Topics: Net present value, Internal rate of return, Cash flow Pages: 95 (2246 words) Published: October 25, 2013
ACCG301: Organisational Planning and Control

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

Dr. Ranjith Appuhami

Department of Accounting and Corporate Governance

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)
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.

Stages of Capital Budgeting and Capital
Expenditure Approval Process


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

Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)

Traditional (non-discounted) Cash Flow Methods:

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

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:
Cost of goods sold
Depreciation expense
Selling & Admin expense
Income before income tax
Income tax
Net Income



Computation of Annual Cash Inflow
Expected annual net cash inflow =
Net income
Depreciation expense


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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