Chapter 16 – Capital Expenditure Decisions
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CHAPTER 16
CAPITAL EXPENDITURE DECISIONS
Learning Objectives
1. Use the net-present-value method and the internal-rate-of-return method to
evaluate an investment proposal.
2. Compare the net-present-value and internal-rate-of-return methods, and state
the assumptions underlying each method.
4. Determine the after-tax cash flows in an investment analysis.
5. Use the Modified Accelerated Cost Recovery System to determine an asset’s
depreciation schedule for tax purposes.
6. Evaluate an investment proposal using a discounted-cash-flow analysis, giving
full consideration to income-tax issues.
8. Use the payback method and accounting-rate-of-return method to evaluate
capital-investment projects.
10. Explain the impact of inflation on a capital-budgeting analysis (Appendix B).
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Chapter Overview
I. Overview of Capital Budgeting
A. General focus
B. Decision types
C. Focus on projects
II. Discounted-Cash-Flow Analysis
A. Net-present-value (NPV)
B. Internal-rate-of-return (IRR)
III. Comparing Two Investment Projects
IV. Managerial Accountant’s Role
A. Postaudit
B. Real option analysis
V. Income Taxes and Capital Budgeting
A. After-tax cash flows
B. Accelerated depreciation
C. Modified accelerated cost recovery system (MACRS)
D. Gains and losses on disposal
E. Investment in working capital
F. Extended illustration of income-tax effects in capital budgeting
G. Cash revenues and cash expenses
VI. Ranking Investment Projects
VIII. Alternative Methods for Making Investment Decisions
A. Payback method
B. Accounting-rate-of-return method (ARR)
IX. Estimating Cash Flows: The Role of Activity-Based Costing
X. Justification of Investments in Advanced Manufacturing Technology
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Key Lecture Concepts
I. Overview of Capital Budgeting
• Major decisions that involve cash flows over several years, such as the
purchase of machinery or a significant change in the production process,
are known as capital-budgeting decisions.
II. Discounted-Cash-Flow Analysis
• Discounted-cash-flow analysis, which takes the time value of money into
consideration, can be used with the net-present-value method and the
internal-rate-of-return method to evaluate investment opportunities.
➢ With the net-present-value method (NPV), an analyst first
determines a project’s yearly cash inflows and outflows. These
amounts are then discounted by using the company’s discount
(hurdle) rate, or the rate that reflects the cost of acquiring
investment capital.
➢ The internal-rate-of-return method (IRR) is another widely used
approach of discounting cash flows. The internal rate of return,
also called the time-adjusted rate of return, is the true economic
return earned by an asset over the asset’s life.
▪ If the IRR were used as the discount rate in a net-present-
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value analysis, the NPV would be zero.
▪ When the cash inflows are identical each year, the IRR is
calculated by performing the following steps:
1. Divide the initial cash outflow on the acquisition date
2. Locate the factor in the annuity table by using the
appropriate number of years, and note the rate for
that factor.
3. Compare the internal rate of return to the hurdle rate.
of return is more difficult to calculate manually, and the
analyst typically turns to calculators and/or software for
assistance.
➢ The net-present-value method has two potential advantages over
the internal rate of return.
▪ If the analysis is being done manually, NPV is simpler to
use.
• Other issues related to discounted cash flow
➢ Assumptions—Discounted-cash-flow analysis is based on several
underlying assumptions:
▪ With the exception of the initial investment, all cash flows
are treated as if they occur at year-end.
▪ Cash flows are treated as if they are known with certainty.
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➢ Hurdle rate—The hurdle rate is determined by management based
on the investment opportunity rate, or the rate of return that an
organization can earn on its best alternative investments of
equivalent risk.
➢ Depreciation—When the capital expenditure being analyzed is a
long-lived asset, depreciation should not be considered because it
does not require a cash outlay.
III. Comparing Two Investment Projects
• Cash flows may be analyzed by using the total-cost approach, whereby all
relevant cash flows of each alternative are included in the analysis and
then discounted. Another approach, the incremental-cost approach, focuses
on differences between alternatives’ relevant cash flows.
IV. Managerial Accountant’s Role
• The managerial accountant often plays a key role in the prediction of a
project’s future cash flows.
• The accountant also becomes involved in conducting a follow-up
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appraisal (i.e., postaudit) once an approved project is underway.
➢ The purpose of the postaudit is to determine how well a project is
measuring up to predictions.
V. Income Taxes and Capital Budgeting
• Investments that increase the profits of a business also increase the firm’s
tax liability. Since the added tax liability impacts cash outflows, the
effects are considered in the discounted-cash-flow investment models.
• Cash revenues result in added taxes for a firm; in contrast, cash expenses
produce tax savings. The formulas to calculate after-tax inflows and
outflows for these items are:
Incremental cash revenue x (1 – Tax rate) = After-tax inflows
• Noncash expenses—Although depreciation is a noncash item, it affects
cash because it increases expenses and, therefore, decreases taxable
income. The subsequent reduction in tax payments is called the
depreciation tax shield.
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➢ Example: Assume a depreciation expense deduction of $100,000
and a tax rate of 30%:
• Some cash flows do not appear on the income statement, for example, the
acquisition of a machine. The acquisition has no immediate tax impact;
instead, a company will depreciate the machine over time and recognize
the related tax savings in the yearly discounted-cash-flow calculations.
• Gains and losses—The accrual-based gains and losses included in taxable
income affect cash paid for taxes. Therefore, in a discounted-cash-flow
analysis, the effect on tax payments must be considered.
➢ Gains and losses are computed as the difference between an asset’s
sales price and book value (cost minus accumulated depreciation).
▪ The tax effects of the gain or loss are combined with the
asset’s selling price when figuring the total cash flow from
the transaction.
▪ Example: X Company has a machine with a book value of
$10,000. The machine is sold for $7,000, and X is subject to a
30% tax rate.
• Some investment projects require additional outlays for working capital
(current assets – current liabilities). Such outlays typically result in an
immediate outflow, followed by a recovery at the end of the project’s life.
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• Unless a special election is made, companies are not permitted to use
straight-line depreciation on their tax returns. Accelerated depreciation is
used, allowing a firm to write off the asset’s cost more quickly than under
the straight-line method.
• Assets are depreciated by a special form of accelerated depreciation
known as the Modified Accelerated Cost Recovery System, or MACRS.
Assets are divided into class-life categories, which do not necessarily
coincide with the more-familiar concept of service life from financial
accounting.
➢ MACRS is calculated by multiplying the percentages presented in
Exhibit 16-9 by the asset’s cost. Note:
VI. Ranking Investment Projects
• When managers have a limited supply of investment capital, they often
attempt to rank investment projects by positive net present values.
• Some managers use the profitability index (or the excess present value
index) to assist in the ranking process. The proper formula is:
Profitability index = Present value of cash flows (exclusive of the
initial investment) ÷ Initial investment
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VIII. Alternative Methods for Making Investment Decisions
• Although discounted-cash-flow models are conceptually preferable, some
managers use methods that ignore the time value of money. Two such
methods are payback and the accounting rate of return.
➢ The payback method shows how long it takes to recover a project’s
initial investment. The following formula is used when annual
after-tax cash inflows are uniform:
Payback = Initial investment ÷ Annual after-tax cash inflow
Teaching Tip: Several years ago, a Business Week article reported
that Starbucks can open a store in 16 weeks (and sometimes
faster), and can recover its investment in three years.
➢ The accounting-rate-of-return (ARR) focuses on incremental
accrual-based accounting income in judging a project’s
attractiveness. The ARR formula is:
ARR = Incremental income1 ÷ Initial or average investment
1 Average incremental revenue – average incremental
expense
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IX. Estimating Cash Flows: The Role of Activity-Based Costing
• Activity-based costing generally improves the accuracy of cash-flow
estimates associated with capital-budgeting projects.
X. Justification of Investments in Advanced Manufacturing Technology
• Projects that move a company toward just-in-time or computer-integrated
manufacturing involve very large expenditures of capital. Although
managers may intuitively know that modernizing is necessary, traditional
decision models may show that modernization projects should be rejected.
➢ It is hard to apply NPV analysis to these projects because of the
following:
▪ Hurdle rates are often set too high.
▪ Proposals often have time horizons that are too short, and
investment benefits may take many more years to occur.
▪ There is a bias toward pursuing smaller incremental projects
rather than one massive project. This sometimes takes place
in an effort to avoid required high-level management
approvals of significant expenditures.
▪ There is a greater uncertainty about operating cash flows
because of inexperience with advanced technology and/or
complexity of the machinery.
▪ Project benefits (such as greater flexibility, shorter cycle
times, and increased product quality) are excluded because
they are difficult to quantify.
XI. Appendix B: Impact of Inflation
• The appendix presents two approaches for considering inflation in capital
budgeting decisions:
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• Interest rates
➢ Real interest rate—the underlying interest rate, which includes
compensation to investors for the time value of money and the risk
of an investment.
• Cash flows
➢ Nominal dollars—the actual cash flows of a company.
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Teaching Overview
Chapter 16 provides a broad-based overview to capital budgeting, giving students a
base on which to build in subsequent finance courses. Much of the presentation focuses
on the concepts of net present value; the internal rate of return; the impact of income
taxes on cash-flow computations; and related issues such as project ranking, payback,
and the accounting rate of return. Quite honestly, there is a considerable amount of
subject matter in this chapter.
Additionally, I spend minimal class time covering the subject of income taxes. Taxes,
although a realistic factor to consider in capital-budgeting projects, are difficult for
introductory students to comprehend. I feel it is a major accomplishment if students
can correctly derive before-tax cash flow amounts and, as a result, my homework
assignments and testing are rather basic with regard to this topic. Also, after-tax cash
flows will often be covered in advanced managerial classes as well as in finance classes.
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Links to the Text
Homework Grid – CHAPTER 16
Item No.
Learning
Objectives
Completion
Time (min.)
Special
Features*
Exercises:
16-24
1
15
16-25
1
15
16-26
1, 2
20
16-27
1, 2
30
I
16-28
1
15
C
16-29
1
15
16-30
4
5
16-31
4
10
16-32
5
30
16-33
5
15
16-34
4
15
16-35
7
20
16-36
1, 8
20
16-37
1, 8
25
16-38
10
20
16-39
10
35
Problems:
16-40
1, 3
30
16-41
1, 3
60
S
16-42
1, 3
45
16-43
1, 3
50
16-44
1, 3
40
W
16-45
1, 3
25
16-46
1, 3
45
16-47
1, 3
30
16-48
4, 5
45
16-49
3, 4, 6
40
W
16-50
3, 4, 6
45
16-51
3, 4, 6, 8
20
16-52
4, 6, 7
20
16-53
8
45
16-54
8
35
E
16-55
4, 6, 10
50
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16-56
4, 6, 10
50
Cases:
16-57
1, 2, 3
60
E, W
16-58
3, 4, 6
60
E, S