Journal of Accounting Education Vol. 4. No. I Spring I986

INTRODUCING THE CAPITAL BUDGETING PROBLEM

Joel E. Thompson

THE OHIO STATE UNIVERSITY

Absfracr: The purpose of thts paper ts to suggest that many of the issues of capital budgeting are

intuitive and can be presented to introductory managerial accounting students using relatively

simple examples. Thus, this paper contains a set of 12 examples which other teachers may find

useful. These examples can be used to supplement the teachmg of tradttional decision models and

can provide the students with a richer understanding of the problem.

INTRODUCING THE CAPITAL BUDGETING PROBLEM

When first introduced to capital budgeting, students sometimes are embroiled with computing net present values or internal rates of return. Even those students who master the computations frequently fail to recognize the underlying issues. The purpose of this paper is to suggest that many of these issues are intuitive and can be presented to introductory managerial account- ing students using relatively simple examples. Such an approach can supple- ment the teaching of traditional decision models used in capital budgeting and can provide the students with a richer understanding of the problem.

Thus, this paper contains a set of examples which other teachers may find useful in teaching capital budgeting. These examples involve either a different way of looking at the problem, issues which are ignored in some textbooks, or issues, although not ignored, are playdowned or left for further study in more advanced courses. While some issues are properly left for solution in further courses or can only be solved in actual practice, they nonetheless can be understood by introductory managerial accounting students and should be understood especially by non-accounting and non-finance majors. To this end the examples have a minimum amount of numbers and computations and are intended for class discussion. The examples involve a grocery store since students should have a fairly good idea of its operations.

Example 1: Choosing an Investment Alternative- The Terminal Wealth Cri- terion [Solomon, 19561. Suppose that the owner-operator of the grocery store

I am grateful to the anonymous reviewers for their helpful comments and to the Academic Faculty of Accountmg and Management Information Systems and the College of Admmlstratlve Saence at The Ohm State Unwerslty who partially supported this research through a grant.

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is considering three investment alternatives each requiring the investment of $6,000. The grocer will use her/ his own funds for the investment and has no debt outstanding. Alternative one is to puchase a certificate of deposit which has a maturity value of $9,663 at the end of five years. Alternative two is to purchase a new meat freezer and expand butcher shop operations. All related net cash flows which would be generated by the additional business are known with certainty and would be deposited in the grocer’s savings account until the end of the five years at which time the grocer would sell the freezer. At the end of five years the grocer would have $12,500 from this investment. Alternative three is to remodel part of the store and purchase the necessary equipment to start a delicatessen. As with alternative two, all related net cash flows are known and would be deposited in the savings account and the deli equipment would be sold at the end of five years. This alternative would result in $ I 1,000 in five years. Thus, assuming the grocer prefers the alternative which would produce the greatest wealth in five years, she/he would invest in the meat freezer. 1

Example 2: Investment vs. Consumption [Hirshleifer, 1970, pp. 31-321. There often is another aspect of the problem. Assuming that the grocer invests in order to consume more goods and services later (as people frequently do), then another option for the grocer is to spend the $6,000 on consumption now rather than investing in the meat freezer and spending $12,500 on consump- tion in five years. Since we each have our own willingness to forego current consumption for future consumption, the appropriate decision depends on the grocer’s preferences.2

Example 3: Financing the Investment. In the previous examples it was assumed that the grocer would use her/ his own funds and did not have debt outstanding. However, suppose that the grocer would need to borrow the entire $6,000 and would repay the bank $10,574 in one payment at the end of five years. Assuming the bank is only willing to lend the money for one of the three investment alternatives and not for immediate consumption, then the grocer would prefer the meat freezer alternative based on the terminal wealth criterion. Thus, the source of financing can affect the grocer’s decision since the $6,000 is no longer available for immediate consumption as it was in Example 2. Alternatively, suppose the grocer has $4,000 of her/ his own funds and would need to borrow $2,000 from the bank requiring repayment of $3,525 at the end of five years. In this case the grocer’s choices are to spend the $4,000 on consumption now or invest the $6,000 in the meat freezer (based on

‘Adeasmn model such as net present value or internal rate of return cannot provide a better choice. In fact, the use of a decismn model can result in a worse choice since, for example, net present value imphcitly assumes that mtermediate cash flows are reinvested at the discount rate

‘Deasmn models can be used which will give the same decismn but they are only different methods of

obtaining the decision. For example. the grocer may spectfy that she/ he IS wdlmg to forego consumption now if the investment will earn 11% per year compounded annually. And by comparmg the mternal rate of return on

the meat freezer to the I I% rate the appropriate decismn can be made But in principle this IS the same as the grocer comparmg consumption of $6.000 now to consumptmn of $12,500 m 5 years.

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terminal wealth criterion) and spend $8,975 ($12,500 - $3,525) on consump- tion in 5 years.’

Example 4: Investments Under Uncertainty [Hertz, 1964 and 19681. Suppose that the outcome of the meat freezer and delicatessen investments are uncer- tain. That is, the meat freezer will result in $25,250 with a two out of five chance and $4,000 with a three out of five chance. The deli investment will result in $13,000 with a three out of five chance and $8,000 with a two out of five chance. Since each of us may differ with respect to our willingness to take a chance, the grocer may prefer the deli investment to the meat freezer investment or she/ he may even prefer the certificate of deposit investment whose $9,663 return is almost certain to occur.4

Example 5: Non-wealth Investment Attributes [Hirshleifer, 1970, pp. 31-321. The grocer may prefer one alternative to another for non-wealth reasons. For example, the grocer may prefer the deli investment to the meat freezer invest- ment since the grocer would spend more of her/ his time directly dealing with customers. Alternatively, the grocer may prefer the deli investment since this would make her/ his a full-line grocery store which already has butcher shop operations. Or assuming that the certificate of deposit would result in the greatest wealth, the grocer may nevertheless prefer one of the other invest- ments to expand business in order to have the largest grocery store in town.

Example 6: Timing of Cash Flows. In the meat freezer and deli investments it was assumed that the net cash flows generated by these investments would be reinvested in a savings account until the end of the five years. But there are other options. For example, these cash flows may be accumulated only for a year or two at which point the grocer would evaluate other investment alternatives. Thus, the deli or freezer investments may be preferred by the grocer simply because they provide greater flexibility than the certificate of deposit which would tie up funds for the entire five year period. Similarly, the grocer may prefer the deli or freezer investments whose net cash flow pattern would allow increased consumption throughout the five-year period even if the certificate of deposit would result in greater wealth (and greater consump- tion) at the end of five years. Note that essentially the same considerations are involved in projects with different termination dates.

Example 7: Unknown Preferences. In order for the grocer to make optimal decisions in any of these cases, both her/ his current and future preferences must be known. However, the grocer’s preferences are likely to depend on

The point of the latter part of this example IS that financing can be dwectly Incorporated into the problem. Incorporating financing through a welghted average discount rate ma net present value analyws (say) can give

the correct decismn but may be more difficult for begmning students to understand and may tend to treat the

choxe of a discount rate as more or less a mystery.

‘It may be worthwhile to point out to the students that the expected value of the meat freezer investment is

$12,500 (= .4 (25,250) + .6 (4,000)) while it is $11,000 for the deli investment and $9,663 for the certificate of

deposit.

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her/ his health, the economy, and who’s running the government. Once the possible future states of the world are considered, preferences at a given point in time may very well be unknown and there may be no obvious solution to the capital budgeting problem. Similarly, there may not be an obvious solution if the future net cash flows are unknown and cannot be reasonably estimated.

Example 8: Decisions by Managers. Suppose that there is a manager-grocer who is employed by the absentee owner to run the store. The manager is told to invest (or not invest) in such a manner that will maximize the satisfaction of the owner’s preferences. In this case, the manager may convey all the invest- ment information to the owner and let the owner make the decision. If so, then this case is similar to the previous examples except that non-wealth invest- ment attributes may not play as important a role. The owner may not care if the manager spends more of her/ his time with customers. On the other hand, the owner may still prefer owning the largest grocery store in town.

Example 9: Manager’s Preferences. But the manager’s preferences may play a role. The manager may prefer the deli investment to the freezer or she/ he may prefer the business surviving to the business not surviving. If the grocery store fails, the manager will need to find a new job which may not be as attractive as her/ his current job. Thus, the manager may prefer those alternatives which increase the probability of the grocery store’s survival to those which maxim- ize the satisfaction of the owner’s preferences. And the manager has means to get her/ his preferences to count in the decision process. For example, the manager may threaten to quit or, more subtly, the manager may bias or not supply all the information regarding the investment alternatives.

Example 10: Multiple Absentee Owners. Suppose that there are three absen- tee owners each owning an equal share of the business. One owner may prefer investing in the freezer, another may prefer the deli, while the third may prefer withdrawing $2,000 for current consumption. Even if the manager faithfully conveys all investment information and polls the owners regarding their preferences, the manager in this case will not be able to maximize the satisfac- tion of each of the owner’s preferences.

Example 11: Multiple Managers. Suppose that there are two butcher shop managers in the grocery store. One manager prefers the deli investment since she/ he would be solely responsible for its operation. However, the other manager prefers the freezer investment since she/ he prefers to be a part of a larger operation. Then, biased or incomplete investment information may flow from manager to manager as well as from the set of managers to the set of owners in order to have their own preferences implemented. Managers’ pref- erences can be important in capital budgeting.

Example 12: Publicly-Held Corporations. All of these issues have their coun- terparts in publicly-held corporations. Even non-wealth investment attributes can be important. Some stockholders may object to the grocery store selling

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meat from animals raised on food harvested by migrant farm workers or selling products of companies who make objectionable sales to third world countries. In addition, communication is restricted between stockholders and managers. Information regarding investment alternatives is not usually con- veyed to stockholders and stockholders’ preferences are not usually conveyed to managers. Nevertheless, stockholders invest in corporations even though managers may not always act in the stockholders’best interests or in a manner that reflects the stockholders’ preferences. But rather than viewing corpora- tions as organizations whose managers try to maximize stockholders’ prefer- ences or even stockholders’ wealth, they may be better viewed as a game played by stockholders and managers [Borch, 19681 for a discussion. Moreover, the preferences of laborers, consumers, and government officials are likely to play an increasing role in the game as the impact of the corpora- tion on society grows.

CONCLUDING REMARKS

Table 1 contains a list of questions which may be useful in a class discussion of the issues illustrated in the examples. Such a class discussion can be quite interesting especially with introductory managerial accounting students. They may quickly see that capital budgeting is neither a science nor an art, but that it’s . . . business.

Table 1 Suggested Discussion Questions

Example Ouestion(s)

Owner-Operator Issues:

1 What criteria should be used to choose invest- ments assuming all related cash flows are known?

2 What else can be done with the owner’s cash required to make the investments? What does the owner’s decision depend upon?

3 How can investment cash be obtained? Can the source of cash affect the owner’s decision?

4 Can uncertain net cash flows from the investments affect the decision? What does the owner’s deci- sion depend upon?

5 Can there be non-wealth considerations in the owner’s decision? Explain.

6 Can the timing of the cash flows from an invest- ment be important? Explain.

7 Are the owner’s future preferences likely to be completely known now? What factors are likely to affect the owner’s future preferences?

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Table 1 (Continued)

Manager and Absentee Owner Issues:

8 How can a manager be sure that her/his decisions are in the best interests of the owner? Will non- wealth considerations have the same importance as in the owner-operator case?

9 Can the manager’s preferences play a role in the decision? How can the manager make her/his preferences count?

10 If there is more than one absentee owner, will the manager always be able to make investment deci- sions that are in the best interests of each of the owners?

11 How is the investment decision complicated by more than one manager in the decision process?

12 Are all of the above issues present in a publicly held corporation? Is there usually much exchange of information between managers and stock- holders? Are managers always likely to try to max- imize stockholders’ preferences? What other par- ties besides managers and stockholders are likely to play a role in the operations of a corporation?

REFERENCES

Borch, Karl (1969) The Economm of Uncerrarnry, (Princeton Umverslty Press, 1968).

Hertz, Dawd B. (1964), “Risk Analysts I” Capital Investment,” Harvard Busmess Revrew. v. 42 (January-February 1964): 95-106.

(1968), “Investment Policies That Pay Off,” Harvard Eusrness Revme. v. 46 (January- February 1968): 96-118.

Hlrshleifer, Jack (1970). Inves/ment. Merest, ond Copiral, (Prentice-Hall, Inc., 1970).

Solomon, Erza (1956). “The Artthmetic of Capital Budgeting Decisions,” Journalof Rtw-n- -’ XXIX (April 1956): 124-129.