Information for capital expenditure decisions

Chapter 21Information for capital expenditure decisions21-1Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithOutlineCapital expenditure decisionsThe capital expenditure approval processTechniques for analysing capital expenditure projectsOther issues in capital expenditure analysisIncome taxes and capital expenditure analysisInvestments in advanced technologiesPost-completion auditsThe limitations of capital expenditure analysis21-2Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithCapital expenditure decisionsLong-term decisions requiring the evaluation of cash inflows and outflows over several years to determine the acceptability of the projectSignificant impact on the competitiveness of the businessFocus on specific projects and programs21-3Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithThe capital expenditure approval processProject generationOften initiated by managers in business unitsConsistent with strategic plan and corporate guidelinesManagers may use their discretion and not submit projects that may be acceptable to the business, but which may pose some risk for their business unitEvaluation and analysis of projected cash flowsOver the life of the projectDifficult to detect biases in estimates of cash flowsBusiness unit managers may have the best knowledge of their business and market21-4(cont.)Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithThe capital expenditure approval process (cont.)Progress to approvalThe larger the project, the higher the level of authority for final approvalA political process may take place due to strong competition for project approvalInitiators need to justify and ‘sell’ their projectAnalysis and selection of projects by corporate managementImplementation of projectsPost-completion audit of projectsEvaluation of accuracy of the initial plan and cash flows21-5Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithTechniques for analysing capital expenditure proposalsConsider costs and benefits of the project over several yearsCash outflowsThe initial cost of the project and operating costs over the life of the projectCash inflowsCost savings and additional revenues, and any proceeds from the sale of assets that result from a project21-6Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Techniques for analysing capital expenditure proposals (cont.)TechniquesPayback methodAccounting rate of returnDiscounted cash flow (DCF) techniquesDCF techniques explicitly consider the time value of moneyMakes future cash flows equivalent to those in the current yearTypes of DCF methods include net present value (NPV) and internal rate of return (IRR)21-7Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithNet present value methodCalculates the present value of future cash flows of a projectStepsDetermine cash flows for each year of the proposed investment Calculate the net present value (NPV) of each cash flow using the required rate of returnCalculate the NPV in totalProject is acceptable on financial grounds if NPV is positive21-8Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith21-9Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithInternal rate of return (IRR) methodActual economic return earned by the project over its lifeThe discount rate at which the NPV of the cash flows is equal to zeroStepsDetermine cash flows for each year of the proposed investment Calculate the IRRIf IRR is greater than the required rate of return, the project is acceptable on financial grounds21-10Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith21-11Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithComparing the NPV and IRR methodsNPV has many advantages over IRREasier to calculate manuallyAdjustments for risk possible under NPVNPV will always yield only one answerNPV overcomes unrealistic reinvestment assumption associated with IRRReinvestment assumptionCash flows available during the life of a project are assumed to be reinvested at the same rate as the project’s rate of return21-12Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithAssumptions underlying discounted cash flow analysis Two important assumptionsThe year-end timing of cash flowsThe certainty of cash flows Determining required rate of returnUsually based on the firm’s weighted average cost of capitalCan be adjusted to take account of the risk of a particular projectDepreciation expense is not a cash flowthe purchase of an asset is cash outflow and the sale of an asset is a cash inflow21-13Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithLeast-cost decisionsA capital expenditure project may be approved even when it yields a negative NPV (or less than the acceptable IRR)Strategic concerns may be driving the investmentIn a least-cost decision, we aim to minimise the NPV of the costs to be incurred rather than maximise the NPV of the cash flows21-14Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithComparing two alternative investment projectsNPV and IRR may give different rankings for alternative projectsDue to reinvestment assumption of IRRNPV results in correct rankingCannot always compare the NPVs from different projects, as projects may not have the same lifeStrategic and competitive concerns must be considered in any decision21-15Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithProfitability index21-16Profitability index (or excess present value index)Another method for comparing investment proposalsCopyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithOther techniques for analysing capital expenditure proposalsPayback methodThe amount of time it will take for the cash inflows from the project to accumulate to cover the original investmentNo consideration of the time value of moneyPayback period= Initial investment ÷ annual cash flowThe simple formula will not work if a project has uneven cash flow patternsUse cumulative cash flows to determine payback21-17Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithPayback: the pros and consTwo drawbacksIgnores the time value of moneyIgnores cash flows beyond the payback periodWidely used for several reasonsSimplicity Useful for screening investment projectsCash shortages may encourage short paybackProvides some insight as to the risk of a project21-18Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithAccounting rate of return methodFocuses on the incremental accounting profit that results from a projectAccounting rate of return= Average annual profit from project ÷ initial investmentAccounting rate of return is, effectively, an average annual ROI for an individual projectThe accounting rate of return methodSimple way to screen investment projectsConsistent with financial accounting methodsConsistent with profit-based performance evaluationHowever, it ignores the time value of money21-19Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithOther issues in capital expenditure analysisWhere cash flow projections are uncertain, managers mayIncrease the required rate of returnUse sensitivity analysis to determine how much cash flow estimates would need to change for a decision to not be supportedPotential conflict between the criteria for evaluating individual projects and those used to evaluate the overall performance of managersA manager may reject a project with a positive NPV if it will reduce divisional profits in the early years of the project21-20Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithIncome taxes and capital expenditure analysisIn profit-seeking enterprises, income taxes are usually payableTaxation payments and tax deductions must be considered in any cash flows used in a capital expenditure proposalAfter-tax cash flowsCash flows after all the tax implications have been taken into account21-21Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithAfter-tax cash flowsTax effect of an increase in salesConsider incremental revenue and costs arising from a capital expenditure decision= (incremental sales revenue less COGS ) x (1-tax rate)Tax effect of additional expenses= incremental expense × (1 – tax rate)Non-cash expenses, such as depreciation are not cash flows but can produce tax savings and hence may reduce cash outflowsSome cash flows do not appear on the income statement in the same period in which they occur21-22Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithDepreciation and cash flowsAustralian taxation laws allow two methods of depreciationStraight line (or prime cost)Diminishing value, based on written-down value of the assetThe method used will affect the after-tax cash flow projectionsThe impact of a capital expenditure project on cash flows will result from taxation depreciation, not accounting depreciation21-23Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithOther cash flow issues arising from taxationProfits or losses on disposal of assets have tax effects and, therefore, affect cash flowsUse the carrying amount resulting from taxation deprecation to calculate profit/loss on disposalThe carrying amount is an asset’s acquisition cost minus the accumulated depreciationInvestment allowances also affect cash flows in the year of purchase of an assetWorking capital may increase due to higher accounts receivable or inventory needed to support a capital investment project, and these are cash outflows21-24Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithInvestments in advanced technologiesHigh-technology projects may yield negative NPVs, even when managers know the project will provide a competitive edgeDifficult to quantify strategic impact of investmentsRelevant benefits and costs arising from investing in advanced technologiesStrategic implications of such investmentsIntangible benefits derived from the investment21-25Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith21-26Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithPost-completion audits of capital expenditure decisionsReviews a past capital expenditure project by analysing the actual cash flows generated and comparing them with the expected cash flowsHelps managersUndertake periodic assessments of outcomesMake adjustments where necessaryControl cash flow fluctuationsAssess rewards for those involvedIdentify under-performing projects21-27Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithThe limitations of conventional capital expenditure analysisUse of unrealistic status quoAssumes that current cash flows will be maintained if the project does not go aheadNeed to compare the cash flows of the new proposal to the reduction in cash flows that will occur if the project does not proceedHurdle rates may be too highTime horizons may be too shortNeed to include benefits over all future years to prevent bias against unfavourable projects21-28Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)The limitations of conventional capital expenditure analysis (cont.)Difficulty in gaining approval for large projects may create incentives for managers to propose small projectsAdvanced technologies may entail greater uncertainty about operating cash flowsSome benefits that are difficult to quantify may be excluded from the analysisSynergistic effects of multiple capital expenditure proposalsGreater flexibility in the production processShorter cycle times and reduced lead timesReduction of non-value-added costs21-29Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithSummaryCapital expenditure analysis entails projecting future cash flows over several time periods and evaluating against required rates of returnDiscounted cash flow methods, such as NPV and IRR, take account of the time value of moneyWhen comparing alternative projects NPV and IRR do not always give the same ranking, particularly where the projects have unequal livesThe payback or accounting rate of return methods may also be used to evaluate projects21-30Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Summary (cont.)Where income taxes are payable, the after-tax cash flows must be taken into account in any capital expenditure analysisDCF techniques may be used to evaluate investments in advanced technologies, but they may not always yield positive outcomes due to the difficulties in quantifying strategic and intangible issuesPost-completion audits may be used to evaluate the outcomes of capital expenditure projects21-31Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith