Capital Budgeting Decisions
| Site: | Saylor Academy |
| Course: | BUS601: Financial Management |
| Book: | Capital Budgeting Decisions |
| Printed by: | Guest user |
| Date: | Tuesday, May 21, 2024, 10:07 AM |
Description
As you can see, any discussion on costs can quickly become complicated, but it is a critical component of a cost/benefit analysis. These sections provide a summary of how to evaluate investment decisions. Pay particular attention to the calculations on the rate of return.
11.1 Describe Capital Investment Decisions and How They Are Applied
Assume that you own a small printing store that provides custom printing applications for general business use. Your printers are used daily, which is good for business but results in heavy wear on each printer. After some time, and after a few too many repairs, you consider whether it is best to continue to use the printers you have or to invest some of your money in a new set of printers. A capital investment decision like this one is not an easy one to make, but it is a common occurrence faced by companies every day. Companies will use a step-by-step process to determine their capital needs, assess their ability to invest in a capital project, and decide which capital expenditures are the best use of their resources.
Fundamentals of Capital Investment Decisions
Capital investment (sometimes also referred to as capital budgeting) is a company's contribution of funds toward the acquisition of long-lived (long-term or capital) assets for further growth. Long-term assets can include investments such as the purchase of new equipment, the replacement of old machinery, the expansion of operations into new facilities, or even the expansion into new products or markets. These capital expenditures are different from operating expenses. An operating expense is a regularly-occurring expense used to maintain the current operations of the company, but a capital expenditure is one used to grow the business and produce a future economic benefit.Capital investment decisions occur on a frequent basis, and it is important for a company to determine its project needs to establish a path for business development. This decision is not as obvious or as simple as it may seem. There is a lot at stake with a large outlay of capital, and the long-term financial impact may be unknown due to the capital outlay decreasing or increasing over time. To help reduce the risk involved in capital investment, a process is required to thoughtfully select the best opportunity for the company.
The process for capital decision-making involves several steps:
- Determine capital needs for both new and existing projects.
- Identify and establish resource limitations.
- Establish baseline criteria for alternatives.
- Evaluate alternatives using screening and preference decisions.
- Make the decision.
CONCEPTS IN PRACTICE
Brexit
The decision to invest money in capital expenditures may not only be impacted by internal company objectives, but also by external factors. In 2016, Great Britain voted to leave the European Union (EU) (termed "Brexit"), which separates their trade interests and single-market economy from other participating European nations. This has led to uncertainty for United Kingdom (UK) businesses.
Because of this instability, capital spending slowed or remained stagnant immediately following the Brexit vote and has not yet recovered growth momentum. The largest decrease in capital spending has occurred in the expansions of businesses into new markets. The UK is expected to separate from the EU in 2019.
The second step, exploring resource limitations, evaluates the company's ability to invest in capital expenditures given the availability of funds and time. Sometimes a company may have enough resources to cover capital investments in many projects. Many
times, however, they only have enough resources to invest in a limited number of opportunities. If this is the situation, the company must evaluate both the time and money needed to acquire each asset. Time allocation considerations can include employee
commitments and project set-up requirements. Fund limitations may result from a lack of capital fundraising, tied-up capital in non-liquid assets, or extensive up-front acquisition costs that extend beyond investment means (Table 11.1). Once the ability
to invest has been established, the company needs to establish baseline criteria for alternatives.
Resource Limitations
| Time Considerations | Money Considerations |
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Table11.1 When resources are limited, capital budgeting procedures are needed.
To evaluate alternatives, businesses will use the measurement methods to compare outcomes. The outcomes will not only be compared against other alternatives, but also against a predetermined rate of return on the investment (or minimum expectation) established for each project consideration. The rate of return concept is discussed in more detail in Balanced Scorecard and Other Performance Measures. A company may use experience or industry standards to predetermine factors used to evaluate alternatives. Alternatives will first be evaluated against the predetermined criteria for that investment opportunity, in a screening decision. The screening decision allows companies to remove alternatives that would be less desirable to pursue given their inability to meet basic standards. For example, if there were three different printing equipment options and a minimum return had been established, any printers that did not meet that minimum return requirement would be removed from consideration.
If one or more of the alternatives meets or exceeds the minimum expectations, a preference decision is considered. A preference decision compares potential projects that meet screening decision criteria and will rank the alternatives in order of importance, feasibility, or desirability to differentiate among alternatives. Once the company determines the rank order, it is able to make a decision on the best avenue to pursue (Figure 11.2). When making the final decision, all financial and non-financial factors are deliberated.
Figure 11.2 Select Between Alternatives.
ETHICAL CONSIDERATIONS
Volkswagen Diesel Emissions Scandal
Sometimes a company makes capital decisions due to outside pressures or unforeseen circumstances. The New York Times reported in 2015 that the car company Volkswagen was "scarred by an emissions-cheating scandal," and "would need to cut its budget next year for new technology and research – a reversal after years of increased spending aimed at becoming the world's biggest carmaker". This was a huge setback for Volkswagen, not only because the company had budgeted and planned to become the largest car company in the world, but also because the scandal damaged its reputation and set it back financially.
Volkswagen "set aside about 9 billion euros ($9.6 billion) to cover costs related to making the cars compliant with pollution regulations;" however, the sums were "unlikely to cover the costs of potential legal judgments or other fines". All of the costs related to the company's unethical actions needed to be included in the capital budget, as company resources were limited. Volkswagen used capital budgeting procedures to allocate funds for buying back the improperly manufactured cars and paying any legal claims or penalties. Other companies might take other approaches, but an unethical action that results in lawsuits and fines often requires an adjustment to the capital decision-making process.
Let's broadly consider what the five-step process for capital decision-making looks like for Melanie's Sewing Studio. Melanie owns a sewing studio that produces fabric patterns for wholesale distribution.
- Determine capital needs for both new and existing projects.
Upon review of her future needs, Melanie determines that her five-year-old commercial sewing machine could be replaced. The old machine is still working, but production has slowed in recent months with an increase in repair needs and replacement parts. Melanie expects a new sewing machine to make her production process more efficient, which could also increase her current business volume. She decides to explore the possibility of purchasing a new sewing machine. - Identify and establish resource limitations.
Melanie must consider if she has enough time and money to invest in a new sewing machine. The Sewing Studio has been in business for three years and has shown steady financial growth year over year. Melanie expects to make enough profit to afford a capital investment of $50,000. If she does purchase a new sewing machine, she will have to train her staff on how to use the machine and will have to cease production while the new machine is installed. She anticipates a loss of $20,000 for training and production time. The estimation of the $20,000 loss is based on the downtime in production for both labor and product output. - Establish baseline criteria for alternatives.
Melanie is considering two different sewing machines for purchase. Before she evaluates which option is a better investment, she must establish minimum requirements for the investment. She determines that the new machine must return her initial investment back to her in three years at a rate of 20%, and the initial investment cost cannot exceed her future earnings. This established a baseline for what she considers reasonable for this type of investment, and she will not consider any investment alternative that does not meet these minimum criteria. - Evaluate alternatives using screening and preference decisions.
Now that she has established minimum requirements for the new machine, she can evaluate each of these machines to see if they meet or exceed her criteria. The first sewing machine costs $45,000. She is expected to recoup her initial investment in two-and-a-half years. The return rate is 25%, and her future earnings would exceed the initial cost of the machine.
The second machine will cost $55,000. She expects to recoup her initial investment in three years. The return rate is $18%, and her future earnings would be less than the initial cost of the machine. - Make the decision.
Melanie will now decide which sewing machine to invest in. The first machine meets or exceeds her established minimum requirements in cost, payback, return rate, and future earnings compared to the initial investment. For the second machine, the $55,000 cost exceeds the cash available for investment. In addition, the second machine does not meet the return rate of 20% and the anticipated future earnings do not compare well to the value of the initial investment. Based on this information, Melanie would choose to purchase the first sewing machine.
These steps make it seem as if narrowing down the alternatives and making a selection is a simple process. However, a company needs to use analysis techniques, including the payback method and the accounting rate of return method, as well as other, more sophisticated and complex techniques, to help them make screening and preference decisions. These techniques can assist management in making a final investment decision that is best for the company. We begin learning about these various screening and preference decisions in Evaluate the Payback and Accounting Rate of Return in Capital
Source: Openstax, https://openstax.org/books/principles-managerial-accounting/pages/11-why-it-matters
This work is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 License.
11.2 Evaluate the Payback and Accounting Rate of Return in Capital Investment Decisions
Many companies are presented with investment opportunities continuously and must sift through both viable and nonviable options to identify the best possible expenditure for business growth. The process to select the best option requires careful budgeting and analysis. In conducting their analysis, a company may use various evaluation methods with differing inputs and analysis features. These methods are often broken into two broad categories: (1) those that consider the time value of money, or the fact that a dollar today differs from a dollar in the future due to inflation and the ability to invest today's money for future growth, and (2) those analysis methods that do not consider the time value of money. We will examine the non-time value methods first.
Non-Time Value Methods
Non-time value methods
do not compare the value of a dollar today to the value of a dollar in the future and are often used as screening tools. Two non-time value evaluative methods are the payback method and the accounting rate of return.
Fundamentals of the Payback Method
The payback method (PM) computes the length of time it takes a company to recover their initial investment. In other words, it calculates how long it will take until either the amount earned or the costs saved are equal to or greater
than the costs of the project. This can be useful when a company is focused solely on retrieving their funds from a project investment as quickly as possible.
The payback period is calculated when there are even or uneven annual cash flows. Cash flow is money coming into or out of the company as a result of a business activity. A cash inflow can be money received or cost savings from a capital investment. A cash outflow can be money paid or increased cost expenditures from capital investment. Cash flow will estimate the ability of the company to pay long-term debt, its liquidity, and its ability to grow. Cash flows appear on the statement of cash flows. Cash flows are different than net income. Net income will represent all company activities affecting revenues and expenses regardless of the occurrence of a cash transaction and will appear on the income statement.
A company will estimate the future cash inflows and outflows to be generated by the capital investment. It's important to remember that the cash inflows can be caused by an increase in cash receipts or by a reduction in cash expenditures. For example, if a new piece of equipment would reduce the production costs for a company from $120,000 a year to $80,000 a year, we would consider this is a $40,000 cash inflow. While the company does not actually receive the $40,000 in cash, it does save $40,000 in operating costs giving it a positive cash inflow of $40,000.
Cash flow can also be generated through increased production volume. For example, a company purchases a new building costing $100,000 that will allow them to house more space for production. This new space allows them to produce more product to sell, which increases cash sales by $300,000. The $300,000 is a new cash inflow.
The difference between cash inflows and cash outflows is the net cash inflow or outflow, depending on which cash flow is larger.
Net annual cash flows = Cash Inflows - Cash Outflows |
Annual net cash flows are then related to the initial investment to determine a payback period in years. When the expected net annual cash flow is an even amount each period, payback can be computed as follows:
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The result is the number of years it will take to recover the cash made in the original investment. For example, a printing company is considering a printer with an initial investment cost of $150,000. They expect an annual net cash flow of $20,000.
The payback period is
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The initial investment cost of $150,000 is divided by the annual cash flow of $20,000 to compute an expected payback period of 7.5 years. Depending on the company's payback period requirements for this type of investment, they may pass this option through the screening process to be considered in a preference decision. For example, the company might require a payback period of 5 years. Since 7.5 years is greater than 5 years, the company would probably not consider moving this alternative to a preference decision. If the company required a payback period of 9 years, the company would consider moving this alternative to a preference decision, since the number of years is less than the requirement.
When net annual cash flows are uneven over the years, as opposed to even as in the previous example, the company requires a more detailed calculation to determine payback. Uneven cash flows occur when different amounts are returned each year. In the previous printing company example, the initial investment cost was $150,000 and even cash flows were $20,000 per year. However, in most examples, organizations experience uneven cash flows in a multiple-year ownership period. For example, an uneven cash flow distribution might be a return of $10,000 in year one, $20,000 in years two and three, $15,000 in years four and five, and $20,000 in year six and beyond.
| Year |
Yearly cash flow |
Outflow or Inflow |
Remaining to Recoup |
Number of Years |
Cumulative Number of Years for Repayment |
| 0 | $150,000 | Outflow | $150,000 | ||
| 1 | 10,000 | Inflow | 140,000 | 1 | 1 |
| 2 | 20,000 | Inflow | 120,000 | 1 | 2 |
| 3 | 20,000 | Inflow | 100,000 | 1 | 3 |
| 4 | 15,000 | Inflow | 85,000 | 1 | 4 |
| 5 | 15,000 | Inflow | 70,000 | 1 | 5 |
| 6 | 20,000 | Inflow | 50,000 | 1 | 6 |
| 7 | 20,000 | Inflow | 30,000 | 1 | 7 |
| 8 | 20,000 | Inflow | 10,000 | 1 | 8 |
| 9 | 20,000 |
Inflow |
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0.5 | 8.5 |
In this case, then, the payback period is 8.5 years.
In a second example of the payback period for uneven cash flows, consider a company that will need to determine the net cash flow for each period and figure out the point at which cash flows equal or exceed the initial investment. This could arise in the middle of a year, prompting a calculation to determine the partial year payback.
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The company would add the partial year payback to the prior years' payback to get the payback period for uneven cash flows. For example, a company may make an initial investment of $40,000 and receive net cash flows of $10,000 in years one and two, $5,000 in year three and four, and $7,500 for years five and beyond.
| Year | Cash Flow |
Outflow or Inflow |
Remaining to Recoup |
Number of years |
| 0 | ($40,000) | Outflow | 40,000 | |
| 1 | $10,000 | Inflow | 30,000 | 1 |
| 2 | 10,000 | Inflow | 20,000 | 1 |
| 3 | 5,000 | Inflow | 15,000 | 1 |
| 4 | 5,000 | Inflow | 10,000 | 1 |
| 5 | 7,500 | Inflow | 2,500 | 1 |
| 6 | 7,500 | Inflow | (5,000) | 0.33 |
| 5.33 |
Figure 11.3 Cash Flow.
We know that somewhere between years 5 and 6, the company recovers the money. In years one and two they recovered a total of $20,000 (10,000 + 10,000), in years three and four they recovered and additional $10,000 (5,000 + 5,000), and in year five they recovered $7,500, for a total through year five of $37,500. This left an outstanding balance after year five of $2,500 (40,000 – 37,500) to fully recover the costs of the investment. In year six, they had a cash flow of $7,500. This is more than they needed to recoup their initial investment. To get a more specific calculation, we need to compute the partial year's payback.
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Therefore, the total payback period is 5.33 years (5 years + 0.33 years).
Demonstration of the Payback Method
For illustration, consider Baby Goods Manufacturing (BGM), a large manufacturing company specializing in the production of various baby products sold to retailers. BGM is considering investment in a new metal press machine. The payback period is calculated as follows:
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We divide the initial investment of $50,000 by the annual inflow of $15,000 to arrive at a payback period of 3.33 years. Assume that BGM will not allow a payback period of more than 7 years for this type of investment. Since this computed payback period
meets their initial screening requirement, they can pass this investment opportunity on to a preference decision level. If BGM had an expected or maximum allowable payback period of 2 years, the same investment would not have passed their screening
requirement and would be dropped from consideration.
To illustrate the concept of uneven cash flows, let's assume BGM shows the following expected net cash flows instead. Recall that the initial investment in the metal press machine is $50,000.
| Year | Net Cash Flow | Outstanding Initial Investment |
Calculations |
| 0 | ($50,000) | ($50,000) | Initial Investment |
| 1 | $10,000 | ($40,000) | 50,000 - 10,000 |
| 2 | 5,000 | (35,000) | 40,000 - 5,000 |
| 3 | 7,000 | (28,000) | 35,000 - 7,000 |
| 4 | 3,000 | (25,000) | 28,000 - 3,000 |
| 5 | 10,000 | (15,000) | 25,000 - 10,000 |
| 6 | 10,000 | (5,000) | 15,000 - 5,000 |
| 7 | 10,000 | 5,000 | 10,000 - 5,000 |
Between years 6 and 7, the initial investment outstanding balance is recovered. To determine the more specific payback period, we calculate the partial year payback.
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The total payback period is 6.5 years (6 years + 0.5 years).
THINK IT THROUGH
Capital Investment
You are the accountant at a large firm looking to make a capital investment in a future project. Your company is considering two project investments. Project A's payback period is 3 years, and Project B's payback period is 5.5 years. Your company requires a payback period of no more than 5 years on such projects. Which project should they further consider? Why? Is there an argument that can be made to advance either project or neither project? Why? What other factors might be necessary to make that decision?
Fundamentals of the Accounting Rate of Return Method
The accounting rate of return (ARR)\ computes the return on investment considering changes to net income. It shows how much extra income the company could expect if it undertakes the proposed project. Unlike the payback method, ARR compares income to the initial investment rather than cash flows. This method is useful because it reviews revenues, cost savings, and expenses associated with the investment and, in some cases, can provide a more complete picture of the impact, rather than focusing solely on the cash flows produced. However, ARR is limited in that it does not consider the value of money over time, similar to the payback method.
The accounting rate of return is computed as follows:
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Incremental revenues represent the increase to revenue if the investment is made, as opposed to if the investment is rejected. The increase to revenues includes any cost savings that occur because of the project. Incremental expenses show the change to expenses if the project is accepted as opposed to maintaining the current conditions. Incremental expenses also include depreciation of the acquired asset. The difference between incremental revenues and incremental expenses is called the incremental net income. The initial investment is the original amount invested in the project; however, any salvage (residual) value for the capital asset needs to be subtracted from the initial investment before obtaining ARR.
The concept of salvage value was addressed in Long-Term Assets. Basically, it is the anticipated future fair market value (FMV) of an asset when it is to be sold or used as a trade-in for a replacement asset. For example, assume that you bought a commercial printer for $40,000 five years ago with an anticipated salvage value of $8,000, and you are now considering replacing it. Assume that as of the date of replacement after the five-year holding period, the old printer has an FMV of $8,000. If the new printer has a purchase price of $45,000 and the seller is going to take the old printer as a trade-in, then you would owe $37,000 for the new printer. If the printer had been sold for $8,000, instead being used as a trade-in, the $8,000 could have been used as a down payment, and the company would still owe $37,000. This amount is the price of $45,000 minus the FMV value of $8,000.
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There is one more point to make with this example. The fair market value is not the same as the book value. The book value is the original cost less the accumulated depreciation that has been taken. For example, if you buy a long-term asset for $60,000 and the accumulated depreciation that you have taken is $42,000, then the asset's book value would be $18,000. The fair market value could be more, less, or the same as the book value.
For example, a piano manufacturer is considering investment in a new tuning machine. The initial investment will cost $300,000. Incremental revenues, including cost savings, are $200,000, and incremental expenses, including depreciation, are $125,000. ARR is computed as:
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This outcome means the company can expect an increase of 25% to net income, or an extra 25 cents on each dollar, if they make the investment. The company will have a minimum expected return that this project will need to meet or exceed before further consideration is given. ARR, like payback method, should not be used as the sole determining factor to invest in a capital asset. Also, note that the ARR calculation does not consider uneven annual income growth, or other depreciation methods besides straight-line depreciation.
Demonstration of the Accounting Rate of Return Method
Returning to the BGM example, the company is still considering the metal press machine because it passed the payback period method of less than 7 years. BGM has a set rate of return of 25% expected for the metal press machine investment. The company expects incremental revenues of $22,000 and incremental expenses of $12,000. Remember that the initial investment cost is $50,000. BGM computes ARR as follows:
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The ARR in this situation is 30%, exceeding the required hurdle rate of 25%. A hurdle rate is the minimum required rate of return on an investment to consider an alternative for further evaluation. In this case, BGM would move this investment option to a preference decision level. If we were to add a salvage value of $5,000 into the situation, the computation would change as follows:
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The ARR still exceeds the hurdle rate of 25%, so BGM would still forward the investment opportunity for further consideration. Let's say BGM changes their required return rate to 35%. In both cases, the project ARR would be less than the required rate, so BGM would not further consider either investment.
YOUR TURN
Analyzing Hurdle Rate
Turner Printing is looking to invest in a printer, which costs $60,000. Turner expects a 15% rate of return on this printer investment. The company expects incremental revenues of $30,000 and incremental expenses of $15,000. There is no salvage value for the printer. What is the accounting rate of return (ARR) for this printer? Did it meet the hurdle rate of 15%?
Solution
ARR is 25% calculated as ($30,000 – $15,000) / $60,000. 25% exceeds the hurdle rate of 15%, so the company would consider moving this alternative to a preference decision.
Both the payback period and the accounting rate of return are useful analytical tools in certain situations, particularly when used in conjunction with other evaluative techniques. In certain situations, the non-time value methods can provide relevant and useful information. However, when considering projects with long lives and significant costs to initiate, there are more advanced models that can be used. These models are typically based on time value of money principles, the basics of which are explained here.
YOUR TURN
Analyzing Investments
Your company is considering making an investment in equipment that will cost $240,000. The equipment is expected to generate annual cash flows of $60,000, provide incremental cash revenues of $200,000, and provide incremental cash expenses of $140,000 annually. Depreciation expense is included in the $140,000 incremental expense.
Calculate the payback period and the accounting rate of return.
Solution
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