Managerial Accounting by James Jiambalvo Chapter 7: Capital Budgeting Decisions Slides Prepared by: Scott Peterson Northern State University

Managerial Accountingby James Jiambalvo

Chapter 7:Capital Budgeting Decisions

Slides Prepared by:

Scott Peterson

Northern State University

Chapter 7: Capital Budgeting DecisionsChapter Themes: It’s all about rates of

return. Cash inflows and

outflows are NOT the same as revenues and expenses.

A dollar today is worth more than a dollar tomorrow.

Learning Objectives:1. Define capital expenditure

decisions and capital budgets.

2. Evaluate investment opportunities using the net present value approach.

3. Evaluate investment opportunities using the internal rate of return approach.

4. Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

More

Chapter 7: Capital Budgeting DecisionsChapter Themes: It’s all about rates of

return. Cash inflows and

outflows are NOT the same as revenues and expenses.

A dollar today is worth more than a dollar tomorrow.

Learning Objectives:5. Use the payback period and the

accounting rate of return methods to evaluate investment opportunities.

6. Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values.

Capital Budgeting DecisionsInvestment decisions involving the acquisition of long-lived assets are often referred to as capital expenditure decisions because they require that capital (company funds) be expended to acquire additional resources. Investment decisions are also sometimes called capital budgeting decisions.

Related Learning Objectives:1. Define capital expenditure





Evaluating Investment Opportunities: Time Value of Money Approaches

Crucial to understanding capital budgeting decisions is an understanding of the time value of money. In short, the time value of money says that a dollar today is worth more than a dollar tomorrow. Because of this we need a way to convert future dollars into their equivalent present value. Two methods for evaluating investments are discussed: the net present value method and the internal rate of return method.






Basic Time Value of Money CalculationsBefore studying these two basic methods, a brief review is in order. To convert a future value to its present value, consider the following formula:

P = F

(1 + i)n

Where:

P = the present value

F = the future value

i = the rate of return






Basic Time Value of Money CalculationsBefore moving on, let’s say you will receive $1 exactly 1-year from now. What is its present (current) value? Assume i = 6% and use the following formula:

P = F

(1 + i)n

The answer is …






Basic Time Value of Money Calculations… 94 Cents.

P = 1

(1 + .06)1






The Net Present Value MethodThe time value of money forms the basis of the net present value method for evaluating capital investments. As discussed in the previous chapter, recall that only incremental cash flows are relevant.






The Net Present Value Method,Step 1:Identify the amount and time period of each cash flow associated with a potential investment. Investment projects have both cash inflows and cash outflows.






The Net Present Value Method,Step 2:Equate or discount the cash flows to their present values using a required rate of return (a.k.a. hurdle rate). This is the minimum return that management will accept.






The Net Present Value Method,Step 3: (final)






Evaluate the net present value. This is the sum of all of the cash inflows and cash outflows. If the net present value (NPV) is greater than or equal to zero, the investment should be made. If less than zero, it should not be made.

The Internal Rate of Return MethodThe internal rate of return method is an alternative to the net present value method. It too uses the time value of money. Specifically, the internal rate of return (IRR) is the rate of return that equates the present value of future cash flows to the investment outlay.






Summary of Net Present Value and Internal Rate of Return Methods

Although both the net present value method and the internal rate of return method take into account the time value of money, they differ in their approach to evaluating investment alternatives.






Estimating the Required Rate of ReturnIn the problems presented earlier, we stated a required rate of return that could be used to calculate an investment’s net present value or that could be compared with an investment’s internal rate of return. In practice, the required rate of return must be estimated by management. Under certain conditions, the required rate of return should be equal to the cost of capital for the firm.






Additional Cash Flow ConsiderationsTo be useful in investment analysis, both the net present value methods and the internal rate of return methods require a proper specification of cash flows. In particular, remember that only cash inflows and cash outflows are discounted back to the present, not revenues and expenses.






Cash Flows, Taxes, and the Depreciation Tax ShieldIn the previous examples, we ignored the effect of income taxes on cash flows. However, tax considerations play a major role in capital budgeting decisions. Although depreciation does not directly affect cash flow, it indirectly affects cash flow because is reduces the amount of tax (which is paid in cash) a company must pay. Thus we call these tax savings the depreciation tax shield.






Depreciation Tax Shield at Amazon.com






Amazon.com has yet to generate a profit. See the most recent figures here! When companies have net losses, they can carry the losses forward and offset future income in the determination of federal income taxes. Depreciation expense in loss years will not act as a tax shield until the firm begins to show a profit, say in the year 2005.

Adjusting Cash Flows for InflationIf inflation is ignored in net present value analysis, many worthwhile investment opportunities may be rejected. The reason is that current rates of return for debt and equity financing already include estimates of future inflation. Inflation is factored into the equation by multiplying the current level of cash flow by the expected rate of inflation.






Simplified Approaches to Capital BudgetingAlthough the net present value and the internal rate of return methods are widely used in industry to evaluate products, many companies continue to use simpler approaches. Two of these are:

1. payback period

2. accounting rate of return

Related Learning Objectives:5. Use the payback period and the



Payback Period MethodThe payback period is the length of time it takes to recover the initial cost of an investment. For example, if an investment costs $1,000 and returns $500 per year, it has a payback period of 2-years. There are two serious limitations with this method. First, it does not consider cash inflows in years beyond the payback year (e. g. years 3, 4 and 5 in the example above. Second, it does not consider the time value of money.




Accounting Rate of ReturnThe accounting rate of return (ARR) is equal to the average after-tax income from a project divided by the average investment in the project.

ARR = Average Net Income Average Investment

Unfortunately, this method also ignores the time value of money.




Conflict Between Performance Evaluation and Capital BudgetingAn NPV greater than zero or an IRR greater than the required rate of return informs managers that an investment opportunity will increase their firm’s value. Managers should use these techniques to maximize shareholder wealth. However, a manager’s performance (and bonus) is often measured in the short-term on accounting income. Thus, there is an inherent conflict between what is good for the firm and what is good for the manager.




Appendix A: The Internal Rate of Return with Unequal Cash FlowsWithin the chapter, the use of the IRR method is presented for the case where cash flows are equal in all years. What if cash flows are not equal? We cannot use a single cash-flow annuity to yield a present value factor. Instead, we estimate the IRR and use the estimate to calculate the net present value of the project. By trial-and-error, we can interpolate the actual internal rate of return.

Related Learning Objectives:1. Explain how the internal rate of

return is calculated when there are uneven cash flows.

Appendix B: Criticisms of Time Value of Money Approaches to Evaluating Investments

Although methods (NPV or IRR) employing the time value of money are preferred approaches, they have also been the subject of some criticism. Specifically critics argue that companies tend to underinvest in high-tech projects of strategic importance.

Related Learning Objectives:1. Discuss criticism of time value

of money approaches to evaluating investment opportunities.

Excessively High Required Rates of Return Discourage Investment

Some managers set unreasonably high required rates of return because is counteracts overly optimistic cash flow projections form subordinates who want “pet projects” funded. Managers should address the real problem in these cases and follow-up on funded projects with audits of cash flows. This way subordinates will be held accountable for their projections.



Ignoring Cash Inflows Far in the Future Discourages InvestmentThe time value of money approach requires that all cash inflows and outflows be considered. Rather managers tend to project out only several years. The rationale is that cash flows far out in the future are highly uncertain. As with assigning excessively high required rates of return, this behavior also leads to underinvestment in certain projects.



Failure to Consider “Soft” Benefits Discourages InvestmentPerhaps the most significant problem in applying time value of money approaches is that so-called soft benefits are often not taken into account. Ignoring “hard to quantify” benefits often leads to underinvestment. Consider the ERP example and the “soft benefit” of being able to close the books in five days rather than three weeks.



Calculating the Value of Soft Benefits Required to Make an Investment Acceptable

It is one thing to include soft benefits in analyzing investment opportunities but it is sometimes quite another to quantify those benefits. It may be too costly to determine those benefits. Here, if the NPV is negative, managers should calculate the amount of additional cash inflows needed to have a positive NVC. Then, if management believes the value of the soft benefits exceeds the additional cash flows, it can decide to fund the project.



Should Time Value of Money Approaches be Rejected?As we have seen, time value of money approaches can lead to poor investment decisions if excessively high required rates of return are used, if cash flows far in the future are ignored, or if soft benefits are ignored. The problem lies with the misapplication of these time value methods, not the use of the method itself.



Copyright© 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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Managerial Accounting by James Jiambalvo Chapter 7: Capital Budgeting Decisions Slides Prepared by: Scott Peterson Northern State University