Managerial Accounting: An Introduction To Concepts, Methods, And Uses

1. Managerial Accounting: An Introduction To Concepts, Methods, And Uses Chapter 9 Capital Expenditure Decisions Maher, Stickney and Weil

2. Learning Objectives (Slide 1 of 2) • Explain the reasoning behind the separation of the investing and financing aspects of making long-term decisions. • Explain the role of capital expenditure decisions in the strategic planning process. • Describe the steps of the net present value method for making long-term decisions using discounted cash flows, and explain the effect of income taxes on cash flows.

3. Learning Objectives (Slide 2 of 2) • Explain how spreadsheets help the analyst to conduct sensitivity analyses of capital budgeting. • Describe the internal rate of return method of assessing investment alternatives. • Explain why analysts will need more than cash flow analysis to justify or reject an investment. • Explain why the capital investment process requires audits. • Identify the behavioral issues involved in capital budgeting.

4. Capital Budgeting • Involves decisions regarding which long-term investments to undertake and how to finance them • Involves estimating future cash flows, selecting an appropriate discount rate to discount those cash flows, and deciding how to finance the project

5. Discounted Cash Flow • Discounted cash flow (DCF) methods aid in evaluating investments involving cash flows over time • Two DCF methods used • Net present value method • Internal rate of return method

6. Discount Rate • Discount rate is the interest rate used to compute the present value of future cash flows • Appropriate discount rate has three elements • Pure rate of interest (riskless rate) • Risk factor reflecting the project’s riskiness • An increase reflecting future inflation

7. Net Present Value Method (Slide 1 of 2) • Involves the following steps: • Estimate future cash inflows and outflows in each period under consideration • Discount the future cash flows to the present • Accept or reject the project

8. Net Present Value Method (Slide 2 of 2) • Decision rule: If the present value (PV) of cash inflows exceeds the PV of future cash outflows, the project should be accepted • Reject projects that have a negative net present value • If one project is to be chosen from a set of alternatives, select the project with the highest net present value

9. Estimating Cash Flows (Slide 1 of 4) • When using the net present value (NPV) method, the following cash flows must be considered: • Initial cash flows occurring at the beginning of the project • Periodic cash flows during the life of the project • Terminal cash flows at the end of the project

10. Estimating Cash Flows (Slide 2 of 4) • Initial cash flows - include cost of purchasing the asset as well as freight and installation • May include cash flows from disposal of existing assets, including tax effect of gain or loss on disposal

11. Estimating Cash Flows (Slide 3 of 4) • Periodic cash flows during the life of the project include: • Cash from sales and for fixed and variable production, selling, general, and administrative costs • Should factor in savings in these items arising from the project under consideration • Tax savings from the depreciation deduction should be factored in to the analysis • Do not include noncash items such as depreciation expense

12. Estimating Cash Flows (Slide 4 of 4) • Terminal cash flows at the end of the project often include: • Cash from the salvage value of the asset • Tax arising on the gain (loss) on disposal of the project

13. Tax Effects • Depreciation expense is not a cash flow, however it is a tax deductible expense • Reduces the amount of taxes that must be paid, so should be considered in NPV analysis • Simplifying assumptions (such as use of straight line method of depreciation) can be used in NPV analysis but may have a significant impact on discounted cash flows

14. Sensitivity of NPV Estimates • NPV analysis is based on three types of estimates: • The amount of future cash flows • The timing of the cash flows • The discount rate • Spreadsheet programs, such as Microsoft Excel, can be used to determine how sensitive the NPV analysis is to changes in estimates

15. Internal Rate of Return • The internal rate of return (IRR) is the discount rate that yields a net present value of 0 • Essentially, discounts the future cash flows of a project to a present value equal to the initial investment • When used to evaluate investment options, a cutoff rate (or hurdle rate) is specified • Generally, a project is accepted if the IRR exceeds the hurdle rate

16. Investments in Advanced Production Systems • Difficult to justify these types of investments using DCF methods because: • Hurdle rate is too high • Bias toward incremental projects • Uncertainty about operating cash flows • Benefits of project may be excluded from analysis because they are difficult to quantify

17. Audits and Capital Budgeting • Capital budgeting relies heavily on estimates • Comparing budgeting estimates with actual results (called auditing) provides several advantages • Identifies estimates that were wrong so planners can avoid similar mistakes in future budgeting • Identifies and rewards those who are good at making capital budgeting decisions • Reduces temptation to inflate estimates associated with a project

18. If you have any comments or suggestions concerning this PowerPoint Presentation for Managerial Accounting, An Introduction To Concepts, Methods, And Uses, please contact: • Dr. Donald R. Trippeer, CPA • donald.trippeer@colostate-pueblo.edu Colorado State University-Pueblo