Chapter 26 – Capital Budgeting
Financial and Managerial Accounting, 17/e 26-1
26 CAPITAL
BUDGETING
Chapter Summary
Capital investment decisions are among the most strategically important
challenges faced by investment center managers.
Three capital budgeting or investment selection techniques are explored in detail.
These are the payback method, return on average investment, and net present value. The
critical importance of cash flows to the decision-making process is emphasized
throughout. A single illustration is used to permit comparison of the three approaches.
This comparative analysis demonstrates that the payback and accounting rate of return
models fail to recognize the timing of cash flows and the time value of money, and are as
a result theoretically deficient to the net present value criterion. An additional illustration
considers the capital budgeting decision regarding replacement of an existing asset.
The importance of nonfinancial considerations in project selection is raised at
several points in the chapter. Finally, the chapter concludes with an analysis of
behavioral considerations that must enter the capital budgeting process.
Learning Objectives
1. Explain the nature of capital investment decisions.
2. Identify nonfinancial factors in capital investment decisions.
3. Evaluate capital investment proposals using (a) payback period, (b) return on
investment, and (c) discounted cash flows.
4. Discuss the relationship between net present value and an investor’s required rate of
return.
5. Explain the behavioral issues involved in capital budgeting and identify how
companies try to control the capital budgeting process.
Chapter 26 – Capital Budgeting
Brief topical outline
A Capital investment decisions
1 Financial and nonfinancial considerations
B Evaluating capital investment proposals: an illustration
1 Payback period
2 Return on average investment
3 Discounting future cash flows – see Your Turn (page 1123)
4 Replacing assets
a Determining the present value of incremental cash flows
b Summary of financial considerations – see Your Turn (page
1125)
c Nonfinancial considerations – see Case in Point (page 1126)
C Behavioral considerations in capital budgeting
D Concluding remarks – see Ethics, Fraud & Corporate Governance
(page 1128)
Topical coverage and suggested assignment
Homework Assignment
(To Be Completed Prior to Class)
Class
Meetings
on Chapter
Topical
Outline
Coverage
Discussion
Questions
Brief
Exercises
Exercises
Problems
1
A
1, 12, 13
1
7
2
B
2, 3, 4, 5
2, 3, 4, 5,
6,
1, 2, 3, 4
1
3
B – D
9, 11, 12, 13
7, 8, 9
5, 6, 8, 9, 10
2
Chapter 26 – Capital Budgeting
Financial and Managerial Accounting, 17/e 26-3
Comments and observations
Teaching objectives for Chapter 26
In this final chapter, we conclude our treatment of the use of accounting information to
support decisions by examining the selection of capital investment projects. This topic
demands a great deal of judgment and reasoning in addition to mechanical computations.
Our classroom objectives during the presentation of the chapter are to:
1 Discuss the nature of capital investment decisions including the importance of
nonfinancial considerations.
2 Analyze the annual net cash flows from a specific investment project.
3 Evaluate a capital investment proposal using the payback period, and the return on
average investment.
4 Come to an understanding of the limitations of techniques that ignore the timing of
future cash flows.
5 Review the use of present value tables in discounting future cash flows.
6 Illustrate the calculation of a project’s net present value, and explain the use of the
NPV in project selection.
7 Discuss the decision to replace existing capital assets emphasizing relevant
information, incremental analysis, discounting future cash flows, and income tax
considerations.
8 Explain what steps might be taken to assure the objectivity of cash flow estimates
provided by employees.
Chapter 26 – Capital Budgeting
General comments
The topic of capital budgeting involves the use of present value tables to discount future
cash flows. If students have not already covered Appendix C, they should read it at this
time. This appendix provides a more thorough discussion of the use of present value
tables than does Chapter 26. It may be necessary to expand the assignment schedule by
one or two classes to cover the appendix material.
In the capital budgeting area, we assign Exercise 4 to be sure that students are able to
use the present value tables. This exercise is particularly important if Appendix C was
not covered earlier in the course. We also like Problems 1 and 2 as a basic capital
budgeting assignment. We recommend using Problem 10 or Case 1 (if time permits) as a
follow-up problem on capital budgeting. The case is relatively unstructured, and requires
students to identify relevant information before applying capital budgeting techniques.
An aside The use of discounted cash flow techniques can bias decisions against
investment in new technologies if managers fail to consider all of the benefits of
investment including reduced inventory levels, reduced floor space, increases in product
quality, shortened cycle times, etc. Unfortunately most traditional cost accounting
systems are not equipped to capture such benefits. One General Electric executive
commented that, “Urgently needed are new cost/benefit formulas and measurements that
go beyond the usual return on investment evaluations to take into account the total impact
of automation on the business.”
Supplemental Exercises
Group Exercise
As students you have all made an important capital budgeting decision by opting to
pursue a college or university degree. Develop a list of the critical financial and
nonfinancial factors that entered into this decision. Without actually making the
calculation, indicate what information would be required to calculate the payback period
or net present value of the investment you are making in your education. Present the
results of your group discussion to the class.
At most colleges and universities there is little if any difference between the tuition
charged for liberal arts programs and that charged for professional or technical degrees.
Under such circumstances how does the net present value of a liberal arts degree compare
to a degree in business or computer science? Using the concepts of capital budgeting
evaluate and discuss the economic merits of this pricing strategy.
Internet Exercise
PricewaterhouseCoopers published a survey, “The Information Reporting Gap in the
U.S. Capital Markets.” In this study, investors were asked to rate the value of a variety of
Chapter 26 – Capital Budgeting
Financial and Managerial Accounting, 17/e 26-5
performance measures. “Capital expenditures” was ranked as particularly valuable by
90% of those surveyed. Only three measures received a higher rate of acceptance, and
one of these was “R&D Investment Amounts.” Clearly, investors are impressed by firms
that pursue aggressive programs of investment spending. We can conduct a crude test of
this hypothesis. Visit the website of Fortune magazine at www.fortune.com. Select the
link to Fortune’s feature “America’s Most Admired Companies” and choose the option
that allows you to compare the Top Ten with the Bottom Ten. Select one or two
companies from each group. Now by using either the SEC’s EDGAR site or your
companies’ annual reports, determine the cash flows from investing activities for each of
the companies you selected. How do those from the Top Ten compare to those from the
Bottom Ten? Do your results seem to confirm the importance investors claim to assign to
capital spending?
Chapter 26 – Capital Budgeting
CHAPTER 26 NAME #___________________
10-MINUTE QUIZ A SECTION
Indicate the best answer for each question in the space provided.
1 Which of the following is not a capital budgeting decision?
a Whether to acquire a subsidiary company.
b Whether to expand a product line.
c Whether to fill a special order.
d Whether to purchase a fleet of trucks.
2 Which of the following is an example of a nonfinancial consideration in capital
budgeting?
a Will an investment generate adequate cash flows to promptly recover its cost?
b Will an investment generate an acceptable rate of return?
c Will an investment have a positive net present value?
d Will an investment have an adverse effect on the environment?
3 Which of the following is not considered when using the payback period to
evaluate an investment?
a The profitability of the investment over its entire life.
b The annual net cash flow of the investment.
c The cost of the investment.
d The expected life of the investment.
Use the following data for questions 4 and 5.
Stone Mfg. is considering expanding operations by investing $300,000 in equipment.
The equipment has a useful life of eight years, with no salvage value. Straight-line
depreciation is used. Stone predicts that net income will increase $37,500 per year as a
result of this strategy.
4 Refer to the above data. The payback period for this investment is:
a 8 years.
b 4 years.
c Over 13 years.
d 2.5 years.
5 Refer to the above data. Return on average investment for this investment is:
a 25%.
b 20%.
c 12 1/2%.
d 15%.