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Capital Expenditure Decisions

CHAPTER 8

Managerial Accounting 11E

Maher/Stickney/Weil

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CHAPTER GOAL

This chapter explains how the differential principle applies to long–term decisions where the focus is on changes in operating capacity over several future time periods. Present value analysis, also called discounted cash flow (DCF), provides analysts with the appropriate technique.

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CAPITAL BUDGETING: Definition

CAPITAL BUDGETING: Definition

Involves deciding which long-term investments to take

involving capital (long-term) assets.

LO 1

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STRATEGIC PLANNING

In strategic planning, an organization decides on major programs and the resources to devote to them. Strategic planning provides the context for capital expenditure decisions.

In strategic planning, an organization decides on major programs and the resources to devote to them. Strategic planning provides the context for capital expenditure decisions.

LO 2

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BENEFITS: Long-Term Investments

Reducing potential to make mistakes improves product

Making goods, delivering services that competitors cannot

Reducing cycle time to make productPermanently reducing costs to provide such an

advantage that competitors cannot afford to enter market

LO 2

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DISCOUNTED CASH FLOW (DCF): Definition

DISCOUNTED CASH FLOW (DCF): Definition

Aids in evaluating investments involving cash flows over time

where there is a significant difference between cash payment

and receipt.

LO 3

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ELEMENTS OF DISCOUNT RATE

The choice of a discount rate should consider the followingA pure rate of interest that reflects the productive

capability of capital assetsA risk factor reflecting the riskiness of the projectAn increase reflecting inflation expected to occur

over the life of the project.

LO 3

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RISK-FREE RATE: DefinitionRISK-FREE RATE: Definition

Is the pure interest rate plus expected inflation.

LO 3

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What is the real interest rate?

The real interest rate is the pure interest rate plus a premium for risk but no

increase for inflation.

LO 3

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NOMINAL INTEREST RATE: Definition

NOMINAL INTEREST RATE: Definition

Includes all three factors: pure interest, risk premium, and

expected inflation.

LO 3

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If the present value of future cash inflows exceeds the present value offuture cash outflows for a proposal, The firm should accept the project

with the largest NPV.Reject any negative PV.

LO 3

DECISION RULEEstimate the amounts of future cash inflows and future cash outflows in each period for each alternative

Discount the future cash flows to the present using the project’s discount rate.

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CASH FLOW VARIETIES

Initial cash flows: Occur at beginning of project

Periodic cash flowsOccur during life of project

Terminal cash flowsOccur at end of project

LO 3

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EXAMPLE: JEP Realty Syndicators

JEP Reality Syndicators, Inc. (JEP) is considering acquisition of computer hardware with a 5-year life. Disposal of current hardware occurs in Year 0 with no gain or loss and no tax consequences.

LO 3

Continued

Cost $ 100,000

Market value of present equipment $ 10,000

Scrap value $ 5,000

JEP

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LO 3

EXHIBITEXHIBIT 8.18.1Projected cash flows over life of

project.

Projected cash flows over life of

project.

JEP

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LO 3

EXHIBITEXHIBIT 8.28.2

JEP

Depreciation is subtracted before

tax

Depreciation is subtracted before

tax

Year 0 & Year 1

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LO 3

EXHIBITEXHIBIT 8.28.2

JEP

Pretax net cash inflow (outflow) – tax payable

= Net cash inflow (outflow) X PV factor

(12%) = NPV

Pretax net cash inflow (outflow) – tax payable

= Net cash inflow (outflow) X PV factor

(12%) = NPV

Year 0 & Year 1

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JEP

EXHIBITEXHIBIT 8.28.2

+ + + + +=

LO 3

Projected cash flows over life

of project is positive $12,469.

>>>ACCEPT

Projected cash flows over life

of project is positive $12,469.

>>>ACCEPT

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THREE ESTIMATES for Calculating NPV

The calculation of NPV for a proposed project requires three types of projectionsAmount of future cash flowsTiming of future cash flowsDiscount rate

Note: errors in predicting amounts of future cash flows will likely have the largest impact.

LO 4

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LO 4JEP

EXHIBITEXHIBIT 8.38.3

= $350,000 in revenues

= $350,000 in revenues

+ + + +

Base case

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LO 4JEP

EXHIBITEXHIBIT 8.38.3

+ + + ++

Amount of future cash flows

= $344,000 in revenues,

less than projected

= $344,000 in revenues,

less than projected

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LO 4JEP

EXHIBITEXHIBIT 8.38.3

= $350,000 in revenues, not received as expected.

= $350,000 in revenues, not received as expected.

+

Timing of future cash flows

+++

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LO 4JEP

EXHIBITEXHIBIT 8.38.3

+ + +

Discount rate changed to 13%

+ = $350,000 in revenues, but discount rate changed.

= $350,000 in revenues, but discount rate changed.

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LO 5

DECISION RULE

Net Present Value Method Internal Rate of Return Method

1. Compute the investment’s net present value, using the organization’s cost of capital adjusted for project-specific risk as the discount rate (hurdle rate).2. Undertake the investment if its net present value is positive. Reject the investment if its net presentvalue is negative.

1. Compute the investment’s internal rate of return.2. Undertake the investment if its internal rate of return is equal to or greater than the organization’s cost of capital adjusted for project-specific risk (hurdle rate). If not, reject the investment.

The decision to accept or reject an investment proposal can be made using either the internal rate of return method or the net present value method under most circumstances.

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LO 5

EXHIBITEXHIBIT 8.48.4

JEP’s hurdle rate

is 12%. Should they accept this project?

JEP’s hurdle rate

is 12%. Should they accept this project?

JEP

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JUSTIFYING INVESTMENTSInvestments in computer-integrated manufacturing are

often difficult because of difficulties in applying discounted cash flow methods Hurdle rate too high

Should be cost of capitalBias toward incremental projectsUncertainty about operating cash flowsExclusion of benefits that are difficult to quantify

More flexibilityShorter cycle and lead timesReduction of non-value-added costs

LO 6

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LONG-TERM INVESTMENTS

Three types of long term capital investments are: Replacement and minor improvementsExpansionStrategic moves

LO 6

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AUDITING

Auditing to compare estimates of capital budgeting projects to actual results provides advantages: Audits identify which estimates were wrong to

correct in futureManagers can use audits to reward good planningAudits create environment that removes the

temptation to inflate estimates and benefits

LO 7

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BEHAVIORAL ISSUES

Planners have a desire to implement a project, meet performance measures. This can influence their objectivity in making estimates. Additionally, conflicts may arise between criteria used to evaluate individual projects and criteria used to evaluate an organization’s overall or unit performance.

Planners have a desire to implement a project, meet performance measures. This can influence their objectivity in making estimates. Additionally, conflicts may arise between criteria used to evaluate individual projects and criteria used to evaluate an organization’s overall or unit performance.

LO 8

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End of CHAPTER 8