Learning Objectives
Explain the strategic role of capital-investment analysis
Describe how accountants can add value to the capital- budgeting process
Provide a general model for determining relevant cash flows associated with capital-expenditure projects
Apply discounted cash flow (DCF) decision models for capital-budgeting purposes

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Strategy and the Analysis of Capital InvestmentsChapter TwelveMcGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.12-2Explain the strategic role of capital-investment analysisDescribe how accountants can add value to the capital- budgeting processProvide a general model for determining relevant cash flows associated with capital-expenditure projectsApply discounted cash flow (DCF) decision models for capital-budgeting purposesLearning Objectives12-3Deal with uncertainty in the capital-budgeting processDiscuss and apply other capital-budgeting decision modelsIdentify behavioral issues associated with the capital-budgeting process(Appendix A): Understand and use alternative presentation formats for the asset-replacement decision Learning Objectives (continued)12-4(Appendix B): Identify selected advanced considerations in making capital-investment decisionsLearning Objectives (continued)12-5Introductory Definitions Capital budgeting:Procedures used to identify, select, monitor, and control capital (i.e., long-term) investments Capital investments:Long-term projects involving substantial initial cash outlays followed by a series of future cash returns Capital budget:Part of the organization’s master budget (Chap. 10) that deals with the current period’s planned capital investment outlays12-6Introductory Definitions (continued)Discounted cash-flow (DCF) decision models:Decision models (e. g., NPV and IRR) for capital budgeting that explicitly incorporate the time-value-of-money Weighted-average cost of capital (WACC): Under normal circumstances, the discount factor used in DCF capital-budgeting decision modelsEstimated as a weighted average of the cost of obtaining capital from various sources (e.g., equity and debt)Non-discounted cash flow decision models:Capital budgeting decision models that do not incorporate the time-value-of-money into the analysis of capital investment projects12-7Role of Accounting in the Capital-Budgeting ProcessLinkage to the Master Budget (planning)Linkage of capital investment decisions to the organization’s chosen strategy (planning) and to the Balanced Scorecard (control): Strategic control systemsMulti-criteria decision models Analytic hierarchy process (AHP)12-8Role of Accounting in the Capital-Budgeting Process (continued) Generation of relevant financial data for investment analysis purposes (decision-making)Conducting post-audits of capital investment projects (control)12-9Identifying Relevant After-tax Cash Flows for Capital-Expenditure AnalysisProject initiation:Required investment outlays, including installation costsIncludes incremental net working capital commitments Cash inflow associated with investment tax creditsProject operation:Cash operating expenses, net of taxAdditional net working capital requirements, if anyOperating cash inflows (or reductions in expenses), net of taxProject disposal: Net of tax proceeds from disposal of the investment Recapture of investment in net working capital 12-10Example: New Investment Decision (Exhibit 12.1)Mendoza Co. manufactures high-pressure pipe for deep-sea oil drilling. The firm is considering the purchase of a drilling machine with a base cost of $465,000. Incremental cash revenues per year = $1,000,000; incremental cash operating expenses per year = $733,333. The combined income tax rate for Mendoza is expected to be 40.00%. 12-11Additional Assumptions: Mendoza Co.(Exhibit 12.1)Machine installation cost = $5,000Testing/Adjustment cost, installation = $10,000Expected useful life = 4.0 yearsExpected salvage value = $100,000 (ignore for tax purposes) End-of-life disposal-related costs = $95,000Depreciation method: straight-line (SL)Year 4 employee relocating expenses = $150,0001st year employee training costs = $50,000Incremental net working capital investment, year 0, equals $200,000 (completely recovered at end of year 4)Mendoza Co.: Net After-Tax CashOutflow, Year 012-12Mendoza Co.:SL Depreciation Calculation, Years 1 through 412-1312-14Project Operation: After-tax Cash Flows (Inflows and Outflows) During Life of the New Machine Transaction Calc. of After-tax Cash Flow Cash receipts Taxable cash receipt × (1 − t)Cash expenditures Pretax cash expense × (1 − t) Depreciated Tax shield Depreciation expense × t Allocated costs No effectProject Operation: After-tax Cash Flows(Exhibit 12.2) 12-1512-16Mendoza Co.: Project Disposal(Exhibit 12.2)12-17Mendoza Co.: Projected After-TaxCash Flow Summary (Exhibit 12.2)12-18Additional Measurement Issues Inflation? Opportunity costs? Sunk costs? Allocated overhead costs?12-19Calculating the Discount Rate (WACC)The weighted average cost of capital (WACC) is used in capital budgeting to discount future after-tax cash flows back to present-dollar equivalents Weights used to calculate the WACC can be determined based on the target capital structure for the firm or they can be based on the current market values of the various sources of funds12-20Calculating the Discount Rate (WACC)(continued) The after-tax cost of debt = Effective interest rate on debt × (1 – t)Cost of common equity is equal to the expected/required market rate of return on the company’s stock (for listed companies, this can be estimated using the CAPM)12-21Example: Calculating the Discount Rate (WACC)—Exhibit 12.9A firm (not the Mendoza Co.) has a $100,000 bank loan with an effective interest rate of 12%; $500,000, 10%, 20-year mortgage bonds selling at 90% of face value; $200,000 of 15%, $20 noncumulative, non-callable preferred stock with a total market value of $300,000; and, 50,000 shares of $1 par common stock, with a total current market value of $750,000. The estimated required rate of return on the common stock, based on application of the CAPM, is 20%. The firm is subject to a 40% income tax rate.Let’s calculate the weighted average cost of capital...12-22Example: Calculating the Discount Rate (WACC) (Exhibit 12.9, continued)Note: the cost of using preferred stock is equal to the current dividend yield on the stock (i.e., current dividend per share of preferred stock ÷ current market price per share)12-23Making the Decision: The NPV Model Discount all future net-of-tax cash inflows to present value using the WACC as the discount rate Discount all future net-of-tax cash outflows to present value using the WACC as the discount rate If NPV > 0, accept the project (that is, the project adds to the value of the company) If NPV WACC, then the proposed project should be accepted (i.e., its anticipated rate of return > the cost of invested capital for the firm)If IRR < WACC, the proposed project should be rejected (i.e., its NPV will be < 0)12-27Estimating the IRR of a ProjectGeneral Solution: Use built-in function in ExcelWhen Future Cash Inflows are Uniform: Use annuity table to identify, in the row corresponding to the life of the project, an amount equal to the ratio of the initial investment outlay to the equal annual net-of- tax cash inflowWhen Future Cash Inflows are Uneven: Use a “trial-and-error” approach (with interpolation) 12-28Mendoza Co.: Estimating the Project’s IRR Using Built-In Function12-29Mendoza Co.: Estimating the Project’s MIRR Using Built-In Function12-30Uncertainty and the Capital-Budgeting ProcessNPV, IRR, and MIRR models provide an investment recommendation—that is, to accept or to reject a given projectSensitivity analysis refers to the sensitivity of the recommendation to estimated values for the variables in the decision model: examples of sensitivity analysis include: “What-if” analysis Scenario analysis Monte Carlo simulation analysis12-31“What-if” Analysis Involves changing one variable (e.g., the discount rate/WACC) at a time; as part of this form of sensitivity analysis we might consider the: Most optimistic case Most pessimistic case Break-even after-tax cash flow amount (use “Goal Seek” option in Excel)12-32Additional Methods for Handling UncertaintyScenario Analysis: Disaster Scenario Disappointing Scenario Optimistic ScenarioMonte Carlo Simulation Analysis: Decision inputs subjected to probability distribution Use of simulation (e.g., @ RISK Excel add-on) 12-33Analysis of Real Options Definition of Real Options Contrast with Financial Options Examples of Real Options: Option to Delay Investment Project (i.e., an Investment-Timing Option) Option to Expand a Profitable Investment Project Option to Abandon and Investment Project Option to Curtail or Scale Back an Investment Project Real Options Analysis Complements, Not Replaces, DCF Analysis12-34Other Capital Budgeting Decision Models: Payback PeriodPayback period = length of time (in years) required for the cumulative after-tax cash inflows from an investment to recover the initial (net) investment outlayWhen after-tax cash inflows are expected to be equal, the payback period is determined as:(Net) initial investment ÷ Annual after-tax cash inflows12-35Mendoza Co. : Use of the Payback Method (Exhibit 12.11) 12-36Strengths of the Payback Decision Model Easy to compute Businesspeople have an intuitive understanding of “payback” periods Payback period can serve as a rough measure of risk—the longer the payback period, the higher the perceived risk12-37Weaknesses of the Payback Decision Model The model fails to consider returns over the entire life of the investment In its unadjusted state, the model ignores the time value of money The decision rule for accepting/rejecting projects is ill-defined (ambiguous or subjective) Use of this model may encourage excessive investment in short-lived projects12-38Present Value (or, Discounted) Payback ModelPresent value payback = the length of time (in years) required for the cumulative present value of after-tax cash inflows to recover the initial investment outlayNote: if the discounted payback period is less that the life of the project, then the project must have a positive NPV12-39Mendoza Co.: Discounted Payback Calculation (Exhibit 12.12)12-40Present Value Payback Model (continued)Strength: Takes into consideration the time value of moneyWeaknesses:Can motivate excessive short-term investmentsReturns beyond the payback period are ignoredDecision rule for project acceptance is ambiguous/ subjective12-41Accounting (Book) Rate of Return (ARR)ARR = Average annual net operating income ÷ Average investment12-42Mendoza Co.: Calculating ARR(continued)Accounting Rate of Return =$58,000$441,500= 13.14%Note, however, that some companies define the denominator of the ARR as the netoriginal investment. Again, there are different ways to define this number. If the ARR iscalculated based on this measure ($680,000), the calculated ARR for the proposed projectwould be 8.53%.Evaluation of ARR Decision ModelAdvantages: Readily available data Consistency between data for capital budgeting purposes and data for subsequent performance evaluationDisadvantages: No adjustment for the time value of money (undiscounted data are used) Decision rule for project acceptance is not well defined The ARR measure relies on accounting numbers, not cash flows (which is what the market values)12-43Behavioral Issues in Capital Budgeting Cost escalation (escalating commitment)—decision makers may consider past costs or losses as relevant Incrementalism (the practice of choosing multiple, small investments) Uncertainty Intolerance (risk-averse managers may require excessively short payback periods) Goal congruence (i.e., the need to align DCF decision models with models used to subsequent financial performance) 12-44Behavioral Issues in Capital Budgeting (Continued) Addressing the goal-congruency problem: Use of Economic Value Added (EVA)Separating Incentive Compensation from Budgeted PerformanceUse of Post-Audits 12-45Appendix A: Spreadsheet Templates for Conducting a DCF Analysis of an Asset-Replacement DecisionThe Mendoza example in the body of the chapter is extended to deal with a replacement decision; this appendix provides three alternative templates for this class of decision problems Panel A (p. 493) reveals the differential approach 12-46Appendix A: Spreadsheet Templates for Conducting a DCF Analysis of an Asset-Replacement Decision (continued)Panel B (p. 494) contains an alternative format to the “differential approach” contained in Panel A Panel C (p. 494) presents an “opportunity cost” approach to the asset-replacement problem All three approaches lead to the same conclusion (NPV of replacement = $148,536; IRR = 20.5%) 12-47Appendix B: DCF Models—Some Advanced ConsiderationsIn “go/no-go” situations for independent projects, the NPV and IRR methods generally lead to the same decision; however, there are some pitfalls in using the IRR method: The potential for multiple IRRs Mutually exclusive projectsCapital rationing (i.e., a capital constraint)12-48Appendix B: DCF Models—Some Advanced Considerations (continued)Except for the capital rationing issue, the general rule is to base capital budget decision-making on project NPVs, not IRRs.Under capital rationing, the indicated approach is to make capital budgeting decisions on the basis of the “profitability index (PI)” associated with each proposed project: PI = NPV/Initial capital investment outlay12-4912-50Chapter SummaryWe explained the nature of capital budgeting decisions and the strategic role of capital budgeting for organizational successWe described out accountants can add value to the capital budgeting process: Linking capital budgets to the master budget for the organization Linking capital budgeting decisions to overall strategy, e.g., to the organization’s Balanced Scorecard (BSC) Providing decision-makers with relevant data for capital- budgeting decision modelsChapter Summary (continued)We developed a general model for determining relevant cash flows for each stage of a project’s life: Project initiation Project operation Project disposalWe defined and learned how to apply the following DCF capital budgeting decision models: NPV IRR MIRR12-51Chapter Summary (continued) We discussed, applied, and learned the advantages and disadvantages of the following “other” capital budgeting decision models: Non-DCF Models: Payback period Accounting (Book) rate of return (ARR) Additional DCF model: Present value payback period12-52Chapter Summary (continued)We discussed the need for, and methods that can be used to perform, “sensitivity analysis” in terms of capital budgeting decisions: “What-if” analysis Scenario analysis Monte Carlo simulation analysis We discussed the use of real options as an additional way to handle risk and uncertaintyWe identified several important behavioral factors associated with the capital budgeting process12-53Chapter Summary (continued)In Appendix A we presented alternative ways to structure a capital-budgeting analysis of an equipment-replacement decisionFinally, in Appendix B we dealt with the following complexities associated with the use of DCF capital budgeting decision models: The case of multiple IRRs The case of mutually exclusive projects The case of capital rationingExcept for the capital rationing situation, the indicated solution is to base capital budgeting decisions on project NPVs12-54