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Chapter 26—Capital Budgeting
Financial and Managerial Accounting, 18e 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 return on average
investment 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
26-2 Instructor’s Resource Manual
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. Data for an illustration
b. Determining the present value of incremental cash flows
c. Summary of financial considerations—see Your Turn (page 1125)
d. Nonfinancial considerations—see Case in Point (page 1126)
5. Behavioral considerations in capital budgeting—see Ethics, Fraud &
Corporate Governance (page 1128)
C. Concluding remarks—see Pathways Connection (page 1128)
Topical Coverage and Suggested Assignment
Class
Meetings
on Chapter
Topical
Outline
Coverage
Discussion
Questions*
Brief
Exercises*
Exercises*
Problems*
Critical
Thinking
Cases*
1
A
1, 12, 13
1
7
1
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
*Homework assignment (to be completed prior to class)
Chapter 26—Capital Budgeting
Financial and Managerial Accounting, 18e 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
26-4 Instructor’s Resource Manual
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 B, 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 B
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 performance measures. “Capital expenditures” was ranked as particularly
valuable by 90% of those surveyed. Only three measures received a higher rate of
Chapter 26—Capital Budgeting
Financial and Managerial Accounting, 18e 26-5
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
Chapter 26—Capital Budgeting
26-6 Instructor’s Resource Manual
CHAPTER 26 NAME #
10-MINUTE QUIZ A SECTION
Indicate the best answer for each question.
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%.
Chapter 26—Capital Budgeting
Financial and Managerial Accounting, 18e 26-7
CHAPTER 26 NAME #
10-MINUTE QUIZ B SECTION
Physician’s Pharmacy is considering the purchase of a copying machine which it will make
available to customers at a per-copy charge. The copying machine has an initial cost of $7,500, an
estimated useful life of five years, and an estimated salvage value of $500. The estimated annual
revenue and expenses relating to operation of the machine are as follows:
Revenue .................................................................................................................... $8,000
Expenses other than depreciation ........................................................................................... $5,500
All revenue will be received in cash; expenses other than depreciation will be paid in cash.
Depreciation will be computed by the straight-line method.
Answer the following questions. If you select answer d, indicate the correct amount in the space
provided.
1 Refer to the above data. Acquisition of the copying machine is expected to
increase Physician’s annual net income by:
a $1,100. c $600.
b $500. d Some other amount.
2 Refer to the above data. The annual net cash flow expected from the investment
in the machine is:
a $1,000. c $500.
b $600. d $2,500.
3 Refer to the above data. The payback period on this investment is estimated at:
a 1.125 years. c 3 years.
b 7.5 years. d None of these answers.
4 Refer to the above data. The expected rate of return on average investment is:
a 27.5%. c 60%.
b 33 1/3%. d Some other rate.
5 Refer to the above data. The net present value of the proposed investment,
discounted at an annual rate of 15% and rounded to the nearest dollar, is (tables
show that using a discount rate of 15%, the present value of $1 due in five years is
0.497, and the present value of a five-year $1 annuity is 3.352):
a $528. c $(1,405).
b $1,128.50. d Some other amount.
Chapter 26—Capital Budgeting
26-8 Instructor’s Resource Manual
CHAPTER 26 NAME #
10-MINUTE QUIZ C SECTION
Port Pharmacy is considering the purchase of a copying machine, which it will make available to
customers at a per-copy charge. The copying machine has an initial cost of $8,500, an estimated
useful life of five years, and an estimated salvage value of $2,500. The estimated annual revenue
and expenses relating to operation of the machine are as follows:
Revenue ...................................................................................................................................... $9,000
Expenses other than depreciation .............................................................................................. $5,500
All revenue will be received in cash; expenses other than depreciation will be paid in cash.
Depreciation will be computed by the straight-line method.
Compute for this proposal the expected:
a Annual increase in Port’s net income: $____________
b Annual net cash flow: $____________
c Payback period: ____________ years
d Return on average investment: ___________ %
e Net present value (round to the nearest dollar) of the proposed investment, discounted
at an annual rate of 15% (Tables show that the present value of $1 to be received in
five periods, discounted at 15%, is 0.497 and that the present value of a five-year
annuity of $1, discounted at 15%, is 3.352): $____________
Chapter 26—Capital Budgeting
Financial and Managerial Accounting, 18e 26-9
CHAPTER 26 NAME #
10-MINUTE QUIZ D SECTION
Beacon Manufacturing, Inc. is planning to buy a new cutting machine. The machine costs
$125,000, has an estimated life of ten years and no salvage value. The machine is expected to
have the following impact:
Increment revenue ......................................................................................................... $30,000
Incremental expenses:
Expenses other than depreciation .............................................................................. (8,000)
Straight-line depreciation ........................................................................................... (12,500)
Incremental net income ................................................................................................. $9,500
All revenue and expenses other than depreciation will be received or paid in cash. Compute the
following for this proposal:
1. What is the annual net cash flow expected from the cutting machine investment?
$____________
2. What is the expected payback period of the cutting machine investment? ______ years
3. What is the expected return on average investment associated with the cutting machine?
____________%
4. What is the net present value of the cutting machine discounted at an annual rate of 10%,
if the present value of a ten-year $1 annuity discounted at 10% is 6.145? $____________
5. What is the net present value of the cutting machine discounted at an annual rate of 20%,
if the present value of a ten-year $1 annuity discounted at 20% is 4.192? $____________
Chapter 26—Capital Budgeting
26-10 Instructor’s Resource Manual
SOLUTIONS TO CHAPTER 26 10-MINUTE QUIZZES
QUIZ A
1 C
QUIZ B
QUIZ C
a $9,000 − $5,500 − [($8,500 − $2,500)/5 years] = $2,300
QUIZ D
1 $9,500 incremental income + $12,500 depreciation expense = $22,000
Chapter 26—Capital Budgeting
Financial and Managerial Accounting, 18e 26-11
Assignment Guide to Chapter 26
Brief
Exercises
Exercises
Problems
Cases
Net
Item Number
1 – 10
1 – 15
1
2
3
4
5
6
7
8
9
1
2
3
4
Time estimate (in minutes)
< 15
< 15
30
25
25
25
25
30
40
50
45
60
20
30
Difficulty rating
E
E
S
M
M
M
M
S
S
S
S
S
M
M
Learning Objectives:
6
1, 2, 3, 6,
7, 8, 9, 10,
15
√
√
√
√
√
√
√
√
√
√
1. Explain the nature of capital
investment decisions.
2. Identify nonfinancial factors
in capital investment
decisions.
6, 10
1, 2, 7, 9,
10, 13, 15
√
√
√
√
√
√
√
√
√
√
√
3. Evaluate capital investment
proposals using (a) payback
period, (b) return on
investment, and (c)
discounted cash flows.
1, 2, 3, 4, 5,
7, 9
1, 2, 3, 4,
5, 6, 7, 8,
10, 11, 12,
13, 14, 15
√
√
√
√
√
√
√
√
√
√
√
