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horngren16ech11im

Chapter11

CapitalBudgeting

LEARNINGOBJECTIVES:

Whenyourstudentshavefinishedstudyingthischapter,theyshouldbeableto:

1.Describecapital-budgetingdecisionsandusethenet-present-value（NPV）modeltomakesuchdecisions.

2.Usesensitivityanalysistoevaluatetheeffectofchangesinpredictionsoninvestmentdecisions.

3.CalculatetheNPVdifferencebetweentwoprojectsusingboththetotalprojectanddifferentialapproaches.

4.IdentifyrelevantcashflowsforNPVanalyses.

5.Computetheafter-taxnetpresentvaluesofprojects.

6.Explaintheafter-taxeffectoncashofdisposingofassets.

7.Usethepaybackmodelandtheaccountingrate-of-returnmodelandcomparethemwiththeNPVmodel.

8.ReconciletheconflictbetweenusinganNPVmodelformakingadecisionandusingaccountingincomeforevaluatingtherelatedperformance.

9.Computetheimpactofinflationonacapital-budgetingproject（APPENDIX11）.

CHAPTER11:

ASSIGNMENTS

CRITICALTHINKINGEXERCISES

25.InvestmentinR&D

26.BusinessValuationandNPV

27.ReplacementofProductionFacilities

28.CapitalBudgeting,Taxes,andEthics

EXERCISES

29.ExerciseinCompoundInterest

30.ExerciseinCompoundInterest

31.ExerciseinCompoundInterest

32.BasicRelationshipsinInterestTables

33.PresentValueandSportsSalaries

34.SimpleNPV

35.NPVRelationships

36.NewEquipment

37.PresentValuesofCashInflows

38.EffectonRequiredRate

39.NPVandIRR

40.SensitivityAnalysis

41.NPVandSensitivityAnalysis

42.Depreciation,IncomeTaxes,CashFlows

43.After-TaxEffectonCash

44.MACRSDepreciation

45.PresentValueofMACRSDepreciation

46.NPV,ARR,andPayback47.WeaknessofthePaybackModel

48.ComparisonofCapital-BudgetingTechniques

49.InflationandCapitalBudgeting

50.SensitivityofCapitalBudgetingtoInflation

PROBLEMS

51.ReplacementofOfficeEquipment

52.ReplacementDecisionforRailwayEquipment

53.DiscountedCashFlow,UnevenRevenueStream,RelevantCosts

54.InvestmentinMachine

55.ReplacementDecision

56.MinimizationofTransportationCostsWithoutIncomeTaxes

57.Straight-LineDepreciation,MACRSDepreciation,andImmediateWrite-Off

58.MACRS,ResidualValue

59.PurchaseofEquipment

60.MACRSandLow-IncomeHousing

61.PVofAfter-TaxCashFlows,Payback,andARR

62.InvestmentJustificationAnalysisandGraphs

63.FixedandCurrentAssets:

EvaluationofPerformance

64.InvestmentBeforeandAfterTaxes

65.After-TaxNPV

66.MinimizationofTransportationCostsAfterTaxes,Inflation

67.InflationandNonprofitInstitution

CASES

68.InvestmentinCAD/CAM

69.InvestmentinTechnology

70.InvestmentinQuality

71.MakeorBuyandReplacementofEquipment

72.Nike10k:

NikeCapitalBudgetingwithNPV

EXCELAPPLICATIONEXERCISE

73.NetPresentValueandPaybackPeriodforaPurchaseDecision

COLLABORATIVELEARNINGEXERCISE

74.CapitalBudgeting,SensitivityAnalysis,andEthics

INTERNETEXERCISE

75.CapitalBudgetingatCarnivalCorporation（）

CHAPTER11:

OUTLINE

I.CapitalBudgetingforProgramsorProjects

CapitalBudgeting—long-termplanningformakingandfinancinginvestmentsthataffectfinancialresultsovermorethanjustthenextyear.Thischapterconcentratesontheplanningandcontrollingofprogramsorprojectsthataffectmorethanoneyear’sfinancialresults.Theinvestmentsrequiredforprogramsorprojectsareoftencalledcapitaloutlays.Accountantsareinformationspecialists（i.e.,gatherandinterpretinformation）.Capitalbudgetinghasthreephases:

1.Identifyingpotentialinvestments,

2.choosingwhichinvestmentstomake,and

3.follow-upmonitoringoftheinvestments.

II.Discounted-Cash-FlowModels

Discounted-Cash-Flow（DCF）Models—focusonaproject’scashinflowsandoutflowswhiletakingintoaccountthetimevalueofmoney.DCFmodelsareusedbythemajorityofthelargeindustrialfirmsintheUnitedStatesandarethebestmeasuresofthefinancialeffectsofaninvestment.

A.MajorAspectsofDCF

DCFmodelsfocusonexpectedcashinflowsandoutflowsratherthanonnetincomeandarebasedonthetheoryofcompoundinterest.AbriefsummaryofthetablesandformulasusedisincludedinAPPENDIXBattheendofthebook.

B.NetPresentValue（NPV）

Net-Present-Value（NPV）Method—aDCFapproachtocapitalbudgetingthatcomputesthepresentvaluesofallexpectedfuturecashflowsusingaminimumdesiredrateofreturn.TheRequiredRateofReturn,HurdleRate,DiscountRate,orCostofCapital—theminimumdesiredrateofreturn.Themanagerselectsitbasedupontheproject’srisklevel.Ifthesumofthepresentvaluesofalltheexpectedcashflowsispositive,theprojectisdesirableandviceversa.AzeroNPVleavesthedecisionmakerindifferentbetweenacceptingandrejectingtheproject（i.e.,breakeven）.

C.ApplyingtheNPVMethod{L.O.1}

SeeEXHIBIT11-1foranexampleofthethreestepsinapplyingtheNPVmethod:

1.Prepareadiagramofrelevantexpectedcashinflowsandoutflows（right-handsideofEXHIBIT11-1）.

2.Findthepresentvalueofeachexpectedcashinfloworoutflow（seeAPPENDIXB）.

3.Sumtheindividualpresentvalues.

D.ChoiceoftheCorrectTable

StudentsshouldbeshowntherelationshipbetweenandproperuseofthetablesappearinginAPPENDIXB.TABLE1shouldbeusedindiscountingsingleamounts,whereasTABLE2isusedforaseries（i.e.,annuities）ofequalamounts.ThefactorsinTABLE2aresimplysummationsofthefactorsfromTABLE1.

E.EffectofMinimumRate

TheminimumdesiredrateofreturncanhavealargeeffectonNPVs.Thehighertheminimumdesiredrateofreturn,thelowerthepresentvalueofeachfuturecashinflowandthelowertheNPVoftheproject.Investmentsthataredesirableatonerateofinterestmaybeundesirableatahigherrateofinterest.

F.AssumptionsoftheNPVModel

First,weactasifthepredictedcashinflowsandoutflowswilloccuratthetimesspecified.Second,weassumeperfectcapitalmarkets（i.e.,borroworlendmoneyatthesameinterestrate—minimumdesiredrateofreturnfortheNPVmodel）.TheuseofDCFmodelsalsopassesthecost-benefittest.

G.DepreciationandNPV

Weareconcernedwithcashflows,notrevenuesandexpenses.Depreciationisanexpensethatdoesnotrequireacurrentcashoutlay.Theentirecostofanassetistypicallyalump-sumoutflowofcashattimezero.Deductingdepreciationfromoperatingcashflowswouldbeadoublecountingofacostthathasalreadybeenconsideredalump-sumoutflow.

H.ReviewofDecisionRules

Net-Present-Value（NPV）Model—Comparisonbyexpressingallamountsintoday’smonetaryunitsattimezero.

1.CalculatetheNPVusingtheminimumdesiredrateofreturnasthediscountrate.

2.IftheNPVispositive,accepttheproject,andviceversa.

I.InternalRateofReturn（IRR）Model

ThismodeldeterminestheinterestrateatwhichtheNPVequalszero.

IfIRR>minimumdesiredrateofreturn,thenNVP>0,acceptproject.

IfIRR

J.RealOptionsModel

Thismodelisacapital-budgetingmodelthatrecognizedthevalueofcontingentinvestments—thatis,investmentsthatacompanycanadjustasislearnsmoreabouttheirpotentialforsuccess.

III.SensitivityAnalysisandRiskAssessmentinDCFModels{L.O.2}

SensitivityAnalysis—showsthefinancialconsequencesthatwouldoccurifactualcashinflowsdifferedfromthoseexpected.Thisapproachofincorporatingriskincapital-budgetingdecisionsanswers“what-if”questionsconcerningthevaluesofNPVwhenthecashflows,usefullife,orrequiredrateofreturnarechanged.Thetwomajortypesofsensitivityanalysisare:

（1）comparingtheoptimistic,pessimistic,andmostlikelypredictionsand

（2）determiningtheamountofdeviationfromexpectedvaluesbeforeadecisionischanged.Sensitivityanalysisshowshowriskyaprojectmightbebyshowinghowsensitiveitistochange.

IV.TheNPVComparisonofTwoProjects

A.TotalProjectVersusDifferentialApproach{L.O.3}

TotalProjectApproach—comparestwoormorealternativesbycomputingthetotalimpactoncashflowsofeachalternativeandthencomputingNPVsforeachalternative.TheprojectwiththelargestNPVoftotalcashflowsispreferred.DifferentialApproach—twoalternativesarecomparedbycomputingthedifferencesincashflowsbetweentwoalternativesandthencomputingtheNPVofthosedifferences.Thedifferentialapproachislimitedtocomparingtwoprojectsatatime,whereasthetotalprojectapproachcanbeusedformorethantwoalternatives.Cashinflowsarepositiveandcashoutflowsarenegativeinananalysis.SeeEXHIBIT11-2foranillustrationofthetwomethodsforakeeporreplacedecision.

B.PredictingRelevantCashFlows{L.O.4}

TypicalitemstobeincludedinanNPVanalysisare:

1.Initialcashinflowsandoutflows—Includedhereareoutflowsforthepurchaseandinstallationofequipmentandotheritemsrequiredbythenewproject,andeitherinflowsoroutflowsfromdisposalofanyitemsthatarereplacedsuchastheirsalvagevalueorcostsofdismantlinganddiscarding.

2.InvestmentsinWorkingCapital—Thesearetypicallyincludedasanoutlayattimezeroandareassumedtoberecoupedattheendoftheproject’slife.Thedifferencebetweentheinitialoutlayforworkingcapital（mostlyreceivablesandinventories）andthepresentvalueofitsrecoveryisthepresentvalueofthecostofusingworkingcapitalintheproject.

3.Cashinflowsandoutflowsattermination—Thedisposalvalueatthedateofterminationofaprojectisanincreaseinthecashinflowint