CHAPTER Capital Expenditure Decisions PowerPoint Presentation by LuAnn Bean Professor of Accounting Florida Institute of Technology © 2012 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use Managerial Accounting 11E Maher/Stickney/Weil ☼ CHAPTER GOAL ☼ This chapter explains how the differential principle applies to long–term decisions where the focus is on changes in operating capacity over several future time periods Present value analysis, also called discounted cash flow (DCF), provides analysts with the appropriate technique LO CAPITAL CAPITAL BUDGETING: BUDGETING: Definition Definition Involves deciding which longterm investments to take involving capital (long-term) assets LO STRATEGIC PLANNING In In strategic strategic planning, planning, an an organization organization decides decides on on major major programs programs and and the the resources resources to to devote devote to to them them Strategic Strategic planning planning provides provides the the context context for for capital capital expenditure expenditure decisions decisions LO BENEFITS: Long-Term Investments  Reducing potential to make mistakes improves product  Making goods, delivering services that competitors cannot  Reducing cycle time to make product  Permanently reducing costs to provide such an advantage that competitors cannot afford to enter market LO DISCOUNTED DISCOUNTED CASH CASH FLOW FLOW (DCF): (DCF): Definition Definition Aids in evaluating investments involving cash flows over time where there is a significant difference between cash payment and receipt LO ELEMENTS OF DISCOUNT RATE The choice of a discount rate should consider the following A pure rate of interest that reflects the productive capability of capital assets A risk factor reflecting the riskiness of the project An increase reflecting inflation expected to occur over the life of the project LO RISK-FREE RISK-FREE RATE: RATE: Definition Definition Is the pure interest rate plus expected inflation LO What is the real interest rate? The real interest rate is the pure interest rate plus a premium for risk but no increase for inflation LO NOMINAL NOMINAL INTEREST INTEREST RATE: RATE: Definition Definition Includes all three factors: pure interest, risk premium, and expected inflation 10 J E P LO Year & Year EXHIBIT 8.2 Depreciation Depreciationisis subtracted subtractedbefore before tax tax 15 J E P LO Year & Year Pretax Pretaxnet netcash cashinflow inflow (outflow) (outflow)––tax taxpayable payable ==Net Netcash cashinflow inflow (outflow) (outflow) XXPV PVfactor factor (12%) (12%)==NPV NPV EXHIBIT 8.2 16 LO J E P = EXHIBIT 8.2 + + + + + Projected Projectedcash cash flows flowsover overlife life of ofproject projectisis positive positive $12,469 $12,469 >>>ACCEPT >>>ACCEPT 17 THREE ESTIMATES for Calculating NPV LO The calculation of NPV for a proposed project requires three types of projections Amount of future cash flows Timing of future cash flows Discount rate Note: errors in predicting amounts of future cash flows will likely have the largest impact 18 LO J E P + + + + ==$350,000 $350,000 ininrevenues revenues Base case EXHIBIT 8.3 19 LO J E P + + + + ==$344,000 $344,000 ininrevenues, revenues, less lessthan than projected projected Amount of future cash flows EXHIBIT 8.3 20 LO J E P + + + + ==$350,000 $350,000 ininrevenues, revenues, not notreceived received as asexpected expected Timing of future cash flows EXHIBIT 8.3 21 LO J E P + + + + ==$350,000 $350,000 ininrevenues, revenues, but butdiscount discount rate ratechanged changed Discount rate changed to 13% EXHIBIT 8.3 22 LO DECISION RULE The decision to accept or reject an investment proposal can be made using either the internal rate of return method or the net present value method under most circumstances Net Present Value Method Compute the investment’s net present value, using the organization’s cost of capital adjusted for project-specific risk as the discount rate (hurdle rate) Undertake the investment if its net present value is positive Reject the investment if its net present value is negative Internal Rate of Return Method Compute the investment’s internal rate of return Undertake the investment if its internal rate of return is equal to or greater than the organization’s cost of capital adjusted for project-specific risk (hurdle rate) If not, reject the investment 23 LO J E P JEP’s JEP’s hurdle hurdlerate rate isis12% 12% Should Shouldthey they accept acceptthis this project? project? EXHIBIT 8.4 24 LO JUSTIFYING INVESTMENTS Investments in computer-integrated manufacturing are often difficult because of difficulties in applying discounted cash flow methods  Hurdle rate too high Should be cost of capital  Bias toward incremental projects  Uncertainty about operating cash flows  Exclusion of benefits that are difficult to quantify More flexibility Shorter cycle and lead times Reduction of non-value-added costs 25 LO LONG-TERM INVESTMENTS Three types of long term capital investments are: Replacement and minor improvements Expansion Strategic moves 26 LO AUDITING Auditing to compare estimates of capital budgeting projects to actual results provides advantages: Audits identify which estimates were wrong to correct in future Managers can use audits to reward good planning Audits create environment that removes the temptation to inflate estimates and benefits 27 LO BEHAVIORAL ISSUES Planners Planners have have aa desire desire to to implement implement aa project, project, meet meet performance performance measures measures This This can can influence influence their their objectivity objectivity in in making making estimates estimates Additionally, Additionally, conflicts conflicts may may arise arise between between criteria criteria used used to to evaluate evaluate individual individual projects projects and and criteria criteria used used to to evaluate evaluate an an organization’s organization’s overall overall or or unit unit performance performance 28 End of CHAPTER 29 ... organization organization decides decides on on major major programs programs and and the the resources resources to to devote devote to to them them Strategic Strategic planning planning provides provides... between between criteria criteria used used to to evaluate evaluate individual individual projects projects and and criteria criteria used used to to evaluate evaluate an an organization’s organization’s... cash flow methods  Hurdle rate too high Should be cost of capital  Bias toward incremental projects  Uncertainty about operating cash flows  Exclusion of benefits that are difficult to quantify