Chapter 25 – Capital Budgeting and Managerial Decisions
CHAPTER 25
CAPITAL BUDGETING AND MANAGERIAL DECISIONS
Related Assignment Materials
Conceptual objectives:
C1. Describe the importance of
relevant costs for short-term
decisions.
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Analytical objectives:
A1. Evaluate short-term managerial
decisions using relevant costs.
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A2. Analyze a capital investment
project using break-even time.
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Procedural objectives:
P1. Compute the payback period
and describe its use.
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P2. Compute accounting rate of
return and explain its use.
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P3. Compute net present value and
describe its use.
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9, 10, 14
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P4. Compute internal rate of return
and explain its use.
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* See additional information on next page that pertains to these quick studies, exercises and problems.
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Chapter 25 – Capital Budgeting and Managerial Decisions
Additional Information on Related Assignment Material
Connect (Available on the instructor’s course-specific website) repeats all numerical Quick Studies, all
Exercises and Problems Set A. Connect provides new numbers each time the Quick Study, Exercise or
Problem is worked. It allows instructors to monitor, promote, and assess student learning. It can be
used in practice, homework, or exam mode.
Corresponding problems in set B also relate to learning objectives identified in grid on previous
page.
Problems 25-1A and 25-4A can be completed using EXCEL. The Serial Problem for Success Systems
starts in this chapter and continues throughout many chapters of the text.
Synopsis of Chapter Revision
Adafruit Industries—New opener and entrepreneurial assignment.
Revised discussion of accounting rate of return
Revised discussion of net present value
Revised discussion of internal rate of return
Updated graphic showing cost of capital estimates by industry
Revised discussion of profitability index
New exhibit for profitability index
Enhanced graphics for NPV and IRR decision rules
Revised discussion of relevant costs and benefits for short-term decisions
Revised discussion and exhibits for short-term decisions, including additional business,
make or buy, scrap or rework, sell or process further, sales mix, and segment
elimination.
Added Sustainability section on computing net present values of investments in solar
energy
Added several end of chapter assignments
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Chapter 25 – Capital Budgeting and Managerial Decisions
Chapter Outline
Section 1 Capital Budgeting
I. Capital budgeting is a process of analyzing alternative long-term
investments and deciding which assets to acquired or sell
A. An objective of capital budgeting decisions is to earn a satisfactory
rate of return.
B. Such decisions require careful analysis because they are difficult
and risky.
1. Difficult because of need to make predictions of events that
will occur well into the future.
2. Risky because: Outcome is uncertain, large amounts of money
are involved, a long-term commitment is required, and the
decision may be difficult or impossible to reverse.
II. Methods Not Using Time Value of MoneyInvestments are expected
to produce net cash outflows; Net Cash flows equal cash inflows
minus cash outflows. Simple analysis methods do not consider the
time value of money.
A. Payback Period
1. Payback period is the expected amount of time recover the
initial investment amount.
2. Managers prefer investments with shorter payback periods.
a. Shorter payback period reduces risk of an unprofitable
investment over the long run.
b. Company’s risk due to potentially inaccurate long-term
predictions of future cash flows is reduced.
3. To compute payback period, exclude all non-cash revenue and
expenses from computation.
a. When annual cash flows are even in amount:
Payback Period = Cost of Investment
Annual net cash flows
b. When annual cash flows are unequal, payback period is
computed using the cumulative total of net cash flows
(starting with the negative cash flow resulting from the
initial investment); when cumulative net cash flow
changes from positive to negative, the investment is fully
recovered. (see Exhibit 25.3)
4. Payback period should not be only consideration in evaluating
investments; two factors are ignored.
a. Differences in the timing of net cash flows within the
payback period are not reflected. Investments that provide
cash more quickly are more desirable.
b. All cash flows after the point where its costs are fully
recovered are ignored.
Notes
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Chapter 25 – Capital Budgeting and Managerial Decisions
Chapter Outline
B. Accounting Rate of Return
1. The percentage accounting return on annual average
investment.
2. Called “accounting” return because it is based on net income
instead of on cash flows.
3. Computed as:
after tax net income
average annual investment
1. Accrual basis after-tax net income is used.
2. Compute the average investment:
a. If straight-line deprecation is used then:
Annual average = (Beg. Book Value + End. Book value)
Investment 2
where ending book value = salvage value if there is one
b. If the depreciation method is other than straight line
method then the general formula is:
Annual = sum of individual year’s average book value
Ave. Invest number of years of the planned investment
3. Accounting Rate of Return = After-tax net income
Average investment amount
4. Risk of an investment should be considered.
a. Investment’s return is satisfactory or unsatisfactory only
when related to returns from other investments with
similar lives and risk.
b. Capital investment with least risk, shortest payback
period, and highest return for the longest time is often
identified as best; analysis can be challenging because
different investments often yield different rankings
depending on measure used.
5. Accounting rate of return method is readily computed, often
used in evaluating investment opportunities, yet usefulness is
often limited. Should never be the only consideration in
evaluating investments. Limitations:
a. Net Incomes may vary from year to year.
b. Ignores the time value of money.
Notes
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Chapter 25 – Capital Budgeting and Managerial Decisions
Chapter Outline
III. Methods Using Time Value of MoneyNet present value and internal
rate of return methods consider time value of money.
A. Net Present Value (see also Appendix B near end of textbook)
1. Net Present Value (NPV) analysis applies the time value of
money to cash inflows and cash outflows so management can
evaluate a project’s benefits and cost at one point in time.
2. NPV is computed by discounting the future net cash flows
from the investment at the required rate of return, and then
subtract the initial amount invested.
a. The required rate of return also called the hurdle rate or
the cost of capital that the company must pay to its long-
term creditors and shareholders.
b. Each annual net cash flow is multiplied by the related
present value of 1 factor or discount factor. (Obtain from
Table B.1 in Appendix B.)
i. Discount factors assume that net cash flows are
received at the end of each year.
ii.Rate of return required by the company and number of
years until cash flow is received are used to determine
discount factors.
c. Initial amount invested includes all costs incurred to get
asset in proper location and ready to use.
3. Net Present Value Decision Rule
a. Net Present Value = PV of cash flows – Amount Invested
b. If the NPV is greater than or equal to $0, then asset is
expected to recover its cost and provide a return at least as
high as that required; invest.
c. If NPV is negative, Do not invest
6. NPV analysis can be used when comparing several investment
opportunities; if investment opportunities have same cost and
same risk, the one with highest NPV is preferred.
7. When annual net cash flows are equal in amount, NPV
calculation can be simplified.
a. Individual annual present value of $1 factors can be
summed, and the total multiplied by annual net cash flow
to get total present value of net cash flows.
b. To simplify the computation, the present value of an
annuity of $1 table may be used
c. Calculator with compound interest function or a
spreadsheet program can also be used.
8. NPV analysis can also be applied when net cash flows are
unequal. (Use procedures and decision-rules above.)
9. If salvage value is expected at end of useful life, treat as an
additional net cash flow received at end the of asset’s life.
Notes
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Chapter 25 – Capital Budgeting and Managerial Decisions
Chapter Outline
10. Accelerated depreciation methods do not change basics of
NPV analysis, but can change results; using accelerated
depreciation for tax reporting affects net present value of
asset’s cash flows
a. Accelerated depreciation produces larger depreciation
deductions in early years of asset’s life and smaller ones in
later years; large net cash inflows are produced in early
years and smaller ones in later years.
b. Early cash flows are more valuable than later ones; as
such, being able to use accelerated depreciation for tax
reporting makes investment more desirable.
11. NPV is of limited value for comparison purposes if initial
investment differs substantially across projects.
12. When a company can’t fund all positive net present value
projects , they can be compared using the profitability index
a. Profitability Index = Net present value of cash flows
Cost of investment
b. A higher profitability index makes the project more
desirable
13. When the projects being compared have different risks, the
NPVs of individual projects should be computed using
different discount rates; the greater the risk, the higher the
discount rate.
B. Internal Rate of Return
1. IRR is a rate used to evaluate acceptability of an investment; it
equals the rate that yields a NPV of zero for an investment.
2. If the total present value of a project’s net cash flows is
computed using the IRR as the discount rate, and then subtract
the initial investment from this total present value, we get a
zero NPV.
3. Two step process in computing IRR (equal cash flows)
a. Step 1: Compute the present value factor for the project
by dividing the amount invested by net cash flows.
b. Step 2: Find discount rate (IRR) yielding the PV factor.
i. A present value of an annuity table (see Appendix B)
can be used to determine the discount rate that relates
to this present value factor given the life of the
project.
ii. If the present value factor in the table does not exactly
equal the one computed, the procedure set forth on
page 1086 in the text.
Notes
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Chapter 25 – Capital Budgeting and Managerial Decisions
Chapter Outline
4. When cash flows are unequal, trial and error must be used;
select any reasonable discount rate and compute the NPV.
a. If amount is positive, recompute NPV using higher
discount rate; if amount is negative, recompute NPV using
lower discount rate.
b. Continue steps until two consecutive computations result
in NPVs that have different signs (positive and negative);
IRR lies between these two discount rates; value can be
estimated.
c. Spreadsheet software and calculators can also be used to
compute the IRR. (See Appendix 25A)
5. Compare IRR with hurdle rate (or minimum acceptable rate of
return); if IRR exceeds hurdle rate, invest.
6. If evaluating multiple projects, rank by extent to which IRR
exceeds hurdle rate.
7. IRR is not subject to limitations of NPV when comparing
projects with different amounts invested; IRR is expressed as
percent rather than an absolute dollar value using NPV.
C. Comparison of Capital Budgeting Methods (see Exhibit 25.10)
1. Payback period and accounting rate of return do not consider
time value of money; NPV and IRR do.
2. Payback period method is simple; sometimes used when
limited cash to invest and a number of projects to choose
from. Gives manager an estimate of how soon the initial
investment can be recovered.
3. Accounting rate of return is a percent computed using accrual
income instead of cash flows, and is an average rate for the
entire investment period; annual returns are not reflected.
4. Net Present Value (NPV):
a. Considers all estimated cash flows of project; can be
applied to equal and unequal cash flows.
b. Can reflect changes in level of risk over life of project.
c. Comparisons of projects of unequal sizes is more difficult
5. Internal Rate of Return (IRR):
a. Considers all estimated cash flows of project.
b. Readily computed when cash flows are equal, but requires
trial and error estimation when cash flows are unequal.
c. Allows comparisons of projects with different investment
amounts.
d. Does not reflect changes in risk over life of project.
Notes
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Chapter 25 – Capital Budgeting and Managerial Decisions
Chapter Outline
Section 2—Managerial Decisions
Emphasis is on use of quantitative measures to make important short-term
decisions. Costs and other factors relevant to decision must be identified.
I. Decisions and Information
A. Decision Making
1. Five steps involved in managerial decision making.
a. Define the decision task
b. Identify alternative courses of action.
c. Collect relevant information and evaluate each alternative.
d. Select the preferred course of action.
e. Analyze and assess the decision.
2. Both managerial and financial accounting information play
important role in making decisions
a. Accounting system provides primarily financial
information such as performance reports and budget
analyses.
b. Non-financial information is also relevant, such as
environmental effects, political sensitivities, and social
responsibility.
B. Relevant Costs and Benefits
1. Most financial measures from cost accounting systems are
based on historical amounts; however, relevant costs, or
avoidable costs, are especially useful. Three types of costs:
a. Sunk cost arises from a past decision; cannot be avoided or
changed, and not relevant to future decisions.
b. Out-of-pocket cost requires future outlay of cash and
results from result of management’s decisions; is relevant.
c. Opportunity cost is a potential benefit lost by taking
specific action when two or more alternative choices are
available; consideration is important.
2. Relevant costs in making decisions are the incremental, also
called differential costs, which are the additional costs
incurred if a company pursues a certain course of action.
3. Relevant benefits are additional or incremental revenue
generated by selecting a particular course of action over
another; relevant to decision-making.
Notes
Chapter Outline Notes
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Chapter 25 – Capital Budgeting and Managerial Decisions
II. Managerial Decision Scenariosconsider each decision task
discussed below independent from the others.
A. Additional Business
1. Effect on net income must be considered when deciding
whether to accept or reject an order; reject if loss results.
2. Historical costs are not relevant to this decision.
3. Incremental or additional costs (also called differential costs)
are additional costs incurred if company pursues certain
course of action; relevant to this decision.
4. Minimum acceptable price per unit can be determined by
dividing incremental cost by the number of units in the order.
5. Incremental costs of additional volume are relevant.
6. If additional volume approaches or exceeds existing available
capacity of factory, incremental costs required to expand
capacity may quickly exceed incremental revenue.
7. Accepting order may cause existing sales to decline; the
contribution margin lost from the decline in sales is an
opportunity cost and is relevant (if future cash flows over
several time periods are affected, net present value should be
computed).
8. Note – Allocated overhead costs, which are historical costs,
should not automatically be considered; only incremental costs
to be incurred are relevant.
9. Key point: management must not blindly use historical costs,
especially allocated to overhead costs. Instead the accounting
system needs to provide incremental cost information if the
additional business is accepted.
B. Make or Buy
1. When determining whether to make or buy a component of a
product, only incremental costs are relevant.
2. Only incremental (additional) overhead costs are relevant; an
incremental overhead rate should be determined.
3. If the incremental costs of making the component exceed the
purchase price paid to buy the component, decision rule would
be to buy; however, several other factors should be
considered.
a. Product quality.
b. Timeliness of delivery (especially in JIT settings).
c. Reactions of customers and suppliers.
d. Other intangibles (employee morale and workload).
e. Must also consider if making the part will require
incremental fixed costs to expand plant capacity.
4. Make or buy decision for component parts can also be used for
decisions about the outsourcing of services.
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Chapter 25 – Capital Budgeting and Managerial Decisions
Chapter Outline
C. Scrap or Rework
1. Costs already incurred in manufacturing units of product not
2. Incremental revenues, incremental costs of reworking defects,
1. Partially completed products can be sold as is or they can be
processed further and then sold as other products.
2. Compute incremental revenue from further processing
3. Compute incremental cost from further processing.
4. Process further and sell if incremental revenue from further
1. When more that one product is sold, some are likely to be
2. If production facilities or other factors are limited, an increase
3. The most profitable combination, or sales mix, of products
should be determined. To identify the best sales mix,
4. Determine the contribution margin of each product, the
5. If demand is unlimited and the products use the same inputs
6. If demand is unlimited but the products use different inputs
then determine contribution margin per unit of the constraint
7. If demand is limited then the company should first produce the
Notes
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Chapter 25 – Capital Budgeting and Managerial Decisions
Chapter Outline
F. Segment Elimination
1. If segment, division, or store is performing poorly,
management must consider eliminating it.
2. It is not sufficient to base the decision on net income (loss) or
its contribution to overhead.
3. Need to consider avoidable and unavoidable expenses:
a. Avoidable (or escapable) expenses are costs or expenses
4. Decision rule – Segment is candidate for elimination if its
revenues are less than its avoidable expenses.
5. Should also assess impact of elimination on other segments.
a. An unprofitable segment might contribute to another
1. Must decide whether the reduction in variable manufacturing
costs over its life is greater than the net purchase price of the
new equipment.
a. Net purchase price is the cost of the new equipment less
any trade in allowance given or cash receipt for the old
equipment.
b. Book value of the old equipment is not used. It is a sunk
cost.
III. Decision AnalysisBreak-Even Time (BET) A variation of the
payback period method – overcomes the limitation of not using the
time value of money
A. The future cash flows are restated in terms of their present values;
B. The payback period is computed using these present values
C. Break-even time (BET) is useful measure; managers know when
to expect cash flows to yield net positive returns.
D. If BET is less than estimated life of investment, positive net
present value can be expected from investment.
E. To compare and rank alternative investment projects, choose the
project with the lowest break-even time.
Notes
Alternate Demo Problem Twenty-Five
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Chapter 25 – Capital Budgeting and Managerial Decisions
A company is planning to buy a new machine at a cost of $200,000. The
machine is expected to last for 10 years and have no salvage value at the
end of its useful life. Straight-line depreciation will be used. The company
expects to save 10,000 hours of direct labor each year because of the new
machine, as well as $4,000 each year in other operating costs.
Management’s best estimate is that on average the hourly rate for the labor
saved will be $5.50. With the exception of the initial purchase, assume all
cash flows take place at the end of the year, and a tax rate of 40%.
Required:
1. Calculate the payback period on the investment in new machinery.
2. Calculate the rate of return on the average investment.
3. Calculate the net present value of the investment and profitability index:
(a) Ignoring income taxes, using a discount rate of 10%.
(b)Including the effect of taxes, using a 10% discount rate.
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