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Capital Budgeting: A Comprehensive Guide to Long-Term Investment Decisions - Prof. Stubing, Study notes of Management Accounting

George Mason University (GMU)Management Accounting
Prof. David Stubing

Capital Budgeting is the process of making long-term planning decisions for investments in projects. Managers evaluate potential investments, gather information, make predictions, and choose the project with the greatest benefit and least cost. the five-step decision-making process, including identifying projects, obtaining information, making predictions, making decisions, and implementing the decision. It also discusses Discounted Cash Flow (DCF), Net Present Value (NPV), Internal Rate of Return (IRR), and Sensitivity Analysis. Capital Budgeting is crucial for managing cash flows, assessing risks, and maximizing returns.

Typology: Study notes

2021/2022

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● Capital Budgeting
○ The process of making long-run planning decisions for investments in projects.
○ In choosing investments, managers select from among multiple projects, each of
which may span several periods.
○ Horizontally across
■ Project dimension
○ Vertically Upward
■ Accounting-period dimension
○ To make capital budgeting decisions, managers analyze each project by
considering all the life-span cash flows from its initial investment through its
termination
■ Process is analogous to life-cycle budgeting and costing
○ Five-step decision-making process
■ Identify Projects
● Identify potential capital investments that agree with the
organization’s strategy
■ Obtain Information
● Gather information from all parts of the value chain to evaluate
alternative projects
■ Make Predictions
● Forecast all potential cash flows attributable to the alternative
projects.
■ Make Decisions by choosing among alternatives
● Determine which investment yields the greatest benefit and the
least cost to the organization
● Managers spend a significant amount of time assessing the risks
of a project, in terms of both the uncertainty of the estimated cash
flows as well as the potential downside risks of the project
(including to the firm as a whole) if the worst-case scenario were
to occur
■ Implement the decision, evaluate performance, and learn
● Obtain funding and make the investments selected in step 4
● Track realized cash flows, compare against estimated numbers,
and revise plans if necessary
○ As the cash outflows and inflows begin to accumulate,
managers can verify whether the predictions made in step
3 agree with the actual flows of cash from the project
○ Equally important for a company to abandon projects that
are performing poorly relative to expectations
● Discounted Cash Flow (DCF)
○ Measure all expected future cash inflows and outflows of a project, discounted
back to the present point in time.
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Download Capital Budgeting: A Comprehensive Guide to Long-Term Investment Decisions - Prof. Stubing and more Study notes Management Accounting in PDF only on Docsity!

● Capital Budgeting ○ The process of making long-run planning decisions for investments in projects. ○ In choosing investments, managers select from among multiple projects, each of which may span several periods. ○ Horizontally across ■ Project dimension ○ Vertically Upward ■ Accounting-period dimension ○ To make capital budgeting decisions, managers analyze each project by considering all the life-span cash flows from its initial investment through its termination ■ Process is analogous to life-cycle budgeting and costing ○ Five-step decision-making process ■ Identify Projects ● Identify potential capital investments that agree with the organization’s strategy ■ Obtain Information ● Gather information from all parts of the value chain to evaluate alternative projects ■ Make Predictions ● Forecast all potential cash flows attributable to the alternative projects. ■ Make Decisions by choosing among alternatives ● Determine which investment yields the greatest benefit and the least cost to the organization ● Managers spend a significant amount of time assessing the risks of a project, in terms of both the uncertainty of the estimated cash flows as well as the potential downside risks of the project (including to the firm as a whole) if the worst-case scenario were to occur ■ Implement the decision, evaluate performance, and learn ● Obtain funding and make the investments selected in step 4 ● Track realized cash flows, compare against estimated numbers, and revise plans if necessary ○ As the cash outflows and inflows begin to accumulate, managers can verify whether the predictions made in step 3 agree with the actual flows of cash from the project ○ Equally important for a company to abandon projects that are performing poorly relative to expectations ● Discounted Cash Flow (DCF) ○ Measure all expected future cash inflows and outflows of a project, discounted back to the present point in time.

○ Key feature of DCF is the Time Value of Money, which means that a dollar or any other monetary unit received today is worth more than a dollar received at any future time. ■ The opportunity cost from not having the money today. ○ Required Rate of Return (RRR) ■ The minimum acceptable annual rate of return on an investment ■ Set internally by the organization, and typically represents the return that an organization could expect to receive elsewhere for an investment of comparable risk. ■ Also called the discount rate, hurdle rate, cost of capital, or opportunity cost of capital. ● Net Present Value Method ○ Calculates the expected monetary gain or loss from a project by discounting all expected future cash inflows and outflows back to the present point in time using the required rate of return. ○ Step 1: Draw a sketch of relevant cash inflows and outflows. ○ Step 2: Discount the cash flows using the correct compound interest table from appendix a and sum the discounted cash flows. ○ Step 3: Make the project decision on the basis of the calculated NPV ■ An NPV that is zero or positive suggests that from a financial standpoint, the company should accept the project because its expected rate of return equals or exceeds the required rate of return. ■ If NPV is negative, the company should reject the project because its expected rate of return is below the required rate of return. ● Internal Rate-of-Return Method ○ Calculates the discount rate at which an investment’s present value of all expected cash inflows equals the present value of its expected cash outflows. ○ IRR is the discount rate that makes NPV = $ ○ Step 1: Use a discount rate and calculate the project’s NPV ○ Step 2: If the calculated NPV is less than zero, use a lower discount rate (a lower discount rate will INCREASE the NPV) ○ Managers only accept a project if its IRR equals or exceeds the firm’s RRR. ○ If the IRR exceeds the RRR, then NPV is positive ○ If the IRR equals the RRR, then NPV = $ ○ If the IRR equals the RRR, then NPV is negative. ● IRR vs NPV ○ NPV method leads to shareholder value maximization and is preferable to the IRR technique ○ NPV is expressed in dollars, not percentages, which is good. ■ Can sum NPVs of individual projects to calculate an NPV of a combination or portfolio of projects. ■ IRRs of individual projects cannot be added or averaged to represent the IRR of a combination of projects. ○ NPV can be expressed as a unique number.

○ Projects with payback periods that are shorter than the cutoff period are considered acceptable, and those with payback periods that are longer than the cutoff period are rejected. ■ Modern risk management calls for using shorter cutoff periods for riskier projects ○ Useful measure when preliminary screening of many proposals is necessary, interest rates are high, and the expected cash flows in later years of a project are highly uncertain. ○ Fails to explicitly incorporate the time value of money and it does not consider a project’s cash flows after the payback period. ○ Choosing a too short a cutoff period can lead to projects with high short-run cash flows being selected. ■ Projects with long-run positive NPVs will tend to be rejected. ○ Nonuniform Cash Flows ■ Discounted payback method calculates the amount of time required for the discounted expected future cash flows to recoup the net initial investment in a project. ● Relevant Cash Flows in Discounted Cash Flow Analysis ○ One of the biggest challenges in capital budgeting is determining which cash flows are relevant in making an investment selection ○ Relevant cash flows are the differences in expected cash flows that will result with vs without the project. ○ Relevant After-Tax Flows ● Categories of Cash Flows ○ Net Initial Investment in the project ■ Includes the acquisition of assets and any associated additions to working capital, minus the after-tax cash flow from the disposal of existing assets ● Cash outflow to purchase ○ These outflows, made for purchasing plant and equipment, occur at the beginning of the project’s life and include cash outflows for transporting and installing the equipment ○ Relevant to the capital budgeting decision because they will only be incurred if the project is pursued ● Cash outflow for working capital ○ Initial investments in plant and equipment are usually accompanied by additional investments in working capital. ■ Take the form of assets minus liabilities ● After-Tax inflow from the current disposal ○ Any cash received from disposal is a relevant cash flow because it is a cash flow that differs between the alternatives of investing and not investing in the new project ○ Book value of the old equipment is generally irrelevant to the decision because it is a past, or sunk, cost.

■ However, when tax considerations are included, the book value does play a role because it determines the gain or loss on the sale of the equipment and, therefore, the taxes paid or saved on the transaction. ○ The After-Tax Cash Flow from Operations ■ Includes income tax cash savings from annual depreciation deductions each year ■ Include the difference between each year’s cash flow from operations under the two alternatives ■ Always focus on the cash flow from operations, not on revenues and expenses under accrual accounting ■ Depreciation results in income tax cash savings. ● These tax savings are a relevant cash flow ○ The After-Tax Cash Flow from Disposing of an Asset and Recovering any Working Capital invested at the termination of a project. ■ Terminal Disposal of investment ● Disposal of an investment generally increases cash inflow of a project at its termination. ● An error in forecasting the disposal value is seldom critical for a long-duration project because the present value of the amounts to be received in the distant future is usually small ● Two components of the terminal disposal value of the investment are: ○ After-tax cash flow from terminal disposal of the equipment ■ Usually considered to be considerably less than the net initial investment (and sometimes zero). ■ Relevant cash inflow is the difference in the expected after-tax cash inflow from terminal disposal at the end of the project under the two alternatives ○ After-tax cash flow from terminal recovery of working-capital investment ■ Initial investment in working capital is usually fully recouped when the project is terminated. ■ Inventories and accounts receivable necessary to support the project are no longer needed. ○ Some capital investment projects reduce working capital. ● Project Management and Performance Evaluation ○ Final stage of capital budgeting begins with implementing the decision and managing the project. ■ Management control of the investment activity itself, as well as the project as a whole. ○ Post-Investment Audits