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Wild, Shaw & Chiappetta: Fundamental Accounting Principles, 23rd Edition
25-1
CHAPTER 25
CAPITAL BUDGETING AND MANAGERIAL DECISIONS
Related Assignment Materials
Student Learning Objectives
Discussion
Questions
Quick
Studies*
Exercises*
Problems*
Beyond the
Numbers
Conceptual objectives:
C1. Describe the importance of
relevant costs for short-term
decisions.
11, 12, 13,
25-17
25-16
25-9
Analytical objectives:
A1. Evaluate short-term managerial
decisions using relevant costs.
11, 12, 13, 15
25-18, 25-19,
25-20, 25-21,
25-17, 25-18,
25-19, 25-20,
25-4, 25-5,
25-6, ES
25-2, 25-5
A2. Analyze a capital investment
project using break-even time.
25-28
25-27
Procedural objectives:
1, 2, 3, 4, 5,
25-1, 25-4,
25-1, 25-3,
25-1, 25-2,
25-4, 25-6,
P2. Compute accounting rate of
return and explain its use.
1, 2, 3, 6, 14
25-6, 25-7
25-7, 25-8
25-1, 25-2,
SP
25-4, 25-7
1, 2, 3, 7, 8,
25-2, 25-8,
25-2, 25-6,
25-1, 25-2,
25-1, 25-3,
Wild, Shaw & Chiappetta: Fundamental Accounting Principles, 23rd Edition
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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 also provides algorithmic versions for Quick Study, Exercises and
Problems. It allows instructors to monitor, promote, and assess student learning. It can be used in
practice, homework, or exam mode.
Connect Insight
The first and only analytics tool of its kind, Connect Insight is a series of visual data displays that are each framed
by an intuitive question and provide at-a-glance information regarding how an instructor’s class is performing.
Connect Insight is available through Connect titles.
The Serial Problem (SP) for Success Systems continues in this chapter.
General Ledger
Assignable within Connect, General Ledger (GL) problems offer students the ability to see how transactions post
from the general journal all the way through the financial statements. Critical thinking and analysis components are
added to each GL problem to ensure understanding of the entire process. GL problems are auto-graded and provide
instant feedback to the student.
Excel Simulations
Assignable within Connect, Excel Simulations allow students to practice their Excel skills—such as basic formulas
and formatting—within the context of accounting. These questions feature animated, narrated Help and Show Me
tutorials (when enabled). Excel Simulations are auto-graded and provide instant feedback to the student.
Synopsis of Chapter Revision
NEW opener—Simply Gum and entrepreneurial assignment.
Added exhibit and discussion of capital budgeting process.
Added exhibit and discussion of cash inflows and outflows in capital budgeting.
Wild, Shaw & Chiappetta: Fundamental Accounting Principles, 23rd Edition
25-3
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. The process begins with department or plant managers submitting
proposals for new investment in property, plant, and equipment. A
capital budget committee evaluates the proposals and recommends
for approval or rejection. Finally, board of directors approves
capital expenditures for the year.
C. Such decisions require careful analysis because they are difficult
and risky.
II. Methods Not Using Time Value of Money⎯Investments 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 to recover the
initial investment amount.
2. Evaluating Payback Period: managers prefer investments with
shorter payback periods.
predictions of future cash flows is reduced.
3. To compute payback period, exclude all non-cash revenue and
expenses from computation. Depreciation is a non-cash
expense, so it is not included.
Notes
Wild, Shaw & Chiappetta: Fundamental Accounting Principles, 23rd Edition
25-4
Chapter Outline
5. Payback period has three major weaknesses: it does not reflect
differences in the timing of net cash flows within the payback
B. Accounting Rate of Return
1. The percentage accounting return on annual average
investment.
3. Computed as:
4. Accrual basis after-tax net income is used.
5. Compute the average investment:
a. If straight-line deprecation is used then:
b. If the depreciation method is other than straight line
method then the general formula is:
7. Risk of an investment should be considered.
a. Investment’s return is satisfactory only when related to
8. Evaluating Accounting Rate of Return – should never be the
only consideration in capital budgeting decisions. Three major
weaknesses:
a. It ignores the time value of money
Notes
Wild, Shaw & Chiappetta: Fundamental Accounting Principles, 23rd Edition
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Chapter Outline
III. Methods Using Time Value of Money⎯Net 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
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
4. 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.
5. When annual net cash flows are equal in amount, NPV
calculation can be simplified.
a. Individual annual present value of $1 factors can be
6. NPV analysis can also be applied when net cash flows are
unequal. (Use procedures and decision-rules above.)
Notes
Wild, Shaw & Chiappetta: Fundamental Accounting Principles, 23rd Edition
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Chapter Outline
8. 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
9. Comparing positive NPV projects is of limited value for
10. When a company can’t fund all positive net present value
projects , they can be compared using the profitability index:
11. NPVs should be computed using different discount rates; the
greater the risk, the higher the discount rate.
12. Capital rationing – hard rationing is imposed by external
13. Inflation – net cash flows can be adjusted for inflation by
using future value computations.
B. Internal Rate of Return
2. Total present value of project’s net cash flows is computed
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 annual net cash flows.
Notes
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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
5. Compare IRR with hurdle rate (or minimum acceptable rate of
return); if IRR exceeds hurdle rate, invest.
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 25.12)
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
3. Accounting rate of return is a percent computed using accrual
4. Net Present Value (NPV):
a. Considers all estimated cash flows of project; can be
5. Internal Rate of Return (IRR):
a. Considers all estimated cash flows of project.
Wild, Shaw & Chiappetta: Fundamental Accounting Principles, 23rd Edition
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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
2. Both managerial and financial accounting information play
important role in making decisions
a. Accounting system provides primarily financial
B. Relevant Costs and Benefits
1. Managers should focus on relevant benefits which exceed
relevant costs.
a. Relevant costs are the incremental costs, or differential
costs which are the additional costs incurred if a company
Notes
Wild, Shaw & Chiappetta: Fundamental Accounting Principles, 23rd Edition
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Chapter Outline
II. Managerial Decision Scenarios⎯consider each decision task
discussed below independent from the others.
A. Additional Business
2. Historical costs are not relevant to this decision.
3. Incremental or additional costs (also called differential costs)
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
7. Accepting order may cause existing sales to decline; the
contribution margin lost from the decline in sales is an
8. Note – Allocated overhead costs, which are historical costs,
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
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. Process of buying from an external supplier is
Notes
Wild, Shaw & Chiappetta: Fundamental Accounting Principles, 23rd Edition
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Chapter Outline
C. Scrap or Rework
1. Costs already incurred in manufacturing units of product not
2. Incremental revenues, incremental costs of reworking defects,
and opportunity costs (the contribution margin lost if sales of
other units are given up) are all relevant.
D. Sell or Process Further
2. Compute incremental revenue from further processing
3. Compute incremental cost from further processing.
4. Process further and sell if incremental revenue from further
processing exceeds related incremental costs.
E. Sales Mix Selection
1. When more than 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
Wild, Shaw & Chiappetta: Fundamental Accounting Principles, 23rd Edition
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Chapter Outline
F. Segment Elimination
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
5. Should also assess impact of elimination on other segments.
a. An unprofitable segment might contribute to another
segment’s revenue and expenses
G. Keep or Replace Equipment
1. Must decide whether the reduction in variable manufacturing
costs over its life is greater than the net purchase price of the
new equipment.
III. Decision Analysis⎯Break-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
IV. Product Pricing – companies often use cost-plus pricing as a starting
point in determining selling prices. Many factors determine price.
Notes
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Chapter Outline
A. Target costing – used when competition is high and they have
little control in setting prices.
Target cost = expected selling price – desired profit
Notes
Wild, Shaw & Chiappetta: Fundamental Accounting Principles, 23rd Edition
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Chapter 25 Alternate Demo Problem
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.
Wild, Shaw & Chiappetta: Fundamental Accounting Principles, 23rd Edition
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Chapter 25 Alternate Demo Problem: Solution
1.
First, calculate annual net cash flow:
Determine increase in after-tax net income:
Labor savings: 10,000 hours @ $5.50 per hour
$55,000
Other operating savings
4,000
2.
The rate of return on average investment equals the increase in net income after
tax divided by the amount of the average investment.
3(a)
There is a cash savings of $59,000 each year for 10 years if income taxes are
ignored. The present value factor for a 10-year annuity at 10% is 6.1446.
3(b)
There is a cash savings of only $43,400 each year for 10 years if income taxes are
considered.
