ACCTG 312Capital

BudgetingChapter 21Week 11A

Two Dimension of Cost Analysis Project-by-Project Dimension: one project spans

multiple accounting periods Period-by-Period Dimension: one period contains

multiple projects

Project and Time Dimensions of Capital Budgeting Illustrated

Capital Budgeting Capital Budgeting is making a long-run planning

decisions for investing in projects Capital Budgeting is a decision-making and control

tool that spans multiple years

Six Stages in Capital Budgeting1. Identification Stage – determine which types of

capital investments are necessary to accomplish organizational objectives and strategies

2. Search Stage – Explore alternative capital investments that will achieve organization objectives

Six Stages in Capital Budgeting:Continued3. Information-Acquisition Stage – consider the

expected costs and benefits of alternative capital investments

4. Selection Stage – choose projects for implementation

5. Financing Stage – obtain project financing6. Implementation and Control Stage – get projects

under way and monitor their performance

Four most popular methods for assessing your business plans (external reason)

1. Net Present Value (NPV)2. Internal Rate of Return (IRR)3. Payback Period4. Accrual Accounting Rate of Return (AARR)

You need to have and exit plan as well

Net Present Value (NPV) Method

NPV method calculates the expected monetary gain or loss from a project by discounting all expected future cash inflows and outflows to the present point in time, using the Required Rate of Return (RRR),

Based on financial factors alone, only projects with a zero or positive NPV are acceptable

The key feature of NPV method is the time value of money (interest), meaning that a dollar received today is worth more than a dollar received in the future

Required Rate of Return (RRR),

RRR is the return that an organization could expect to receive elsewhere for an investment of comparable risk

RRR is also called the discount rate, hurdle rate, cost of capital or opportunity cost of capital

Three-Step NPV Method

1. Indentify the relevant cash inflows and outflows

2. Convert the inflows and outflows into present value figures using tables or a calculator

3. Sum the present value figures to determine the NPV. Positive or zero NPV signals acceptance, negative NPV signals rejection

NPV Method Illustrated

Internal Rate of Return (IRR) Method The IRR Method calculates the discount rate at which

the present value of expected cash inflows from a project equals the present value of its expected cash outflows

A project is accepted only if the IRR equals or exceedsthe required rate of return (RRR)

As with NPV, the key feature of IRR method is the time value of money (interest), meaning that a dollar received today is worth more than a dollar received in the future

IRR Method

You may use a calculator or computer program to provide the IRR

Trial and Error Approach: Use a discount rate and calculate the project’s NPV. Goal:

find the discount rate for which NPV = 01. If the calculated NPV is greater than zero, use a higher

discount rate2. If the calculated NPV is less than zero, use a lower discount

rate3. Continue until NPV = 0

IRR Method Illustrated

Payback Method

Payback measures the time it will take to reimburse, in the form of expected future cash flows, the net initial investment in a project

Shorter payback period are preferable

In risky environment payback method is preferable. The greater the risk, the shorter the payback period

Easy to understand

Payback Method Continued

Payback Net Initial InvestmentPeriod Uniform Increase in Annual Future Cash Flows=

With uniform cash flows:

With non-uniform cash flows: add cash flows period-by-period until the initial investment is recovered; count the number of periods included for payback period

Accrual Accounting Rate of Return Method (AARR)

AARR Method divides an accrual accounting measure of average annual income of a project by an accrual accounting measure of its investment

Also called the Accounting Rate of Return

Increase in Expected AverageAccrual Accounting Annual After-Tax Operating Income

Rate of Return Net Initial Investment=

AARR Method

Firms vary in how they calculate AARR Easy to understand, and use numbers reported in

financial statements Does not track cash flows Ignores time value of money

Assessing your project: an example A potential investor is considering to buy 10% of a BBIM project (which is a special- designing software) for $23,000. It is expected to have a useful life of 4 years with no terminal disposal value. The BBIM team manager estimates the following saving for 10% share for next 4 years:

The potential investor uses a required rate of return of 16% for its potential investments and wants to use the software for its own business. Ignore income taxes in your analysis. Assume all cash flows occur at year-end except for initial investment amounts.

1. Calculate net present value for the 10% share of the project (using 16% interest rate)

Discount factor for the end of year 1 1/ (1.16) = 0.862Discount factor for the end of year 2 1/ (1.16)2= 0.743 Discount factor for the end of year 3 1/ (1.16)3= 0.641Discount factor for the end of year 4 1/ (1.16)4= 0.552

2. Calculate the payback period for the project

3. Calculate the internal rate of return for the project

4. Calculate the accounting rate of return for the project

Comparison NPV and IRR Methods IRR is widely used NPV can be used with varying projects NPV of projects may be combined for evaluation

purposes, IRR cannot Both may be used with sensitivity analysis (“what-if”

analysis)