Summary of Study Objectives
Discuss capital budgeting evaluation, and explain inputs used in capital budgeting. Management gathers project proposals from each department; a capital budget committee screens the proposals and recommends worthy projects. Company officers decide which projects to fund, and the board of directors approves the capital budget. In capital budgeting, estimated cash inflows and outflows, rather than accrual-accounting numbers, are the preferred inputs.
Describe the cash payback technique. The cash payback technique identifies the time period required to recover the cost of the investment. The formula when net annual cash flows are equal is: Cost of capital investment ÷ Estimated net annual cash flow = Cash payback period. The shorter the payback period, the more attractive the investment.
Explain the net present value method. The net present value method compares the present value of future cash inflows with the capital investment to determine net present value. The NPV decision rule is: Accept the project if net present value is zero or positive. Reject the project if net present value is negative.
Identify the challenges presented by intangible benefits in capital budgeting. Intangible benefits are difficult to quantify, and thus are often ignored in capital budgeting decisions. This can result in incorrectly rejecting some projects. One method for considering intangible benefits is to calculate the NPV, ignoring intangible benefits; if the resulting NPV is below zero, evaluate whether the benefits are worth at least the amount of the negative net present value. Alternatively, intangible benefits can be incorporated into the NPV calculation, using conservative estimates of their value.
Describe the profitability index. The profitability index is a tool for comparing the relative merits of alternative capital investment opportunities. It is computed as: Present value of net cash flows ÷ Initial investment. The higher the index, the more desirable the project.
Indicate the benefits of performing a post-audit. A post-audit is an evaluation of a capital investment's actual performance. Post-audits create an incentive for managers to make accurate estimates. Post-audits also are useful for determining whether a company should continue, expand, or terminate a project. Finally, post-audits provide feedback that is useful for improving estimation techniques.
Explain the internal rate of return method. The objective of the internal rate of return method is to find the interest yield of the potential investment, which is expressed as a percentage rate. 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 of return.
Describe the annual rate of return method. The annual rate of return uses accrual accounting data to indicate the profitability of a capital investment. It is calculated as: Expected annual net income ÷ Amount of the average investment. The higher the rate of return, the more attractive the investment.
Demonstration ProblemDemonstration Problem
Sierra Company is considering a long-term capital investment project called ZIP. ZIP will require an investment of $120,000, and it will have a useful life of 4 years. Annual net income is expected to be $9,000 a year. Depreciation is computed by the straight-line method with no salvage value. The company's cost of capital is 12%. (Hint: Assume cash flows can be computed by adding back depreciation expense.)
(Round all computations to two decimal places.)
Compute the cash payback period for the project. (Round to two decimals.)
Compute the net present value for the project. (Round to nearest dollar.)
Compute the annual rate of return for the project.
Should the project be accepted? Why?
Calculate the time it will take to pay back the investment: cost of the investment divided by net annual cash flows.
When calculating NPV, remember that net annual cash flow equals annual net income plus annual depreciation expense.
Be careful to use the correct discount factor in using the net present value method.
Calculate the annual rate of return: expected annual net income divided by average investment.
Present Value at 12%
Discount factor for 4 periods
Present value of net cash flows:
$39,000 × 3.03735
Negative net present value
The annual rate of return of 15% is good. However, the cash payback period is 77% of the project's useful life, and net present value is negative. The recommendation is to reject the project.
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