1Copyright © 2008 Cengage Learning South-Western

Heitger/Mowen/Hansen

Capital Investment Decisions

Chapter Twelve

Fundamental Cornerstones of Managerial Accounting

Fundamental Cornerstones of Managerial Accounting

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Capital Investment Decisions

• Long range decisions involving opportunities to invest in new assets or projects

• Among the most important decisions made by managers

• Place large amounts of resources at risk for long periods of time

• Affect the future development of the firm• Decision making process is called “Capital

Budgeting”

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Capital Budgeting

• Two types:◦ Independent projects (“Mutually exclusive

projects”)∙ If accepted or rejected, do not affect the cash

flows of other projects

◦ Competing projects∙ Acceptance of one alternative precludes the

acceptance of another

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Capital Budgeting• Managers must decide whether or not a

capital investment will:◦ Earn back its original outlay◦ Provide a reasonable return

∙ Covering the opportunity cost of the funds invested

• To make a capital investment decision, managers must: ◦ Make estimates of the quantity and timing of after-

tax cash flows◦ Assess the risk of the investment◦ Consider the impact of the project on the

firm’s profits

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Making Capital Investment Decisions• Managers must:

◦ Set goals and priorities set for capital investments◦ Establish basic criteria for acceptance or rejection of proposed

investments

• Two types of methods:1. Nondiscounting models

∙ Do not consider time value of money∙ Two methods

∙ Payback period∙ Accounting rate of return (ARR)

2. Discounting models∙ Use time value of money∙ Two methods

∙ Net present value (NPV)∙ Internal rate of return (IRR)

• Most companies use both types of methods

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Definition

= Original investment / Annual cash flowPayback period

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Accounting Rate of Return

• Measures the return on a project in terms of income as opposed to using cash flow◦ Formula:

Average income / Initial investmentAccounting

Rate of Return

=

• Average income is not the same as cash flows◦ Formula:

∙ Add net income for each year of the project and divide by the number of years

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Definition

= Average Net Income / Initial InvestmentAccounting

Rate of Return

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Net Present Value (NPV)

• Difference between the present value of the cash inflows and outflows associated with a project

• Measures the net cash flows of the project• Size of the positive NPV measures the increase

in value of the firm resulting from an investment• To use NPV method, a required rate of return

must be defined◦ Minimum acceptable rate of return

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Evaluating Net Present Value (NPV)• If NPV is positive:

◦ Rate of return on the investment is greater than the required rate of return

◦ Investment, the minimum rate of return, and a return in excess of profit are all recovered

◦ Investment is acceptable• If NPV is zero:

◦ Rate of return on the investment is exactly the required rate of return

◦ Investment and the minimum rate of return are recovered◦ Decision maker will be ambivalent regarding acceptance

or rejection

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Evaluating Net Present Value (NPV)

• If NPV is negative:◦ Rate of return on the investment is less than the required

rate of return◦ Investment cost may or may not be recovered, and the

minimum rate or return is not recovered◦ Initial investment should be rejected

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Internal Rate of Return (IRR)

• Interest rate that sets the project’s NPV to zero◦ Formula:

• Can be found using trial and error, or • Using PV tables• Compared to required rate of return

◦ If IRR > Required rate of return…∙ Project is deemed acceptable

◦ If IRR < Required rate of return∙ Project is rejected

I = ∑CFt / (1 + i)t

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Definition

Internal Rate of Return

Discount factor = Investment / Annual Cash Flow

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Post Audit of Capital Projects

• Follow-up analysis of project once it is implemented

• Should be completed by independent party◦ Often internal audit staff

• Compares:◦ Actual benefits to estimated benefits◦ Actual operating costs to estimated costs

• Evaluates the overall outcome of the investment• Proposes corrective action if needed

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Benefits of a Postaudit

• By evaluating profitability and cash flows, firms ensure that assets are used wisely

• Managers held accountable for results of capital investment decisions◦ More likely to make decisions in the best interest of

the firm◦ Feedback is gained and used in future decision

making

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Drawbacks of a Postaudit

• Costly• Limitations:

◦ Assumption driving original analysis may often be invalidated by changes in the actual operating environment

• Accountability must be qualified:◦ By the impossibility of foreseeing every possible

eventuality

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Mutually Exclusive Projects

• Net Present Value (NPV) and Internal Rate of Return (IRR) can produce different results

• NPV • Assumes that each cash flow received is reinvested

at the required rate of return• Measures cash flow profitability in absolute terms

◦ IRR ◦ Assumes that each cash flow is reinvested at the

computed IRR◦ Measures cash flow profitability in relative terms

◦ NPV consistently selects the project which maximizes the firm’s wealth

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Steps in Selecting Best Project

1. Assess the flow pattern for each project2. Compute the net present value (NPV) for each

project3. Identify the project with the greatest NPV