Chapter 12 - Strategy and the Analysis of Capital Investments
Collectively, the discussion at this point is meant to both emphasize the strategic role of capital budgeting
and the role that management accounting plays in the capital budgeting process.
We then present students with information regarding a proposed long-term investment project that a
hypothetical firm (Mendoza Company) is considering. This information is presented in Exhibit 12.1.
Next, we provide a structure that can be used to identify relevant cash flows data at each of three primary
stages of a capital budgeting project: project initiation (Stage I), project operation (Stage II), and project
disposal (Stage III). Using this framework, we cast the data from Exhibit 12.1 into a form (Exhibit 12.2)
that can be used for properly analyzing proposed investment projects. Of particular importance to the
discussion is the tax savings associated with the depreciation deductions associated with an investment.
Background information for discussing this issue is provided in Exhibit 12.3 (Recovery Periods under
MACRS) and Exhibit 12.4 (MACRS depreciation rates for various asset lives). The discussion of
generating relevant cash flow data for evaluating a proposed long-term investment concludes with a
discussion regarding the income tax effects associated with an asset disposal (i.e., gain or loss on sale);
Exhibit 12.5 is meant to provide guidance in this regard.
After setting the stage by gathering pertinent cash flow data, we then transition to the topic of how such
data can be properly analyzed in a manner that informs the investment decision. We begin this topic by
asking students how prices in the market for common stocks are set. This leads to a discussion of DCF-
based (NPV, IRR, etc.) versus non-DCF-based capital budgeting decision models (e.g., ARR, Payback).
We point out to students that appropriate financial formulas in Excel can (and should) be used to calculate
NPV and IRR.
At this point, students may wonder “which of these approaches are used in practice?” The information in
Exhibit 12.6 & Exhibit 12.7 can be used to address this question of the relative use of DCF-based vs.
non-DCF-based capital budgeting decision models.
Depending on the background of students, the instructor may spend additional time discussing the
appropriate discount rate for DCF-based models. In general, this discount rate (sometimes referred to as
the “hurdle rate”) is defined as the company’s “weighted-average cost of capital (WACC).” Exhibit 12.8
could be discussed with students at this point; an example of estimating the WACC for a hypothetical
situation is presented in Exhibit 12.9. It is then appropriate to discuss with students the need to conduct
sensitivity analysis (given the assumptions that need to be made to estimate an entity’s WACC). There is
ample material in the text, both in the form of Brief Exercises, Exercises, and Problems to cover DCF
models, estimating the firm’s WACC, and using sensitivity analysis as an integral part of the capital
New to the 6th edition was an expanded discussion of the asset-replacement decision; this extended
discussion is extended into the 7th edition. Our experience is that this decision is one of the more
complicated ones for students (and professionals!) to properly structure and analyze. Alternative formats
for structuring the investment decision are presented in the templates associated with Appendix A.
Depending on the goals of the instructor, and the audience, one can then discuss non-DCF decision models
(i.e., Payback Period, and the Accounting (Book) Rate of Return methods). We like to use Exhibit 12.13
as the basis for comparing DCF and non-DCF capital budgeting decision models.
The text then provides an extensive discussion—probably more than any other cost accounting text—of
ways of dealing with uncertainties in the capital budgeting process. Given the long-term planning horizon
embedded in typical capital budgeting projects, this topic is deemed critical for students to understand.
Thus, we provide a discussion of two broad approaches to dealing with uncertainty: sensitivity analysis
(what-if analysis; scenario analysis; and, Monte Carlo Simulation (MCS)) and real options. Relative to