8- 1 2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Capital Budgeting Chapter 8

8- 1 2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young

Capital Budgeting

Chapter 8


Introduction

In early August of 1999, Dow Chemical Company announced that it was acquiring Union Carbide Corporation for $9.3 billion.

Their merger reflected a global trend among companies that made primary or intermediate chemical products.


Introduction

Dow Chemical believed that the acquisition would increase its earnings and that rationalization and reengineering would create, within two years, at least $500 million of annual cost savings relative to the existing cost structures of the two organizations.

After reading this chapter you should be able to...


Learning Objectives

1 Describe the nature and importance of long-term assets.

2 Use the basic tools and concepts of financial analysis: investment, return, future value, present value, annuities, and required rate of return.


Learning Objectives

3 Demonstrate how capital budgeting is used to evaluate investment proposals and how the concepts of payback, accounting rate of return, net present value, internal rate of return, and economic value added relate to capital budgeting.


Learning Objectives

4 Evaluate the effect of income taxes on investment decisions and show how to incorporate tax considerations in capital budgeting.

5 Define and use what-if and sensitivity analysis in capital budgeting including strategic considerations in capital budgeting.

6 Use postimplementation audits in capital budgeting.


Learning Objective 1

Describe the nature and importance of long-term

assets.


Long-Term (Capital) Assets

What are long-term capital assets? Long-term capital assets are equipment or

facilities that provide productive services to the organization for more than one accounting period.



Organizations have developed specific tools to control the acquisition and use of long-term assets for three reasons:

1 Organizations commit to long-term assets for extended periods of time.

2 The amount of capital committed is usually very large.

3 The long-term nature of capital assets creates technological risk for organizations.



What is capital budgeting? It is a systematic approach to evaluating

an investment in long-term assets.



Use the basic tools and concepts of financial analysis:

investment, return, future value, present value, annuities, and required rate

of return.


Investment and Return

Investment is the monetary value of the assets that the organization gives up to acquire a long-term asset.

Return is the increased cash inflows in the future that are attributable to the long-term asset.

Investment and return are the foundations of capital budgeting analysis.


Time Value of Money

A central concept in capital budgeting is the time value of money.

Because money can earn a return, its value depends on the time period in which it is received.

Amounts of money received at different periods of time must be converted to their value on a common date to be compared.


Time Value of Money

The future value of money is the value that an amount invested today will be after a stated number of periods at a given rate of return.

How much would an initial amount of $100 accumulate over five years when the rate of return is 5% per year?


Time Value of Money

Today Year 5

5% 5% 5% 5% 5%

$100.00 $127.63

FV = PV × (1 + r)n


Time Value of Money

Compound Growth of Investment, 5 periods at 5%

Year 0: $1.00

Year 1: $1.05

Year 2: $1.1025

Year 3: $1.1576

Year 4: $1.2155

Year 5: $1.2763


Present Value

What is the present value of money? It is the current monetary worth of an

amount to be paid in the future under stated conditions of interest and compounding.

Analysts call a future cash flow’s value at time zero its present value.

The process of computing present value is called discounting.


Present Value

What is the present value of $127.63 to be received 5 years from now when the rate of return is 5% per year?

$100.00

PV = FV ÷ (1 + r)n


Time Value of Money

Today Year 5

5% 5% 5% 5% 5%

$127.63$100.00

Present value of $127.63 in 5 years at a 5% annual rate of return


Present Value and Future Value of Annuities

What is an annuity? It is a contract involving a series of constant

payments or receipts to be paid or received for a stated number of periods at a specified rate.



What is the future value of an annuity? It is the sum of payments plus accumulated

interest. What is the present value of an annuity? It is the value today of a series of future

payments or receipts.



Future value of an annuity of $1, 5 periods at 5%

Periods Future Value 1 $1.000 2 $2.050 3 $3.153 4 $4.310 5 $5.526



Present value of an annuity of $1, 5 periods at 5%

Periods Present Value 1 $0.952 2 $1.859 3 $2.723 4 $3.546 5 $4.329


Cost of Capital

What is the cost of capital? It is the interest rate organizations use in

computing the time value of money. It equals the return that the organization

must earn on its investments to meet its investor’s return requirements.

The cost of capital is the benchmark the organization uses to evaluate investment proposals.



Demonstrate how capital budgeting is used to evaluate

investment proposals and how the concepts of payback, accounting rate of return, net present value,

internal rate of return, and economic value added relate to

capital budgeting.


Approaches to Capital Budgeting

– Payback– Accounting rate of return– Net present value– Internal rate of return– Profitability index– Economic value added


Approaches to Capital Budgeting

Shirley’s Doughnut Hole is considering the purchase of a new machine that will cost $70,000 and last five years.

Its salvage value is $10,000. The machine will increase profits by

$20,000 per year. The cost of capital is 10%. Is this investment worthwhile?


Payback Criterion

The payback period, or payback criterion, computes the number of periods needed to recover a project’s initial investment.

Payback time = 70,000 ÷ 20,000= 3.5 years


Accounting Rate of Return Criterion

The accounting rate of return approximates the return of investment.

Accounting Rate of Return=

Average Income ÷ Average Investment



What is the straight-line method annual depreciation?

($70,000 – $10,000) ÷ 5 = $12,000 What is the increased annual income? $20,000 – $12,000 = $8,000 What is the average investment? ($70,000 + $10,000) ÷ 2 = $40,000



What is the accounting rate of return? ARR = $8,000 ÷ $40,000 = 20% If the accounting rate of return exceeds the

criterion, or target rate of return, the project is acceptable.

The accounting rate of return does not consider the explicit timing of cash flows.


Net Present Value Criterion

The net present value is the sum of the present values of all cash inflows and outflows associated with a project.

This model is the most widely recommended approach to capital budgeting.

It specifically considers the time value of money.



What are the steps in computing NPV?1 Choose the period length.2 Identify the firm’s cost of capital.3 Identify the incremental cash flows.4 Compute the PV of the cash flows.5 Sum the project’s cash flows and determine

the NPV.6 Accept or reject the project.



Periods Amount PV Factor Present Value

0 ($70,000) 1.0000 ($70,000.00)

1 20,000 0.9091 18,181.82

2 20,000 0.8264 16,528.93

3 20,000 0.7513 15,026.30

4 20,000 0.6830 13,660.27

5 30,000 0.6209 18,627.64

Total $12,024.96


Internal Rate of Return Criterion

The internal rate of return (IRR) is the actual rate of return expected from an investment.

The IRR is the discount rate that makes the investment’s net present value equal zero.


Internal Rate of Return Criterion

Periods Amount PV Factor Present Value

0 ($70,000) 1.0000 ($70,000.00)

1 20,000 0.8610 17,220.60

2 20,000 0.7414 14,827.45

3 20,000 0.6383 12,766.87

4 20,000 0.5496 10,992.66

5 30,000 0.4733 14,197.51

Total $ 5.09

Internal Rate of Return: 16.14%


Profitability Index

The profitability index is a variation on the net present value method.

It is computed by dividing the present value of the cash inflows by the present value of the cash outflows.

A profitability index of 1 or greater is required for the project to be acceptable.


Profitability Index

What is Shirley’s profitability index? $82,025 ÷ $70,000 = 1.17


Economic Value Added Criterion

Economic value added is used as a tool to evaluate organizational performance.

Economic Value Added=

Adjusted Accounting Income–

(Cost of Capital × Investment)



Evaluate the effect of income taxes on investment decisions and show how to incorporate tax considerations in capital

budgeting.


Effect of Taxes

Organizations must pay taxes on net benefits (taxable income).

The allocation of the cost of a capital investment through depreciation can offset some taxes.

Taxable income, the tax rate, and tax depreciation methods are determined by legislation.


Time

0

1

2

3

4

5

5

Total

Cash Flow

($70,000)

20,000

20,000

20,000

20,000

20,000

10,000

Depreciation

$12,000

12,000

12,000

12,000

12,000

0

Tax Income

$8,000

8,000

8,000

8,000

8,000

0

Tax @ 40%

$3,200

3,200

3,200

3,200

3,200

0

Net Cash Flow

($70,000)

16,800

16,800

16,800

16,800

16,800

10,000

PV Factor

1.0000

0.9346

0.8734

0.8163

0.7629

0.7130

0.7130

PV

($70,000)

15,701

14,674

13,714

12,817

11,978

7,130

$6,013

Net Present Value Calculations with Taxes

Effect of Taxes



Define and use what-if and sensitivity analysis in capital budgeting including strategic

considerations in capital budgeting.


What-if and Sensitivity Analysis

What-if analysis is the process of varying the assumptions underlying a forecasting model to determine the effects of those assumptions on the forecasted amounts.

Sensitivity analysis is the process of varying the assumptions underlying a decision to determine the decision’s sensitivity to those assumptions.


What-if and Sensitivity Analysis

Why are what-if and sensitivity analyses important tools?

They allow decision makers to estimate the opportunity cost of the imperfect information upon which decisions are based.


Strategic Considerations

Strategic benefits reflect the enhanced revenue and profit potential that derive from some attribute or long-term asset.

What are some strategic benefits provided by long-term assets?


Strategic Considerations

1 They allow an organization to make goods or deliver a service that competitors cannot.

2 They support improving product quality by reducing the potential to make mistakes.

3 They help shorten the cycle time needed to make the product.



Use postimplementation audits in capital budgeting.


Postimplementation Audits and Capital Budgeting

A postimplementation audit of the capital budgeting decision is revisiting the decision to purchase a long-lived asset.

It is an opportunity to re-evaluate a past decision by comparing expected and actual inflows and outflows.



What are some benefits of postimplementation audits?

Planners can avoid future mistakes. By comparing estimates with results,

planners can determine why their estimates were incorrect.



Rewards can be given to those who make good capital budgeting decisions.

It controls planners. If the audit is not done, there are no controls

on planners who might be tempted to inflate the benefits in order to get their projects approved.


Conclusion

Dow Chemical paid $9.3 billion to acquire Union Carbide.

We can account for a value of $7.3 billion from this acquisition.

We then have to explain the $2 billion difference which is approximately 23% of the acquisition price.


End of Chapter 8

Documents

8- 1 2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Capital Budgeting Chapter 8