Copyright 2014 Pearson Education Accounting 13 e Horngren Sundem Stratton

Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 - 1

Chapter 11 Capital Budgeting Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 - 2

Chapter 11 Learning Objectives 1. Describe capital-budgeting decisions and use the netpresent-value (NPV) method to make such decisions. 2. Use sensitivity analysis to evaluate the effect of changes in predictions on investment decisions. 3. Calculate the NPV difference between two projects using both the total project and differential approaches. 4. Identify relevant cash flows for NPV analyses. 5. Compute the after-tax net present values of projects. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 - 3

Chapter 11 Learning Objectives 6. Explain the after-tax effect on cash received from the disposal of assets. 7. Use the payback model and the accounting rate-of-return model and compare them with the NPV model. 8. Reconcile the conflict between using an NPV model for making decisions and using accounting income for evaluating the related performance. 9. Compute the impact of inflation on a capital-budgeting project (Appendix 11). Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 - 4

Learning Objective 1 Capital Budgeting Capital budgeting describes the long-term planning for making and financing major long-term projects. 1. Identify potential investments. 2. Choose an investment. 3. Follow-up or “post audit. ” Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 - 5

Discounted-Cash-Flow Models (DCF) These models focus on a project’s cash inflows and outflows while taking into account the time value of money. DCF models compare the value of today’s cash outflows with the value of the future cash inflows. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 - 6

Net Present Value Model The net-present-value (NPV) method computes the present value of all expected future cash flows using a minimum desired rate of return. The minimum desired rate of return depends on the risk-the higher the risk, the higher the rate. The required rate of return (also called hurdle rate or discount rate) is the minimum desired rate of return based on the firm’s cost of capital. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 - 7

Applying the NPV Method Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 - 8

NPV Example Original investment (cash outflow): $5, 827 Useful life: four years Annual income generated from investment (cash inflow): $2, 000 Minimum desired rate of return: 10% Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 - 9

NPV Example Present Value of $1 Total Sketch of Cash Discounted Present Flows at End of Year At 10% Value 0 1 2 3 4 Approach 1: Discounting Cash Flows Cash flows Annual savings. 9091 $1, 818 2, 000. 8264 1, 653 2, 000. 7513 1, 503 2, 000. 6830 1, 366 2, 000 Present value of Future inflows $6, 340 Initial Outlay 1. 0000 (5, 827) $(5, 827) Net present value $ 513 Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 10

NPV Example Because the four annual cash flows in the example are all equal, this table can be used to make one PV computation instead of four individual computations. Approach 2: Using an Annuity Table Sketch of Cash Flows at End of Year 0 1 2 3 4 Annual Savings 3. 1699 $6, 340 $2, 000 Initial Outlay 1. 0000 (5, 827) $(5, 827) Net present value $ 513 Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 11

Assumptions of the NPV Model Two Major Assumptions World of certainty. There are perfect capital markets. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 12

Decision Rules Managers determine the sum of the present values of all expected cash flows from the project. If the sum of the present values is positive, the project is desirable. If the sum of the present values is negative, the project is unattractive. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 13

Internal Rate of Return Model The IRR determines the interest rate at which the NPV equals zero. If IRR > minimum desired rate of return, then NPV > 0 and accept the project. If IRR < minimum desired rate of return, then NPV < 0 and reject the project. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 14

Real Option Model This model recognizes the value of contingent investments. Contingent investments are investments that a company can adjust as it learns more about their potential for success. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 15

Learning Objective 2 Sensitivity Analysis Sensitivity analysis shows the financial consequences that would occur if actual cash inflows and outflows differ from those expected. Managers often use sensitivity analysis to deal with uncertainty, to answer the what-if questions. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 16

Sensitivity Analysis Example Suppose that a manager knows that the actual cash inflows in the previous example could fall below the predicted level of $2, 000. How far below $2, 000 must the annual cash inflow drop before the NPV becomes negative? Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 17

Sensitivity Analysis Example (3. 1699 × Cash flow) – $5, 827 = 0 Cash flow = $5, 827 ÷ 3. 1699 = $1, 838 If the annual cash flow is less than $1, 838, the NPV is negative, and the project should be rejected. Annual cash inflows can drop only $2, 000 – $1, 838 = $162 or 8. 1% Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 18

Learning Objective 3 Comparison of Two Projects Two common methods for comparing alternatives are: Total project approach Differential approach Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 19

Total Project Approach The total project approach computes the total impact on cash flows for each alternative and then converts these total cash flows to their present values. The alternative with the largest NPV of total cash flows is best. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 20

Differential Approach The differential approach computes the differences in cash flows between alternatives and then converts these differences to their present values. This method cannot be used to compare more than two alternatives. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 21

Learning Objective 4 Relevant Cash Flows for NPV Three types of inflows and outflows should be considered when the relevant cash flows are arrayed: 1) Initial cash inflows and outflows at time zero 2) Future disposal values 3) Operating cash flows Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 22

Operating Cash Flows The only relevant cash flows are those that will differ among alternatives. Fixed overhead can be ignored. A reduction in cash outflow is treated the same as a cash inflow. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 23

Cash Flows for Investments in Technology Decision: Invest in a highly automated production system to replace a traditional system. Cash flows predicted for the automated system should be compared to cash flows predicted for continuation of present system. A changing competitive environment can cause failure to invest in an automated system which causes a decline in sales and an uncompetitive cost structure. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 24

Learning Objective 5 Income Taxes and Capital Budgeting Another type of cash flow that must be considered when making capital-budgeting decisions is after-tax cash flows. In capital budgeting, the relevant tax rate is the marginal income tax rate. This is the tax rate paid on incremental taxable income. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 25

Effects of Depreciation Deductions Depreciation expense is a noncash expense and is ignored for capital budgeting, except that it is an expense for tax purposes and will provide a cash inflow from income tax savings. Organizations that pay income taxes usually keep two sets of books one set that follows the rules for financial reporting and one that follows the tax rules, a practice that is not illegal or immoral – it is necessary. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 26

Effects of Depreciation Deductions U. S. tax authorities allow accelerated depreciation. The focus is on the tax reporting rules, not those for public financial reporting. The recovery period is the number of years over which an asset is depreciated for tax purposes. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 27

Effects of Depreciation Deductions Assume the following: Cash inflow from operations: $60, 000 Tax rate: 40% What is the after-tax inflow from operations? $60, 000 × (1 – tax rate) = $60, 000 ×. 6 = $36, 000 Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 28

Effects of Depreciation Deductions What is the after-tax effect of $25, 000 depreciation? $25, 000 × 40% = $10, 000 tax savings The depreciation deduction reduces taxes, and thereby increases cash flows, by $10, 000 annually. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 29

Modified Accelerated Cost Recovery System Under U. S. income tax laws, companies depreciate most assets using the Modified Accelerated Cost Recovery System (MACRS). MACRS specifies a recovery period an accelerated depreciation schedule for all types of assets in eight classes. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 30

Present Value of MACRS Depreciation Tax Deduction Depreciation Tax Shield is the tax savings due to depreciation deductions, generally the present value of the product of the tax rate and the depreciation deduction. The value of a depreciation deduction depends on timing. MACRS specifies the timing of deductions for each recovery period. The present value of the depreciation tax shield for any recovery period can be easily computed. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 31

Learning Objective 6 Gains or Losses on Disposal The disposal of equipment for cash can also affect income taxes. Suppose a 5 -year piece of equipment purchased for $125, 000 is sold at the end of year 3 after taking three years of straight-line depreciation. What is the book value? $125, 000 – (3 × $25, 000) = $50, 000 Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 32

Gains or Losses on Disposal If the equipment is sold for $50, 000 (book value), there is no gain or loss and there is no tax effect. If it is sold for more than $50, 000, there is a gain and an additional tax payment. If it is sold for less than $50, 000, there is a loss and a tax savings. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 33

Gains or Losses on Disposal Assume that the equipment is sold for $70, 000 and the tax rate is 40%. What is the tax savings on the sale? ($70, 000 – $50, 000) = 20, 000 × 40% = $8, 000 What is the net cash inflow from the sale? $70, 000 – $8, 000 = $62, 000 Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 34

Cash Flow Effects of Disposal of Equipment Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 35

Learning Objective 7 Other Models for Analyzing Long. Range Decisions Payback time, or payback period, is the time it will take to recoup, in the form of cash inflows from operations, the initial dollars invested in a project. P=I÷O Assume that $12, 000 is spent for a commercial stove with an estimated useful life of 4 years. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 36

Payback Model Example Annual savings of $4, 000 in cash outflows are expected from operations. What is the payback period? P = $12, 000 ÷ $4, 000 = 3 years Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 37

Accounting Rate-of-Return Model The accounting rate-of-return (ARR) model expresses a project’s return as the increase in expected average annual operating income divided by the required initial investment. ARR *Average annual incremental cash inflow from operations minus incremental average annual depreciation. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 38

Accounting Rate-of-Return Example v. Assume the following: v. Investment is $5, 827. v. Useful life is four years. v. Estimated disposal value is zero. v. Expected annual cash inflow from operations is $2, 000. Annual depreciation = (cost – disposal value)/useful life Annual depreciation = ($5, 827 – 0)/4 = $1, 456. 75 Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 39

Accounting Rate-of-Return Example ARR = Average annual incremental cash inflow – Incremental annual depreciation ARR = ($2, 000 – $1457) ÷ $5, 827 = 9. 3% Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 40

Accounting Rate-of-Return Example Some companies use the “average” investment (often assumed to be the average book value over the useful life) instead of original investment in the denominator Average annual incremental cash inflow – Incremental annual depreciation ARR = ($2, 000 – $1457) ÷ $2, 913. 50 = 18. 6% Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 41

Learning Objective 8 Performance Evaluation Many managers are reluctant to accept DFC models as the best way to make capital-budgeting decisions. Their superiors evaluate them using a non-DCF model. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 42

Reconciliation of Conflict Use DCF for both capital-budgeting decisions and performance evaluation. Use Economic Value Added (EVA) Follow-up evaluation of capital decisions Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 43

Post Audit Most large companies conduct a follow-up evaluation of selected capital-budgeting decisions. One follow-up evaluation of capital-budgeting decisions often used is a post-audit. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 44

Post Audit Investment expenditures are on time and within budget. Comparing actual versus predicted cash flows. Improving future predictions of cash flows. Evaluating the continuation of the project. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 45

Learning Objective 9 Capital Budgeting and Inflation What is inflation? It is the decline in general purchasing power of the monetary unit. The key in capital budgeting is consistent treatment of the minimum desired rate of return and the predicted cash inflows and outflows. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 46

Watch for Consistency can be achieved by including an element for inflation in both the minimum desired rate of return and in the cash-flow predictions. Many firms base their minimum desired rate of return on market interest rates (nominal rates) that include an inflation element. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 47

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2014 Pearson Education, Accounting 13/e, Horngren/Sundem/Stratton © 2005 Prentice Hall Business Publishing, Introduction to Management. Inc. publishing as Prentice Hall 11 11 -- 48