# accg301

**Topics:**Net present value, Internal rate of return, Cash flow

**Pages:**95 (2246 words)

**Published:**October 25, 2013

LECTURE 11

Capital Budgeting Decisions

Chapters 21: Management Accounting (6e) Langfield-Smith

Dr. Ranjith Appuhami

Department of Accounting and Corporate Governance

accg301@mq.edu.au

Learning Outcomes

1. Recognise the multiyear focus of capital budgeting

2. Understand the stages of capital budgeting and approval

process for a capital expenditure project

3. Use and evaluate the two main discounted cash flow (DCF)

methods: the net present value (NPV) method and the

internal-rate-of-return (IRR) method

4. Use and evaluate the payback method (PB)

5. Use and evaluate the accounting rate-of-return (ARR)

method

6. Income taxes and capital expenditure analysis

7. Post-completion audits

Capital Budgeting

• Capital budgeting involves investment decisions in projects that spans multiple years.

– A good investment decision

• One that raises the current market value of the firm’s equity, thereby creating value for the firm’s shareholders

– Capital budgeting involves

• Comparing the amount of cash spent on an investment today with the cash inflows expected from it in the future

– Time value of money

• A dollar received today is worth more than a dollar received tomorrow – Apart the timing issue, there is also an issue of the risk associated with future cash flows

• Since there is always some probability that the cash flows realized in the future may not be the expected ones

Types of Projects

•

•

•

•

Brand new line of business

Expansion of existing line of business

Replacement of existing asset

Independent vs. Mutually Exclusive

– Independent projects – if the cash flows of one are

unaffected by the acceptance of the other – more than

one project may be accepted.

– Mutually exclusive projects – if the cash flows of one project can be adversely impacted by the acceptance of

the other – accept one or the other.

BRIDGE VS.

BOAT

Stages of Capital Budgeting and Capital

Expenditure Approval Process

Industry

Analysis

Capital Budgeting Methods

Discounted Cash Flows Methods:

• Discounted Cash Flow (DCF) Methods measure all expected future cash inflows and outflows of a project as if they occurred at a single point in time • The key feature of DCF methods is the time value of money (interest), meaning that a dollar received today is worth more than a dollar received in the future

1.

Net Present Value (NPV)

2.

Internal Rate of Return (IRR)

3.

Profitability Index (PI)

Traditional (non-discounted) Cash Flow Methods:

1.

2.

Payback Period (PB)

Accounting Rate of Return (ARR)

Net Present Value (NPV)

• The is the current value of a project.

Initial Investment Less present value of expected

future cash inflows

• Method:

1. estimate the expected future cash flows.

2. estimate the required rate of return for projects at a given risk level.

3. find the present value of the cash flows and subtract the initial investment (use time value of money concept –

discounted cash flows (DCF).

• Decision Rule: Accept the project if the NPV is

positive

Example

Orix Co. is considering an investment of $130,000 in new

equipment. The new equipment is expected to last 10 years. It will have zero salvage value at the end of its useful life. The straight-line method of depreciation is used for accounting

purposes. Assume the company requires a minimum return of

12%. The expected annual revenues and costs of the new

product that will be produced from the investment are:

Sales

Cost of goods sold

Depreciation expense

Selling & Admin expense

Income before income tax

Income tax

Net Income

$200,000

$145,000

13,000

22,000

180,000

$20,000

7,000

$13,000

Computation of Annual Cash Inflow

Expected annual net cash inflow =

Net income

Depreciation expense

$13,000

13,000

$26,000

The uniform/equal amount Orix

Co. will receive every year for the

next 10 years

Present value interest factor of $1...

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