The Capital Budgeting Authorization Process
CHAPTER REVIEW
The Capital Budgeting Authorization Process
1.(L.O. 1) The capital budgeting evaluation process generally has the following steps:
a.Project proposals are requested from departments, plants, and authorized personnel.
b.Proposals are screened by a capital budget committee.
c.Officers determine which projects are worthy of funding; and
d.Board of directors approves capital budget.
Cash Flow Information
2.While accrual accounting has advantages over cash accounting in many contexts, for purposes of capital budgeting, estimated cash inflows and outflows are preferred for inputs into the capital budgeting decision tools.
3.Sometimes cash flow information is not available, in which case adjustments can be made to accrual accounting numbers to estimate cash flows.
4.The capital budgeting decision, under any technique, depends in part on a variety of considerations:
a.The availability of funds;
b.Relationships among proposed projects;
c.The company’s basic decision-making approach; and
d.The risk associated with a particular project.
Cash Payback
5.The cash payback technique identifies the time period required to recover the cost of the capital investment from the net annual cash flow produced by the investment. The formula for computing the cash payback period is:
Cost of Capital Investment ÷ Net Annual Cash Flow = Cash Payback Period
Net annual cash flow can be approximated by adding depreciation expense to net income; it can also be approximated by “Net cash provided by operating activities” from the statement of cash flows.
6.The evaluation of the payback period is often related to the expected useful life of the asset.
a.With this technique, the shorter the payback period, the more attractive the investment.
b.This technique is useful as an initial screening tool.
c.This technique ignores both the expected profitability of the investment and the time value of money.
Net Present Value Method
7.(L.O. 2) Under the net present value (NPV) method, cash flows are discounted to their present value and then compared with the capital outlay required by the investment. The difference between these two amounts is the net present value (NPV).
a.The interest rate used in discounting the future net cash flows is the required minimum rate of return.
b.A proposal is acceptable when NPV is zero or positive.
c.The higher the positive NPV, the more attractive the investment.
8.When there are equal annual cash inflows, the table showing the present value of an annuity of 1 can be used in determining present value. When there are unequal annual cash inflows, the table showing the present value of a single future amount must be used in determining present value of each annual cash flow.
9.The discount rate used by most companies is its cost of capital—that is, the rate that the company must pay to obtain funds from creditors and stockholders.
10.The net present value method demonstrated in the text requires the following assumptions:
a.All cash flows come at the end of each year;
b.All cash flows are immediately reinvested in another project that has a similar return; and
c.All cash flows can be predicted with certainty.
Intangible Benefits
11.By ignoring intangible benefits, such as increased quality or improved safety, capital budgeting techniques might incorrectly eliminate projects that could be financially beneficial to the company. To avoid rejecting projects that actually should be accepted, two possible approaches are suggested;
a.Calculate net present value ignoring intangible benefits, and then, if the NPV is negative, ask whether the intangible benefits are worth at least the amount of the negative NPV.
b.Project rough, conservative estimates of the value of the intangible benefits, and incorporate these values into the NPV calculation.
Mutually Exclusive Projects
12.In theory, all projects with positive NPVs should be accepted. However, companies rarely are able to adopt all positive-NPV proposals because (1) the proposals are mutually exclusive (if the company adopts one proposal, it would be impossible to also adopt the other proposal), and (2) companies have limited resources.
13.In choosing between two projects, one method that takes into account both the size of the original investment and the discounted cash flows is the profitability index. The profitability index formula is as follows:
÷ =
The project with the greater profitability index should be the one chosen.
14.Another consideration made by financial analysts is uncertainty or risk. One approach for dealing with uncertainty is sensitivity analysis. Sensitivity analysis uses a number of outcome estimates to get a sense of the variability among potential returns. In general, a higher-risk project should be evaluated using a higher discount rate.
Post-Audit of Investment Projects
15.A post-audit is a thorough evaluation of how well a project’s actual performance matches the projections made when the project was proposed. Performing a post-audit is beneficial for the following reasons:
a.Management will be encouraged to submit reasonable and accurate data when they make investment proposals;
b.A formal mechanism is used for determining whether existing projects should be supported or terminated;
c.Management improves their estimation techniques by evaluating their past successes and failures.
16.A post-audit involves the same evaluation techniques that were used in making the original capital budgeting decision—for example, use of the net present value method. The difference is that, in the post-audit, actual figures are inserted where known, and estimation of future amounts is revised based on new information.
Internal Rate of Return Method
17.(L.O. 4) The internal rate of return method finds the interest yield of the potential investment. This is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected net annual cash inflows.
Determining the internal rate of return can be done with a financial (business) calculator, computerized spreadsheet, or by employing a trial-and-error procedure.
18.The decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return, and reject the project when the internal rate of return is less than the required rate.
Annual Rate of Return Method
19.(L.O. 5) The annual rate of return method is based directly on accrual accounting data rather than on cash flows. It indicates the profitability of a capital expenditure and its formula is:
Expected Annual Net Income ÷ Average Investment = Annual Rate of Return
Average investment is based on the following:
=
20.The annual rate of return is compared with management’s required minimum rate of return for investments of similar risk. The minimum rate of return (the hurdle rate or cutoff rate) is generally based on the company’s cost of capital. The decision rule is: A project is acceptable if its rate of return is greater than management’s minimum rate of return; it is unacceptable when the reverse is true.
21.When the rate of return technique is used in deciding among several acceptable projects, the higher the rate of return for a given risk, the more attractive the investment.
LECTURE OUTLINE
A.Capital Budgeting Evaluation Process
1.The process of making capital expenditure decisions in business is referred to as capital budgeting.
2.Capital budgeting involves choosing among various projects to find the one(s) that will maximize a company’s return on its financial investment.
3.Top management requests proposals for projects from each department and a capital budgeting committee screens the proposals and recommends worthy projects to company officers.
4.Company officers decide which projects to fund and submit this list of projects to the board of directors for approval.
5.For purposes of capital budgeting, estimated cash inflows and outflows are the preferred inputs.
B.Cash Payback.
1.The cash payback technique identifies the time period required to recover the cost of the capital investment from the net annual cash flow produced by the investment.
2.Net annual cash flow is computed by adding back depreciation expense to net income. Depreciation expense is added back because it is an expense that does not require an outflow of cash.
a.The formula when net annual cash flows are equal is: Cost of Capital Investment ÷ Net Annual Cash FIow = Cash Payback
Period.
b.The shorter the payback period, the more attractive the investment.
c.The cash payback technique recognizes that:
(1)The earlier the investment is recovered, the sooner the company can use the cash funds for other purposes.
(2)The risk of loss from obsolescence and changed economic conditions is less in a shorter payback period.
d.In the case of uneven net annual cash flows, the company determines the cash payback period when the cumulative net cash flows from the investment equal the cost of the investment.
e.The cash payback technique is relatively easy to compute and
understand.
f.It should not ordinarily be the only basis for the capital budgeting decision because it ignores the expected profitability of the project and the time value of money.
C.Net Present Value Method.
1.Discounted cash flow techniques are generally recognized as the most informative and best conceptual approaches to making capital budgeting decisions.
2.These techniques consider both the time value of money and the estimated net cash flow from the investment.
3.The primary discounted cash flow technique is the net present value method.
4.The net present value method involves discounting net cash flows to their present value and then comparing that present value with the capital outlay required by the investment. The difference between these two amounts is referred to as net present value (NPV).
a.Company management determines what interest rate to use in discounting the future net cash flows. This rate is often referred to as the discount rate or required rate of return.
b.A proposal is acceptable when net present value is zero or positive, because this means the rate of return on the investment equals or exceeds the required rate of return.
c.The higher the positive net present value, the more attractive the investment.
MANAGEMENT INSIGHT
Verizon has spent billions of dollars to upgrade its network from 3G to 4G. But, there aren’t that many 4G-compatible devices, coverage is spotty, and most applications don’t really need higher speeds. Verizon is hoping that its investment in 4G works out.
Based on the potentially slow initial adoption of 4G by customers, how might the conclusions of a cash payback analysis of Verizon’s 4G investment differ from a present value analysis?
Answer:If the initial adoption of 4G by customers is slow, then the amount of cash received in the early years will be low. This would lengthen the cash payback period, making it unlikely that the investment would get high marks with this test. However, the long-run potential of 4G is probably quite high as more people switch to smart phones and consequently increase their use of services that benefit from a high-speed connection. These later cash flows may well be large enough that they provide a positive net present value amount.
D.Intangible Benefits.
1.Intangible benefits, such as increased quality, improved safety, or enhanced employee loyalty, are difficult to quantify, and thus often are ignored in capital budgeting decisions.
2.To avoid rejecting projects that should actually be accepted, managers can either
a.Calculate net present value (NPV) ignoring intangible benefits, and if the resulting NPV is negative, evaluate whether the intangible benefits are worth at least the amount of the negative NPV.
b.Incorporate intangible benefits into the NPV calculation by projectingrough, conservative estimates of their value. If, after using conservative estimates, the net present value is positive, the project should be accepted.
ETHICS INSIGHT
Most manufacturers say that employee safety matters above everything else, but “safety doesn’t sell.” Recently a woodworking hobbyist with a Ph.D. in physics invented a device that automatically stops a power saw if the blade comes in contact with human flesh. The inventor eventually started his own company to build the devices and sell then directly to businesses that use power saws since existing saw manufacturers were unwilling to include the device into their saws.
In addition to the obvious humanitarian benefit of reducing serious injuries, how else might the manufacturer of this product convince potential customers of its worth?
Answer:Serious injuries cost employers huge sums, which can sometimes force small companies out of business. In addition to the obvious humanitarian benefit, the manufacturer can demonstrate that this device is a sound financial investment in terms of reduced health-care and workers’ compensation costs and fewer hours missed due to injury. Also, as the device gains wider acceptance, employers that do not have the device may ultimately be found negligent with regard to worker safety.
E.Mutually Exclusive Projects.
1.Proposals are often mutually exclusive—if the company adopts one proposal, it would be impossible to also adopt the other proposal.
2.The profitability index is a method that compares the relative merits of alternative capital investment projects.
3.This method takes into account both the size of the original investment and its discounted cash flows.
4.It is computed by dividing the present value of net cash flows by the initial investment.
5.The higher the profitability index, the more desirable the project.
MANAGEMENT INSIGHT
Building a new factory to produce 50-inch-plus TV screens can cost billions of dollars and manufacturers are wondering whether such investments are worth the gamble. Recently, the supply of big-screen TVs was estimated to exceed demand by 12%, and this imbalance may rise to 16% in the future. .
What implications does the excess capacity have for the cash payback and net present value calculations of these investments?
Answer:Because the companies have excess capacity, they are not selling as many units as expected. Also, to increase sales, they are being forced to cut selling prices in order to sell units. Therefore, the revenues that they generate are lower than the amounts that would have been estimated when the plants were planned and built. This means that cash payback periods are longer and net present values are lower than desired levels.
F.Post-Audit of Investment Projects.
1.A post-audit is a thorough evaluation of how well a project’s actual performance matches the original projections.
2.Performing a post-audit is important for several reasons.
a.Since managers know that their results will be evaluated, there is an incentive for them to make accurate estimates rather than presenting overly-optimistic estimates in an effort to get projects
approved.
b.A post-audit provides a formal mechanism for determining whether existing projects should be continued, expanded, or terminated.
c.Post-audits improve future investment proposals because managers improve their estimation techniques by evaluating past successes and failures.
3.A post-audit involves the same evaluation techniques used in making
the original capital budgeting decision. In the post-audit, managers use actual figures where known, and they revise estimates of future amounts based on new information.
MANAGEMENT INSIGHT
Inaccurate trend forecasting and market positioning are more detrimental to capital investment decisions than using the wrong discount rate. Companies often adopt projects or businesses only to discontinue them in response to market changes. Texas Instruments has dropped out of 12 business lines in recent years.
How important is the choice of discount rate in making capital budgeting decisions?
Answer:The point of this discussion is that errors in implementation, as well as the accuracy of the estimated future benefits and costs as measured by cash inflows and outflows, are what matters the most when making capital expenditure decisions. While the choice of discount rates will result in incremental differences in present value calculations. “missing the big picture” has the potential to cause much bigger decision
errors. Underestimating potential future cash inflows can result in missed opportunities. Underestimating future costs can result in failed investments.
G.Internal Rate of Return.
1.The internal rate of return method differs from the net present value method in that it finds the interest yield of the potential investment.
a.The internal rate of return is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected net annual cash flows.
b.The determination of the internal rate of return involves the use of a financial calculator or computerized spreadsheet to solve for the rate (if the cash flows are uneven).
c.If the net annual cash flows are equal, an easier approach to solving for the internal rate of return can be used. This approach involves two steps:
(1)Compute the internal rate of return factor.
(2)Use the factor and the present value of an annuity of 1 table to find the internal rate of return.
d.When cash flows are equal, the formula for determining the internal rate of return factor is: Capital Investment ÷ Net Annual Cash Flows = Internal Rate of Return Factor.
e.Once managers know the internal rate, of return, they compare it to the company’s required rate of return (the discount rate).
f.The IRR decision rule is: Accept the project when the internal rate
of return is equal to or greater than the required rate of return. Reject the project when the internal rate of return is less than the required rate.