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1Copyright © 2008 Cengage Learning South-Western
Heitger/Mowen/Hansen
Capital Investment Decisions
Chapter Twelve
Fundamental Cornerstones of Managerial Accounting
Fundamental Cornerstones of Managerial Accounting
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Capital Investment Decisions
• Long range decisions involving opportunities to invest in new assets or projects
• Among the most important decisions made by managers
• Place large amounts of resources at risk for long periods of time
• Affect the future development of the firm• Decision making process is called “Capital
Budgeting”
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Capital Budgeting
• Two types:◦ Independent projects (“Mutually exclusive
projects”)∙ If accepted or rejected, do not affect the cash
flows of other projects
◦ Competing projects∙ Acceptance of one alternative precludes the
acceptance of another
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Capital Budgeting• Managers must decide whether or not a
capital investment will:◦ Earn back its original outlay◦ Provide a reasonable return
∙ Covering the opportunity cost of the funds invested
• To make a capital investment decision, managers must: ◦ Make estimates of the quantity and timing of after-
tax cash flows◦ Assess the risk of the investment◦ Consider the impact of the project on the
firm’s profits
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Making Capital Investment Decisions• Managers must:
◦ Set goals and priorities set for capital investments◦ Establish basic criteria for acceptance or rejection of proposed
investments
• Two types of methods:1. Nondiscounting models
∙ Do not consider time value of money∙ Two methods
∙ Payback period∙ Accounting rate of return (ARR)
2. Discounting models∙ Use time value of money∙ Two methods
∙ Net present value (NPV)∙ Internal rate of return (IRR)
• Most companies use both types of methods
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Definition
= Original investment / Annual cash flowPayback period
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Accounting Rate of Return
• Measures the return on a project in terms of income as opposed to using cash flow◦ Formula:
Average income / Initial investmentAccounting
Rate of Return
=
• Average income is not the same as cash flows◦ Formula:
∙ Add net income for each year of the project and divide by the number of years
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Definition
= Average Net Income / Initial InvestmentAccounting
Rate of Return
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Net Present Value (NPV)
• Difference between the present value of the cash inflows and outflows associated with a project
• Measures the net cash flows of the project• Size of the positive NPV measures the increase
in value of the firm resulting from an investment• To use NPV method, a required rate of return
must be defined◦ Minimum acceptable rate of return
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Evaluating Net Present Value (NPV)• If NPV is positive:
◦ Rate of return on the investment is greater than the required rate of return
◦ Investment, the minimum rate of return, and a return in excess of profit are all recovered
◦ Investment is acceptable• If NPV is zero:
◦ Rate of return on the investment is exactly the required rate of return
◦ Investment and the minimum rate of return are recovered◦ Decision maker will be ambivalent regarding acceptance
or rejection
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Evaluating Net Present Value (NPV)
• If NPV is negative:◦ Rate of return on the investment is less than the required
rate of return◦ Investment cost may or may not be recovered, and the
minimum rate or return is not recovered◦ Initial investment should be rejected
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Internal Rate of Return (IRR)
• Interest rate that sets the project’s NPV to zero◦ Formula:
• Can be found using trial and error, or • Using PV tables• Compared to required rate of return
◦ If IRR > Required rate of return…∙ Project is deemed acceptable
◦ If IRR < Required rate of return∙ Project is rejected
I = ∑CFt / (1 + i)t
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Definition
Internal Rate of Return
Discount factor = Investment / Annual Cash Flow
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Post Audit of Capital Projects
• Follow-up analysis of project once it is implemented
• Should be completed by independent party◦ Often internal audit staff
• Compares:◦ Actual benefits to estimated benefits◦ Actual operating costs to estimated costs
• Evaluates the overall outcome of the investment• Proposes corrective action if needed
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Benefits of a Postaudit
• By evaluating profitability and cash flows, firms ensure that assets are used wisely
• Managers held accountable for results of capital investment decisions◦ More likely to make decisions in the best interest of
the firm◦ Feedback is gained and used in future decision
making
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Drawbacks of a Postaudit
• Costly• Limitations:
◦ Assumption driving original analysis may often be invalidated by changes in the actual operating environment
• Accountability must be qualified:◦ By the impossibility of foreseeing every possible
eventuality
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Mutually Exclusive Projects
• Net Present Value (NPV) and Internal Rate of Return (IRR) can produce different results
• NPV • Assumes that each cash flow received is reinvested
at the required rate of return• Measures cash flow profitability in absolute terms
◦ IRR ◦ Assumes that each cash flow is reinvested at the
computed IRR◦ Measures cash flow profitability in relative terms
◦ NPV consistently selects the project which maximizes the firm’s wealth
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Steps in Selecting Best Project
1. Assess the flow pattern for each project2. Compute the net present value (NPV) for each
project3. Identify the project with the greatest NPV