FAP ch25 Summary

CHAPTER 25
CAPITAL BUDGETING AND MANAGERIAL DECISIONS
Related Assignment Materials

Conceptual objectives:
C1. Describe the importance of
relevant costs for short-term
decisions.
25-7
25-10
25-9
Analytical objectives:
A1. Evaluate short-term managerial 11, 12, 13, 15 25-8, 25-9, 25-11, 25-12, 25-4, 25-5,
25-10, 25-11, 25-13, 25-14, 25-6
decisions using relevant costs.
25-2, 25-5,
25-7
25-12, 25-13 25-15, 25-16,

25-14
25-17
25-15
25-18
1, 2, 3, 4, 5,
14
25-1, 25-2,
25-16
25-1, 25-2,
25-3, 25-5,
25-18
25-2
25-4, 25-6,
25-7
1, 2, 3, 6, 14
25-3
25-4, 25-5
25-1, 25-2
25-4, 25-7
P3. Compute net present value and 1, 2, 3, 7, 8,

9, 10, 14
describe its use.
25-4, 25-5,
25-16
25-6, 25-7,
25-8
25-1, 25-2,
25-3
P4. Compute internal rate of return 14

and explain its use.
25-6
25-1, 25-3,
25-4, 25-6,
25-7, 25-8
25-4, 25-7
A2. Analyze a capital investment

project using break-even time.
Procedural objectives:
P1. Compute the payback period
and describe its use.
P2. Compute accounting rate of
return and explain its use.
i.
25
* See additional information on next page that pertains to these quick studies, exercises and problems.
2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution
in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
25-1
Additional Information on Related Assignment Material

Connect (Available on the instructors course-specific website) repeats all numerical Quick Studies, all
Exercises and Problems Set A. Connect provides new numbers each time the Quick Study, Exercise or
Problem is worked. It allows instructors to monitor, promote, and assess student learning. It can be used
in practice, homework, or exam mode.
Corresponding problems in set B also relate to learning objectives identified in grid on previous page.
Problems 25-1A and 25-4A can be completed using EXCEL. The Serial Problem for Success Systems
starts in this chapter and continues throughout many chapters of the text. It is most readily solved
manually if you use the working papers that accompany text.
Synopsis of Chapter Revision
Charlies Brownies: NEW opener with new entrepreneurial assignment

Updated graphic on industry cost of capital estimates
New discussion on outsourcing of information and technology services
New presentation on payback periods for health care providers
New discussion on link between CEO compensation and IRR
Simplified computation of the accounting rate of return
New example showing calculation of net present value with salvage value
New exhibit showing formula for computing average investment
Simplified discussions and exhibits for several examples of managerial decisions
Enhanced graphics on NPV and IRR decision rules
Narrated PowerPoint Correlation Guide

Learning Objective
P1
P2
P3
P4
C1
A1
A2
Slides
3-7
8-10
11-14
15-19
20-22
23-29
40
25-2
Chapter Outline
Notes
Section 1 Capital Budgeting

Capital budgeting is the process of analyzing alternative long-term investments
and deciding which assets to acquired or sell. Fundamental goal of capital
budgeting decisions is to earn a satisfactory rate of return. Such decisions
require careful analysis, and are the most difficult and risky decisions made by
managers. Difficult because of need to make predictions of events that will
occur well into the future. Risky because outcome is uncertain, large amounts
of money are involved, long-term commitment is required, and decision may
be difficult or impossible to reverse. Several techniques are used to make
capital budgeting decisions.
I.
Methods Not Using Time Value of Money Investments are

expected to produce net cash outflows; Net Cash flows equal cash
inflows minus cash outflows. Simple analysis methods do not consider
the time value of money.
A. Payback Period
1. Payback period is the time period expected to recover the
initial investment amount.
2. Managers prefer investments with shorter payback periods.
a. Shorter payback period reduces risk of an unprofitable
investment over the long run.
b. Companys risk due to potentially inaccurate long-term
predictions of future cash flows is reduced.
3. To compute payback period, exclude all non-cash revenue and
expenses from computation.
a. When annual cash flows are even in amount,
Payback Period =
Cost of Investment
Annual net cash flows
b. When annual cash flows are unequal, payback period is
computed using the cumulative total of net cash flows
(starting with the negative cash flow resulting from the
initial investment); when cumulative net cash flow
changes from positive to negative, the investment is fully
recovered. (see Exhibit 25.3)
4. Payback period should not be only consideration in evaluating
investments; two factors are ignored.
a. Differences in the timing of net cash flows within the
payback period are not reflected. Investments that provide
cash more quickly are more desirable.
b. All cash flows after the point where its costs are fully
recovered are ignored.
25-3
Chapter Outline
Notes
B. Accounting Rate of Return (or return on average investment)

1. Also called return on average investment; is computed by
dividing the projects after tax net income by the average
amount invested in it.
2. Accrual basis after-tax net income is used.
3. Compute the average investment:
a. If straight-line deprecation is used and there is zero
salvage value then:
Annual average = (Beg. Book Value + End. Book value)
Investment
2
b. If straight-line deprecation is used and there is a salvage
value then:
Annual average = (Beg. Book Value + Salvage Value)
Investment
2
c. If the depreciation method is other than straight line
method then the general formula is:
Annual = sum of individual years average book value
Ave. Invest
2
4. Accounting Rate of Return =
After-tax net income

Average investment amount
5. Risk of an investment should be considered.
a. Investments return is satisfactory or unsatisfactory only
when related to returns from other investments with
similar lives and risk.
b. Capital investment with least risk, shortest payback
period, and highest return for the longest time is often
identified as best; analysis can be challenging because
different investments often yield different rankings
depending on measure used.
6. Accounting rate of return method is readily computed, often
used in evaluating investment opportunities, yet usefulness is
often limited.
a. Amount invested is based on book values for future
periods not predicted market values.
b. If assets net incomes may vary from year to year, then
average annual net incomes must be used; method fails to
distinguish between two investments with same average
annual net income when one investment yields higher
amounts in early years and the other in later years.
25-4
Chapter Outline
II.
Notes
Methods Using Time Value of Money Net present value and

internal rate of return methods consider time value of money.
A. Net Present Value (see also Appendix B near end of textbook)
1. NPV is computed by discounting the future net cash flows
from the investment at the required rate of return, and then
subtract the initial amount invested.
a. The required rate of return also called the hurdle rate or
the cost of capital that the company must pay to its longterm creditors and shareholders.
b. Each annual net cash flow is multiplied by the related
present value of 1 factor or discount factor. (Obtain from
Table B.1 in Appendix B.)
i. Discount factors assume that net cash flows are
received at the end of each year.
ii.Rate of return required by the company and number of
years until cash flow is received are used to determine
discount factors.
c. Initial amount invested includes all costs incurred to get
asset in proper location and ready to use.
2. Net Present Value Decision Rule
a. Net Present Value = PV of cash flows amount invested
b. If the net present value is greater than or equal to $0, then
asset is expected to recover its cost and provide a return at
least as high as that required; project is accepted.
c. If net present value is negative, project is rejected.
3. NPV analysis can be used when comparing several investment
opportunities; if investment opportunities have same cost and
same risk, the one with highest positive net present value is
preferred.
4. When annual net cash flows are equal in amount, NPV
calculation can be simplified.
a. Individual annual present value of $1 factors can be
summed, and the total multiplied by annual net cash flow
to get total present value of net cash flows.
b. To simplify the computation, the present value of an
annuity of $1 table may be used
c. Calculator with compound interest function or a
spreadsheet program can be used.
5. NPV analysis can also be applied when net cash flows are
unequal. (Use procedures and decision-rules above.)
6. If salvage value is expected at end of useful life, treat as an
additional net cash flow received at end the of assets life.
25-5
Chapter Outline
Notes
7. Accelerated depreciation methods do not change basics of

NPV analysis, but can change results; using accelerated
depreciation for tax reporting affects net present value of
assets cash flows
a. Accelerated depreciation produces larger depreciation
deductions in early years of assets life and smaller ones in
later years; large net cash inflows are produced in early
years and smaller ones in later years.
b. Tax savings from depreciation is called depreciation tax
shield.
c. Early cash flows are more valuable than later ones; as
such, being able to use accelerated depreciation for tax
reporting makes investment more desirable.
8. NPV is of limited value for comparison purposes if initial
investment differs substantially across projects.
9. When a company cant fund all positive net present value
projects , they can be compared using the profitability index
a. Profitability Index = Net present value of cash flows
Cost of investment
b. A higher profitability index makes the project more
desirable
10. When the projects being compared have different risks, the
NPVs of individual projects should be computed using
different discount rates; the greater the risk, the higher the
discount rate.
B. Internal Rate of Return
1. IRR is a rate used to evaluate acceptability of an investment; it
equals the rate that yields a NPV of zero for an investment.
2. If the total present value of a projects net cash flows is
computed using the IRR as the discount rate, it will equal the
initial investment.
3. Two step process in computing IRR (equal cash flows)
a. Step 1: Compute the present value factor for the project
by dividing the amount invested by net cash flows.
b. Step 2: Find discount rate (IRR) yielding the PV factor.
i. A present value of an annuity table (see Appendix B)
can be used to determine the discount rate that relates
to this present value factor given the life of the
project.
ii. If the present value factor in the table does not exactly
equal the one computed, the procedure set forth in
Exhibit 25.9 can be used to estimate the IRR.
25-6
Chapter Outline
Notes
4. When cash flows are unequal, trial and error must be used;
select any reasonable discount rate and compute the NPV.
a. If amount is positive, recompute NPV using higher
discount rate; if amount is negative, recompute NPV using
lower discount rate.
b. Continue steps until two consecutive computations result
in NPVs that have different signs (positive and negative);
IRR lies between these two discount rates; value can be
estimated.
c. Spreadsheet software and calculators can also be used to
compute the IRR. (See Appendix 25A)
5. Compare IRR with hurdle rate (or minimum acceptable rate of
return); if IRR exceeds hurdle rate, accept project.
a. Choice of hurdle rate is subjective, depending on the risk
involved.
b. If project financed from borrowed funds, hurdle rate
should exceed interest rate paid on borrowed funds; return
on investment must cover interest and provide additional
profit to reward company for risk.
c. If project is internally financed, hurdle rate is often based
on actual returns from comparable projects.
d. If evaluating multiple projects, rank by extent to which
IRR exceeds hurdle rate.
6. IRR is not subject to limitations of NPV when comparing
projects with different amounts invested; IRR is expressed as
percent rather than an absolute dollar value using NPV.
C. Comparison of Capital Budgeting Methods (see Exhibit 25.10)
1. Payback period and accounting rate of return do not consider
time value of money; NPV and IRR do.
2. Payback period method is simple; sometimes used when
limited cash to invest and a number of projects to choose
from. Gives manager an estimate of how soon the initial
investment can be recovered.
3. Accounting rate of return is a percent computed using accrual
income instead of cash flows, and is an average rate for the
entire investment period; annual returns are not reflected.
4. Net Present Value (NPV):
a. Considers all estimated cash flows of project; can be
applied to equal and unequal cash flows.
b. Can reflect changes in level of risk over life of project.
c. Comparisons of projects of unequal sizes is more difficult
25-7
Chapter Outline
Notes
5. Internal Rate of Return (IRR):

a. Considers all estimated cash flows of project.
b. Readily computed when cash flows are equal, but requires
trial and error estimation when cash flows are unequal.
c. Allows comparisons of projects with different investment
amounts.
d. Does not reflect changes in risk over life of project.
Section 2Managerial Decisions

Emphasis is on use of quantitative measures to make important short-term
decisions. Costs and other factors relevant to decision must be identified.
I.
Decisions and Information

A. Decision Making
1. Five steps involved in managerial decision making.
a. Define task and goal.
b. Identify alternative courses of action.
c. Collect relevant information.
d. Select course of action.
e. Analyze and assess the decision.
2. Both managerial and financial accounting information play
important role in making decisions
a. Accounting system provides primarily financial
information such as performance reports and budget
analyses.
b. Non-financial information is also relevant, such as
environmental effects, political sensitivities, and social
responsibility.
B. Relevant Costs
1. Most financial measures from cost accounting systems are
based on historical amounts; however, relevant costs, or
avoidable costs, are especially useful. Three types of costs:
a. Sunk cost arises from a past decision; cannot be avoided
or changed, and not relevant to future decisions.
b. Out-of-pocket cost requires future outlay of cash and
results from result of managements decisions; is relevant.
c. Opportunity cost is a potential benefit lost by taking
specific action when two or more alternative choices are
available; consideration is important.
2. Relevant benefits are additional or incremental revenue
generated by selecting a particular course of action over
another; relevant to decision-making.
Chapter Outline
Notes
25-8
II.
Managerial Decision Scenarios consider each decision task

discussed below independent from the others.
A. Additional Business
1. Effect on net income must be considered when deciding
whether to accept or reject an order; reject if loss results.
2. Historical costs are not relevant to this decision.
3. Incremental or additional costs (also called differential costs)
are additional costs incurred if company pursues certain
course of action; relevant to this decision.
4. Minimum acceptable price per unit can be determined by
dividing incremental cost by the number of units in the order.
5. Incremental costs of additional volume are relevant.
6. If additional volume approaches or exceeds existing available
capacity of factory, incremental costs required to expand
capacity may quickly exceed incremental revenue.
7. Accepting order may cause existing sales to decline; the
contribution margin lost from the decline in sales is an
opportunity cost and is relevant (if future cash flows over
several time periods are affected, net present value should be
computed).
8. Note Allocated overhead costs, which are historical costs,
should not automatically be considered; only incremental costs
to be incurred are relevant.
9. Key point: management must not blindly use historical costs,
especially allocated to overhead costs. Instead the accounting
system needs to provide incremental cost information if the
additional business is accepted.
B. Make or Buy
1. When determining whether to make or buy a component of a
product, only incremental costs are relevant.
2. Only incremental overhead costs are relevant; an incremental
overhead rate should be determined.
3. If the incremental costs of making the component exceed the
purchase price paid to buy the component, decision rule would
be to buy; however, several other factors should be
considered.
a. Product quality.
b. Timeliness of delivery (especially in JIT settings).
c. Reactions of customers and suppliers.
d. Other intangibles (employee morale and workload).
e. Must also consider if making the part will require
incremental fixed costs to expand plant capacity.
4. Make or buy decision for component parts can also be used for
decisions about the outsourcing of services.
25-9
Chapter Outline
Notes
C. Scrap or Rework
1. Costs already incurred in manufacturing units of product not
meeting quality are sunk costs; are irrelevant in any decision
on whether to sell to substandard units as scrap or rework to
meet quality standards.
2. Incremental revenues, incremental costs of reworking defects,
and opportunity costs (the contribution margin lost if sales of
other units are given up) are all relevant.
D. Sell or Process
1. Partially completed products can be sold as is or processed
further and then sold.
2. Compute incremental revenue from further processing
(amount of revenue after further processing less revenue from
selling the products as partially completed)
3. Compute incremental cost from further processing.
4. Process further and sell if incremental revenue from further
processing exceeds related incremental costs.
E. Sales Mix Selection
1. When more that one product is sold, some are likely to be
more profitable than others; management should concentrate
sales efforts on more profitable products.
2. If production facilities or other factors are limited, an increase
in production and sale of one product usually requires
reduction in production and sale of others.
3. The most profitable combination, or sales mix, of products
should be determined.
4. Determine the contribution margin of each product, the
facilities required to produce these products and any
constraints on facilities and markets for the products.
5. If demand is unlimited and the products use the same inputs
then the product with the highest contribution margin should
be produced.
6. If demand is unlimited but the products use different inputs
then determine contribution margin per unit of the constraint
(the factor that limits capacity, such as machine time
required); produce the product with the highest contribution
margin per unit of the constraint.
7. If demand is limited then the company should first produce the
most profitable product, up to the point of the total demand.
The remaining capacity should be used to produce the next
most profitable product.
Chapter Outline
Notes
25-10
F. Segment Elimination
1. If segment of company is performing poorly, management
must consider eliminating it.
2. Decision should not be based on net income (loss) or its
contribution to overhead.
3. Need to consider avoidable and unavoidable expenses:
a. Avoidable (or escapable) expenses are costs or expenses
that would not be incurred if the segment is eliminated.
b. Unavoidable (or inescapable) expenses are costs or
expenses that would continue even if the segment is
eliminated.
4. Decision rule Segment is candidate for elimination if its
revenues are less than its avoidable expenses.
5. Should also assess impact of elimination on other segments.
a. An unprofitable segment might contribute to another
segments revenue and expenses
b. A profitable segment might be eliminated if its space,
assets and staff can be more profitably used by another
segment or new segment.
G. Keep or Replace Equipment
1. Must decide whether the reduction in variable manufacturing
costs over its life is greater than the net purchase price of the
new equipment.
a. Net purchase price is the cost of the new equipment less
any trade in allowance given or cash receipt for the old
equipment.
b. Book value of the old equipment is not use - sunk cost.
H. Qualitative Decision Factors
1. Management should not rely solely on financial data to make
managerial decisions.
2. Various qualitative factors should also be considered.
III.
Decision Analysis Break-Even Time (BET) A variation of the

payback period method overcomes the limitation of not using the
time value of money
A. The future cash flows are restated in terms of their present values;
B. The payback period is computed using these present values
C. Break-even time (BET) is useful measure; managers know when
to expect cash flows to yield net positive returns.
D. If BET is less than estimated life of investment, positive net
present value can be expected from investment.
E. To compare and rank alternative investment projects, choose the
project with the lowest break-even time.
25-11
Alternate Demo Problem Twenty-Five

A company is planning to buy a new machine at a cost of $200,000. The
machine is expected to last for 10 years and have no salvage value at the
end of its useful life. Straight-line depreciation will be used. The company
expects to save 10,000 hours of direct labor each year because of the new
machine, as well as $4,000 each year in other operating costs.
Managements best estimate is that on average the hourly rate for the labor
saved will be $5.50. With the exception of the initial purchase, assume all
cash flows take place at the end of the year, and a tax rate of 40%.
Required:
1. Calculate the payback period on the investment in new machinery.

2. Calculate the rate of return on the average investment.
3. Calculate the net present value of the investment and profitability index:
(a)
Ignoring income taxes, using a discount rate of 10%.
(b)
Including the effect of taxes, using a 10% discount rate.
25-12
Solution: Alternate Demo Problem Twenty-Five

1.
First, calculate annual net cash flow:

Determine increase in after-tax net income:
Labor savings: 10,000 hours @ $5.50 per hour
Other operating savings
Annual cash savings before tax
Less: annual depreciation expense
Increase in net income before tax
Less: Increase in annual income tax @ 40%
Increase in net income after tax
$55,000
4,000
59,000
20,000
39,000
15,600
$23,400
Then, add back depreciation expense (noncash):

Increase in net income after tax
Plus annual depreciation expense
Annual net cash flow
$23,400
20,000
$43,400
Payback period equals cost of new machine divided by annual net cash flow or
$200,000 / $43,400 = 4.6 years.
2.
The rate of return on average investment equals the increase in net income after
tax divided by the amount of the average investment.
The average investment would be $200,000 / 2, or $100,000.
Rate of return on average investment = $23,400 / $100,000 = 23.4%
3(a)
There is a cash savings of $59,000 each year for 10 years if income taxes are
ignored. The present value factor for a 10-year annuity at 10% is 6.1446.
Present value of cash savings ($59,000 x 6.1446)
Present value of investment
Net present value (positive)
Profitability Index
3(b)
Net Present Value

Cost of Investment
$362,531
200,000
$162,531
=
$ 162,531
$ 200,000
.813
There is a cash savings of only $43,400 each year for 10 years if income taxes are
considered.
Present value of cash savings ($43,400 x 6.1446)
Present value of investment
Net present value (positive)
Profitability Index
Net Present Value

Cost of Investment
$266,676
200,000
$ 66,676
=
$ 66,676
$ 200,000
.333
25-13
25-14

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CHAPTER 25

CAPITAL BUDGETING AND MANAGERIAL DECISIONS

Related Assignment Materials

25-12, 25-13 25-15, 25-16,

P3. Compute net present value and 1, 2, 3, 7, 8,

P4. Compute internal rate of return 14

A2. Analyze a capital investment

Additional Information on Related Assignment Material

Synopsis of Chapter Revision

Charlies Brownies: NEW opener with new entrepreneurial assignment

Narrated PowerPoint Correlation Guide

Section 1 Capital Budgeting

Methods Not Using Time Value of Money Investments are

B. Accounting Rate of Return (or return on average investment)

After-tax net income

Methods Using Time Value of Money Net present value and

7. Accelerated depreciation methods do not change basics of

5. Internal Rate of Return (IRR):

Section 2Managerial Decisions

Decisions and Information

Managerial Decision Scenarios consider each decision task

Decision Analysis Break-Even Time (BET) A variation of the

Alternate Demo Problem Twenty-Five

1. Calculate the payback period on the investment in new machinery.

Ignoring income taxes, using a discount rate of 10%.

Including the effect of taxes, using a 10% discount rate.

Solution: Alternate Demo Problem Twenty-Five

First, calculate annual net cash flow:

Then, add back depreciation expense (noncash):

Net Present Value

Net Present Value

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