March 10, 2020

Chapter 12 - Strategy and the Analysis of Capital Investments

Chapter 12

Strategy and the Analysis of Capital Investments

Learning Objectives

LO 12-1Explain the strategic role of capital-investment analysis

LO 12-2Describe how accountants can add value to the capital-budgeting process

LO 12-3 Provide a general model for determining relevant cash flows associated with capital-

investment projects

LO 12-4 Apply discounted cash flow (DCF) decision models for capital-budgeting purposes

LO 12-5 Deal with uncertainty in the capital-budgeting process

LO 12-6 Discuss and apply other capital-budgeting decision models

LO 12-7 Identify behavioral issues associated with the capital-budgeting process

LO 12-8 Understand and use alternative presentation formats for the asset-replacement decision

(Appendix A)

LO 12-9 Identify selected advanced considerations in making capital-investment decisions

(Appendix B)

New in this Edition

All new beginning-of-chapter real-world examples of capital expenditure decisions undertaken by

a variety of organizations

Shorter, more parsimonious discussion of material throughout the chapter

Newly added pedagogical references: the mechanics of the discounting process (Martinez, 2013);

application of Monte Carlo Simulation to the problem of estimating an entity’s weighted-average

cost of capital (Berry et al., 2014); the proper interpretation of the Internal Rate of Return (IRR)

(Rich and Rose, 2014); and, the structuring of an asset-replacement capital investment analysis

(Chen and Mayes, 2012)

Revision of two new Real-World Focus (RWF) items: Retirement Planning/Sensitivity Analysis,

and the Application of Real Options Analysis

Revision of three end-of-chapter problems

Teaching Suggestions

Depending on the depth required, this chapter can be taught in two or three 75-minute classes. (If the topic

of “real options” is covered, then a fourth class meeting might be required.) To pique the interest of

students in the subject matter, we begin chapter 12 is a variety of long-term investment examples, as taken

from the business press (WSJ, etc.). The introductory sections of the chapter provide a discussion of the

linkage between capital budgeting and strategy. This sets the stage for a strategic positioning of the topic

of capital budgeting and long-term investment analysis. Included as well in the introduction is a statement

regarding the role of accounting in the capital budgeting process. That is, we attempt here to anticipate

student questions such as “Isn’t this a finance topic?” Thus, we connect the subject of capital budgeting to

other accounting topics to which the student has been exposed. For example, we discuss the linkage

between capital budgeting and the master budgeting process (Chapter 10) and the Balanced Scorecard

(BSC) (Chapter 18). We then tell students that, in particular, management accountants add value to the

capital budgeting process by generating relevant after-tax cash-flow data, which serve as inputs to modern

(i.e., discounted cash flow) capital budgeting decision models. Finally, in terms of accounting’s role in the

capital-budgeting decision process, we discuss with students the role of post-completion audits.

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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

budgeting process.

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

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Chapter 12 - Strategy and the Analysis of Capital Investments

other texts, the discussion of real options is particularly in-depth. Specifically, we provide an example of

an investment-timing option and then address the issue of the underlying value of real options.

Time permitting, the instructor can cover one or both of the following topics: (1) behavioral considerations

in the capital budgeting process (viz., cost escalation, incrementalism, and uncertainty intolerance, and

goal-congruency issue), and (2) selected complexities associated with the use of DCF models. Of

particular interest in terms of the former is the “goal congruency” problem that arises when one type of

model is used for decision-making (DCF-based) and another model (accrual accounting income) is used to

evaluate subsequent financial performance. We offer some insight as to ways to minimize this goal-

congruency issue. The latter material, found in Appendix B, comprises three topics: the problem of

multiple IRRs (depending on the pattern of project net cash flows), the question of mutually exclusive

projects, and the issue of capital rationing. Except for the capital rationing issue, where some measure of

relative profitability is appropriate (e.g., use of the profitability index [PI]), the general conclusion is to

rely on the use of the NPV decision criterion for capital budgeting purposes.

Appendix C contains present value tables. Notes appended to these tables provide the student with

formulas that can be used to generate the figures presented in Tables 1 and 2 of Appendix C.

New References—7th Edition

V. Martinez, “Time Value of Money Made Simple: A Graphic Teaching Method,” Journal of Financial

Education 39, Numbers 1/2 (Spring/Summer 2013), pp. 96-113. This article presents a visual aid for

structuring a variety of time-value-of-money problems, including: future value of a lump sum;

present value of a lump sum; future value of an annuity; present value of an annuity; and present

value of a perpetuity. As such, the article may be helpful in responding to some of the end-of-chapter

assignments in this chapter.

S. G. Berry, C. E. Betterton, and I. Karagiannidis, “Understanding Weighted-Average Cost of Capital: A

Pedagogical Application,” Journal of Financial Education 40, Numbers 1/2 (Spring/Summer, 2014),

pp. 115-136. This article includes an interactive spreadsheet model for estimating a company’s

WACC. The model allows students to explore alternative mixes of debt and equity in terms of a

company’s WACC. In addition, the model uses Crystal Ball (registered trademark of Oracle

Corporation) to perform Monte Carlo simulation analysis on several input variables to the WACC

calculation.

S. P. Rich and J. T. Rose, “Re-Examining an Old Question: Does the IRR Method Implicitly Assume a

Reinvestment Rate?” Journal of Financial Education 40, Numbers 1/2 (Spring/Summer 2014), pp.

152–166. This paper demonstrates that IRR can be interpreted as a constant rate of return on the

declining balance of an investment. As such, and similar to a typical mortgage, each receipt (or

payment in a mortgage context) consists of a partial return on investment and a partial return of the

original investment (capital).

N. Dhiensiri and N. Balsara, “An Introductory Application of Monte Carlo Simulation in Capital

Budgeting Analysis,” Journal of Financial Education 40, Numbers 1/2 (Spring/Summer 2014), pp.

94–114.

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Chapter 12 - Strategy and the Analysis of Capital Investments

Assignment Matrix

End-of-Chapter Exercises & Problems Chapter Learning Objectives (LOs) Text Features

7th ed.

EOC

6th ed.

EOC

Transition

6e to 7e

X = included in Connect

Est. Time

1. Strategic Role of Cap. Budgeting

2. How accountants add value

3. Determining relevant cash flows

4. Apply DCF models

5. Uncertainty analysis

6. Non-DCF decision models

7. Behavioral considerations

8. Asset-replacement decisions

9. Advanced considerations

Strategy

Service

International

Ethics

Sustainability

Brief Exercises

12-16 12-16 - X 5 min X

12-17 12-19 - X 5 min X

12-18 12-20 - X 10 min X

12-19 12-21 - X 5 min X

12-20 12-22 - X 10 min X X

12-21 12-24 - X 10 min X

12-22 12-17 - X 10 min X X

12-23 12-18 - X 10 min X

12-24 12-26 - X 10 min X

12-25 12-27 - X 10 min X

12-26 12-23 - X 15 min X X

12-27 12-25 - X 10 min X X

Exercises

12-28 12-28 - X 25 min X

12-29 12-32 - X 40 min X X

12-30 12-31 - X 30 min X

12-31 12-33 - X 25 min X

12-32 12-35 - X 45 min X X

12-33 12-36 - - 40 min X

12-34 12-34 - X 15 min. X X

12-35 12-43 - X 50 min. X X

12-36 12-30 - X 30 min. X X

12-37 12-40 - X 35 min X X

12-38 12-41 - X 40 min X X X

12-39 12-46 - X 45 min X X

12-40 12-37 - X 45 min X X

12-41 12-38 - X 30 min X X X

12-42 12-39 - X 45 min X X X X

12-43 12-29 Revised X 60 min X X

12-44 12-42 - X 60 min X X X

Continued on next page…

Chapter 12 Assignment Matrix—Continued

End-of-Chapter Exercises and Problems Chapter Learning Objectives Text Features

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Education.

7th ed.

EOC

6th ed.

EOC

Transition

6e to 7e

X = included in Connect

Est. Time

1. Strategic Role of Cap. Budgeting

2. How accountants add value

3. Determining relevant cash flows

4. Apply DCF models

5. Uncertainty analysis

6. Non-DCF decision models

7. Behavioral considerations

8. Asset-replacement decisions

9. Advanced considerations

Strategy

Service

International

Ethics

Sustainability

12-45 12-44 - X 50 min X X X

12-46 12-45 Revised X 50 min. X X X X

Problems

12-47 12-47 Revised - 60 min X X

12-48 12-48 Revised - 75 min X X X

12-49 12-49 Revised - 75 min X X X

12-50 12-50 - - 60 min X X

12-51 12-51 - - 60 min X X

12-52 12-52 - - 60 min X X X

12-53 12-53 - - 60 min. X X X X

12-54 12-54 - - 75 min X X

12-55 12-55 Revised - 75 min X X X X X

12-56 12-56 Revised - 60 min X X X X

12-57 12-57 - - 60 min X X X X

12-58 12-58 - - 60 min X X X X

12-59 12-59 - - 60 min X X X X

12-60 12-60 - - 60 min X X

12-61 12-61 - - 45 min X X X

12-62 12-62 - - 50 min X X

Lecture Notes

Introductory Definitions

A capital investment requires committing a large sum of funds to a project with expenditures and benefits

expected to stretch well into future. There are, in general, three types of capital investments: investments

to meet regulatory, safety, health, and environmental requirements; investments to enhance efficiency

and/or increase revenue; and, investments to enhance competitive effectiveness.

A capital budget is a listing of approved investment projects for an upcoming (budget) period. As such,

the capital budget is an integral part of the organization’s Master Budget (covered in Chapter 10).

The term capital budgeting refers to the process of making capital investment decisions. Capital

budgeting processes include project identification and definition, project evaluation and selection, and

project monitoring and review.

Discounted cash flow (DCF) capital budgeting decision models are those that explicitly incorporate the

time-value of money. The following five DCF decision models are covered in Chapter 12: net present

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Chapter 12 - Strategy and the Analysis of Capital Investments

value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), present value payback

period, and present value index (PI).

Non-discounted cash flow (non-DCF) capital budgeting decision models are those that do not explicitly

incorporate the time-value of money into the analysis. Chapter 12 discusses two such models: (unadjusted)

payback period, and accounting (book) rate of return (ARR).

Discount rate equals the interest rate (“hurdle rate” or “minimum rate of return”) used in DCF models to

convert estimated future after-tax cash flows (inflows and outflows) back to a present-value basis. For

projects of average risk, financial theory specifies that the discount rate be defined as the weighted-

average cost of capital (WACC) for the company. For projects of greater-than--average risk, the hurdle

rate > WACC (and vice versa).

Strategic Cost Management and Capital Investments

A capital investment analysis needs to take into consideration the firm’s strategic positioning and

competitive advantage, effect of the investment on both upstream and downstream activities in the firm’s

value chain, and impact of strategic structural and executional cost drivers.

Important factors considered or methods used in evaluating capital investments are likely to be different

for projects that fulfill different strategic missions. Volume is not the only cost driver in activities

considered in a capital investment project. Effects of structural or executional cost drivers are important

considerations in investment decisions.

How Can Accountants Add Value to the Capital Budgeting Process?

Accounting students need to understand how accounting adds value to what could otherwise be considered

a “finance topic,” capital budgeting. We propose at least four areas in which accounting can add value to

the process:

Linkage (of the Capital Budget) to the organization’s Master Budget

Linkage (of the capital budgeting process) to the organization’s Balanced Scorecard (BSC) through

the use of:

scoring models

multi-attribute utility theory (MAUT)

the Analytic Hierarchy Process (AHP)

Generation of relevant financial data for decision-making purposes (similar to the discussion in

Chapter 11)

Conducting capital budgeting post-audits (post-project reviews)

Relevant (Cash Flow) Data for Capital Budgeting Purposes

As noted above, accounting can value to the capital budgeting process by providing decision-makers with

relevant financial data, which can be used in either DCF or non-DCF decision models. In theory, the

market uses estimates of cash flows in making valuation decisions (e.g., in valuing shares of stock traded

on an open exchange). Thus, the text focuses on the determination of relevant cash-flow data for capital

budgeting purposes.

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