to recoup, in the form of netcash inflows, the net initialinvestment in a project.

Companies often use both thepayback and DCF method to select

positive NPV projects with an acceptablyshort payback period.

acquire machine 1. Machine 2, with a negative NPV, would fail to meet the NPVcriterion. The payback method gives a different answer from the NPV methodbecause the payback method (1) does not consider cash flows after the paybackperiod and (2) does not discount cash flows.

An added problem with the payback method is that choosing too short a cutoffperiod for project acceptance may promote the selection of only short-lived projects.The organization will tend to reject long-term, positive-NPV projects.

Nonuniform Cash FlowsThe payback formula on the preceding page is designed for uniform annual cashinflows. When annual cash inflows are not uniform, the payback computation takes acumulative form. The years’ net cash inflows are accumulated until the amount ofthe net initial investment has been recovered. Assume that Venture Law Group isconsidering the purchase of videoconferencing equipment for $150,000. The equip-ment is expected to provide total cash savings of $380,000 over the next five years,due to reduced travel costs and more-effective use of associates’ time. The cash sav-ings occur uniformly throughout each year, but nonuniformly across years. Paybackoccurs during the third year:

Cumulative Net Initial Investment Yet toYear Cash Savings Cash Savings Be Recovered at the End of the Year

0 — — $150,0001 $50,000 $ 50,000 100,0002 60,000 110,000 40,0003 80,000 190,000 —4 90,000 280,000 —5 100,000 380,000 —

Straight-line interpolation within the third year, which has cash savings of $80,000,reveals that the final $40,000 needed to recover the $150,000 investment (that is,$150,000 � $110,000 recovered by the end of year 2) will be achieved halfway throughyear 3 (in which $80,000 of cash savings occur):

Payback � 2 years � ( � 1 year) � 2.5 years

The videoconferencing example has a single cash outflow of $150,000 at year 0.Where a project has multiple cash outflows occurring at different points in time,these outflows are added to derive a total cash outflow figure for the project. Noadjustment is made for the time value of money when adding these cash outflows incomputing the payback period.

$40,000$80,000

825CAPITAL BUDGETING ANDCOST ANALYSIS

Accrual Accounting Rate-Of-Return MethodWe now consider a fourth method for analyzing the financial aspects of capital-budgeting projects. The accrual accounting rate of return (AARR) is anaccounting measure of income divided by an accounting measure of investment. It isalso called accounting rate of return or return on investment (ROI). Note that NPV,IRR, and payback are all based on cash flows whereas AARR is based on accrualaccounting. We illustrate AARR for the Lifetime Care example using the project’snet initial investment as the denominator:

AARR �

If Lifetime Care purchases the new X-ray machine, the increase in expectedaverage annual savings in operating costs will be $98,000: This amount is the totaloperating savings of $490,000 ($100,000 for four years and $90,000 in year 5) � 5.

Increase in expected averageannual operating income

Net initial investment

O B J E C T I V E 8

Use and evaluate the accrualaccounting rate-of-return(AARR) method

Accrual accounting rate of return(AARR) (accounting rate of return,return on investment, ROI). Account-ing measure of income divided by anaccounting measure of investment.

The new machine has a zero terminal disposal price. Straight-line amortization onthe new machine is $372,890 � 5 � $74,578. The net initial investment is $379,100.

The accrual accounting rate of return is equal to

AARR � � = 6.18%$23,422

$379,100$98,000 − $74,578

$379,100

In practice there are variations onthis formula. Some companies use

“increase in expected average annualoperating income” in the numeratorand/or “average investment per year”in the denominator.

Comparison of Capital Budgeting Methods

G L O B A L S U R V E Y S O F C O M P A N Y P R A C T I C E

826 CHAPTER 21

What methods do companies around the world use for analyzing capital investmentdecisions? The percentages in the following table indicate how frequently particularcapital budgeting methods are used in eight countries. The reported percentages exceed100% because many companies surveyed use more than one method.

United United Statesa Australiab Canadac Cyprusd Japan Polande Scotlandf Kingdomg

Payback 35% 61% 50% 37% 52% 40% 78% 70%IRR 45% 37% 62% 9% 4% 25% 58% 81%NPV 50% 45% 41% 11% 6% 30% 48% 80%AARR 5% 24% 17% 4% 36% — 31% 56%Other 8% 7% 8% 49% 5% 50% — 31%

Some observations about these surveys:

1. Companies in the United States, Australia, Canada, Poland, Scotland, and the UnitedKingdom tend to use more than one method to evaluate capital investments. (Thesum of the capital budgeting percentages in the columns for each of these countriesranges from approximately 150% to 300%.)

2. Japanese and Cypriot companies tend to use one method. (The sum of the capitalbudgeting percentages for Japan and Cyprus are approximately 100%.)

3. The payback method is popular in all countries. Japanese companies use the pay-back method as their primary method of analysis in their capital budgeting decisions.Companies in the United States, Australia, Canada, Poland, Scotland, and the UnitedKingdom use discounted cash flow (DCF) methods (IRR and NPV) extensively.

4. In addition to Canada and the United Kingdom, IRR is the most-used capital-budgeting method in Singapore and Thailand.h,i

5. The AARR method lags behind DCF methods in all surveyed countries except Japan,where it is preferred over IRR and NPV.

aRyan, P., and G. Ryan, “Capital Budgeting Practices of the Fortune 1000: How Have Things Changed?” Journal ofBusiness and Management (2002).

bBlayney, P., and I. Yokohama, “Comparative Analysis of Japanese and Australian Cost Accounting andManagement Practices” (Working Paper, The University of Sydney, Australia, 1991).

cJog, V., and A. Srivastava, “Corporate Financial Decision Making in Canada,” Revue Canadienne des Sciencesde l'Administration (1994).

dLazaridis, I., “Capital Budgeting Practices: A Survey of Firms in Cyprus,” Journal of Small BusinessManagement (2004).

eSzychta, A., “The Scope and Application of Management Accounting Methods in Polish Enterprises,”Management Accounting Research (2002).

fSangster, A., “Capital Investment Appraisal Techniques: A Survey of Current Usage,” Journal of Business,Finance & Accounting (April 1993).

gArnold, G., and P. Hatzopoulos, “The Theory-Practice Gap in Capital Budgeting: Evidence from the UnitedKingdom,” Journal of Business, Finance & Accounting (2000).

hKester, G., and T. Chong, “Capital Budgeting Practices of Listed Firms in Singapore,” Singapore ManagementReview (1998).

iArsiraphongphisit, O., G. Kester, and T. Skully, “Financial Policies and Practices of Listed Firms in Thailand:Capital Structure, Capital Budgeting, Cost of Capital, and Dividends,” Journal of Business Administration (2000).

In this section, we consider some challenging aspects of predicting outcomes in theinformation-acquisition stage and of choosing projects in the selection stage.

Predicting the Full Set of Benefits and CostsThe factors that companies consider in making CIM decisions are far broaderthan costs alone. For example, the reasons for introducing CIM technology—faster response time, higher product quality, and greater flexibility in meetingchanges in customer preferences—are often to increase revenues and contribu-tion margins. Ignoring the revenue effects underestimates the financial benefits ofCIM investments. As we describe below, however, the revenue benefits of tech-nology investments are often difficult to quantify in financial terms. Nevertheless,competitive and revenue advantages are important managerial considerationswhen introducing CIM.

Exhibit 21-6 on page 828 presents examples of the broader set of factors thatcompanies in the United States, Australia, Japan, and the United Kingdom weigh inevaluating CIM technology. The benefits include

1. Faster response to market changes. An automated plant can, for example,make major design modifications (such as switching from a two-door to a four-door car) relatively quickly. To quantify this benefit requires some notion ofconsumer demand changes that may occur many years in the future and of themanufacturing technology choices made by competitors.

2. Increased worker knowledge of automation. If workers have a positiveexperience with CIM, the company can implement other automation projectsmore quickly and more successfully. Quantifying this benefit requires a predictionof the company’s subsequent automation plans. Survey evidence emphasizes theimportance of linking CIM decisions to a company’s overall competitive strategies.

Predicting the full set of costs also presents problems. Three classes of costs aredifficult to measure and are often underestimated:

1. Costs associated with a reduced competitive position in the industry. If othercompanies in the industry are investing in CIM, a company not investing in CIM

827CAPITAL BUDGETING ANDCOST ANALYSIS

3Note that if amortization is calculated as economic amortization (the decline in the present valueof future cash flows) under the AARR method, and if operating income and investment areadjusted each year for this amortization, the AARR each year will equal the project’s IRR. Inpractice, however, the book amortization and investment value used in AARR computations arenot calculated in this way.

The AARR method focuses on how investment decisions affect operating incomenumbers routinely reported by organizations. The AARR of 6.18% indicates therate at which a dollar of investment generates operating income.

While there is no uniform method of calculating AARR, the interpretation inany situation is that the greater the positive difference between the AARR of aproject and the AARR hurdle rate, the more preferable is the project. This methodis similar to the IRR method because it provides the answer to the question “what isthe rate of return on this project,” but the AARR uses operating income rather thancash flow. Because cash flow and time value of money are central to investmentproject decisions, both the IRR and NPV methods are preferred over the AARRmethod.3 On the other hand, AARR calculations use numbers reported in thefinancial statements and provide managers with forecasts of operating income onthe statement of earnings if a project is accepted. In contrast to the paybackmethod, AARR includes income earned throughout the lifetime of a projectwhereas the payback method only includes cash flows up to the point of payback.The Global Surveys of Company Practice box on p. 826 indicates that companiesreport a combination of these methods.

Complexities In Capital Budgeting Applications

will probably suffer a decline in market share because of its inferior quality andslower delivery performance. Several companies in the machine tool industrythat continued to use a conventional manufacturing approach experienced rapiddrops in market share after their competitors introduced CIM.

2. Costs of retraining the operating and maintenance personnel to handle theautomated facilities.

3. Costs of developing and maintaining the software and maintenance programsto operate the automated manufacturing activities.

Recognizing the Full Time Horizon of the ProjectThe time horizon of CIM projects can stretch well beyond ten years. Many of thecosts are incurred and are highly visible in the early years of adopting CIM. In con-trast, important benefits may not be realized until many years after the adoption ofCIM. A long time horizon should be considered when evaluating CIM investments.

Difficulties in predicting the full set of benefits and costs and long time hori-zons also arise in other investment decisions—for example, R&D projects and oilexploration.

Performance Evaluation and the Selection of ProjectsThe use of the accrual accounting rate of return for evaluating performance canoften deter a manager from using DCF methods for capital budgeting decisions.Consider Peter Costner, the manager of the X-Ray Department at Lifetime CareHospital. The NPV method for capital budgeting indicates that Peter shouldpurchase the new X-ray machine, since it has a positive NPV of $20,200.

Suppose top management of Lifetime Care uses the AARR for judging theX-Ray Department’s performance. Peter Costner may consider not purchasing thenew X-ray machine if the AARR of 6.18% on the investment reduces his overallAARR and so negatively affects his department’s performance. The AARR on thenew X-ray machine is low because the investment increases the denominator and, asa result of amortization, also reduces the numerator (operating income) in the AARRcomputation.

Obviously, there is an inconsistency between citing DCF methods as beingbest for capital budgeting decisions and then using a different method to evaluatesubsequent performance. As long as such practice continues, managers will betempted to make capital budgeting choices on the basis of accrual accountingrates of return, even though such choices are not in the best interests of the

828 CHAPTER 21

EXHIBIT 21-6Factors Considered in Making Capital Budgeting Decisions for CIM Projects

Examples of Examples of Financial Outcomes Nonfinancial and Qualitative Outcomes

Lower direct labour costs Reduction in manufacturing cycle timeLower hourly support labour costs Increase in manufacturing flexibilityLess scrap and rework Increase in business risk due to higher

fixed cost structure Lower inventory costs Improved product delivery and serviceIncrease in software and related costs Reduction in product development timeCosts of retraining personnel Faster response to market changes

Increased learning by workers about automationImproved competitive position in the industry

O B J E C T I V E 9

Identify investment projectsaffecting different functionsin the value chain and reduceconflict between projectapproval and performanceevaluation measures.

organization. Such temptations become more pronounced if managers are fre-quently transferred (or promoted), or if annual operating income is important intheir evaluations and their compensation plans. Why? Because the manager’sperformance is being evaluated over short time horizons. The manager has nomotivation to use a DCF model to take into account cash flows that will occur inthe distant future. Those cash flows will not influence the manager’s performanceevaluation.

829CAPITAL BUDGETING ANDCOST ANALYSIS

Postinvestment audits of capitalprojects require information on the

costs and benefits attributable to theproject. It can be costly, however, tountangle those cash flows from thecompany’s overall cash flows.

Managing the ProjectThis section discusses implementation and control of investment projects thatimprove performance in various functions in the value chain. Two different aspectsof management control are discussed––management control of the investmentactivity itself and management control of the project as a whole.

Management Control of the Investment ActivitySome initial investments such as purchasing X-ray or videoconferencing equipmentare relatively easy to implement. Other initial investments such as building shoppingmalls or new manufacturing plants are more complex and take more time. In the lat-ter case, monitoring and controlling the investment schedules and budgets is criticalto the success of the overall project.

Management Control of the Project––Postinvestment AuditA postinvestment audit compares the predictions of investment costs and outcomesmade at the time a project was selected to the actual results. It provides managementwith feedback about the investment’s performance. Suppose, for example, that actualoutcomes (operating cash savings from the new X-ray machine in the Lifetime Careexample) are much lower than predicted outcomes. Management must then investi-gate whether this occurred because the original estimates were overly optimistic orbecause there were problems in implementing the project. Both types of problemsare a concern.

Optimistic estimates are a concern because they may result in the accept-ance of a project that would otherwise have been rejected. To discourage opti-mistic estimates, companies such as DuPont maintain records comparing actualperformance to the estimates made by individual managers when seekingapproval for capital investments. DuPont believes that postinvestment auditsdiscourage managers from making unrealistic forecasts. Problems in imple-menting a project are an obvious concern because the returns from the projectwill not meet expectations. Postinvestment audits can point to areas requiringcorrective action.

Care should be exercised when performing a postinvestment audit. It shouldbe done only after project outcomes have stabilized. Doing the audit early maygive a misleading picture. Obtaining actual data to compare against estimates isoften not easy. For example, actual labour cost savings from the new X-raymachine may not be comparable to the estimated savings, because the actual num-ber and types of X-rays taken may be different from the quantities assumed duringthe capital budgeting process. The Focus on Values and Behaviours feature onpage 830 describes how the incentive systems at Enron and the absence of postin-vestment audits led managers to overstate project cash inflows and to accept proj-ects that should never have been undertaken. Implementation problems, such asnot achieving budgeted revenues or exceeding budgeted costs, are a concernbecause the returns from the project will then be inadequate. Postinvestmentaudits can point to areas of implementation that need improvement (such as betterquality-control processes). Other benefits, such as the impact on patient treat-ment, may be difficult to quantify.

Capital investment decisions that are strategic in nature require managers toconsider a broad range of factors that may be difficult to estimate. Consider someof the difficulties of justifying investments in computer-integrated manufac-turing (CIM) technology made by companies such as Mitsubishi, Sony, and Audi.

A company’s strategy is the source of its strategic capital budgeting decisions.Strategic decisions by WestJet, such as expansion to fly to U.S. and Europeandestinations, required capital investments to be made in several countries (see alsothe Concepts in Action feature, p. 831). The strategic decision by Barnes & Noble tosupport book sales over the Internet required capital investments creatingbarnesandnoble.com and an Internet infrastructure. Bell Canada Enterprise’sdecision to enter the media industry resulted in a big investment to acquire bothThe Globe and Mail and CTV.

830 CHAPTER 21

Long-Term Contracts and Performance Evaluation at EnronA basic tenet in finance is that when managers make positive NPV decisions andcommunicate these decisions to financial markets, the stock prices of their companiesrise in response. So when Enron entered into a long-term contract to sell gas to theChicago-based Peoples Gas, Light & Coke Co., Enron’s stock price rose to represent thefinancial market’s assessment of the deal. Stock prices change in anticipation of futurecash flows. In contrast, accounting income numbers generally measure performanceachieved—revenues, expenses, and cash flows that have already occurred during thepast year.

Enron, however, recorded the present value of the future cash flows from thecontract as income in the year the contract was signed. Enron also compensatedmanagers who brought in these deals on the basis of the NPV of the contract, whichrequired highly subjective judgments based on future prices of natural gas that werevery difficult to predict when a contract was signed. Enron’s chief risk officer wasresponsible for challenging and validating these future prices. Enron also soughtexternal verification of price estimates whenever possible. Nevertheless, the absenceof established public market prices and postcontract audits created incentives formanagers to assume high prices of natural gas in the future, report higher operatingincome, and claim higher rewards.

Pressure is part of every business, but employees at Enron were under severescrutiny. Its performance management system ranked all employees within a businessgroup from the best to the worst performers. Employees in the bottom 20% were warnedabout their performance and were terminated if they showed no significant improvement.This pressure to perform coupled with the opportunity to report higher operating incomecreated a strong temptation to inflate estimates of future cash flows. Enron’s culture andlack of values and controls encouraged unethical behaviour. At the time of Enron’s collapsein 2001, many managers had been rewarded for anticipated future performance that didnot materialize. The important message here for management accountants: Be aware ofcontrol-system weaknesses when making capital investment decisions and act with thehighest integrity.

Source: M. Salter, L. Levesque, and M. Ciampa, “The Rise and Fall of Enron,” Harvard Business School workingpaper, 2002.

F O C U S O N V A L U E S A N D B E H A V I O U R S

Strategic Considerations in Capital Budgeting

Some strategic investments aremade to avoid putting a company at

a competitive disadvantage. For example,cellular telephone companies such asMotorola, Nokia, and Samsung have addedfeatures providing customers Internetaccess and e-mail capabilities; companiesnot providing these features will suffer adecline in market share. The benefit ofcapital investments in this case isn’t higherrevenues but the prevention of a decline inrevenues and profits. Such benefits may bedifficult to quantify.

AES Corporation, a Fortune 500 company, is a leading global electricity producer withmore than US$30 billion in assets stretched across 30 countries and five continents.Despite impressive international growth throughout the company’s 20-year history, theglobal economic downturn that began in late 2000 devastated AES. The devaluation of keySouth American currencies, adverse changes in energy regulatory environments, anddeclines in energy prices weakened AES’s cash flow and ability to service debt. As aresult, AES stock collapsed and its market capitalization fell nearly 95%, from US$28 billionin December 2000 to US$1.6 billion just two years later.

In response, the AES board of directors asked Rob Venerus, director ofthe company’s new Corporate Analysis & Planning Group, to develop a newmethodology for evaluating capital budgeting projects. Historically, capitalbudgeting at AES was fairly straightforward. Early in the company’s history,a relatively simple model was developed, and a 12% discount rate was appliedto all projects, regardless of geographic location. This model remainedunchanged through the years, despite rapid expansion into new internationalmarkets that required advanced financial-analysis methods. For example,when AES entered countries such as Brazil and Argentina, the model failed toproperly adjust the required rate of return to account for higher risk, such asregulatory and currency risk. Another factor that created fundamental difficul-ties for applying this model overseas was an ever-increasing complexity in thefinancing of international operations.

To overhaul the capital budgeting process so that managers could evaluate eachinternational investment as a distinct opportunity with unique risks, Venerus knew hewould have to calculate a cost of capital for each of the many diverse AES businesses.These businesses included power plant construction, energy generation, and powerdistribution. As a starting point, he considered 15 representative projects from variouscountries and derived a weighted average cost of capital (WACC) for each project. Thisinvolved measuring all of the constituent parts for the projects: the cost of debt, thetarget capital structure, the local-country tax rates, and an appropriate cost of equity.

During this process Venerus knew he had to find a way to capture the country-specific risks in foreign markets. He developed an approach with two parts. First, hecalculated a cost of debt and a cost of equity for each of the 15 projects using U.S.market data. Second, he added the difference between the yield on local governmentbonds and the yield on corresponding U.S. Treasury bonds to both the cost of debt andthe cost of equity. Venerus and his team believed that this difference, or “sovereignspread,” approximated the incremental borrowing costs (and market risk) in the localcountry.

These efforts provided AES with a more sophisticated way to think about capitalbudgeting risk and its cost of capital around the world. As a global company withoperations in countries that were significantly different from the United States, thisframework helped AES more accurately evaluate capital projects and protect againstoverleveraging its assets, which almost imploded the company in 2002. Althoughsubsequent changes to the model’s calculations and methodology were made, thisprocess helped AES regain its financial footing through the reevaluation andrestructuring of existing capital projects while ensuring that the company only selectednew capital projects that met these revised criteria. So far, the company has beensuccessful! By 2004, AES was projecting long-term financial stability and double-digitearnings per share growth through 2008.

Sources: Based on “Globalizing the Cost of Capital and Capital Budgeting at AES,” Harvard Business SchoolCase No. 9-204-109, AES Corporation 2003 annual report, and discussions with the case writer and companymanagement.

C O N C E P T S I N A C T I O N

Globalizing Capital Budgeting at AES Corporation

831CAPITAL BUDGETING ANDCOST ANALYSIS

In CIM, computers give instructions that quickly and automatically set up andrun equipment to manufacture many different products. Quantifying these bene-fits requires some notion of consumer-demand changes that may occur manyyears in the future. CIM technology also increases worker knowledge of andexperience with automation; however, the benefit of this knowledge and experi-ence is difficult to measure. Managers need to develop judgment and intuition tomake these decisions.

Customer Value and Capital BudgetingConsider Potato Supreme, which makes potato products for sale to retail outlets. Itis currently analyzing two of its customers: Shine Stores and Always Open. PotatoSupreme predicts the following cash flow from operations, net of income taxes (inthousands), from each customer account for the next five years:

832 CHAPTER 21

To remain viable, companies mustkeep profitable customers (and

gain new ones).

Shine StoresAlways Open

2007

$1,450690

2008

$1,3051,160

2009

$1,1751,900

2010

$1,0582,950

2011

9504,160

$

Which customer is more valuable to Potato Supreme? Looking at only thefirst year, 2007, Shine Stores provides more than double the cash flow compared toAlways Open ($1,450 versus $690). A different picture emerges, however, whenlooking over the entire five-year horizon. Using Potato Supreme’s 10% RRR, theNPV of the Always Open customer is $7,610, compared to $4,591 for Shine Stores(computations not shown). Note how NPV captures in its estimate of customervalue the future growth of Always Open. Potato Supreme uses this information toallocate more resources and salespersons to service the Always Open account.Potato Supreme can also use NPV calculations to examine the effects of alternativeways of increasing customer loyalty and retention, such as introducing frequent-purchaser cards.

A comparison of year-to-year changes in customer NPV estimates highlightswhether managers have been successful in maintaining long-run profitable relation-ships with their customers. Suppose the NPV of Potato Supreme’s customer basedeclines 15% in one year. Management can then examine the reasons for the decline,such as aggressive pricing by competitors, and devise new-product development andmarketing strategies for the future.

Capital One, a financial-services company, uses NPV to estimate the value ofdifferent credit-card customers. Cellular telephone companies such as Cellular Oneand Verizon attempt to sign up customers for multiple years of service. Theobjective is to prevent “customer churn,” customers switching frequently from onecompany to another. The higher the probability of customer churn, the lower theNPV of the customer to the telecommunications company.

Investment in Research and DevelopmentCompanies such as QLT, Inc., in the Canadian pharmaceutical industry, andResearch In Motion (RIM), a Canadian company that is the global leader in design-ing, manufacturing, and marketing innovative wireless mobile communications suchas the BlackBerry™, regard R&D projects as important strategic investments. R&Dpayoffs are not only more uncertain than other investment projects, but often willoccur far into the future. Most companies engaged in these types of investmentprojects stage their R&D so they have the choice to increase or decrease theirinvestment at different points in time based on its success. This option feature ofR&D investments—called real options—is an important aspect of R&D investmentsand increases the NPV of these investments. That’s because a company can limit itslosses when things are going badly and take advantage of new opportunities whenthings are going well.

These NPV amounts are calculatedusing the 10% present value

discount factors in Table 2 of Appendix A.For example, year 1 has a present valueof $1,318 ($1,450 � 0.909) for ShineStores and $627 ($690 � 0.909) forAlways Open.

PROBLEM FOR SELF-STUDY

PROBLEMLet us revisit the Lifetime Care X-ray machine project. Assume that theexpected annual cash inflows are $130,000 instead of $100,000. All other factsare unchanged: a $379,100 net initial investment, a five-year useful life, a zeroterminal disposal price, and an 8% required rate of return. Year 5 cash inflowsinclude $10,000 recovery of working capital. When calculating breakeven time,assume that the investment in the X-ray machine will occur immediately aftermanagement approves the project. Compute the following:

1. Discounted cash flowa. Net present valueb. Internal rate of return

2. Payback period3. Accrual accounting rate of return on net initial investment4. Nonuniform cash flows

Assume (for calculation purposes) that cash outflows and cash inflows occur at theend of each period.

SOLUTION1. a. NPV � ($130,000 � 3.993) � $379,100

� $519,090 � $379,100 � $139,990b. There are several approaches to computing the IRR. One is to use a calcu-

lator with an IRR function; this gives an IRR of 21.16%. An alternativeapproach is to use Table 4 in Appendix A:

$379,100 � $130,000F

F � � 2.916

On the five-period line of Table 4, the column closest to 2.916 is 22%. Toobtain a more accurate number, straight-line interpolation can be used:

Present Value Factors

20% 2.991 2.991IRR — 2.91622% 2.864 —Difference 0.127 0.075

IRR � 20% � (2%) � 21.18%

2. Payback �

� $379,100 � $130,000 � 2.92 years

3. AARR �

� [($130,000 � 4) � $120,000] � 5

� $128,000Average annual amortization � $372,890 � 5 � $74,578

� $128,000 � $74,578

� $53,422

Increase in expected averageannual operating income

Increase in expected averageannual operating savings

Increase in expected averageannual operating income

Net initial investment

Net initial investmentUniform increase in annual cash flows

(difference due to rounding of PVfactor to 3 decimals)

0.0750.127

$379,100130,000

AARR � � 14.09%

4. Nonuniform cash flow computations are as follows:

$53,422 $379,100

CumulativePV PV of PV of Cumulative

Discount Investment Investment Investment PV of PV ofFactor Cash Cash Cash Cash Cash Cashat 8% Outflows Outflows* Outflows* Inflows Inflows* Inflows*

Year (1) (2) (3) � (1) � (2) (4) (5) (6) � (1) � (5) (7)

0 1.000 $379,100 $379,100 $379,1001 0.926 $130,000 $120,380 $120,3802 0.857 130,000 111,410 231,7903 0.794 130,000 103,220 335,0104 0.735 130,000 95,550 430,5605 0.681 130,000 88,530 519,090

*At year 0.

BET � 3 years �

� 3 years �

� 3.46 years

44,09095,550

($379,100 � $335,010)95,550

The following decision guidelines use a question-and-answer format to summarize the chapter’s mainpoints. Each decision presents a key question. The guideline is the answer to that question.

D E C I S I O N P O I N T S S U M M A R Y▼

DECISIONS

1. Over what time horizon is capitalbudgeting done?

2. What does the term “time value ofmoney” recognize?

3. What are the six stages of capitalbudgeting?

4. What are the two main discountedcash flow (DCF) methods? Whatare their advantages?

5. What are two advantages of thenet present value (NPV) methodover the internal-rate-of-return(IRR) method?

GUIDELINES

Capital budgeting is a long-term planning process for proposed capital projects. The lifeof a project is usually longer than one year, so capital budgeting decisions considerrevenues and costs over long periods. In contrast, accrual accounting measures income on a year-by-year basis.

The term recognizes that money received earlier is worth more because of the returns thatcan be generated sooner.

The six stages are (a) the identification stage, (b) the search stage, (c) the information-acquisition stage, (d) the selection stage, (e) the financing stage, and (f) the implementationand control stage.

The two main DCF methods are the net present value (NPV) method and the internal rate-of-return (IRR) method. The NPV method calculates the expected net monetary gain or lossfrom a project by discounting to the present all expected future cash inflows and outflows,using the required rate of return. A project is acceptable in financial terms if it has apositive NPV. The IRR method computes the rate of return (also called the discount rate)at which the present value of expected cash inflows from a project equals the presentvalue of expected cash outflows from a project. A project is acceptable in financial termsif its IRR exceeds the required rate of return. DCF is the best approach to capital budgeting.It explicitly includes all project cash flows and recognizes the time value of money.

The NPV method computes a result in dollars not percentages and can be used where therequired rates of return vary over the life of the project.

6. What are the relevant cashinflows and outflows for capitalbudgeting decisions? How shouldaccrual accounting concepts beconsidered?

7. What is the payback method?What are its limitations?

8. What is the accrual accountingrate-of-return (AARR) method?What is its limitation?

9. What conflicts can arise betweenusing discounted cash flowmethods for capital budgetingdecisions and accrual accountingfor performance evaluation? Howcan these conflicts be reduced?

Relevant cash inflows and outflows in DCF analysis are the differences in expected futurecash flows as a result of making the investment. Only cash inflows and outflows matter;accrual accounting concepts are irrelevant for DCF methods.

The payback method measures the time it will take to recoup, in the form of cash inflows,the total cash amount invested in a project. The payback method neglects both the cashflows after the payback period and the time value of money.

The accrual accounting rate of return (AARR) is after-tax operating income divided by ameasure of investment. AARR considers profitability but does not consider time value ofmoney.

Using accrual accounting to evaluate the performance of a manager or division may createconflicts with using DCF methods for capital budgeting. Frequently, the decision made usinga DCF method will not report good “operating income” results in the project’s early yearsunder accrual accounting. For this reason, managers are tempted not to use DCF methodseven though the decisions based on them would be the best for the company over the longrun. This conflict can be reduced by evaluating managers on a project-by-project basis,looking at their ability to achieve the amounts and timing of forecasted cash flows.

QUESTIONS21-1 “Capital budgeting has the same focus as accrual accounting.” Do you agree? Explain.21-2 List and briefly describe each of the six stages in capital budgeting.21-3 What is the essence of the discounted cash flow method?21-4 “Only quantitative outcomes are relevant in capital budgeting analyses.” Do you agree?

Explain.21-5 How can sensitivity analysis be incorporated in DCF analysis?21-6 What is the payback method? What are its main strengths and weaknesses?21-7 Describe the accrual accounting rate-of-return method. What are its main strengths and

weaknesses?21-8 “The trouble with discounted cash flow techniques is that they ignore amortization costs.”

Do you agree? Explain.21-9 “Let’s be more practical. DCF is not the gospel. Managers should not become so enchanted

with DCF that strategic considerations are overlooked.” Do you agree? Explain.21-10 “The net present value method is the preferred method for capital budgeting decisions.

Therefore, managers will always use it.” Do you agree? Explain.21-11 “All overhead costs are relevant in NPV analysis.” Do you agree? Explain.21-12 “Managers’ control of job projects generally focuses on four critical success factors.” Identify

those factors.21-13 Bill Watts, president of Western Publications, accepts a capital-budgeting project advo-

cated by Division X. This is the division in which the president spent his first 10 yearswith the company. On the same day, the president rejects a capital-budgeting project

A S S I G N M E N T M A T E R I A L▼

T E R M S T O L E A R N▼This chapter contains definitions of the following important terms:

accounting rate of return (p. 825)accrual accounting rate of

return (AARR) (p. 825)capital budgeting (p. 812)cost of capital (p. 816)discount rate (p. 816)discounted cash flow (DCF) (p. 815)hurdle rate (p. 816)internal rate of return (IRR) (p. 817)

investment programs (p. 812)investment projects (p.812)net present value (NPV) method (p. 816)opportunity cost of capital (p. 816)payback method (p. 823)required rate of return (RRR) (p. 816)return on investment (ROI) (p. 825)time-adjusted rate of return (p. 817)

835CAPITAL BUDGETING ANDCOST ANALYSIS